I. INTRODUCTION II. CORPORATE GOVERNANCE RATINGS A. Growth of Governance Rating Agencies B. Governance Rating Process 1. Rating Scales 2. Rating Criteria C. Influence of Governance Ratings 1. Wide Range of Clients and Users 2. Deep Impact on Governance Practices III. DISCONNECT BETWEEN GOVERNANCE RATING CRITERIA AND CORPORATE PERFORMANCE A. The Lack of Correlation Between Rating Criteria and Corporate Financial Performance B. The Lack of Correlation Between Rating Criteria and Management Behavior and Ethics IV. CONNECTING GOVERNANCE RATING CRITERIA TO CORPORATE PERFORMANCE A. Management Behavior and Ethics Affect Financial Performance B. Employees as a Source of Information About Management Behavior and Ethics C. Benefits of Employee Assessments as a Corporate Governance Rating Criterion D. Conducting Employee Assessments V. CONCLUSION
Corporate governance rating agencies currently do not, but should, include in their rating criteria an employee assessment of managerial behavior and ethics. Governance rating agencies strive to distinguish themselves from their competitors by establishing governance rating criteria that are indicative of whether directors and officers are serving shareholder interests instead of management prerogatives. Adding a rating criterion that is based on a company's implementation of, and the results from, periodic assessments of managerial behavior and ethics would provide insight into whether the company's directors and officers are performing their responsibilities to advance shareholder interests.
Governance rating agencies are for-profit providers of corporate governance ratings. These governance rating agencies have experienced tremendous growth in size as well as influence during the past decade. There is a wide range of users and uses for the corporate governance ratings. Some of the users include investors, insurance companies, financial and securities analysts, lawyers, accountants, financial institutions, and the rated companies themselves. These users utilize the data compiled and the ratings assigned by governance rating agencies to make investment and voting decisions, determine premiums, prepare financial and stock reports, provide governance advice, determine credit risk, and benchmark governance practices. Knowing that there is a broad base of clients for and users of corporate governance ratings, public companies pay close attention to the governance ratings assigned to their companies by governance rating agencies. The rated companies strive to adopt governance practices advocated by governance rating agencies in order to garner favorable governance ratings.
Governance rating agencies develop rating criteria that mirror disclosure obligations and operational measures required under law or for listing on stock markets. Rating agencies also establish standards of governance that extend beyond legal and listing requirements or dominant corporate practices to include governance mechanisms that may not be prevalent but that are perceived by rating agencies to be conducive to enhancing directors' and officers' performance of their responsibilities to advance shareholder interests.
Empirical evidence has not established a strong correlation between corporate financial profitability and the structural mechanisms relied upon by rating agencies in their rating systems. The rating criteria also do not provide assurance that officers and directors of the corporation are performing their respective responsibilities of management and oversight. The lack of strong linkage between governance rating criteria and corporate performance, financial or otherwise, may be due to the rating agencies' focus on observable, structural mechanisms as indicators of corporate conduct. Structural mechanisms such as board composition and charter provisions neither indicate the board's fulfillment of its responsibility to monitor managerial performance nor ensure management's fulfillment of its responsibility to apply fundamental business precepts. Missing from the current governance rating criteria is an evaluation of the actual conduct and decision-making of the management group, an evaluation that would provide necessary data for the board to perform its oversight responsibility and enhance shareholder value.
Assessment of management's business standards and conduct can be implemented through a company-wide survey of employees, the internal stakeholders with daily and direct access to the actual conduct and decision-making of the management group. Employee assessments can provide valuable information to the board in carrying out its fiduciary duty to monitor management performance. Employee assessments can also provide information that is of interest to investors, customers, and other stakeholders, but which is currently unavailable, about management's affinity for ethical behavior or inclination for ethical lapses.
Part II of this Article examines the governance rating industry, focusing on three prominent rating agencies, their rating scales and criteria, and their influence in the corporate governance arena. Part III discusses the lack of correlation between governance rating criteria and corporate performance, on both financial and nonfinancial dimensions. Part IV demonstrates that management behavior and ethics affect shareholder value. Investors, customers, and other stakeholders are interested in information about management's actual decision-making process and behaviors. With insider access and opportunity to witness managerial conduct on a routine basis, employees constitute a unique source of nonpublic information about the realities of the company's governance. This Article proposes that corporate governance rating agencies include an employee assessment of managerial behavior and ethics as part of the rating agencies' governance rating criteria. A rating criterion that focuses on management's behavior and ethics may correlate more closely with the corporation's performance on both financial and nonfinancial measures.
