Beware the corporate raters

Board oversight is a good thing, but the procedures of the new governance firms leave a lot to be desired.

By Jeffrey Pfeffer, Business 2.0 Magazine columnist

(Business 2.0 Magazine) -- About 20 years ago, a Stanford business school colleague and I launched an executive education program for board directors - one of the first in the United States to offer training in board management, executive compensation and the board's role in setting strategy. Yet after just five years, we canceled the program due to lack of interest.

That's no longer an issue in the post-Enron era, of course: Corporate governance has become a thriving business, with the education of directors a major piece of the market. According to Institutional Shareholder Services, a firm that rates companies' board performance and recommends how shareholders should vote their proxies, there are now 66 "accredited" director-education programs across the country.

One study found that practices for which firms are downgraded are actually associated with better performance.

ISS itself is a good indicator of how hot the market has gotten in recent years. Based in Rockville, Maryland, the company has 601 employees and offices in nine countries. It sells services that help companies improve their governance ratings. Last year ISS was acquired by RiskMetrics for about $550 million. And RiskMetrics, largely owned by private equity and venture capital firms, is contemplating an IPO.

Two things bother me about this booming but nascent business. The first is a kind of "check the box" mentality that has arisen from the process of evaluating boards. ISS has some 65 rules and guidelines - that the board chair and the CEO be different people, for example - and companies that enlist ISS's services are often tempted to simply conform to these guidelines to raise their scores.

Yet there is almost no evidence that ISS's prescribed practices are actually related to outcomes, such as higher rates of return for shareholders or improved company performance. Do firms with directors who have attended an accredited program actually benefit?

One study I found - on the ISS Web site, no less - reported that some practices for which ISS downgrades companies, such as giving directors multiyear terms or implementing "poison pill" provisions to prevent takeovers, either have no effect on performance or are actually associated with better performance. And such studies seldom attempt to control for alternative explanations for the results, meaning that the correlations can be spurious. The rating of board management practices should be based on empirical evidence, not on guidelines seemingly plucked from thin air.

I am even more concerned about potential conflicts of interest. ISS requires the companies it rates to report how much "nonaudit" work their auditors do; it wants supporting data, not just assurances, that there are no conflicts of interest. But ISS doesn't reveal who it consults for, or the fees it receives, so there's no way to know whether its ratings are affected by its own self-interest.

The general counsel at one Nasdaq-listed firm told me his company paid ISS more than $20,000 for help in constructing a stock options plan that would bring it a positive ISS rating. Although ISS openly publishes its criteria for evaluating options plans, the general counsel himself couldn't figure out how to use the criteria to design a real plan. In came the ISS consultants, pushing advice that was designed to meet ISS rating criteria. Soon there was not only a positive recommendation for the plan but a small uptick in the firm's governance score.

Companies are rightfully concerned about governance scores because they affect how institutional shareholders vote their shares. But whether the ratings are reliable and valid and whether the governance business itself is going to face its own "governance" issues remain open questions.

Business 2.0 columnist Jeffrey Pfeffer is the Thomas D. Dee II Professor of Organizational Behavior at Stanford University's Graduate School of Business. Top of page

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