A study by Stanford law and business faculty members casts strong doubt upon the value and validity of the ratings of governance advisory firms that compile indexes to evaluate the effectiveness of a publicly held company's governance practices.
Enron, Worldcom, Global Crossing, Sunbeam. The list of major corporations that appeared rock solid — only to founder amid scandal and revelations of accounting manipulation — has grown, and with it so has shareholder concern. In response, a niche industry of corporate watchdog firms has arisen — and prospered.
Governance advisory firms compile indexes that evaluate the effectiveness of a publicly held company's governance practices. And they claim to be able to predict future performance by performing a detailed analysis encompassing many variables culled from public sources.
Institutional Shareholder Services, or ISS, the best known of the advisory companies, was sold for a reported $45 million in 2001. Five years later, ISS was sold again; this time for $553 million to the RiskMetrics Group. The enormous appreciation in value underscores the importance placed by the investing public on ratings and advisories issued by ISS and its major competitors, including Audit Integrity, Governance Metrics International (GMI), and The Corporate Library (TCL).
But a study by faculty at the Rock Center for Corporate Governance at Stanford questions the value of the ratings of all four firms. "Everyone would agree that corporate governance is a good thing. But can you measure it without even talking to the companies being rated?" asked David Larcker, codirector of the Rock Center and Stanford GSB's James Irvin Miller Professor of Accounting and one of the authors. "There's an industry out there that claims you can. But for the most part, we found only a tenuous link between the ratings and future performance of the companies."
The study was extensive, examining more than 15,000 ratings of 6,827 separate firms from late 2005 to early 2007. (Many of the corporations are rated by more than one of the governance companies.) It looked for correlations among the ratings and five basic performance metrics: restatements of financial results, shareholder lawsuits, return on assets, a measure of stock valuation known as the Q Ratio, and Alpha — a measure of an investment's stock price performance on a risk-adjusted basis.
In the case of ISS, the results were particularly shocking. There was no significant correlation between its Corporate Governance Quotient (or CGQ) ratings and any of the five metrics. Audit Integrity fared better, showing "a significant, but generally substantively weak" correlation between its ratings and four of the five metrics (the Q ratio was the exception.) The other two governance firms fell in between, with GMI and TCL each showing correlation with two metrics. But in all three cases, the correlations were very small "and did not appear to be useful," said Larcker.
There have been many academic attempts to develop a rating that would reflect the overall quality of a firm's governance, as well as numerous studies examining the relation between various corporate governance choices and corporate performance. But the Stanford study appears to be the first objective analysis of the predictive value of the work of the corporate governance firms.
The Rock Center for Corporate Governance is a joint effort of the schools of business and law. The research was conducted jointly by Robert Daines, the Pritzker Professor of Law and Business, who holds a courtesy appointment at the Business School; Ian Gow, a doctoral student at the Business School; and Larcker. It is the first in a series of multidisciplinary studies to be conducted by the Rock Center and the Corporate Governance Research Program.
The current study also examined the proxy recommendations to shareholders issued by ISS, the most influential of the four firms. The recommendations delivered by ISS are intended to guide shareholders as they vote on corporate policy, equity compensation plans, and the makeup of their company's board of directors. The researchers initially assumed that the ISS proxy recommendations to shareholders also reflect their ratings of the corporations.
But the study found there was essentially no relation between its governance ratings and its recommendations. "This is a rather odd result given that [ISS's ratings index] is claimed to be a measure of governance quality, but ISS does not seem to use their own measure when developing voting recommendations for shareholders," the study says. Even so, the shareholder recommendations are influential; able to swing 20 to 30 percent of the vote on a contested matter, says Larcker.
There's another inconsistency in the work of the four rating firms. They each look at the same pool of publicly available data from the Securities and Exchange Commission and other sources, but use different criteria and methodology to compile their ratings.
ISS says it formulates its ratings index by conducting "4,000-plus statistical tests to examine the links between governance variables and 16 measures of risk and performance." GMI collects data on several hundred governance mechanisms ranging from compensation to takeover defenses and board membership. Audit Integrity's AGR rating is based on 200 accounting and governance metrics and 3,500 variables while The Corporate Library does not rely on a quantitative analysis, instead reviewing a number of specific areas, such as takeover defenses and board-level accounting issues.
Despite the differences in methodology, one would expect that the bottom line of all four ratings — a call on whether a given corporation is following good governance practices — should be similar. That's not the case. The study found that there's surprisingly little correlation among the indexes the rating firms compile. "These results suggest that either the ratings are measuring very different corporate governance constructs and/or there is a high degree of measurement error (i.e., the scores are not reliable) in the rating processes across firms," the researchers wrote.
The study is likely to be controversial. Ratings and proxy recommendations pertaining to major companies and controversial issues such as mergers are watched closely by the financial press and generally are seen as quite credible. Indeed, board members of rated firms spend significant amounts of time discussing the ratings and attempt to bring governance practices in line with the standards of the watchdogs, says Larcker.
But given the results of the Stanford study, the time and money spent by public companies on improving governance ratings does not appear to result in significant value for shareholders.