This Article concludes that governance rating agencies should utilize their strong influence in the realm of corporate governance to motivate companies to conduct employee assessments of management's behavior and ethics. By utilizing public companies' implementation of, and results from, employee assessments of managerial conduct as a rating criterion, governance rating agencies can employ their authority in the corporate governance arena to improve the transparency of managerial behavior and ethics, which in turn can enhance corporate integrity and financial performance. Employee assessments can provide information that is of interest to the investing public and potential employees, thereby attracting investors, customers, and employees to the company. In addition, the employee assessments of managerial behavior and ethics will provide the board with information to enhance the board's performance of its oversight function and to promote management's business ethics and corporate integrity. As we have learned from the notable corporate events of the past decade, companies can collapse because of poor managerial behavior and ethics. Employees constitute a unique source of information about management conduct, and gathering and evaluating that information for the use of the board and the stakeholders may ultimately act to preserve the company's financial performance and existence.
II. CORPORATE GOVERNANCE RATINGS
A. Growth of Governance Rating Agencies
The growth in number, size, and influence of corporate governance rating agencies may be attributed to the rise of institutional investors, the implementation of regulatory requirements governing the voting of proxies by investment advisers and money managers, and the continual revelation of financial scandals and governance weaknesses since the beginning of this millennium. (1) Corporate governance rating agencies' services include compiling, comparing, and assigning scores on various governance practices deemed significant in determining company performance and shareholder value. (2) These private, profit-making rating agencies also provide research services, advise on proxy voting, and consult with clients on corporate governance matters. (3)
The largest and most influential corporate governance rating agency is Institutional Shareholder Services (ISS), (4) which launched its corporate governance research and advisory business in 1985 (5) and began to rate companies' governance in 2002. (6) The rise of ISS' role in the corporate governance arena is evident in the growth of its market value, from $40 million in 2001 to $550 million in 2006. (7) ISS has more than 3300 clients worldwide. (8) As it owes its growth to the rise in number and activism of institutional investors, (9) ISS has committed to conducting "its entire business in the best interests of its institutional clients." (10)
ISS rates more than 8000 companies in 31 countries. (11) ISS charges a subscription fee ranging from $10,000 to $17,000 per year for access to its governance ratings of companies. (12) In addition to providing governance rating services, ISS also performs research and provides advice regarding proxy issues in order to assist shareholders cast their votes. (13)
Another well-known name in the governance rating industry is GovernanceMetrics International (GMI), which was formed in 2000 as a corporate governance research and rating agency. (14) GMI counts among its clients the large pension funds TIAA-CREF and the New York State Retirement Fund, (15) in addition to other pension funds, investment managers, banks, insurance companies, credit rating agencies, regulatory agencies, public companies, lawyers, accountants, and consulting firms. (16)
GMI rates over 4100 companies throughout the world, (17) and the subscription fee to view the governance ratings issued by GMI starts at $18,000 per year. (18) In addition to providing governance rating services, GMI also performs research and consulting services on governance matters. (19) GMI does not provide advice on proxy issues. (20)
The third main provider of governance ratings is The Corporate Library (TCL), which was formed in 1999 as an adviser on corporate governance matters and a source of information about corporate directors and executives. (21) TCL began to issue governance ratings in 2003. (22) TCL's founders, Robert Monks and Nell Minow, are former executives of ISS. (23) TCL focuses on corporate governance in the United States, and its clients include insurance brokers and underwriters, institutional investors, lawyers, investment banks, academic researchers, consultants, and director and executive search firms. (24)
TCL's ratings cover more than 1500 companies. (25) Access to TCL's Board Analyst database, which contains TCL's governance ratings, (26) costs from $8000 to $35,000 per year. (27) In addition to providing governance rating services, TCL performs custom research services and compiles an extensive database of information about director and executive compensation, insider trading, takeover defenses, shareholder proposals, securities class action litigation, mergers and acquisitions, and governance policies. (28)
B. Governance Rating Process
1. Rating Scales
ISS's name for its governance ratings is the Corporate Governance Quotient (CGQ). (29) The CGQ is a comparative rating in that it ranks a company against other rated companies within a stock index (e.g., S&P 500, Fortune 1000, or Russell 3000). (30) The CGQ also ranks a company against other rated companies that are industry peers within Standard & Poor's sector groupings. (31) CGQ ratings range from 0% to 100%. (32) Thus, a rating of 75% indicates that the rated company has "better governance" than 75% of the company's industry peers. (33)
GMI reports its governance ratings on a scale from one to ten, with the higher number signifying a better governance structure. (34) GMI ratings are comparative in that they compare the rated company against all other companies rated by GMI in the world and against all other companies rated by GMI in the same country of domicile. (35)
TCL rates companies on a scale from A to F, assigning an A to those companies that TCL believes have the lowest level of governance risk and designating an F to those companies that TCL believes represent the highest level of governance risk. (36) The letter grades signify the varying degrees of board effectiveness relating to board composition, compensation practices, takeover defenses, and accounting concerns. (37)
2. Rating Criteria
ISS, GMI, and TCL have each developed their own rating criteria (38) and scoring methodology (39) to arrive at the governance ratings. Although ISS, GMI, and TCL have their own collection of rating criteria, each governance rating agency focuses on several common areas and variables of corporate governance.
