Does Your Corporate Governance Rate?

Why are companies and their boards, more than ever, aiming to assure investors of their commitment to best corporate governance practices? Significant new mandates by the SEC and stock exchanges regarding disclosure, governance, and accounting procedures are the legacy of Tyco, Enron, WorldCom, etc. Also, corporate governance issues have become matters of regular media reports and new publications focused on governance. Once passive institutional and retail shareholders have become increasingly vocal and successful on shareholder ballots. There is also an increasing amount of empirical data to support the position that better governance correlates to better shareholder value.

In the context of these developments, there have been established published rating systems that rank on an absolute basis, and analyze and compare the relative corporate governance practices of public companies. Directors should address the implications of the ratings programs and the criteria they use.

Why Should Directors and Executives Care About Corporate Governance Ratings?

• Bad Press. Given the widespread media focus on corporate governance recently, it is clear that bad ratings can make good press. Ratings, including ones in investment firms' analyst reports, are now widely published.
• Empirical Data. Although still not certain, empirical evidence is mounting that good governance correlates with increased shareholder value, and particularly bad governance sounds alarms for increased risk. These include recent studies jointly sponsored by ratings services to support the proposition that ratings are a valuable investment management tool.
• Shareholder Activism. Irrespective of any empirical support for better corporate governance, directors and management cannot afford to dismiss the surge of shareholder activism at recent stockholder annual meetings. Shareholder resolutions are achieving unprecedented success and boards of directors are listening. For example, as of early July 2004, boards had taken steps to implement more than 70 majority votes on shareholder proposals calling for such measures as an end to poison pills and declassifying the board.

New Regulations Favoring Shareholder Governance

For all of these reasons, whether directors or executives believe in the value of governance ratings, they cannot turn a blind eye to them.

The firms that provide direct ratings are as follows:

• GovernanceMetrics International's governance rating system;
• Institutional Shareholder Services' Corporate Governance Quotient (CGQ) rating system;
• Standard & Poor's Corporate Governance Score (CGS) service;
• The Corporate Library's (TCL) Board Analyst rating service;
• The Investor Responsibility Research Center's (IRRC) Benchmarker tool;
• TrueCourse, Inc.'s SharkRepellent net tool to assess the defensive characteristics of specific companies; and
• Moody's Investors Service corporate governance assessments.

This article addresses the ISS metric, the GMI metric, the TLC “Board Analysis” service, and the S&P scoring system.

ISS

ISS has sought to leverage its impressive institutional proxy advisory business into sales of the Corporate Governance Quotient (the CGQ). The CGQ rating appears on the front page of each ISS proxy analysis along with information providing context for the rating.

The Corporate Governance Quotient Rating

The ISS CGQ ratings are relative and are reported on a percentile basis ranging from zero to 100%. Each company receives two CGQ ratings:

• One score comparing the company's corporate governance practices against a relevant market index, for example, the S&P 500.
• A second score comparing the company's corporate governance practices against its industry peers using S&P's 23 sector groupings.

The CGQ ratings comprise eight core topics:

• Board structure and composition;
• Charter and bylaw provisions;
• Audit issues;
• Anti-takeover practices;
• Executive and director compensation;
• Progressive practices such as board performance review;
• Director and officer stock ownership; and
• Director education.

The core topics currently have 61 ratings variables that determine the total CGQ score.

Data Gathering

ISS gathers the majority of the data for the CGQ rating from publicly available disclosure documents such as proxy statements, annual reports and prospectuses, press releases, and corporate Web sites. Companies may also 1) visit the CGQ Web site at http://www.isscgq.com/ to submit to ISS, at no charge, changes or corrections to their corporate governance profile, and 2) subscribe to a fee-based subscription service to learn how to improve ratings and benchmark corporate governance practices against a self-selected peer group.

Contact ISS

Companies that do not subscribe to the ISS CGQ service will not know their CGQ rating until it is released by ISS. Subscribing companies can optimize their CGQ through trial and error utilizing the ISS material. Companies should consider subscribing to the CGQ rating service for at least 1 year to maximize the company's potential CGQ rating. Although the CGQ ratings are computed relative to peer companies, after the first year of subscription to the service it may not be possible to materially increase a company's CGQ rating. Public companies should annually submit their corporate governance data points to ISS free of charge.

