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To get the answer, ratings agencies and several shareholder groups have devised corporate governance metrics. But will the benchmarking tools catch on?
Jennifer Caplan, CFO.com | US
June 6, 2002
Today, executives at the New York Stock Exchange announced new rules for improving corporate governance for NYSE-listed companies. The proposal, which still must be approved by the Securities and Exchange Commission, requires companies on the exchange to maintain a majority of independent directors on their boards, conduct regular meetings among non-management directors, and get investor approval for all equity-based compensation plans.
The announcement from the NYSE comes on the same day that rival Nasdaq submitted its own set of governance standards to the SEC. (For an indepth look at the Nasdaq proposal, click here). The Nasdaq proposal contains similar provisions tightening up governance standards for publicly listed companies.
It's hardly surprising that the major stock exchanges would come out with more stringent governance requirements. These days, investor confidence in the U.S. capital markets is about as low as it gets -- slammed by months of high-profile bankruptcies, revenue restatements, and financial scandals.
Institutional investors are none-too-pleased with current corporate governance and disclosure, that's for sure. In a survey of U.S. institutional investors released in late December, more than 76 percent of the 89 survey fund managers said they expect pressure from institutional investors on corporations related to corporate governance matters to increase this year. One common complaint: More than 70 percent of the respondents said they are unhappy about the rising quantity of stock options being issued to employees -- and their potential dilutive effect.
But some observers say tougher listing standards is only part of the governance solution. To truly restore faith in U.S. corporates -- and the managers who run them -- they say investors need to be able to gauge if companies are committed to good governance, or merely committed to paying lip service to the concept.
And in fact, a number of organizations have recently come out with governance metrics. Standard and Poor's for instance, has developed what it calls a Corporate Governance Score (CGS). Likewise, Institutional Shareholder Services (ISS), a provider of proxy services for institutional investors, just this week began including a Corporate Governance Quotient (CGQ) in its proxy reports for Russell 3000 companies. In addition, The Corporate Library and GovernanceMetrics International, a privately-held global corporate governance ratings agency, will release a governance metric later this year.
"In light of the new standards that have been issued by the New York Stock Exchange," says Nell Minow, editor of The Corporate Library, "these metrics will really help shareholders distinguish between companies that are paying attention and those that aren't."
Who's the Boss?
And that's the idea. Afterall, as the COO at a publicly traded midwest manufacturer, says: "Senior managment may run this company, but investors own the joint."
The new slew of governance metrics are designed to show if officers and directors truly understand that concept.
Standard and Poor's corporate governance score has been in the works for almost four years. It began as an emerging market service to help gauge governance in some lesser developed capital markets. But the recent fracturing of U.S. investor confidence -- triggered initially by the collapse of Enron Corp. -- prompted S&P to roll out the service to U.S. and European companies.
"Many companies are still trying to make themselves believe that investors don't really care about governance," asserts Nick Bradley, managing director of S&P's Corporate Governance Services. "But the investors we have spoken to strongly indicate that it is very important to them. They just lack standard and effective ways of measuring it."
S&P scores companies in four different categories: ownership structure, financial stakeholder relations, financial transparency/ information disclosure, and board and management structure. Under these general categories, the rating agency considers numerous sub-categories -- things like concentration and influence of ownership, voting and shareholder meeting procedures, independence of the company's auditor, anti-takeover provisions, and the like.
So far, the credit rating agency has not been flooded with requests from U.S. companies for its governance-scoring product. Why? Mostly, because proposals for improving corporate governance in the U.S. are exactly that -- proposals. They have yet to be approved by the SEC.
Hence, some corporate executives are taking a wait and see approach before overhauling practices and processes which have been in place for years. What's more, many are only just beginning to shed serious light on areas that could lead to conflicts of interest and breaches of corporate governance.
With that is mind, S&P has chosen to rate only those companies that will go under the microscope voluntarily. The rater has also taken pressure off otherwise reluctant companies by giving them the option not to go public with their score.
That, of course, would seem to defeat the purpose of the yardstick. "Many companies we have worked with, are doing this on a confidential basis either because they are disappointed with the outcome of the original score and want to improve before they go public," grants Bradley. "Or, because they feel it's a useful process for their boards to go through."
Other managers seem to view the metric as a way to get third-party validation of the strength of internal governance practices. To date, only about 40 companies globally have submitted themselves to S&P's rating process, and only about 10 percent have gone public with their scores. Among the forthright four: British Petroleum and the Hong Kong Stock Exchange.
Admits Bradley. "We need some leaders in the market to say 'we believe corporate governance is paramount to our investors and we are going to take the lead on this.'"