One common area of focus in the rating criteria is the board of directors' composition and structure, which seeks to address the board's ability to effectively monitor management activities. (40) For this area, rating agencies evaluate governance measures such as the independence of the board and key committees, director term and age limits, and directors' service on other boards. (41)
ISS, GMI, and TCL each reviews the company's audit and accounting processes for purposes of assessing the independence, effectiveness, and transparency of the company's financial and audit procedures. (42) Rating criteria for this topic include the financial expertise of audit committee members, the relative amounts of audit and nonaudit fees, and audit and accounting practices at the company. (43)
Another common area of interest to all three primary governance rating agencies is the directors' and officers' stock ownership in the company and the company's compensation system for directors and officers. Rating agencies believe stock ownership and compensation systems should be designed to motivate directors and officers to advance the long-term interests of the company. (44) For this governance category, rating agencies evaluate the amounts and forms of compensation and the extent to which compensation is related to clearly articulated performance measures. (45)
ISS, GMI, and TCL each measures the rated company's protection of shareholder interests, particularly in relation to voting rights and takeover defenses. With respect to shareholder voting, rating agencies believe shareholders should be empowered with the ability to voice their opinions and make decisions on certain corporate issues in order to protect their interests. (46) With respect to takeover defenses, rating agencies believe that directors and executives should be open to changes in leadership and ownership structures that would increase shareholder value. (47) Governance features affecting shareholder interests include whether all directors on the board are subject to election on an annual basis, the amount of votes required for shareholders to take action, and the types of anti-takeover provisions adopted by the company. (48)
C. Influence of Governance Ratings
1. Wide Range of Clients and Users
Governance rating agencies have developed a large client base in the marketplace. Following the financial and accounting scandals in the early years of this millennium, investors, stakeholders, industry and professional groups, and regulatory agencies voiced their desire for more information about the governance practices of American corporations. (49) The increasing concentration of stock ownership in the hands of institutional investors, and the interest of these institutional investors in the governance of public companies, have also fueled the need for information about corporate governance practices. (50)
Moreover, regulatory requirements have contributed to the demand for corporate governance ratings and other governance advisory services. Regulations under the Employee Retirement Income Security Act require pension fund managers to establish procedures for proxy voting, to vote proxies in the best interests of fund beneficiaries, and to maintain proxy voting records. (51) In addition, the Securities and Exchange Commission (Commission) has promulgated rules to require investment advisers to adopt policies and procedures to reasonably ensure that the advisers vote proxies in their clients' best interests, to disclose those policies and procedures to the clients, to inform clients how to obtain the voting records for the clients' proxies, and to maintain records relating to the advisers' proxy voting. (52)
The Commission has also adopted rules requiring mutual funds to disclose in their registration statements the policies and procedures that the mutual fund uses to determine how to vote proxies, to file with the Commission and to make available to shareholders the mutual fund's records of proxy votes, and to disclose to shareholders the methods by which shareholders may obtain information about the mutual fund's proxy voting. (53) These regulatory requirements may have motivated investment funds and investment advisers to purchase access to the corporate governance ratings. (54) Reviewing the governance ratings of companies in which the funds invest in order to determine how to vote the proxies that the funds and their advisers hold may assist the funds and advisers to demonstrate compliance with their legal obligations to establish procedures for proxy voting and to vote proxies in the best interests of beneficiaries. (55)
Although there are questions about the accuracy and validity of the governance ratings, which will be discussed later in this Article, governance ratings influence a wide group of clients and users. In addition to the investment funds and advisers discussed above, the clients and users for the governance ratings include the following: investors, insurance companies, financial and securities analysts, lawyers, accountants, financial institutions, and the rated companies themselves. (56)
Investors, both individual and institutional, utilize the governance ratings to make investment and voting decisions. (57) Governance ratings reflect the philosophies and perspectives of rating agencies regarding various governance practices, and these philosophies and perspectives are also incorporated into the consulting and advisory services that rating agencies provide to their investor clients. (58) In addition to directly influencing the investment and voting decisions of investors who subscribe to the ratings, governance rating agencies may also indirectly influence investment and voting choices when stock analysts incorporate governance ratings into their stock research reports. (59) Investment banks Prudential Securities, Solomon Smith Barney, and Goldman Sachs, for example, include in their research reports the governance rating assigned by IS S to the companies analyzed in the stock research reports. (60)
