Rating Governance Ratings
by Mark Michael, Board Member
Does good corporate governance correlate positively with investor goals? Will corporate governance — along with related environmental and social practices — make the world a better place? Grow is founded on a vision that such questions are very important to investors, and particularly the latest generation to place a premium on values-based investing.
This goal of doing well by doing good may be deceptively simple. However, if corporate governance may be used to evaluate socially positive investing, how might governance be rated? For example, is it helpful for investors to place their reliance on commercial ratings of corporate governance?
The answer may be “no.” At least for individual investors, and probably also for institutions. As noted below, some of these ratings aren’t particularly successful in predicting business performance, even if best practices in corporate governance may be positively correlated with improved financial returns.
In recent years, various proxy advisory services and corporate governance rating organizations have proliferated, including: RiskMetrics/Institutional Shareholder Services (ISS), GovernanceMetrics International (GMI) and The Corporate Library (TCL). On the Yahoo!Finance website, under the company profile section, there is a report of any company’s ISS Governance QuickScore, broken down into “pillars” for audit, board, shareholder rights, and compensation. In 2010, GMI Ratings consolidated rating services of GovernanceMetrics International, The Corporate Library and Audit Integrity. In 2014 GMI Ratings was acquired by MSCI Inc., seeking to be a leading provider of investment decision support tools regarding environmental, social and governance (ESG) factors.
How much attention should shareholders pay to such commercial ratings?
Scholars from Stanford University and the Kellogg School of Management at Northwestern published an extensive study of this question in 2009. See, Rating the ratings: How good are commercial governance ratings?, Robert M. Daines, Ian D. Gow and David Larcker, Rock Center for Corporate Governance at Stanford University, Working Paper Series №1.
The market for commercial ratings of corporate governance is premised on a belief that objective rankings of the quality of corporate governance may serve as a basis for advising shareholders how to vote on proxy proposals or in advocating changes in practices at particular companies. The target market for governance ratings is so-called institutional investors; namely, the funds that manage more than two-thirds of U.S. public equities (see, speech: Institutional Investors: Power and Responsibility, Commissioner Luis A. Aguilar, U.S. Securities and Exchange Commission, April 19, 2013). As of 2009, institutional shareholders owned in the aggregate 73% of the outstanding equity in the 1,000 largest U.S. corporations, and 67% of the total U.S. market for public equities.
Unfortunately, the 2009 study published by Stanford did not validate this assertion, finding instead that “commercial ratings do not predict governance-related outcomes with the precision or strength necessary to support the bold claims made by most of these firms.”
The Stanford study goes into considerable detail “to examine the association between the ratings produced by leading commercial corporate governance rating firms and subsequent undesirable outcomes such as accounting restatements and shareholder litigation, as well as future operating performance, stock returns and the cost of debt.” The academics found that ratings from ISS, GMI and TCL had both weak and mixed predictive results. Moreover, there was “very little correlation among the ratings.” This is curious, insofar as the information used in making the ratings comes from the publicly-available governance data that companies disclose in filings with the Securities and Exchange Commission.
Any one interested in rating corporate governance is encouraged to read the Stanford study. In the meantime, those who have access to governance ratings such as ISS Governance QuickScore or MSCI ESG research, might place some weight on the rating services, but consider other factors such as adoption of corporate governance best practices and principles. A principles-based approach to evaluating potential investments may be more productive than simply looking at the numbers generated by the commercial rating services.
Note: Mark Michael served as S.V.P., General Counsel and Secretary of a publicly-traded company — 3Com Corporation. He was a member of the American Society of Corporate Secretaries and Governance Professionals, including its board of directors and corporate practices committee. After leaving 3Com he served as a board member for public and private companies. He was a founding member of the advisory board of ISS’ GovernanceExchange and collaborated with Navigant Consulting on numerous consulting engagements with public company boards to perform their annual board self-assessment.
