June 12, 2006
Bill Henderson on The Corporate Governance Industry
Posted by Bill Henderson

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.

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