While it’s impossible to put a dollar figure on the amount of money companies have spent implementing new corporate governance measures over the last year and half, it’s likely in the billions. One estimate puts the price of good governance for a mega-cap corporation in the seven figure range. That’s big bucks – albeit for a worthwhile cause.
Corporate governance’s end goal, after all, is to give shareholders a say – or at least confidence – in how the company they own is run on a day-to-day basis. Arguing against good governance is tantamount to opposing prejudice; it’s a morally vapid stance. But in order for companies to make a lasting, long-term commitment to corporate governance, it has to make sense economically.
If governance is to be more than a passing trend in investor communications – like the fad for retail shareholder communications at the height of the bull market – it has to make money for the companies that are currently spending on it. That is the bottom line of corporate governance. For investor relations officers to get the budget and time to spend on communicating about governance, they need to be able to tell senior management that the buy side is indeed watching governance.
Buy-side investors and analysts have various ways of factoring governance into their decision-making but, generally speaking, the majority view corporate governance as part of their risk assessment when looking at a company. ‘We look at corporate governance in a broader context in that we have to have a certain level of confidence in the management team,’ says Mark Freeman, director of research for Dallas-based Westwood Holdings Group. ‘The extent to which [corporate governance] adds or detracts from management credibility can make it a significant issue.’
Weighing governance
According to Jeffrey Knight, managing director and chief investment officer for Putnam Investments, ‘Corporate governance is having a direct impact on buy and sell decisions’ among buy-side investors.
The hot button governance issues for institutional investors are ‘board independence, committee makeup and general board composition,’ notes Knight. But ‘board independence is the biggest,’ he adds. So while companies around the world are addressing these very issues in an effort to comply with new regulatory environments, the buy side is watching closely to make sure the audit and compensation committees are made up of independent directors.
For IR professionals, the big question is how the buy side is monitoring a company’s corporate governance. Are they using third-party governance ratings put out by a flurry of players including Institutional Shareholder Services (ISS), Moody’s, Standard & Poor’s, GovernanceMetrics International (GMI) and the Corporate Library? The answer is yes, but they are also doing their own analysis and these third-party assessments aren’t impacting buy-side decisions directly. Governance ratings are ‘more of a supplement’ for the buy side, says Anne Yerger, director of research for the Council of Institutional Investors.
A June 2003 study by Citigate Financial Intelligence supports Yerger’s claim. According to the study, only two among 50 US portfolio managers said they use third-party governance ratings in their formal stock selection process. ‘The real key issue is that there is no connection today between the governance scores that are being widely publicized and valuation,’ notes Paul Hebert, managing director of Citigate Financial Intelligence.
So while corporate governance is having a direct impact on buy and sell decisions, third-party assessments of governance are not, says Putnam’s Knight. Putnam’s analysts and portfolio managers have access to ISS’s Corporate Governance Quotient service and use the ratings as another piece of data, he reports. ‘We do not use them formulaically; we watch them for changes or warning signs but tend not to rely on them as a definitive measure of good governance.’
Westwood, a value-oriented firm with around $4 bn under management, subscribes to ISS’s Corporate Governance Quotient and S&P’s Governance Services. ‘We use them as independent voices on specific issues pertaining to companies,’ says Freeman. ‘While each analyst is responsible for reviewing corporate governance and proxy materials for the companies they cover, it’s helpful to have another point of view.’
Other big name firms have trouble coming up with answers to questions about how third-party governance ratings are being used in their research and decision-making processes. Fidelity, for example, was unable to respond to IR magazine’s basic questions regarding governance ratings and Prudential, a firm with around $299 bn in assets under management, has this to say: ‘The story on the sell side isn’t that sexy in that we have added ISS’s Corporate Governance Quotient but we use it as just another data point for our clients to look at; it’s additional research so there is no one-to-one relationship between the quotient and the way the analyst judges the company.’ When queried about how Prudential’s buy-side arm uses ISS data, the firm’s spokesperson couldn’t come up with a response in time for publication.
Feeling the heat
The inability of Fidelity and Prudential to respond to simple questions is indicative of the pressure the buy side feels to defend investment decisions. Along with the call for corporations to become more responsible to shareholders, pension funds and mutual funds are feeling pressure to be accountable to their beneficiaries after losing a lot of money. Most of them are implementing new internal structures – like appointing a head of governance or compliance and subscribing to governance ratings services – so their backs are covered if they happen to have a big position in the next WorldCom. But when it comes to actually talking about how they factor in governance, some firms are clearly more sensitive than others.
Gavin Anderson, founder and CEO of GovernanceMetrics International (GMI), reports that institutional investors with about $2 tn in assets currently receive GMI’s ratings. Buy-side subscribers use the service in different ways, he says.
