Paul Rose’s recent paper throws welcomed light on a sizable but neglected niche in our securities markets: the corporate governance industry (CGI). Based on the citations in the paper, this is the first academic commentary that focuses on CGI’s market structure and operations. Thus, despite my skepticism (noted below) of Paul’s assessment that CGI poses a potentially troublesome threat to optimal corporate government, his careful descriptive summary of the industry is an important contribution. (I agree with Larry that the paper’s descriptive portions could be shortened to make room for additional analysis; but the place to cut is the 9 pages that comprise Part II.A-C, not Part II.D, which focuses on CGI).
According to Paul, the CGI is comprised of approximately six companies that provide corporate governance rating and/or proxy advising services to institutional investors; within this market space, Institutional Shareholder Services (ISS) is the dominant player. The statistics cited by Paul (p. 5) are staggering:
- ISS has 1,600 institutional clients, with assets under management in excess of $25 trillion;
- ISS advises 24 or the top 25, and 81 of the top 100 mutual funds (I presume “top” in this context means assets under management);
- All 25 of the top 25 asset managers;
- 17 of the top 25 pension funds;
- 15 to 20 percent of ISS clients use a service that automatically votes according to ISS recommendations, though clients can override it;
- ISS is rumored to control over 1/3 of all shareholder votes.
One area that Paul might want to explore is what types of market incentives and dynamics would support this type of market structure. This statistic, cited by Paul on page 15, is a good place to start: “in 1965, institutional investors held 16% of U.S. equities; by 2001, institutional investors held 61%.” What does this seismic shift connote? That ordinary investors have discovered portfolio theory—i.e., investors can profit over the long term by diversifying (through a stock portfolio) firm-specific risk. And one aspect of firm-specific risk is suboptimal corporate governance.
Mutual funds, of course, are the most common method of diversification. To my mind, it is unclear whether institutional investors really care that much about corporate governance. What is a better use of a money manager’s time: Assuming an activist role in the governance of companies that comprise only a small fraction of the fund’s holdings, or focusing on the decision to buy or sell stock? For most money managers, the answer is almost certainly the buy/sell decision—and corporate governance is only one of literally dozens of factors that might influence this outcome. At one point in the paper, Paul succinctly describes these incentives:
Although it is generally true that institutional investors and other governance services clients have more time and resources to evaluate companies than the individual investor (and, of course, are paid specifically for their expertise in such evaluation), institutional investors do not have an unlimited ability to conduct research, and so they outsource some of this research work to corporate governance advisors. (p. 37)
Thus, in a marketplace where both individual and institutional shareholders have abdicated their roles as monitors of corporate officer and directors, companies like ISS have stepped into the breach. And why has ISS assumed a dominant position? Because money managers like the comfort of saying to their investors (in promotional literature, SEC filings, or in court) that they hire the market leader to assess corporate governance and provide advice on proxy matters on companies in the portfolio. In short, it is a cost-effective way to cover one’s ass.
At various points in the paper, Paul suggests that ISS’s market dominance (or the lack of competition generally) may have deleterious market consequences. For example, Paul argues that many institutional investors use CGI metrics “to decide whether or not to invest in or divest from a company” and that issuers must therefore “pay attention to the ratings” (p. 18). In turn, companies fall in line with ISS “checklist” or “one-size-fits-all” standards. This market coercion, Paul argues, stifles potentially valuable innovation in corporate governance and makes it too “homogeneous” (see generally pp. 18-19 and Part IV).
There are a number of potential problems with this analysis. First, if ISS ratings really matter to the market, such a claim is probably amenable to empirical investigation, such as an event study. For example, in the time period shortly after the ISS releases its new ratings (note: the rating are supposedly weighted and calculated in a proprietary way, so the release truly is an event), do downgraded companies lose valuation and upgraded companies gain valuation, after controlling for all relevant variables?
Second, the market is probably a sufficient check against a coercive one-size-fits all ISS standard. As Paul notes, there are empirical studies that document a relationship between various good governance measures and long-term corporate performance. See, e.g., Bebchuk, Cohen & Ferrell, What Matters In Corporate Governance? Insofar as ISS competitors can devise a more compact governance metric that eliminates irrelevant variables and leads to better investment decisions by money managers, ISS’s dominant position will be eroded and the "methodological issues" that Paul aludes to will work themselves out. In fact, Paul notes on page 25 that Glass Lewis is currently marketing a rating product (“Board Accountability Index”) based on the research of Bebchuk, Cohen and Ferrell.
