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As governance ratings have become ubiquitous, they have also attracted an increasing about amount of attention, not all of it positive. As I noted in a prior post (here), one academic study questions the "predictive validity" of the governance ratings. A more recent academic study questions the applicability of uniform governance standards to disparate companies.

In any April 2009 paper entitled "Elusive Quest for Global Governance Standards" (here), Harvard Law Professor Lucien Bebchuk and Hebrew University of Jerusalem Professor Assaf Hamdani question whether the effort to establish uniform governance metrics suffers from a "basic shortcoming"; that is, the authors question whether certain corporate arrangements counted as good governance should be considered equally valuable for all companies.

In particular, the authors contend that the value of certain arrangements "depends considerably on companies’ ownership structure" and that "measures that protect outside investors in a company without a controlling shareholder are often irrelevant or even harmful when it comes to investor protection in companies with a controlling shareholder."

In elaborating on this perspective, the authors note that in the U.S. most public companies lack a controlling shareholder, by contrast to companies outside the U.S. that often have a controlling shareholder. Given the absence of a controlling shareholder, "for anyone approaching governance arrangement from a U.S. perspective finds it is natural to assume that the arrangements governing control contests are a key element in the governance of public companies." This kind of bias results in a preference for governance arrangements that, for example, relate to takeovers and proxy fights. However, for companies that have controlling shareholders, "the presence of arrangements providing protection against a hostile takeover or a proxy fight is neither good nor bad, but simply irrelevant."

In view of these differences deriving from this important ownership distinction, certain governance practices, the authors suggest, should be weighed in assessing governance according to whether or not companies have a controlling shareholder.

The authors reviewed the governance rating methodology of three governance rating systems: RiskMetrics’ Corporate Governance Quotient (CGQ); and two measures developed by academics, the Anti-Self-Dealing Index and the Anti-Director-Rights Index. The authors conclude that presumptions built into the measures reflect a "failure" to "properly take into account the relationship between ownership structure and corporate governance," which "substantially undermines the indices’ ability to serve as effective metrics for the quality of the governance at firms or countries worldwide."

The authors are not against the development of governance metrics; as they put it, they "do not question the feasibility of developing a methodology for large-scale governance assessments." Rather they argue that commentators and practitioners should "develop separate systems – one for controlled and one for widely held firms," so that the rating methodology "fits the company’s ownership structure."

The authors’ analysis makes an important contribution for the understanding and use of the now ubiquitous governance measures. In particular, it may be critical for those relying on these measures to understand their limitations in certain contexts. By the same token, it is worth emphasizing that the limitations the authors cite will be most relevant in connection with companies outside the Unites States. The authors apparently do not question the general usefulness of the measures for U.S.-domiciled companies that lack a controlling shareholder (or for that matter, for any company lacking a controlling shareholder).

The more interesting question may be whether or not there are other limitations on the one-size-fits all approach to corporate governance measurement. I have often been concerned that governance metrics applicable to larger companies may not be as applicable to smaller companies, or that governance requirements best suited for mature companies may not be the same as those suited, say, for a developmental stage company. I have also often wondered whether the standards should be applied the same to all companies in all industries.

All of which to me suggests that there could be room for additional research along the lines undertaken in this study, to examine whether or not there may be other ways in which governance metrics should reflect separate methodologies for assessing different categories of companies.

He’s At It Again: Some readers may recall the recent post (here) in which I reported on the lawsuit that purported to be brought on behalf of Bernard Madoff by federal prison inmate Jonathan Lee Riches against Brittney Spears. As reported in a May 23, 2009 article in the Spokane Spokesman-Review (here), Riches has now filed another lawsuit in the Eastern District of Washington seeking an injunction to stop the Guinness Book of World Records from naming him as the person who has filed the most lawsuits in the history of mankind. A copy of Riches’ latest complaint can be found here.

Riches contends that the Guinness Book plans to print false information about him, among other things apparently by undercounting the number of lawsuits Riches claims he has filed. He also objects to the names the Guinness Book intends to call him, including "Johnny Sue-nami," "Sue-per-man," "the Patrick Ewing of Suing" and the "the Lawsuit Zeus." He says that these phrases "hurt my feelings and violates my civil rights."