Big pension funds that use outside money managers might use GMI’s scores to monitor outside managers, for example. ‘They can go to their outside money managers and say, Did you know that 12 percent of the portfolio you’re running for us receives a three or below from GovernanceMetrics?’ Other buy-side subscribers find GMI’s ratings highlight issues they can then address when meeting with management. ‘We also have clients using it on the fixed income side. They are looking at risk on the debt side,’ Anderson adds.
He describes GMI’s service as part of the buy side’s risk screen. ‘I would be mistaken if I led you to believe that ours is the first screen they look at,’ he admits. ‘They tend to look at fundamental financial performance first and then apply this screen.’ As Anne Yerger of the Council of Institutional Investors points out, ‘For pension funds hiring money managers, these products are one more piece of information they are looking at; it’s part of their mosaic.’
So if governance ratings are just part of the mosaic buy-side investors use to measure corporate governance, how else do institutions assess governance? According to Putnam’s Knight, ‘We rely extensively on face-to-face meetings with management as a principal tool for measuring governance.’ After assessing a company’s financials, Westwood’s Freeman says, ‘We incorporate other issues like corporate governance structure and look at the management as a whole and [determine] the degree of credibility we can assign to them.’
Publicizing governance
‘The buy side is very interested in hearing about corporate governance,’ notes Eric Pillmore, senior vice president for corporate governance at Tyco. The now infamous conglomerate replaced its board and much of its management after former CEO Dennis Kozlowski stepped down and was subsequently indicted on sales tax evasion charges. Recognizing Tyco’s need to boost its governance reputation, the first person hired by Edward Breen, the company’s newly appointed chairman and CEO, was Pillmore.
Since starting at Tyco a year ago, Pillmore has been out talking to investors about the company’s corporate governance changes. When Tyco did a $6 bn bond offering in January 2003, Pillmore made presentations before the fixed income investors who were purchasing the company’s debt. ‘I walked them through the actions we had taken to date and told them what our game plan was going forward in terms of additional actions to strengthen our governance process,’ he says.
Interestingly, what Tyco’s debt investors most wanted to know about the company’s approach to governance was how it was publicizing its progress. ‘They wanted to know how we were going to get this information out so investors would know what we have done,’ Pillmore explains. The answer is that the company has created a corporate governance section on its web site and Pillmore has been talking to employees, investors and the press about Tyco’s commitment to governance. He has also been speaking at corporate governance conferences.
Pillmore’s experience underlines why companies, and especially those that have suffered a reputation crisis, need to communicate their commitment to corporate governance. Tyco’s debt investors are likely concerned with the buy side’s perception of the company’s management and board in the wake of a big scandal and want to know how they are being informed of the company’s progress. In that sense, publicizing governance is as much about informing the buy side of changes that could have a direct impact on investment decisions as it is about changing perceptions among all investors about a company’s credibility.
Emphasizing the positive
While a lot of companies are making great strides when it comes to governance, they aren’t necessarily doing a good job of spelling out those changes. Michael Ellison, vice president of New York-based Corporate Insight, a web site audit firm, brings up the example of E*Trade. The company is in the midst of revamping its governance image and, as the Wall Street Journal reported in August, many of the changes E*Trade is making go beyond proposed exchange guidelines and Sarbanes-Oxley requirements.
‘What is interesting is that a lot of the policies they are putting in place are not available on their web site,’ says Ellison. ‘There is no corporate governance section [on their web site] and the only place you can get information on the board of directors is from last year’s annual report which is eight months old. There is no readily available information about executive compensation or committees that they have set up for corporate governance.’
The fact that there is currently no information online about changes to executive compensation could be negatively affecting perceptions of the stock considering E*Trade’s former CEO, Christos Cotsakos, had to resign after it came out that he had received $80 mn in compensation in 2001 – the year the stock tanked.
The reason corporate governance information is not ingrained as a regular part of investor communications is the perception that the only time governance matters is when something goes wrong. Institutional investors don’t tend to ask questions about governance unless it goes amiss, notes Thomas Richlovsky, senior vice president and treasurer at National City Corp. ‘Investors want to know what the investment story is here, and corporate governance is kind of a defensive thing – if it’s bad, it’s bad but if it’s great, it doesn’t add value beyond a point.’
‘When governance fails it really shatters the trust the investor has in management, which is one of their key buying criteria,’ says Stuart Borden, a partner with capital markets intelligence firm Brendan Wood International. ‘If governance is not working properly it seems to have a larger impact on investor confidence.’
But since governance is having a direct impact on buy and sell decisions, the onus is on investor relations departments to communicate the commitment to strong governance. Information about corporate governance should be incorporated into investor presentations and posted on companies’ IR web sites. The buy side is basically looking for specific steps like audit committee independence which establish credibility and demonstrate management’s commitment to governance. As Westwood’s Freeman sums up, ‘You don’t have to run governance up the flag pole at every meeting but it could be one aspect of a conference call or presentation.’
