Independent Study of Corporate Governance Ratings Agencies Dissects Governance Rankings

By Cydney Posner

Below are links to an interesting study and related article, both of which you might really enjoy. The independent study of various corporate governance ratings agencies, such as ISS/RiskMetrics Group (ISS), confirms that corporate governance rankings do not provide useful information for shareholders. As the study concludes: "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. Moreover, we find little or no relation between the governance ratings provided by RiskMetrics with either their voting recommendations or the actual votes by shareholders on proxy proposals." Here is a link to the article, as well as a link to the study itself.

The study notes that ISS claims as clients over 1,700 institutions managing $26 trillion in assets, while GovernanceMetrics International (GMI) advises clients managing $15 trillion. These governance ratings also serve as inputs into tradable indices, such as the index created by ISS/FTSE Group. The premise of the governance ratings is that users of ratings will benefit by either investing in firms with good governance or avoiding firms with poor governance, thereby earning better returns on their investments. The ratings can also lead to changed practices as boards seek to improve companies' ratings. The study notes that both Aetna and GE reportedly hired ISS to recommend governance changes, with the result that their ratings rose from 10% to more than 90%. (What a coincidence!) The study also cites a recent survey showing that public company directors viewed corporate governance advisors as highly influential and low governance rating as important red flags, "just behind the firm's missing analysts' earnings estimates in importance."

But the real question is whether these ratings should merit such deference. The study looked at the association between the ratings produced by three leading commercial corporate governance rating firms (ISS, GMI and The Corporate Library) and subsequent undesirable outcomes, including accounting restatements and shareholder litigation, as well as three other measures of corporate performance -- future operating performance, stock returns and the cost of debt. (The study also examined rankings from Audit Integrity (AGR), which produces rankings that focus instead on the risk of certain accounting and financial statement practices and turned out to be a bit more predictive on some of the measures).

The study found that "these governance ratings have either limited or no success in predicting firm performance or other outcomes of interest to shareholders. Moreover, even when there is a statistical association with future outcomes, the substantive economic effect is small." For your moment of schadenfreude: " One especially interesting result is that CGQ [the ISS ratings standard]… exhibits virtually no predictive ability, and when CGQ is significant, more often than not it has an unexpected sign [statistics-speak for a negative correlation, i.e., better ratings yield worse results]…."

In addition, as ISS was the only firm examined that also provides advice on shareholder voting, the study also looked at (1) the correlation between a company's CGQ rating and ISS' own recommendations regarding that company's proposals and (2) whether CGQ appeared to affect the shareholder support for a proposal. (A different study was cited for the proposition that approximately 20% of ISS' clients follow its recommendations).   For management proposals voted on at meetings in the years 2005 to 2007, the study showed a "surprisingly weak" association between CGQ and ISS recommendations; "for an increase point in a firm's CGQ rating, the change in probability that ISS recommends a vote in favor of a proposal is approximately 0.0022, which suggests that a one-standard deviation increase in CGQ (28.50 points) is associated with a 6.3 percentage-point increase in the probability of ISS favoring a proposal." With regard to shareholder voting outcomes, the data suggested "that the higher the CGQ rating, the lower the percentage of votes cast in favor of a proposal." Even when the study was limited to votes by institutional holders (which are presumably the main consumers of ISS ratings), there was no change to the " basic finding that CGQ has a very small impact on voting outcomes."

How can this be? The study's interpretation of "the weak and mixed results we find is that the commercial ratings contain a large amount of measurement error." For example, "many large firms with substantial investor followings and long track records receive wildly disparate grades from the various services: AT&T, General Electric, General Motors, and Safeway received nearly perfect scores from one rating firm (a 99 or 100 from ISS) and near-failing grades from another (a D from TCL)." As a result, the study advises that "boards of directors should not implement governance changes solely for the purpose of increasing their ranking." The article quotes one of the authors contention that, while ratings firms imply that they measure "the platonic ideal of good governance, our study suggests that it's far from clear what good governance is, let alone that forcing firms to adopt a checkbox approach to governance will produce good outcomes." Two comments posted regarding the article suggested that it would be wrong to take away from the study that good governance is irrelevant. Rather, the study showed that the ratings were overly simplistic and, because they are "based solely on publicly available information, will never properly reflect the true status of governance" within a company; "there are too many assumptions to result in a level playing field (even the village idiot can be an independent director)…."

The article reports that, initially, the governance ratings firms all squawked about the methodology employed in the study; however, one commentator characterized the study as the "straw that broke the camel's back." Ultimately, ISS dropped CGQ in favor of its new GRId ratings system (which may or may not represent an improvement), and calls continue for the SEC to step up its regulation of these firms. (See the 8/10/09 posting).

This posting is not intended to provide legal advice or create an attorney-client relationship. Prior results do not guarantee future outcome.

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