The day is not here when a company’s share price drops or rises dramatically based on a corporate governance score. But institutional investors and analysts are looking closely at corporate governance ratings coming out of a handful of agencies including Standard & Poor’s, CoreRatings, Institutional Shareholder Services (ISS) and GovernanceMetrics International. The Corporate Library is also coming out with a ‘board effectiveness rating’ in early 2003 and Investor Responsibility Research Center (IRRC) plans also to launch its own corporate governance-indexing product in coming months.
Sell-side companies are paying more attention to governance ratings with some even incorporating governance databases into their research processes. Given the attention governance is receiving from both buy-side and sell-side analysts, the relationship between investor relations and corporate governance is changing. The scandalous revelations that flowed out of recent corporate debacles – these are too obvious and oft cited to list them again – have stirred a hunger for information about the quality of corporate governance on a company-by-company level. To come up with their ratings, most of the players in this new arena are focusing on board independence and compensation, transparency, disclosure and stakeholder rights.
Of course, corporate governance is not a new topic. For years, shareholder activists have been providing information and naming and shaming companies that don’t meet specific thresholds for good governance practices. In Europe, the idea of rating companies on the quality of their corporate governance practices has been around in some form for years.
‘What you’re seeing is a broadening of the umbrella covering social and environmental ratings, which have been around for a while,’ says Peter Hall, energy giant BP’s investor relations manager. ‘The new services are adding corporate governance. That is fine with us, because we’ve been pushing forward on this front on our own.’
In fact, some agencies have been offering governance ratings services in Europe and are now introducing them to the US. Standard & Poor’s, for example, has been marketing corporate governance analysis services in emerging market countries since 1998. French conglomerate Fimalac, which owns credit rating agency Fitch, has created CoreRatings by combining the teams of London-based research company Global Risk Management and Paris-based Arese. The newly created agency will now rate the ‘social and environmental risk related to corporate governance.’
Given its European pedigree and breadth of coverage, CoreRatings – and Standard & Poor’s for that matter – already focuses on companies around the world. This raises the question of comparability. If a company scores well in Guatemala, does the same score for a UK company mean they’re equal? For CoreRatings, the answer is a qualified yes.
‘Our first question is what is the regulatory framework. If a company wants access to the broadest amount of capital, then they must have higher aspirations and work toward a best standard. Our ratings are comparable across different countries. But if a Polish company is lowering its aim in keeping with lower local regulatory standards, they won’t get a great rating,’ says CoreRatings CEO Alan Banks.
Serving two masters
All of the firms are catering to two audiences: investors and other non-corporate entities; and corporations. The methodology they are employing to research and rate corporate governance is different for the two client bases.
‘We have a system that splits into those two areas, and for now we are focusing on the S&P 500,’ says Gavin Anderson, CEO of a brand new firm, New York-based GovernanceMetrics International. ‘We rate companies based on their publicly disclosed information and then compare them to each other. But they’re all rated on whatever they disclose. On the other hand, if a company wants us to come in and conduct a comprehensive review, that involves extra steps. We still do a basic review, but we would also ask to see internal documents such as codes of conduct.’
Given that these governance scorers are relying on public information for their research which is not sponsored by specific companies, there have been complaints that their conclusions can be misleading. PeopleSoft, for example, ranked poorly in annual report disclosure according to Standard & Poor’s, which released a global Transparency & Disclosure (T&D) study in October 2002. PeopleSoft’s CFO, Kevin Parker, explains Standard & Poor’s rated a supplemental report instead of the 10K, which serves as the annual report and is mailed to shareholders.
‘They did not go back and correct it, and we were obviously disappointed,’ says Parker. ‘We take our reporting responsibility very seriously. The issue is that different companies can have different ways of presenting information, and you can’t assume the interpretation is going to be comparable across companies based on public information alone, especially when you have a third party rating the information.’
Recognizing the difficulties of rating companies on public information alone, firms such as GovernanceMetrics allow for feedback. They send companies a report for them to review and in the case of a dispute, provide conclusive evidence. As for Standard & Poor’s, the publicly-available rankings are separate from full-blown, interactive corporate governance scoring offered to companies on a case-by-case basis, as well as research reports provided to institutional investors, says Andrea Esposito, managing director and North American practice leader for Standard & Poor’s Governance Services.
‘Companies didn’t get a chance to look over the raw data but were provided with their composite and annual report rankings and how they compared with the median ranking results,’ Esposito says. ‘The reason we made this decision was that this was a binary study, and either the data point existed in the public documents or it did not. We had a stringent methodology for checking data accuracy, and given the transparent methodology, companies could repeat the study and obtain the same results as Standard & Poor’s.’