Governance ratings are being used for more than just investment and voting purposes. Insurance companies, for example, analyze the governance ratings to determine a company's risk of being sued by shareholders. (61) Such analysis assists the insurance companies to determine directors' and officers' liability insurance premiums. (62)
Financial and security analysts use governance ratings to gain governance information about the companies, industries, markets, countries, and regions for which the analysts cover or advise. (63) Lawyers, accountants, and other professional advisers may use the governance ratings in their practice of advising corporate clients and benchmarking governance policies and compensation practices. (64) In addition, banks and other financial institutions use the ratings to adjust for governance risks in their capital asset pricing and credit risk models. (65)
Public companies use governance ratings to benchmark their governance practices with industry peers and competitors. (66) In order to attract investors, especially pension funds, mutual funds, and other institutional investors, public companies closely monitor the governance practices that will garner favorable marks from corporate governance rating agencies. (67) Rated companies may also strive for good governance ratings in order to lower their capital costs, reduce the risk of shareholder actions, and increase the chance of attracting director and executive candidates. (68) A good governance rating may enable a company to reduce its insurance premium costs. (69) In addition, public companies may monitor the ratings of their governance practices in order to avoid or manage potential negative publicity. (70)
2. Deep Impact on Governance Practices
Corporate governance rating criteria not only reflect, but in many cases extend, the requirements under securities laws, stock market listing standards, and codes of corporate governance promulgated by industry and professional groups. (71) For example, the Sarbanes-Oxley Act requires public companies to have an audit committee composed entirely of independent directors. (72) The listing standards of the NYSE (73) and the Nasdaq Stock Market (74) require public companies to have a majority of the board composed of independent directors and to have the entire nominating, compensation, and audit committees composed of independent directors.
The reasoning for the director independence requirement is that outside directors may be more effective than inside directors in monitoring management conduct, as the outside directors' financial dependence on the corporation in most cases is limited to a fixed director's fee instead of a variable management compensation package that is subject to fluctuation depending on the financial performance of the corporation. (75) Adhering to this philosophy, governance rating agencies give strong emphasis to director independence, defining independence more strictly than the Commission and the securities markets do. (76) GMI, for example, explains its director classification system as "simply, an independent director is someone whose only connection to the company is his or her board seat." (77) Rating agencies also assign favorable ratings to a company's board only when a majority (78) or supermajority (79) of the board is composed of independent directors, and each of the audit, compensation, and nominating committees is composed entirely of independent directors. (80)
The influence of governance ratings on corporate governance practices extends beyond reiterating legal and listing standards and documenting the currently dominant governance practices. In addition to comparing rated companies' governance practices to regulatory and stock market listing standards and against the practices of industry peers, governance rating agencies also establish rating criteria to promote governance mechanisms that are not common or prevalent in practice but that are viewed by business leaders, governance experts, and professional groups as indicative of strong corporate governance. (81)
Although no legal or listing standards require companies to have two different individuals in the roles of board chair and chief executive officer, governance rating agencies assign strong ratings to companies that separate their board chair and chief executive positions. (82) The reasoning behind the preference for splitting the posts of chief executive and board chair is to enhance the board's role as an independent monitor of management's performance. (83) The rating agencies also advocate that companies impose limits on the term and age of directors (84) and prohibit their retired chief executive from serving on the board. (85)
There is no regulatory or stock exchange limit on the number of boards on which directors can serve, but rating agencies look unfavorably upon and will lower the ratings of boards with over-committed directors. (86) Governance rating agencies perceive that a director who serves on many boards will spend less time and effort in serving the rated company's shareholder interests. (87) Rating agencies also disfavor "board interlocks," which entail chief executive officers of different companies serving on each other's boards of directors. (88) Board interlocks give rise to issues of independent oversight because interlocked directors may lack the independence to objectively evaluate the company's chief executive officer, (89) as that same chief executive officer sits on the boards of companies for which the interlocked directors serve as chief executives.
Governance ratings assist investors to evaluate information that is …