June 12, 2006
Larry Ribstein on The Corporate Governance Industry
Posted by Account Deleted

In his Corporate Governance Industry, Paul Rose focuses on the for-profit companies, including Glass Lewis and ISS, that have been established to develop corporate governance metrics, rate firms according to those metrics and, in some cases, advise companies how to do well in the ratings (henceforth referred to collectively as the CGI).

The paper’s first half describes what these firms do, putting their work in the context of the light state and federal (at least until SOX) regulation of internal corporate governance. The rest of the paper discusses potential problems and solutions. The problems include the obvious conflicts inherent in providing both ratings and advice; the dubious evidence on correlation between governance variables and firm performance; and the costs of applying inflexible criteria to diverse firms. The potential solutions, about which Rose is appropriately wary, include government regulation of the CGI.

I liked the paper's topic and approach, as indicated by the fact that I noted it on my blog even before becoming involved in this Forum. I found the paper’s descriptions useful and criticisms accurate, as far as they went. My comments will focus on what more I’d like to see in the paper. (Though the paper is plenty long enough, the author could make room by significantly cutting the descriptive part of the paper.)

First, what’s the problem? I don’t like how Wheaties taste, but I would defend to the death consumers’ right to buy them. Should we take the same approach to issuers’ and investors’ purchase of products from the CGI? One can’t criticize the CGI’s output like one would criticize, say, the SEC and Congress, whose edicts are forced on firms. So, assuming for the sake of argument that Rose’s criticisms of the CGI are apt, why would anybody buy their products?

Perhaps issuers buy faulty advice because the CGI effectively controls a sizeable slice of institutional investors’ votes. Directors like to be reelected. But then why are institutional investors voting per advice that we’re assuming is faulty, given that their portfolios could suffer and their customers would leave? Is it that they figure that, even if ISS is wrong, this won’t affect relative returns enough to drive away customers? On the other hand, if they don’t vote as ISS says, they open themselves to criticism. So, in effect, the investors are buying “criticism insurance.”

But then we should ask who would criticize institutional investors not following assumedly faulty advice? Well, among others, Gretchen Morgenson and other journalists of her ilk. Morgenson in particular, as I've discussed at length, has repeatedly advised mutual fund investors to sell funds that are not acting according to her CGI-influenced criteria. Investors probably won’t sell funds that are performing well even if their managers are voting “wrong,” but what if the fund isn’t performing well, for whatever reason, or the investor is choosing a fund in a very crowded field in the first instance? Surely a prominent NYT columnist achieves the sort of salience in investors’ minds that the behavioral finance people are telling us matters to investors’ decisions.

Let me emphasize that I’m not suggesting that Rose reach my particular, perhaps idiosyncratic, conclusions, but only that these are questions he might ask.

Second, assuming CGI advice does affect governance even if it’s faulty, I’d like to know more about the costs of this faulty advice. Rose alludes to these costs, but doesn’t elaborate. For example, he suggests that the CGI is inhibiting innovation or adaptation to specific circumstances. Some examples would help elucidate the theory. More importantly, I’d like to see testable hypotheses. For example, we might be able to estimate the costs of faulty CGI metrics by looking at what happens to the value of companies that follow CGI advice or where governance changes otherwise can be attributed to this advice.

Finally, I’d like more on the paper’s regulatory implications. The paper does a good job discussing the costs and benefits of regulating the CGI, but what about the paper’s implications for regulation of corporate governance generally? My own take would be that criticisms of CGI’s metrics demonstrate the folly of mandating particular criteria. Also, the existence of the CGI suggests, as Henry Butler and I discuss in our AEI book, that even if we like some of the stuff that SOX did, SOX wasn’t necessary.

Again, Rose doesn’t have to agree with these conclusions, but might ask the question. After all, he does spend some time in the paper talking about how the CGI fits with the existing matrix of corporate governance regulation. I’m suggesting that he connect the dots: what does the CGI tell us about what the matrix should be?

So, in general, the paper is a worthwhile contribution that could be developed into something even more consequential.

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Comments (3)

1. Posted by Paul Rose on June 12, 2006 @ 9:02 | Permalink

Larry’s first point is one that has troubled me a great deal—if these firms’ advice is not increasing the returns for these customers, why do customers keep using them? Larry comments that investors may be buying “criticism insurance”, and I think that is a large part of the explanation. As Richard Koppes (former general counsel of CALPERS) has noted, those voting against ISS better have a pretty good reason. If investors knew that ISS was wrong with respect to a particular governance metric, it would be easy to justify saying no to any changes based on the metric. The trouble is, I believe that investors generally do not know—they have largely outsourced much of this analysis to CGI firms, and are not running statistical tests to determine whether a certain number of independent directors are ideal, for example, let alone whether they would be ideal for this particular company at this particular time. I am certainly not suggesting that investors should run such tests themselves, but I certainly think they should be more skeptical of the advice.