Despite what appears to be a potential conflict of interest between the ‘database’ approach for investors and the interactive, corporate-initiated research, rating agencies say they don’t release any confidential information such as board minutes without the corporate client’s blessing. ‘There is a Chinese wall between the Governance Services unit and the credit rating unit,’ Esposito adds. ‘The corporate governance score can be made public, but that’s up to the company.’
An audience real or imagined?
Methodology aside, the larger issue is whether or not new governance ratings will have a significant impact. Two nagging questions have often surfaced along with the topic of good corporate governance: does good governance translate into better share performance; and do investors care enough to allow a company’s corporate governance practices to influence their decision-making processes?
On the first question, the answer remains in dispute. A National Bureau of Economics study conducted in 2001 suggests a link between good corporate governance and strong stock performance. Other studies, however, have reached different conclusions. The reality is corporate governance issues are now receiving far more visibility than ever before, and companies are, arguably, paying close attention.
‘The idea at the end of the day is to ensure shareholders’ objectives are met from a corporate governance standpoint, and, over the last year, that’s become very topical,’ says BP’s Hall. ‘It’s also been a major effort of ours.’
The prominence of corporate governance, however, may not cause companies to sign up for the governance research services. Houston-based Baker Hughes received one of the highest rankings in Standard & Poor’s transparency and disclosure study. However, Baker Hughes’ IR director, Gary Flaharty, says there was no impact on the stock. Flaharty doesn’t believe there exists a significant demand on the corporate side to commission specialized governance research or ratings. But he does see the usefulness of the information that the ratings firms are publicizing.
‘We’ll look at the criteria they’re using in their analysis to see if there’s an item we want to disclose,’ says Flaharty. ‘We’re not going to blindly follow their checklists, but they’re useful. Right now, our proxy contains detailed information on the members of the board, in terms of background and their committees. We’ll probably add some of that information to the annual report, which is what Standard & Poor’s was reviewing.’
‘I’m not sure we need fee-based rating agencies providing a quantitative review of companies,’ Parker adds. ‘What would be more helpful would be clearly defined standards. Part of the problem is that we have so many different parties trying to come up with standards.’
So does a company’s corporate governance practices have any affect on investors? The answer is a less than resounding yes.
According to a recent Thomson Financial poll of 35 institutional investors, more than 71 percent say they don’t anticipate taking a more activist stance on corporate governance issues. More than 68 percent do say a company’s corporate governance structure affects their research and investing decisions. However, respondents say they consider corporate governance to be a secondary influence behind fundamental and macroeconomic factors such as earnings and real-world issues.
So will they sign up for the services? Both GovernanceMetrics and CoreRatings cite significant investor interest, having signed up institutions representing trillions of dollars in assets under management. ‘The demand is reflective of the times. The fact is, for institutions to devote the time and resources to do the types of checking we do would be a horrendous undertaking, ‘ says GovernanceMetric’s Anderson.
Fleet Investment Advisors executive vice president Robert Armknecht, who manages the $1 bn plus Galaxy Equity Growth Fund, seems to represent the current sentiment among the majority of investors. Does he care about corporate governance? Yes. Is he looking for a corporate governance database or rankings? Well, he’s interested.
‘There are some services we already get which look into corporate governance and accounting, so yes, we do care,’ says Armknecht. ‘Some things are open to interpretation, but even if we interpret it differently, we may still want to know about the issue or possibly reevaluate our own conclusion. Ultimately, how we respond will be on a case-by-case basis. We may not agree with what they tell us, but we listen.’
Sign of the times
Buy-side institutions and sell-side firms are already using ISS’s corporate governance database in their research. ‘Some institutions incorporate the database into their internal analytics and their research,’ notes Cheryl Gustitus, vice president of marketing and communications at ISS. Currently, around five sell-side firms and 40 buy-side institutions use ISS’s Corporate Governance Quotient (CGQ). The database covers around 7,500 publicly traded companies and will soon grow to around 9,000.
The fact that buy-side and sell-side players are using CGQ is a sign of the times, notes Gustitus. ‘Corporate governance has been very much a piece of the investment picture nowadays whether it’s for actually making decisions or double-checking that you are not going to recommend something that could blow up later,’ she says. ‘Our scoring system includes companies whether they want to be rated or not, and that is what investment firms need.’
In late November 2002, Salomon Smith Barney decided to include ISS’s governance ratings in its research reports on companies. The firm is using CGQ to inform its research while listing the governance scores of individual companies in research reports.
Salomon Smith Barney decided that the increased focus on corporate governance among investors warranted inclusion of the corporate governance ratings in research notes and reports on individual companies. The corporate governance statement will provide the firm’s clients with information on how companies score on a number of corporate governance issues and is designed to help investors with their risk assessment. As Gustitus says, ‘It makes sense for governance to be a part of the research picture.’