Third, Paul makes a theoretical claim that CGI, as it presently structured, could stifle corporate governance innovations; yet, as Larry notes, he fails to provide any persausive examples. Virtually all good corporate governance principles are designed to promote disclosure, align management and shareholder incentives, eliminate conflicts of interests, and reduce the likelihood of management entrenchment. Militating against their adoption is the market for managerial talent, since managers presumably prefer things like poison pills, staggered boards, and generous stock option programs with low strike prices.
This flouting of good corporate governance may be (a) agency costs, or (b) good faith decisions by corporate directors to attract and retain the best human capital to the firm and otherwise preserve shareholder value. But what innovations fall outside this paradigm and thus would be disfavored by the CGI? On page 30-31, Paul briefly discusses how annual elections, favored by the CGI, may open the door for event-driven trading by hedge fund managers that could work to the detriment of long-term investors. But if that is a significant problem, I suspect that ISS (or it competitors) will eventually take note. They certainly have an incentive to improve their metrics.
In summary, I think this paper makes a valuable contribution, albeit by fleshing out the structure of a previously understudied niche industry. I realize there is a strong bias in legal academy for papers that identify problems and suggest reforms; and I think that is unfortunate, because is discourages exploratory research into understudied fields. I think the “hook” here should be evolution of the securities markets that eventually opened the door for this new industry and why market dynamics strongly favor a dominant industry player.
1. Posted by Susan Morse on June 12, 2006 @ 12:03 | Permalink
I agree that an interesting point raised by Paul's article is the motivation of institutional investors in using ISS checklists, Glass Lewis research etc. Certainly the convenient CYA element of doing what ISS says could be part of the motivation. But I heard Dennis Johnson, the CALPERS corporate governance point person, speak at a conference at Berkeley this spring and he seemed pretty earnest in talking about the challenge of mobilizing large institutions to ask for change at corporations. ISS and Glass Lewis and the consistent advice these and other firms give to institutions appears to permit them to at least join together (sometimes) in potentially meaningful numbers to use that mighty weapon . . . the withhold vote. Johnson's presentation emphasized the importance of unification and simplification -- i.e. in his case "It's Director Independence, Stupid" -- if institutions were to succeed in getting anything done in terms of corporate governance change.
Regardless of where the motivation point goes, I think the conflict of interest point stands on its own. This appeared to me to be one of several points that in Paul's view distinguished ISS from others like Glass Lewis. Disclosing such a conflict of interest seems like a low-cost and value-add solution to me. Finally, one area that might bolster the conflicts discussion is consideration of whether (regardless of firewalls and separated office space) financial benefits (comp, perks) of ISS people who evaluate companies depends in any way on the performance of ISS people who advise them on how to improve their rating.
2. Posted by Paul Rose on June 12, 2006 @ 13:24 | Permalink
Bill raises a number of important points, the first of which concerns the general thrust of the paper. I had thought about discussing the market conditions that would give rise to the corporate governance industry, but I will have to leave that to another author. There is a lot to say about the rise of institutional investment (as a result of the increased importance of mutual funds), but I am not sure that there is much to say about market dynamics in the CGI. We are talking about an industry that is really only a few years old (ISS has been around for a while, but only recently have they engaged in governance ratings along with proxy advice, and only recently have other firms entered the market). I don’t think that we can say that market dynamics favor a dominant player—only that ISS was a first-mover, and we will have to see if newly arrived firms will make this a more competitive market.
Bill also notes a number of concerns with my analysis. His first point is that if ISS ratings really matter to the market, such a claim is probably amenable to empirical investigation, such as an event study. I think that is true, and while my paper would benefit from data showing that relationship, much of CGI’s influence would not be revealed by such analysis. The corporate governance industry is not just about governance ratings, but, especially in the case of ISS, is also about proxy advice. With proxy voting, ISS has a more direct effect on governance by voting according to its metrics of good governance. As I note in the paper, we need to look more carefully at the metrics underlying these recommendations. Such an analysis is beyond the scope of my paper, and indeed I think it is beyond the scope of any single paper, since we need to go beyond looking at whether a given metric is related to the performance of a broad segment of the market, but whether the relationship holds true under all kinds of variables—industry, company size, presence of other metrics, etc.
