2.5 Rating agencies: corporate governance indices
A number of rating agencies, including credit rating agencies, have developed indices to measure corporate governance performance. Among the more well-known indices are FTSE-Institutional Shareholder Services (ISS) Corporate Governance Index, Standard & Poor's Corporate Governance Scores, Dow Jones Sustainability Index and Business in the Community Corporate Responsibility Index. Rating agencies can act as catalysts for corporate governance by either directly factoring corporate governance into their scoring systems, or complementing their financial scoring systems with corporate governance ones. Of the 30 largest European asset managers, 20 factor governance into their investments. Some commentators believe that this is starting to change the dynamics of the investor side in the corporate governance game (Business Week, 2004). If the analysts do their homework properly, an index can give a thumbnail sketch of a company and how it is improving. The indices make it easier for investors to assess the quality of corporate governance. They highlight the significance of good governance and, through publicising it, put pressure on companies to respond.
The FTSE-ISS index series for the UK, USA, Europe and Japan rank over 2000 companies using the following five areas of comparison:
board composition and independence
shareholder rights/takeover defences.
The index is designed to incorporate the corporate governance rating into the financial index by tracking financial performance against the corporate governance variables. Supposedly, it offers a way of assessing the impact on portfolio performance.
Standard & Poor's (S&P's) corporate governance score gives an assessment of a company's policies and practices benchmarked against international codes and guidelines and governance best practices. S&P scores are based on ownership structure and influence, financial stakeholder rights and relations, financial transparency and information disclosure, and board structure and process. Unique to the S&P index is an interactive assessment with the company officials to capture how they work together. S&P evaluates companies only upon their request, and hence the companies pay for the rating. S&P's governance scoring and its credit ratings are different forms of analysis that complement each other.
Box 1 Components of S&P corporate governance score
Component 1: Ownership structure and influence
Transparency of ownership.
Concentration and influence of ownership.
Component 2: Financial stakeholder rights
Voting and shareholder meeting procedures.
Ownership and financial rights.
Component 3: Financial transparency and information disclosure
Quality and content of public disclosure.
Timing of and access to public disclosure.
Independence and integrity of audit process.
Component 4: Board structure and process
Board structure and composition.
Role and effectiveness of board.
Role and independence of outside directors.
Director and executive compensation, evaluation and succession policies.
Source: Standard & Poor's Governance Services (2002)
It is thought that such indices could help determine if well-governed companies outperform their rivals. As we have noted, studies relating corporate governance to company performance have not shown a consistent relationship. Recently, researchers at the Wharton School examined data from four agencies specialising in rating corporate governance, including Governance Metrics International, Investor Responsibility Research Center, Institutional Shareholder Services and The Corporate Library. They analysed the association between the ratings and subsequent company operating performance and stock returns. They found no conclusive evidence that the summary ratings were related to stock returns, but they did find evidence that corporate governance ratings are associated with the level of future operating performance (Larcker et al., 2005).
What corporate governance indices might show best is the degree of risk an investor takes when he invests in a company. Thus, asset managers looking at the ratings in terms of corporate governance ‘risk’ might avoid the companies at the bottom of the index but would not necessarily use a top ranking as the sole criterion for their investment decisions, particularly if the market is rising. The Asia Corporate Governance Association has found that when markets are rising and investors are willing to take more risks, then even companies with poor CG may tend to outperform their benchmarks. On the other hand, when markets decline and investors are more risk averse, companies with good CG tend to perform better (UNCTAD, 2005). Thus, when looking at these studies one should note if they were done during an up-cycle or down-cycle.
CG indices are in their infancy and each one contains some different and some common variables. The common variables rest on the assumption that there is a single, optimal governance structure and any company that deviates has a ‘governance’ problem. Corporate failures such as Enron would have scored well in terms of an index that was based on best practice structures and that did not examine the ‘quality’ of relationships. Sceptics wonder if governance ratings based largely on structural measures provide a useful basis for identifying good governance.
The main benefit of the ratings so far is to serve as a benchmark to show if corporate governance is changing over time. But after several years in operation, optimists believe that the indices could be having an impact on corporate governance. According to Business in the Community, the performances of companies have moved upwards, creating a bunching at the top and diminishing the differences between the companies. Peer pressure creates this race to the top and impacts positively on corporate governance performance (Baker, 2006). Furthermore, the growth of the indices industry in itself is creating a strong demand for better corporate governance disclosure.
The Myners Report, commissioned by the UK Government in 2000, recommended that shareholders should be encouraged to intervene in company matters. This resulted in a consultation paper published by the Department for Work and Pensions ‘Encouraging shareholder activism – a consultation document’.
Read the report, then identify and comment on the main government proposals. (Note: the paper can be requested via the Department for Work and Pensions website.)
The Myners Report found that institutional investors exhibit ‘a lack of active intervention in [companies in which they invest] even when there is a reasonable expectation that this would enhance the value of investments’ (p. 3). The review recommended that UK law should be changed to incorporate a duty ‘to actively monitor and communicate with the management of investee companies and to exercise shareholder votes where … there is a reasonable expectation that such activities are likely to enhance the value of an investment’ (p. 3).
The consultation paper acknowledges that shareholders cannot manage public companies, but says that issues such as the performance of senior management and the appropriateness of their strategy are legitimately the concern of shareholders. However, it is not clear that investors could be expected to have any better notion of the appropriate strategy for a company than its management. If one takes the example of Marks and Spencer, it is clear that shareholders can express concern at falling profits and share prices, but not so obvious that they could find a strategy that would combat the problem.
It would seem that the area where shareholders could be active is very difficult to define. Legislation might serve to put investors on notice that they must be pro-active. The consequences of this might be to encourage investment managers to develop greater insights into management, or it might simply create a means of redress where pensioners, for example, might claim compensation from professional fund managers for failing to maximise returns.