S&P

Known for credit and debt ratings services, S&P also offers the S&P CGS service. S&P approaches the governance rating with a process more similar to their debt rating then the mechanistic approach of some of the other governance ratings, and benchmarks governance practices to corporate governance standards on a global basis.

Governing Principles

S&P uses a set of core principles articulated by the Organisation for Economic Cooperation and Development (OECD) as the basis of its scoring methodology to analyze governance both at a country and a company level.

Process and Structure of Corporate Governance Scores

S&P's CGS assesses a company's corporate governance practices and policies and how these serve the interests of financial stakeholders, in particular shareholders' interests. Typically, analysts from S&P and S&P's affiliates, local law firms and other professionals (the “Committee”) will conduct interviews of directors and officers, key shareholders and creditors and the auditor of the company being evaluated. The Committee will also inspect company documentation, including, for example, its public filings, regulatory filings, board and board committee minutes.

A CGS is assigned on a scale from 1 (lowest) to 10 (highest). A score of zero will be awarded in cases where a company fails to provide adequate information for analysis. Additionally, scores from 1 to 10 are awarded to the four following individual components that contribute to the overall CGS:

• Ownership structure and external influences;
• Shareholder rights and stakeholder relations;
• Transparency, disclosure and audit; and
• Board structure and effectiveness.

Following the company meeting, the Committee will prepare a detailed report covering the main elements of the analysis and will also articulate the CGS and individual scores for each of the four components.

Governance Metrics International

The GMI corporate governance rating system is generated by its proprietary scoring algorithm that incorporates more than 450 data points across the following six categories:

• Board accountability;
• Financial disclosure and internal controls;
• Executive compensation;
• Market for control and ownership base;
• Reputational & SRI (socially responsible investment) issues, “corporate behavior”; and
• Shareholder rights.

GMI's research process includes a review of pertinent public data, including regulatory filings, company Web sites and news services. The collected data are entered into a relational database, and GMI runs a scoring model that calculates the ratings. Companies are scored on a scale of 1 (lowest) to 10 (highest). GMI scores are relative and each company is assigned 14 ratings in all, including global ratings that are relative to the 2100 companies in GMI's research universe and “home market” ratings that reflect a company's governance policies relative to others in its home country.

The Corporate Library

TCL provides “Board Analyst,” a system for rating board effectiveness covering over 2000 U.S. companies. Subscribers receive a review of each company's CEO compensation policies and practices and individual director information. Board Analyst Pro also allows for comparison of the company performance of multiple directorship for each individual director and to screen for multiple audit, compensation or nominating committee appointments.

TCL also runs a proprietary system for rating board effectiveness comprised of:

• CEO compensation;
• Outside director shareholdings;
• Board structure and make-up;
• Accounting and audit oversight; and
• Board decision-making.

The Criteria

(See page 3 for a comprehensive list of corporate governance ratings criteria for use in reviewing matters that may affect your company's governance rating.) Management or the Board should review these criteria and its effects upon the company's rating. Some criteria are easy to improve and have no practical cost to implement, while other changes may be more serious and present fundamental business considerations (eg, removing poison pills and staggered boards) that should not be made simply to improve ratings.

What to Do

The following are simple measures that directors and executives should require that their company take to improve its governance rating:

• Actively review ratings and correct inaccuracies;
• Discuss and negotiate issues with rating services;
• Post committee charters, policies and codes of conduct on the company's Web site;
• Monitor institutional voting policies; and
• Review governance-rating criteria to fix easy items (independence, committee charters, corporate governance principles, board procedures), and to examine tough issues (staggered boards, poison pills, executive severance).

If the company does not noticeably improve its corporate governance ratings after having implemented recommendations, it should consider purchasing a subscription service or ratings “consulting” from ISS and other rating services.

Conclusion

It is unclear what importance corporate governance ratings will ultimately be to investors. Indeed, the case for ratings is weakened by the apparent lack of consistency between rating services. Purely mechanical ratings by design give no subjective assessment of the quality of management or the board. Warren Buffet and Berkshire Hathaway best prove this point, with Berkshire Hathaway having received an “A” rating from TCL, but a rating of only 1.5 from ISS. To the extent ratings are relative, they will also become less important over time as practices generally improve and the bar is uniformly raised. Nevertheless, both investors and issuers may find it increasingly difficult to avoid the implications of governance ratings that may be viewed as a proxy to a company's regard for its shareholders.

