Ratings game comes of age

London, 11 July 2003

The examination season has just finished in the Northern hemisphere, and hundreds of thousands of teenagers are awaiting results that will determine their future.

But this year there is nail-biting in boardrooms too as the corporate governance ratings invigilators prepare reports that will signify whether or not companies get a pass, distinction or fail.

Rating corporate governance is a relatively new phenomenon, but it has already come of age, says Mark Anson, chief investment officer of CalPERS, the state pension fund of California. It has also spread widely beyond United States to cover listed companies from most of the primary markets of the world in Asia and Europe.

“This is no longer a niche industry", says Mr Anson. “It is fully developed, complete with competing and complementary products".

What this means is that every major corporation can now expect its policies to be thoroughly checked and tested to see if they are effective. The theory is that investors will warm to those companies that get it right, but recoil from those who are named and shamed, and at the foot of the league tables.

It remains to be seen if this works in practice. Other non-financial ratings, such as those covering the environment, have not dissuaded institutions or individuals from supporting companies that flunk the test.

Another factor is the widespread difference in the approach of the various ratings agencies. For a start, they adopt different criteria, and give different weightings to these. Many agencies derive income from institutions that see their work as a valuable service, but a few charge the companies being rated, and only publish if the company concerned concurs.

Delegates at the International Corporate Governance Network conference in Amsterdam, the US giant Standard & Poor's, attacked one of these for having a conflict of interest. “No one can serve two masters", said Pierre-Henri Leroy, the principal of Paris-based Proxinvest. But S&P defends its policy by stating its aim as getting companies to improve their corporate governance.

The main agencies, which publish their findings no matter what, are: The Corporate Library, ISS Corporate Governance Quotient, Governance Metrics International, TRUE Course-Shark Repellent, and the Centre for Financial Research Analysis. The last named does not provide a rating but instead publishes a quality of earnings analysis.

“Their goal is to warn investors and creditors about companies that employ unusual or aggressive accounting practices that camouflage operations", says Mr Anson.

TRUE Course-Shark Repellent is also a niche operator, using 13 bullet points to assess the takeover defences of a company. These include, for instance, whether there is a locked-in charter or bylaws that might inhibit bidders. “It's really a measure of the entrenchment of management", Mr Anson points out.

Of the others, GMI is the newest kid off the block, and expanding fast, with ratings of top European companies due to be published shortly. It has a highly systemised checklist which covers a number of categories, including board accountability, financial disclosure and internet controls, shareholder rights, executive compensation, and the ownership base. It produces seven category ratings and one overall number.

ISS Corporate Governance Quotient looks at 49 factors in eight core categories. These include the board structure and composition; audit issues; charter and bylaw provisions; laws of the legislature under which a company is incorporated; executive compensation, CEO accession plans; executive stock ownership; and director education.

Finally, The Corporate Library, which takes the chief executive's pay and board composition as by far the most significant factors accounting for 40% each of the marks. The remaining 20% is accounted for by the company's ownership profile and outside director shareholdings.

While these disparities provide a pockmarked view of a company's corporate governance, investors believe the ratings business will evolve rapidly and become extremely important to them. “Investors need something that can be measured", says Jan van der Poel, director of Governance Metrics in Amsterdam. “We are not measuring laws. We are measuring what we see."

It is also clear that corporate policies on boardroom pay packages is attracting as much interest amongst institutions as the tabloid press. However, Mr van der Poel points out that corporate governance will only be taken seriously if “investors use the services that ratings agencies provide". His point is a good one. If institutions ignore the ratings, then measures to improve governance may be seen as a waste of time. But if begin to have the same impact as financial ratings, their power will be great indeed.