Riches filed his case in the Eastern District of Washington despite the February 23, 2009 order (here) entered in that court by Judge Justin Quackenbush, in a case in which Riches had sued the Peanut Corporation of America claiming to have been poisoned with Salmonella-tainted peanut butter. In the order, Judge Quackenbush had admonished Riches that his "ability to file future cases in this court will be enjoined" if Riches continue to filed cases that fail to state a claim or that are "deemed frivolous or malicious."

Among other things, in his latest lawsuit, Riches claims that the Guinness Book has "no right to publish my work, my legal masterpieces." Riches prior lawsuit targets include among others Somali pirates, Plato, Nostradamus, George Bush and New England Patriots Coach Bill Belichick. (Riches undoubtedly filed the Belichick lawsuit to prove that not all of his lawsuits are frivolous.) In his latest complaint, Riches says he has also sued Black History Month, the president of Iran and butter substitute "I Can’t Believe It’s Not Butter!"

Riches also asserts that "when I get out of prison, I’m going to start a Lawsuit 101 shop and teach Americans how to file pro se lawsuits." He also said "I will sell Jonathan Lee Riches T-shirts" saying "Watch out what you do, or I’ll sue you."

Hat tip to the Overlawyered blog (here) for the link to the Spokane Spokesman-Record article.

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One of the received truths from the era of corporate scandals earlier this decade is that corporate governance matters. As a result, a high-profile part of the current assessment of any company is whether or not the company practices “good” governance. Even though the evaluation of any particular company’s governance has an eye-of-the-beholder aspect, several different commercial enterprises have emerged in recent years, each offering to provide their subscribers with objective governance ratings.

In the space of just a few short years, these governance ratings have become ubiquitous. They are now a critical part of company evaluations for investors, regulators, the financial press, and even D&O insurance underwriters. The quick acceptance of these ratings suggests that they meet a widely perceived need. However, their wide acceptance notwithstanding, it is still worth asking what exactly these ratings actually tell us about the companies and future company performance.

In a June 26, 2008 paper entitled “Rating the Ratings: How Good Are Commercial Governance Ratings?” (here), Stanford Law Professors Robert Daines and Ian Gow, and Stanford Business School Professor David Larcher examine four leading ratings firms’ ratings and analyze “the association between these ratings and future firm performance and undesirable outcomes such as accounting restatements and shareholder litigation.”

The authors reach a number of provocative conclusions, including in particular their finding that “the level of predictive validity for these ratings is well below the threshold necessary to support the bold claims made for them” by the commercial ratings firms.

The authors examined the corporate governance ratings produced by Audit Integrity, RiskMetrics (previously Institutional Shareholder Services), Governance Metrics International, and The Corporate Library. The authors compiled ratings for U.S. firms for each of the four ratings services, cover the period from late 2005 to early 2007. The analysis was primarily focused on ratings available as of December 31, 2005, as that was the earliest date at which the authors established “a sizeable cross-section of ratings across the four ratings firms.”

The authors first looked at whether the various ratings were at least consistent with each other. The authors noted that “if, as seems to be often posited, there is an agreed upon definition of ‘good governance’ and each of these commercial measures seeks to measure it, then we would expect these measure to be highly correlated.”

However, the authors found that there is “surprisingly little cross-sectional correlation among the ratings.” Indeed, the ratings are “close to being uncorrelated.”

In particular, the authors found that in certain instances, the various ratings rated specific companies dramatically differently. The authors concluded that “either the ratings are measuring very different corporate governance constructs and/or there is a high degree of measurement error (i.e., scores that are not reliable) in the rating process across the firms.”

With respect to future outcomes, the authors found that three of the ratings have “a very modest ability to predict accounting restatements” and two of the ratings have “a very modest ability to predict class action lawsuits.” The authors further concluded that at least one rating firm’s ratings exhibited “virtually no predictive validity.” Overall, the authors concluded that “the level of predictive validity even for the best ratings is well below the threshold necessary to support the bold claims by the corporate rating firms.”

The authors’ observation about the lack of agreement between the four ratings is, to me at least, unsurprising, as they various ratings clearly aim to measure different things, based on different visions of “good governance.” Even though “good governance” is a widely used term, there is no consensus definition. As the authors themselves note, “defining good governance and distinguishing good governance from bad governance has proved…elusive.”

The authors’ conclusions about the ratings’ relative lack of predictive power undoubtedly will be disputed by the ratings firms themselves. From my perspective, the authors’ overall conclusion about the ratings’ overall lack of strong predictive power is unsurprising, particularly as it relates to predicting securities class action litigation.

