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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 information.

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.

Corporate Governance and Public Policy Articles "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 problems."

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.

Earlier this 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.

Socially responsible 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.

 

 
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