Corporate Governance Ratings and Firm Performance

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We examine the corporate governance ratings provided by three premier US rating agencies and find that summary scores are generally poor predictors of primary and secondary measures of future firm performance. However, some component sub-ratings that focus on the eight key dimensions of dynamic governance structures provide more positive and reliable evidence of their information content in predicting the multiple dimensions of firm performance. These results reflect the recent observations by academic researchers and money managers that it is extremely difficult to distill all of the complex governance mechanisms into a single integrated, yet informative overall score.

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In the wake of recent corporate scandals and the resulting focus on firms' corporate governance mechanisms, many money managers have been pressured by their clients to integrate corporate governance quality in their portfolio management processes. However, the analysis of how corporate governance can affect firm performance is complicated by the fact that there are very few reliable metrics of corporate governance.

There have been many attempts by rating services to quantify the quality of corporate governance in the form of commercially available ratings. The premier rating agencies in the United States are The Corporate Library (TCL), Institutional Shareholder Services (ISS), Governance Metrics International (GMI), and Standard & Poor's (S&P). These agencies use a proprietary scoring method to assess the soundness of governance practices at public corporations. Large investor groups are the typical customers of these governance rating agencies. Further, since the recent corporate scandals, these governance scores have become increasingly influential and popular among retail investors, client firms, and regulators. But surprisingly, there is little systematic study of the value of these third-party governance ratings in assessing firm performance.

Analyzing these ratings is important for several reasons. First, these rating services claim to use comprehensive governance databases and sophisticated analyses to construct their scores. For instance, TCL asserts, "Our TCL Ratings employ quantitative formulae and methodology that go far above and beyond the industry's typical reliance on "check-the-box" best practices compliance. Our proprietary methodology is based on a variety of governance practices statistically proven to be significant measures of value and risk" (see http://www.thecorporatelibrary.com). If these ratings are indeed useful in assessing the quality of corporate governance, then they might add significant social value by improving corporate governance practices through better measurement and transparency. The fact that these ratings are independent further strengthens the latter argument.

Second, notwithstanding their expert analysis, rating services all use raw data from publicly available documents, such as Securities and Exchange Commission (SEC) filings, tax filings, annual reports, and press releases. This reliance raises questions about the information content of governance ratings supplied by the vendors. Any evidence that they can help construct trading rules to generate systematic profits would seem to question the semi-strong form of the efficient markets hypothesis. Given that large, sophisticated institutions are willing to pay for these ratings, it would be valuable to examine the link between these governance analyst ratings and future firm performance.

Third, the prominence of these ratings has increased considerably over recent years. Frequently, these rating vendors conduct in-house research and offer their expert opinions and recommendations on current governance-related issues. For example, shareholders in prominent firms such as General Electric and Altria (parent company of Kraft Foods and Philip Morris) have used their respective firms' low TCL corporate governance ratings to propose separating the chairmanship of the board from the CEO position. …