October 25, 2002
Corporate Governance Now Rated by Mainstream Investment Research Firms
by William Baue
Mainstream investment research firms are now evaluating corporate governance as a potential
indicator of stock valuation.
Besides eliciting abundant media coverage, the corporate governance scandals at Enron, WorldCom,
and elsewhere have spurred mainstream investors to evaluate the corporate governance performance of
their current and prospective investments. Mainstream investors are joining with socially
responsible investors in the understanding that corporate governance is a potential correlate of
stock valuation. In response to the increase in demand for corporate governance evaluations, some
mainstream investment research firms are now developing corporate governance rating services.
Mainstream firms are also incorporating corporate governance into their existing rating systems.
Last week, the New York-based investment research firm Standard and Poors (S&P) announced their new
multi-faceted approach to assessing corporate governance performance. S&P launched a U.S.
Governance Services Unit, with a staff of about 15 people, that offers three services. The
Corporate Governance Score, as the name implies, assesses companies' corporate governance
performance for investors. The Corporate Governance Evaluation Service confidentially diagnoses
corporate governance for companies. The Corporate Governance Customized Research tailors research
for investors, companies, regulators, or other organizations.
"To underscore our
commitment to corporate governance, starting this year, Standard and Poor's will produce an annual
assessment--a report card--that examines how well U.S. and other companies perform the very basic
task of disclosing a wide range of information that is required reading for serious investors,"
said S&P President Leo C. O'Neill. "This will complement our more in-depth interactive corporate
governance scoring service."
In conjunction with the launch of the new service, S&P
released a white paper entitled Global Transparency and Disclosure: Overview of Methodology and
Study Results' United States. The study, which focused on S&P 500 companies, evaluated 98
transparency and disclosure (T&D) items in three categories: ownership structure and investor
rights, financial transparency and information disclosure, and board and management structure and
process. This assessment resulted in companies receiving a rating of between 1 and 10, with 10
representing the greatest transparency and disclosure.
The study found a wide
discrepancy between the T&D on annual reports and the composite T&D found in all publicly available
filings. In addition to annual reports, evaluations in the composite category include information
from proxy statements and 10-K forms. The 10-K form is the U.S. Securities and Exchange Commission
(SEC) required filing for comprehensive disclosure of corporate financial and nonfinancial
Of importance to investors, the study correlates greater T&D, both in
annual reports and in composite disclosures, with lower market risk and higher stock valuations.
"In addition, companies with higher T&D
rankings based on annual reports alone tend to have higher price-to-book ratios," the study states.
"These correlations are significant because they suggest that the market pays a premium for
companies that provide more information in their annual reports than is required by regulation,"
the study later concludes.
The New York-based credit rating agency Moody's Investors Service is approaching the issue in way that is
slightly different from S&P's approach. Moody's is overhauling the corporate governance assessment
in its existing ratings. Earlier this month, the firm hired Kenneth Bertsch to serve as director
of corporate governance, a position he held at TIAA-CREF.
"[Moody's has] no current
plans to introduce a corporate governance rating tool as such," Mr. Bertsch told SocialFunds.com.
"Our immediate goal, and the purpose for which I was hired, is to improve systematic consideration
of corporate governance in core credit ratings and to do research on red flags for potential
Chicago-based Morningstar, a global investment research firm, has yet to
jump on the corporate governance rating bandwagon.
"We analyze socially responsible
funds, but we don't have any [corporate governance] rating tools in place for individual
companies," said Kathy Habiger of Morningstar Corporate Communications.
month, the Investor Responsibility Research
Center (IRRC), an investment research firm geared toward corporate governance issues, announced
its plans to launch an objective corporate governance rating tool.
investment (SRI) firms have long assessed corporate governance in their purchasing decisions.
However, even the SRI community is reconsidering the way it assesses corporate governance, with
some firms, such as the Calvert Group,
choosing to establish a separate screen for corporate governance.
As more investors
evaluate corporate governance when purchasing stocks and mutual funds, companies may feel the
pressure to pay closer attention to their policies and practices. It remains to be seen whether
placing corporate governance under the microscope will actually improve the way companies operate.