As to the costs of faulty CGI advice, I agree that it would be helpful to add some more examples. There are certainly some real-world examples out there. For example, ISS recommended declassification of the McDonald’s board at a time when, because of a relatively low share price, ISS would have been susceptible to a takeover (I believe it was 1999). In this case, like many others, ISS systematically applied the standard template to McDonald’s, without considering whether the particular metric would be appropriate. Declassification may increase director accountability, but it also increases takeover risk, as might other “good governance” changes suggested by the CGI.

One direct cost of advocating certain accountability changes like declassification is that the changes may make it easier for hedge funds to get a seat on the board, and influence other changes which would not be in the best interests of CGI’s core constituency—the mutual funds. At a recent conference here at Northwestern, a noted practitioner characterized hedge funds’ interest in corporate governance as “event driven” rather than “performance driven”. In other words, the hedge funds are not using good governance changes like declassified boards as a means of encouraging better long-term performance, but to enable the hedge funds to catalyze events that will create value for the hedge funds (say, a sale of the business), but that may not be in the interests of most shareholders.

Larry suggests looking at some of the direct costs of issuers’ following faulty metrics. This is a tricky problem in large part because it is not easy to identify why an issuer adopted a certain measure. I doubt that issuers will disclose that CGI pressure induced a change. As a practitioner, I worked on a couple of proxy proposals where the actual justification (at least as expressed by the general counsel) was essentially that the change would increase the issuer’s corporate governance rating. The proposal didn’t quite state the justification the same way; instead, the proposal discussed general justifications for the change as had been expressed by the CGI and other firms that had made similar changes.

Finally, Larry suggests that I address the paper’s implications for the regulation of corporate governance generally. I will try to do a better job at this, and I generally agree with his remarks—criticisms of CGI’s metrics demonstrate the folly of mandating particular criteria. But to clarify, I am an agnostic, not an atheist, when it comes to good governance metrics. I don’t know if I would say that there are not generally applicable standards that seem to work in most cases, but I would say that I don’t think the CGI has done a good job of justifying things that really seem to affect firm performance from those that do not.

Again, my thanks to Larry for his initial comments.


2. Posted by Christine on June 12, 2006 @ 10:10 | Permalink

Paul, your comments on the faulty advice prove your point about qualitative v. quantitive metrics of corporate governance. If voting to force McDonald's to declassify its board led to McDonald's being taken over, is that a good or bad thing? Perhaps ISS was advocating declassification specifically because ISS was concerned that management was entrenched and that a takeover would be a good thing. Collective action is always a double-edged sword: reducing collective action problems and giving voice to a scattered majority is great unless the scattered majority wants something that you don't want. Or, as you point out, the scattered majority is organized by others pushing their own agenda. Any time one person or group has the incentive to organize others, there is an agenda or at least a fee!

So, if we think that the CGI have an imperfect agenda, what then is the answer? Certification? Regulation of conflicts? More competition from other CGI, who can tout "no conflicts" or better metrics? As you say in your article, several institutional investors have left ISS for other CGI firms because of conflicts, so isn't the market working?


3. Posted by Paul Rose on June 12, 2006 @ 11:55 | Permalink

To Christine's point, I don't think that ISS considered whether McDonald's should have been taken over--form the limited inside information I have on that particular recommendation, ISS was simply applying its standard formula to the problem--declassification is good because it increases board accountability. Now, it would be more interesting if ISS was advocating declassification in order to promote a takeover--this would suggest at least that ISS was thinking about McDonald's particularly, rather than just applying the template.

On your second point about whether the market can police itself, my response is that I hope it can, because I would rather not see the SEC get involved, and if it did get involved, it should only be on the conflicts side. Market self-regulation would be my best-case solution. However, the benefits of this competition may be a long time coming, especially on the metrics side. Even with respect to conflicts, there has been no changes from ISS, even after the defection of the pension funds, except that perhaps they have engaged in a little PR to show that they have a conflicts-prevention mechanism in place (see ISS website).

I would like to see if Glass Lewis and the Corporate Library can make some headway with their more risk-based approaches--instead of applying hard rules, Glass Lewis, for example, takes a more standards-based approach, and attepmts to identify risk factors that investors should consider. This seems to me a much more sensible way to evaluate governance. On the other hand, I assume that many investors with large portfolios would rather look at a simple numerical rating than read a 30 page report on governance.

I think that academics can continue to play a part by investigating some of these issues more deeply--in effect, academics can push the market along. My paper discusses why we should be skeptical of the corporate governance industry; more research is needed to figure out where they have specifically gone wrong, as well as what they have done right. The market should take care of the rest.

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