In my prior life running a D&O underwriting facility, my colleagues and I spent a great deal of time and effort attempting to determine what factors might predict securities litigation. We had conjectured early on that corporate governance might afford a useful tool in segmenting litigation risk. Over many years’ time,  we concluded that corporate governance alone was not sufficiently predictive of securities litigation risk, and that certain other criteria (including company size, industry, and age) were much more highly correlated with securities litigation risk.

Because of this experience, my colleagues and I were always somewhat skeptical of commercial governance-based securities litigation prediction tools. In my own experience, these tools are at their best when used negatively, that is, when identifying companies to avoid, but they were less helpful when used to determine which risks to accept, which is of course how D&O underwriters earn their keep.

The authors’ conclusions are more or less consistent with my own experience on these points. However, the real value of the authors’ thorough examination of these issues is that it will likely start a dialogue on these issues. It may well be that a different analysis or a different approach might support a different conclusion about the predictive power of the ratings.

Indeed, the authors themselves expressly acknowledge that they might not have used the “right model” to measure the ratings, and that “given the right model specification,” the ratings “might well prove to be significant and informative.” The authors state that, to the degree this is true, then the ratings firms should “disclose the ‘right’ model” and disclose “how well their ratings predict future performance using the ‘right’ model.” This disclosure “would enable investors to evaluate the net benefits produced by their purchase of the ratings.”

The authors’ interesting analysis and discussion undoubtedly will provoke debate, particularly in the corporate governance community itself. I would welcome responsible comments from the representatives of the ratings firms who might wish to respond on this blog to the authors’ conclusions about the ratings’ predictive power. (PLEASE see below for responses.)

 A June 30, 2008 Stanford Law School press release describing the article can be found here. A June 26, 2008 Fortune report discussing the article can be found here.

Very special thank to the authors for their permission to quote their article on this blog.

UPDATE: In response to my invitation to the governance rating firms to respond to the authors's study, Ric Marshall, the Chief Analyst at The Corporate Library, and Kimberly Gladman, the Director of Research and Ratings at The Corporate Library, submitted this repsonse:

Thank you for your invitation to respond to the recent Stanford study regarding the predictive value of governance ratings, including those of The Corporate Library (TCL).
 
The study found that TCL’s ratings have a statistically significant ability to predict accounting restatements and future operating performance. In addition, at the extremes (very poor or very good ratings), the study found that our ratings correlated with future alpha.  The authors state that these relationships are modest, and suggest that they may be inadequate to make our ratings useful. Our clients, however, who come from a wide range of industries, do find value in our ratings. For example, a portfolio manager who has used our ratings over the past four years in stock selection has told us that doing so has contributed substantially to his returns; our insurance clients regularly and successfully employ our ratings to identify companies that warrant greater due diligence and may present higher risk.
 
We understand that, as you point out in your recent posting about the study, it is not always effective to use governance indicators alone as a guide to financial or litigation risk.  Indeed, most of our clients combine our ratings with a number of other tools, and our own Securities Litigation Risk Analyst Ratings (which were not examined in the Stanford study) combine governance data with a number of financial and industry-related variables. We also agree with your assessment that governance indicators are often most useful in identifying areas of concern, rather than strengths; this is the essence of our approach. Client feedback has shown that taking governance ratings into account, especially in cases where doing so helps chiefly to avoid problems, brings substantial benefits to their businesses.  The Stanford study suggests that corporations themselves tend to agree: according to interviews the authors conducted with boards of directors, they often use low governance ratings as a red flag indicating that they should step up monitoring.
 
The authors’ surprise at how “little cross-sectional correlation” they found among these ratings reveals the study’s chief flaw, which is the assumption that, “there is an agreed upon definition of ‘good governance’ and each of these commercial measures seeks to measure it.” This is not the case at all, as each of the four rating services reviewed have a different focus, and are employed in different ways by a wide range of commercial clients. While Riskmetrics and GMI do both measure ‘good governance’ against specific standards, our own focus is on identifying governance weaknesses and thereby companies for clients to avoid. We have always taken issue with the notion that any one governance model can be the most effective for every company.

Special thanks to Ric and Beverly for taking the time to provide a detailed written response.

FURTHER UPDATE: Jack Zwingli, the CEO of Audit Integrity, has also provided a detailed response to the academic study. Jack's response can be found here.
 

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