(see below)

[IMGCAP(1)]

Why are companies and their boards, more than ever, aiming to assure investors of their commitment to best corporate governance practices? Significant new mandates by the SEC and stock exchanges regarding disclosure, governance, and accounting procedures are the legacy of Tyco, Enron, WorldCom, etc. Also, corporate governance issues have become matters of regular media reports and new publications focused on governance. Once passive institutional and retail shareholders have become increasingly vocal and successful on shareholder ballots. There is also an increasing amount of empirical data to support the position that better governance correlates to better shareholder value.

In the context of these developments, there have been established published rating systems that rank on an absolute basis, and analyze and compare the relative corporate governance practices of public companies. Directors should address the implications of the ratings programs and the criteria they use.

Why Should Directors and Executives Care About Corporate Governance Ratings?

• Bad Press. Given the widespread media focus on corporate governance recently, it is clear that bad ratings can make good press. Ratings, including ones in investment firms' analyst reports, are now widely published.
• Empirical Data. Although still not certain, empirical evidence is mounting that good governance correlates with increased shareholder value, and particularly bad governance sounds alarms for increased risk. These include recent studies jointly sponsored by ratings services to support the proposition that ratings are a valuable investment management tool.
• Shareholder Activism. Irrespective of any empirical support for better corporate governance, directors and management cannot afford to dismiss the surge of shareholder activism at recent stockholder annual meetings. Shareholder resolutions are achieving unprecedented success and boards of directors are listening. For example, as of early July 2004, boards had taken steps to implement more than 70 majority votes on shareholder proposals calling for such measures as an end to poison pills and declassifying the board.

New Regulations Favoring Shareholder Governance

For all of these reasons, whether directors or executives believe in the value of governance ratings, they cannot turn a blind eye to them.

The firms that provide direct ratings are as follows:

• GovernanceMetrics International's governance rating system;
• Institutional Shareholder Services' Corporate Governance Quotient (CGQ) rating system;
• Standard & Poor's Corporate Governance Score (CGS) service;
• The Corporate Library's (TCL) Board Analyst rating service;
• The Investor Responsibility Research Center's (IRRC) Benchmarker tool;
• TrueCourse, Inc.'s SharkRepellent net tool to assess the defensive characteristics of specific companies; and
• Moody's Investors Service corporate governance assessments.

This article addresses the ISS metric, the GMI metric, the TLC “Board Analysis” service, and the S&P scoring system.

ISS

ISS has sought to leverage its impressive institutional proxy advisory business into sales of the Corporate Governance Quotient (the CGQ). The CGQ rating appears on the front page of each ISS proxy analysis along with information providing context for the rating.

The Corporate Governance Quotient Rating

The ISS CGQ ratings are relative and are reported on a percentile basis ranging from zero to 100%. Each company receives two CGQ ratings:

• One score comparing the company's corporate governance practices against a relevant market index, for example, the S&P 500.
• A second score comparing the company's corporate governance practices against its industry peers using S&P's 23 sector groupings.

The CGQ ratings comprise eight core topics:

• Board structure and composition;
• Charter and bylaw provisions;
• Audit issues;
• Anti-takeover practices;
• Executive and director compensation;
• Progressive practices such as board performance review;
• Director and officer stock ownership; and
• Director education.

The core topics currently have 61 ratings variables that determine the total CGQ score.

Data Gathering

ISS gathers the majority of the data for the CGQ rating from publicly available disclosure documents such as proxy statements, annual reports and prospectuses, press releases, and corporate Web sites. Companies may also 1) visit the CGQ Web site at http://www.isscgq.com/ to submit to ISS, at no charge, changes or corrections to their corporate governance profile, and 2) subscribe to a fee-based subscription service to learn how to improve ratings and benchmark corporate governance practices against a self-selected peer group.

Contact ISS

Companies that do not subscribe to the ISS CGQ service will not know their CGQ rating until it is released by ISS. Subscribing companies can optimize their CGQ through trial and error utilizing the ISS material. Companies should consider subscribing to the CGQ rating service for at least 1 year to maximize the company's potential CGQ rating. Although the CGQ ratings are computed relative to peer companies, after the first year of subscription to the service it may not be possible to materially increase a company's CGQ rating. Public companies should annually submit their corporate governance data points to ISS free of charge.