Another effect of the corporate governance industry with respect to governance ratings is that companies are making changes based on the metrics, and I don’t know of a reliable way of measuring that influence, although corporate practitioners will certainly tell you that it exists. I don’t mean this as a cop-out—if there are ideas on how to get at this information, I truly would appreciate hearing them. From my own limited experience, though, I am pretty well convinced that it will not appear in any disclosure.
Bill also states that the market is probably a sufficient check against a coercive one-size-fits all ISS standard. That is certainly true if we are looking at a perfectly competitive market, but the market has not reached that point yet. I hope that Glass Lewis and others competitors will bring some discipline to the market, but simply by looking at the way ISS operates you can see that, despite the existence of other competitors, ISS still uses a check-the-box approach which will fall short of providing an accurate assessment of the quality of a firm’s governance. At the very least, we can see that a series of yes/no questions will fail to capture “the tone at the top”—as The Corporate Library likes to point out, Enron had good governance ratings, and I suspect that they are not the only example of how a check-the-box analysis can get it wrong. I guess I see Bill’s concern as akin to saying that the existence of Apple provides a check against Microsoft producing a terrible operating system. Sure, Apple and Linux place some pressure on Microsoft to improve the O/S, but that does not mean that it does not contain significant flaws.
Bill also questions whether the CGI, as it presently structured, really stifles corporate governance innovations. He notes that “Virtually all good corporate governance principles are designed to promote disclosure, align management and shareholder incentives, eliminate conflicts of interests, and reduce the likelihood of management entrenchment.” My concern is not that ISS is promoting general standards that are designed to reduce agency costs (although if applied to all companies, even some general standards may be a problem), but that ISS is promoting quite specific rules. For example, the second most important metric in ISS’ CG rating is the burn rate annual burn rate over the past three fiscal years is 2% or less, or is within one standard deviation of the industry mean. (equity burn rates measure a company' s annual cost of granting equity to executives and employees). Unlike most ISS metrics, this metric at least has a built-in industry measure. Still, why 2%? Even within an industry, might there not be some variability as to the appropriate burn rate (say, depending on the age of the company). Where is the evidence that companies should adopt this particular measure? Bill notes that even if ISS’ miscalculations create a significant problem, ISS (or it competitors) will eventually take note. Agreed, but this depends on healthy competition and investors being willing to discipline firms.
My thanks to Bill for his useful (and by useful I mean tough!) comments.
3. Posted by David Zaring on June 12, 2006 @ 20:25 | Permalink
I'm not too familiar with the ISS process, though that is a stunning amount of market share to have acquired in a very short amount of time, and it is worth thinking about why the services are so popular - so kudos to Paul Rose for doing so. Private or semi-private standardization is a very prominent method of international harmonization of regulatory standards, and the conventional concerns administrative law scholars bring to the phenomenon relate to capture and transparency of the process. ISS appears to act quite transparently, but who is doing the capturing? Although my sense is that boards experience ISS as adversarial, they'd be the most logical choice (by which I don't mean that it has happened or fits the evidence, but it might be worth thinking about).
The other thing to note, and I take it Bill was hinting at this in his comments, is: can these guys really be doing something so transformative - are companies really being managed radically differently because of the advice of who seem like just a bunch of consultants to institutional investors? And to put things more broadly, why is what these people are doing something that the analysts who have been advising institutional investors all along not doing? Coming up with an explanation for that seems well worth doing. So I'd like to see a historical account, and I didn't see one on my admittedly brief skim of the paper....this could be one of those "guess you didn't do x, and that could have been good" kind of comments.
4. Posted by Jeff Lipshaw on June 13, 2006 @ 8:38 | Permalink
I was the GC of a NYSE company (about Fortune 850 in size) from 1999 to 2005, so I spanned the entire "rise of corporate governance" era, and dealt with ISS and the other CG entrepreneurs extensively. Granted my empirical evidence is limited and casual; nevertheless I suspect my experience is typical.
