Rating the Raters of Corporate Governance

In the wake of the Enron and WorldCom corporate scandals, a number of firms began to provide ratings of the quality of companies’ corporate governance. These firms claim that their ratings help investors improve the performance of their portfolios by identifying firms with good or bad governance. Many companies work hard to improve their governance ratings in the belief that doing so will make them more attractive to investors. However, a study co-authored by Ian Gow, assistant professor of Accounting Information and Management at the Kellogg School of Management, raises serious questions about the value of governance ratings in predicting performance. Commercial ratings, Gow and his co-authors conclude, are not the reliable indicators of corporate governance the ratings companies would have you believe. The products, in other words, do not live up to the marketing.

Industry groups and analysts have long expressed skepticism about the value of the ratings. But previous studies of the issue have had limited focus or have lacked credibility because they were sponsored by the ratings firms themselves. The new study is different. “Ours is the first paper to conduct an independent, rigorous examination of these governance ratings,” Gow explains. “We’re also the first to look across different ratings. No one had looked across the board previously.”

The study has particular significance because advising on corporate governance is big business. In 2007 the risk advisory firm RiskMetrics bought Institutional Shareholder Services (ISS), the largest corporate governance advisory firm, for $550 million. ISS claims more than 1,700 institutional clients managing $26 trillion in assets. Individual corporations also engage ISS to help improve their Corporate Governance Quotient (CGQ), the governance rating provided by ISS. Clients of another large player, Governance Metrics International (GMI), manage $15 trillion. Institutional investors, such as mutual funds, that are too small to have their own analytical teams make up the majority of the ratings firms’ client lists.

Differentiating Factors in Corporate Governance
What factors differentiate good corporate governance from bad? Three of the ratings—CGQ, GMI, and The Corporate Library’s TCL rating—take similar approaches. “While they differ in the details,” Gow points out, “they all focus on how companies stack up relative to so-called ‘best practices,’ such as having mostly independent directors or having a separate chairman and CEO.” In contrast, Audit Integrity’s Accounting and Governance Risk (AGR) produces its ratings primarily using financial statement information. Different firms also express their ratings in different ways: letter grades, for example, or numbers from 1 to 10 or 1 to 100.

But do the ratings, however they are expressed, have any relationship to future corporate performance? That was the question addressed by Gow and his collaborators, Robert Daines and David Larcker, both professors at Stanford University. “We had the ratings,” Gow says. “So it was natural to see whether the claims for them were substantiated.”

Determining Outcomes
To determine the predictive value of the ratings, team members studied two relatively rare “bad” outcomes—accounting restatements and class action lawsuits—and three traditional measures of corporate performance—operating performance, market values, and excess stock returns. They also looked at the relationship between companies’ governance ratings and their cost of debt. The team obtained the ratings from a variety of data services and public sources.

Detailed analysis gave a clear picture. “We find that these governance ratings have either limited or no success in predicting firm performance or other outcomes of interest to shareholders,” the team writes. “Moreover, even when there is a statistical association with future outcomes, the substantive effect is small.”

One finding suggests why that result is hardly unexpected: The data show very little correlation among the different governance ratings. “This suggests that either the ratings are measuring very different corporate governance constructs or that there is substantial measurement error in at least some of the ratings,” the team reports. “Since the firms use the same basic governance data . . . we believe that each firm is attempting to measure a similar corporate governance construct.” In fact the most obviously different rating—AGR, which is based on information in financial statements rather than observable corporate governance mechanisms – showed the strongest ability to predict corporate performance.

Muddy Waters
Gow argues that while the leading ratings firms claim to be “measuring 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.”

While ratings agencies initially responded to the study by complaining about the researchers’ methodology, in February RiskMetrics announced that it was dropping CGQ. In its place the company now offers Governance Risk Indicators, or GRId, which rate companies in four categories, thus effectively dispensing entirely with the notion of a single governance score. GRId will also provide each company with its absolute ratings rather than ratings relative to its industry or peers. And it will no longer give extra credit to firms whose corporate directors take ISS courses. Walter Gangl, former director of the Society of Corporate Secretaries and Governance Professionals and former deputy general counsel at Armstrong World Industries Inc., described the study by Gow and his colleagues as the “straw that broke the camel’s back.”

Whether the changes will improve the rating’s ability to predict corporate outcomes remains to be seen. Plainly, the study by Gow and his colleagues has shown deficiencies in the leading governance ratings. Recently leading industry bodies have cited the study in support of calls for the Securities and Exchange Commission to provide more regulatory oversight of firms such as RiskMetrics and GMI that not only rate firms’ corporate governance but also advise investors on how to vote their shares. Gow says, “Companies should definitely question whether taking measures to improve their ratings is worthwhile. For clients of the rating firms the message seems simple: Don’t pay for this stuff.”