With Corporate Governance Quotients now ubiquitous, a study questions such ratings' validity and relevance to performance.
Commercial governance ratings have become so ubiquitous that anyone can peruse Corporate Governance Quotient (CGQ) scores for a wide range of companies on Yahoo! Finance. Hardly surprising, then, that a study questioning the relevance of ratings has appeared: ‘Rating the ratings’ was published in June by Stanford University’s Rock Center for Corporate Governance.
The study analyzes the commercial governance ratings issued in 2005 by RiskMetrics, Audit Integrity, GovernanceMetrics International (GMI) and the Corporate Library, and compares them with the ensuing fate of the rated companies through 2007. Authors David Larcker, Ian Gow and Robert Daines probe the validity of the ratings, stating the raters make ‘bold claims’ about indices’ power to predict future performance, risk and outcomes like accounting restatements and shareholder litigation.
In addition to finding virtually no statistical evidence linking the ratings and stock performance, the authors say the results show almost no correlation between the scores and the likelihood that a company would issue restatements or become the target of a shareholder lawsuit. In fact, the study found companies rated highly by the rating firms did no better than poorly rated firms in avoiding such problems.
‘There’s nothing wrong with shedding light on poorly governed firms,’ says Daines, a professor of law and business at Stanford. ‘What we found, however, is that it is easy to spot the problems in hindsight, but difficult to predict them and find a potential Tyco.’
No invitation to participate
Three of the rating firms – GMI, RiskMetrics and the Corporate Library – question the data on which the study was based. ‘It’s not clear where they got the data – they didn’t contact us,’ says Richard Bennett, CEO of the Corporate Library. He suggests the study authors approached governance ratings as though they were credit ratings, which are paid for by issuers. ‘It’s a very simplistic view; we’re not paid by the issuers,’ he says. ‘The people who pay for this information – investors – are the people who benefit from the ratings. It’s not the same on the credit side.’
Howard Sherman, CEO of GMI, describes the study as ‘weak’, with analysis based on too short a period of time. ‘They looked at about one third of our total universe, and saw only ratings we make available at the public level,’ he says. ‘It was a very limited snapshot.’
Daines defends the data. ‘We looked at whether the ratings were able to predict important outcomes like restatements and used a variety of measures and methods,’ he says. ‘Every now and then, one of the ratings would predict something small, but the correlation wasn’t robust or large enough to conclude that they were measuring a real governance effect.’
What’s the point?
But is there supposed to be a measurable correlation between governance ratings and performance? RiskMetrics’ governance business head, Rich Leggett, says the study is looking for a correlation when no one in the business of scoring actually claims there is one. ‘No one can say whether there is a correlation,’ he observes. ‘There are many factors that come into play, including market cycles. Until the tech bubble, for example, no one cared.
‘The original intent of CGQ was to add a layer of insight into the substantial amount of information we were providing, based on a client request to help it understand its governance practices and compare corporate governance practices between companies. It was not designed to be a predictive tool.’
A different potential correlation to consider is the link between corporate governance and capital. ‘The basic idea is that better-governed companies generate more trust in the market and have lower costs of capital,’ Leggett explains. ‘If you look at that link and think about the pricing model used by investors, then if corporate governance affects cost of capital, it will affect the discount rate run through these models.’
Sherman says his investment manager clients value the governance data. ‘They use GMI to either support their research process and use corporate governance as one of many inputs, or to support very specific products aimed at the environmental, social and governance market,’ he notes. ‘They wouldn’t use us if they weren’t making money from it.’
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GovernanceMetrics International
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RiskMetrics
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Audit Integrity
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