I think there is still lots of work to be done - but my intuition is that if there is a relationship between governance and performance (and I'm still not convinced there is, or that if you weighted it against industry trends, technological innovation, value differentiation, etc, etc, it would make any difference), it relates to a variable much deeper and common to both. My not-very-articulate speculation on that, as well as a discussion of the jurisprudential vacuity of trying to do this by way of positive law rules is Sarbanes-Oxley, Jurisprudence, Game Theory, Insurance & Kant: Toward a Moral Theory of Good Governance, 50 Wayne L. Rev. 1083 (2004). That is to say, I'm not convinced that any individual proxy for good governance in the indices, or the various measurements taken together, have a functional relationship to "good governance." Indeed, I'm not sure we have ever defined good governance, and I suspect that the buzzwords Bill Henderson uses (alignment with shareholders, avoid conflicts of interest, etc.) get you part of the way there, but still don't capture the X factor stew of judgment, serendipity, intuition, luck, trust, respect, experience and wisdom that create great (or even consistently effective) boards or managers. Is the company run in a way that it appears that employees are treated with honesty and respect? I'll bet, regardless of the governance indicies, it's a well-governed company because it is part of the culture that honesty and respect are fundamental to how all decisions are made.
Having said all that, here are some thoughts on where to go from here:
1. I think the ISS and other metrics DO have an effect on boards. As do shareholder votes. You do tend to respond to that on which you are measured, and I'd be shocked if responsible GCs haven't scoured (as I did) the list of GCQ factors to see what can be changed to manipulate the score. Moreover, in forming stock plan proposals, managers and compensation committees DO look at the ISS guidelines.
2. Whether the boards' responses to the metrics are meaningful to good governance depends on whether the proxies for good governance are meaningful.
3. I think you need to break down further the impact of ISS's work product. We would receive ISS's proxy analysis at the company. It was more than an up or down on the voting issues. Agree or disagree, the positions on stock and incentive comp plan approvals was fairly sophisticated. ISS did have hot button issues, like poison pills and classified boards, but often the analysis on other issues was fairly dispassionate, well-reasoned and not predictable. I think it also tended to be fairly thoughtful on proxy fight and other shareholder vote issues (my recollection is you could see this in the HP-Compaq merger). Its proxy positions, however, were not related to its overall governance scores. I had a long, somewhat annoyed, conversation with Jill Lyons at ISS once over the fact that we had a CGQ score in the mid 90s, but ISS was recommending a withhold vote on our directors because we had not adopted a shareholder resolution that had passed by a majority vote.
4. Public companies have proxy solicitation and advisory firms like Morrow or Georgeson working for them even when it is not a contested vote. Those firms have a lot of data on how various institutional holders react to ISS and other proxy advisor recommendations. You have to be careful about making generalizations. At some institutions (I think Fidelity and maybe T. Rowe Price, for example), each asset manager has the discretion to vote the shares under his/her management as he/she sees fit. There is no overall institutional position.
5. I agree with Larry Ribstein's observation that shareholders have every right to buy these services. But people also had or have a right to buy Y2K advisory services, natural male enhancement pills, and metabolism increasing weight loss pills. Since my semi-empirical intuition is that (i) governance as a factor in endogenous company performance or in share price performance is either (a) not a significant factor, or (b) is already correlated to other factors that more fundamentally impact performance, (ii) investors know that, and (ii) the ISS or other product is proven to be effective about as persuasively as the stuff you can buy to lose 25 pounds in five weeks, I'd buy the theory already offered that as a fund manager you buy the cheapest reputable "CYA" insurance you can find. I don't know enough about it to comment further, but clearly there must be agency costs (talk to the companies that bought Y2K consulting) as between the investors buying the services, and the companies seeking to build an industry. (An analogous industry: law firms selling document retention systems and advice. But that's another rant for another time.)
5. Posted by Jeff Lipshaw on June 13, 2006 @ 9:00 | Permalink
Sorry. One other thing. On the subject of measurable proxies, I agree "it's director independence, stupid" cuts to the heart of the governance question. But it's intellectual integrity and independence we really seek, and for that impose various structural and financial relationships as proxies for its lack (former executives, family members, vendor relationships). But do, for example, the NYSE Rule 303A listing standard indicia of lack of independence bear a relationship to real independence in the board? I'm afraid they don't, because they don't bear a relationship necessarily to integrity, courage, and the resistance to groupthink (there was an interesting Cincinnati L. Rev. article on that issue in a symposium issue a few years ago).
6. Posted by Paul Rose on June 14, 2006 @ 8:42 | Permalink
Thanks to Susan, David & Jeff for their comments. Jeff's comments on the GC's view of ISS help round out my understanding of how practitioners view the CGI, and I suspect that his thoughts are fairly representative of in-house folks.
My sincere thanks to Christine, Gordon, Vic, Fred and Lisa for putting together this virtual conference. I look forward to the rest of the papers!