The Credit Question
Although some observers have suggested that corporate governance metrics be included directly in credit ratings, S&P has purposely keep the two separate.
Bob Mittelstaedt, an adjunct associate professor of management at the University of Pennsylvania's Wharton School of Business, reckons that's a good idea. "I think the rating agencies are going to be skating on thin ice if they try to put this directly into the credit rating structure," he asserts. After all, there isn't necessarily a strong correlation between governance and credit risk. A company may be extremely responsive to shareholders, Mittelstaedt notes, but it may not necessarily be a great credit.
But Bradley disagrees. He argues that, over time, poor governance does translate into poor credit worthiness. "We think that, at a fundamental level, bad governance is a major risk not just to equity providers but to creditors as well."
Other credit rating agencies don't have any immediate plans to follow S&P's lead and devise governance scores of their own. But some raters do admit that governance needs to be a more central component of the credit rating process. Says Christopher Mahoney, a senior managing director at Moody's Investors Service: "At the moment we do not incorporate governance in our ratings as much as we should."
That will likely change, however. Already, Moody's is starting to train its analysts to scrutinize corporate governance practices more closely. "Our goal over the next year," says Mahoney, "is to introduce a corporate governance section into our research reports."
Other Groups, Other Metrics
Efforts to raise the governance bar are not just coming from stock exchanges and credit rating agencies, either. Institutional Shareholder Services (ISS), a provider of proxy-voting services for institutional investors, has developed its own governance-rating system. So, too, has the Corporate Governance Library, a research organization, and GovernanceMetrics International, a governance rating-agency.
The ISS metric is called the corporate governance quotient (CGQ). The scoring system is based on seven key factors, including board structure and composition, executive and director compensation, and D&O stock ownership. ISS assigns a corporation both a raw CGQ and a percentile score that benchmarks the company against others in an index or industry.
Because scores are expressed on a relative basis, companies that don't make any governance changes year-to-year are likely to see their scores diminish over time, explains Mark Brockway, director of research and business development at ISS. He notes: "We hope this will encourage companies to raise the bar each year." Companies will be given the opportunity to supplement their filings and request a review -- if they make substantial improvements in their governance.
The CGQ is becoming a vital part of ISS's analysis of publicly traded companies. As of this week, a CGQ will appear on the front page of each ISS proxy analysis of Russell 3000 companies, along with a discussion of the rating. Institutional investors will then be able to screen portfolio companies on the basis of their CGQ using a Web-based research system.
"We wanted to give investors a quick, at-a-glance metric for evaluating governance practices at their portfolio companies without having to do in-depth research on multiple companies," says Brockway. ISS hopes to expand its coverage to 9,500 U.S. publicly traded companies within a year, and make the CGQ available to individual investors in the future.
The Corporate Governance Library and GovernanceMetrics International plan to launch their rating products this summer. The Corporate Governance Library will launch a board effectiveness metric, which assigns companies a letter grade (A to F). The tool will weigh several different factors -- things like CEO compensation, accounting practices, and strategic decision-making.
"We will look at the areas where we think that the management and shareholders could have a conflict of interest," says The Corporate Library's Minow, "and determine whether the board is capable of resolving that conflict in favor of the shareholders."
For its part, GovernanceMetrics International will begin rating companies later this year, using a proprietary scoring algorithm based on asymmetric geometric scoring. Companies will be assigned two ratings: the first will compare a company to all others in a research sample, and the second against other businesses in the company's home market or an emerging market peer group. GMI would not comment further, claiming its product was still in development.
Got the Horse Right Here
It's still too early to tell if one of these metrics -- or any -- will catch on. Some critics maintain that scoring systems do little to tackle the heart of the governance issue, namely, transparent disclosure.
"These scoring systems are subjected and limited to the level of transparency that a company provides or that is required by regulation," argues Claire Bowie, director of research services at the Investor Responsibility Research Center. By her lights, governance-rating tools are only as good as the data that goes into them. "Enron's board, at least on paper, looked perfectly independent," Bowie notes. "Nobody doing a rating would have been aware of the governance breaches that were going on unless they were properly disclosed."
She has a point. And as other observers argue, getting investors to place their faith in governance metrics may be a tough sell -- particularly if there are a lot of these governance scores floating around. After all, many of these ratings are derived using qualitative factors -- factors which are then assigned different weightings by each organization.
If investors are to take such governance ratings at face value, they must be convinced that the providers of the scores are on the side of shareholders -- and not corporate clients.
Minnow doesn't see this as a big problem. "I am confident that the market will determine which information is really useful," she predicts. "It's like buying a tip-sheet at the race-track. After a while, you learn which ones really work."