S&P

Known for credit and debt ratings services, S&P also offers the S&P CGS service. S&P approaches the governance rating with a process more similar to their debt rating then the mechanistic approach of some of the other governance ratings, and benchmarks governance practices to corporate governance standards on a global basis.

Governing Principles

S&P uses a set of core principles articulated by the Organisation for Economic Cooperation and Development (OECD) as the basis of its scoring methodology to analyze governance both at a country and a company level.

Process and Structure of Corporate Governance Scores

S&P's CGS assesses a company's corporate governance practices and policies and how these serve the interests of financial stakeholders, in particular shareholders' interests. Typically, analysts from S&P and S&P's affiliates, local law firms and other professionals (the “Committee”) will conduct interviews of directors and officers, key shareholders and creditors and the auditor of the company being evaluated. The Committee will also inspect company documentation, including, for example, its public filings, regulatory filings, board and board committee minutes.

A CGS is assigned on a scale from 1 (lowest) to 10 (highest). A score of zero will be awarded in cases where a company fails to provide adequate information for analysis. Additionally, scores from 1 to 10 are awarded to the four following individual components that contribute to the overall CGS:

• Ownership structure and external influences;
• Shareholder rights and stakeholder relations;
• Transparency, disclosure and audit; and
• Board structure and effectiveness.

Following the company meeting, the Committee will prepare a detailed report covering the main elements of the analysis and will also articulate the CGS and individual scores for each of the four components.

Governance Metrics International

The GMI corporate governance rating system is generated by its proprietary scoring algorithm that incorporates more than 450 data points across the following six categories:

• Board accountability;
• Financial disclosure and internal controls;
• Executive compensation;
• Market for control and ownership base;
• Reputational & SRI (socially responsible investment) issues, “corporate behavior”; and
• Shareholder rights.

GMI's research process includes a review of pertinent public data, including regulatory filings, company Web sites and news services. The collected data are entered into a relational database, and GMI runs a scoring model that calculates the ratings. Companies are scored on a scale of 1 (lowest) to 10 (highest). GMI scores are relative and each company is assigned 14 ratings in all, including global ratings that are relative to the 2100 companies in GMI's research universe and “home market” ratings that reflect a company's governance policies relative to others in its home country.

The Corporate Library

TCL provides “Board Analyst,” a system for rating board effectiveness covering over 2000 U.S. companies. Subscribers receive a review of each company's CEO compensation policies and practices and individual director information. Board Analyst Pro also allows for comparison of the company performance of multiple directorship for each individual director and to screen for multiple audit, compensation or nominating committee appointments.

TCL also runs a proprietary system for rating board effectiveness comprised of:

• CEO compensation;
• Outside director shareholdings;
• Board structure and make-up;
• Accounting and audit oversight; and
• Board decision-making.

The Criteria

(See page 3 for a comprehensive list of corporate governance ratings criteria for use in reviewing matters that may affect your company's governance rating.) Management or the Board should review these criteria and its effects upon the company's rating. Some criteria are easy to improve and have no practical cost to implement, while other changes may be more serious and present fundamental business considerations (eg, removing poison pills and staggered boards) that should not be made simply to improve ratings.

What to Do

The following are simple measures that directors and executives should require that their company take to improve its governance rating:

• Actively review ratings and correct inaccuracies;
• Discuss and negotiate issues with rating services;
• Post committee charters, policies and codes of conduct on the company's Web site;
• Monitor institutional voting policies; and
• Review governance-rating criteria to fix easy items (independence, committee charters, corporate governance principles, board procedures), and to examine tough issues (staggered boards, poison pills, executive severance).

If the company does not noticeably improve its corporate governance ratings after having implemented recommendations, it should consider purchasing a subscription service or ratings “consulting” from ISS and other rating services.

Conclusion

It is unclear what importance corporate governance ratings will ultimately be to investors. Indeed, the case for ratings is weakened by the apparent lack of consistency between rating services. Purely mechanical ratings by design give no subjective assessment of the quality of management or the board. Warren Buffet and Berkshire Hathaway best prove this point, with Berkshire Hathaway having received an “A” rating from TCL, but a rating of only 1.5 from ISS. To the extent ratings are relative, they will also become less important over time as practices generally improve and the bar is uniformly raised. Nevertheless, both investors and issuers may find it increasingly difficult to avoid the implications of governance ratings that may be viewed as a proxy to a company's regard for its shareholders.

(see below)

[IMGCAP(1)]