Corporate Governance Ratings: Caveat Emptor

Looking in the rear view mirror reveals many examples over the past decade of massive corporate failures from essentially every sector of our economy, including Enron, WorldCom, Tyco, Global Crossing, and Bear Sterns, just to name a few. Unfortunately, the natural reaction to these types of events is to develop one-size-fits-all solutions. And these one-size-fits-all solutions turn out to be either burdensome and costly, or overly simplified and misleading.

In the case of the problems of the past decade, we've seen both types of solutions. Much attention has been given to the burdens imposed by Sarbanes-Oxley â€" attention that has led to reforms designed to correct its problems. Corporate governance ratings, on the other hand, have been given scant attention and remain a real risk to investors.

Indeed, increasingly the business community and investors alike are looking to corporate governance ratings as a first line of defense in their efforts to head off the next major meltdown. Yet, the evidence suggests that most corporate governance ratings are, at best, a meaningless waste of money but, more troubling, create moral hazards for investors.

Check the Box How do corporate governance ratings work? Simply put, self-appointed corporate governance "experts" develop checklists of so-called "good corporate governance" practices. These practices set forth their view of desirable corporate and board structures, policies, and procedures against which they compare and rate every company. Companies that conform to these "best" practices are deemed to have "good" corporate governance and those that do not are given bad ratings.

Simple enough, but the end results don't measure up. A recent draft study by Stanford University looked at the ratings of four major corporate governance rating agencies. The results:

• There is little or no correlation between ratings and the real-world likelihood of a corporate governance problem at a rated company.
• There is little consistency between the ratings. For instance, a company that has a good corporate rating with one provider may have a poor rating with another provider.
• In the case of ratings provided by RiskMetrics/ISS (formerly Institutional Shareholder Services), there is no correlation between the ratings it issues and its voting recommendations.

Been There, Done That None of this should come as a surprise. In early 2003, Fannie Mae became the first company to release its corporate governance score (a 9 out of 10) from Standard & Poor's Governance Services. The results were widely reported in the press, which noted that the score reflected "strong or very strong" corporate governance practices in all four areas analyzed.

The good news didn't last long. Just two years later, Standard & Poor's withdrew its evaluation of Fannie Mae and left the business in the U.S. of issuing corporate governance scores amid signs of serious trouble at the mortgage giant. By December 2006, Fannie Mae's top two executives had been forced from office and it had restated $6.3 billion in earnings amid accusations that earnings had been manipulated to hide massive losses during 2002 and 2003 -- a period of time covered by the corporate governance score.

Yet, despite this debacle, business and the investment community continue to rely on the illusory protection afforded by one-size-fits-all corporate governance ratings.

Something Smells Equally troubling are the conflicts of interest connected with corporate governance rating services.

This issue arises when corporate governance ratings agencies, most notably RiskMetrics/ISS, sell to investors corporate governance ratings on companies while at the same time selling consulting services to those very same companies on how to improve their corporate governance rating. The ethical conflict is obvious. This is like having the same person serve as both umpire and coach in the same baseball game. One way or another, every business must deal with conflicts of interest, but this is way over the top â€" and investors are paying for it, one way or another.

Monopoly--It's Not a Game when Real Investors' Savings Are at Stake To make matters worse, one corporate governance rating agency, RiskMetrics/ISS, controls an overwhelmingly large portion of the ratings business. Sporting a market cap of $1.5 billion, more than $119 million in revenue from its corporate governance services, and continuing double-digit growth, gives RiskMetrics/ISS inordinate market power. This market power places RiskMetrics/ISS in much the same position as the old, pre-divestiture AT&T, which had little incentive to innovate or improve its customer service. In this case, a lack of meaningful competition or oversight by regulators has allowed RiskMetrics/ISS to become a de facto standard setter for corporate governance. Given the serious shortcomings of the "one-size-fits-all" approach, investors are being misled and misadvised about the inherent risks they face.

The Solution Finding a solution starts with the simple recognition that one-size-fits-all approaches to corporate governance rarely fit anyone.

If you are a corporate officer or board members seeking to improve your company's corporate governance, recognize that every business faces unique challenges. Consult a corporate governance expert who takes that perspective and will provide you with meaningful advice relevant to your company's situation. Additionally, keep in mind that regulatory officials increasingly seek to hold corporate officials personally accountable for business decisions, so it may be worth getting more than one perspective in situations involving difficult issues.

Similarly, if you work for a mutual fund, hedge fund, pension fund or other institutional investor, use a proxy advisory and voting service that does not bring with it the ethical issues that come from offering corporate governance ratings. Such ethical issues have no upside, but bring plenty of downside risk.

And, no matter where you sit, recognize that there is much that remains to be done. While there's no "magic bullet" to solve all corporate governance issues, understanding the issues confronting the corporate governance industry and insisting that the industry adhere to the highest levels of ethical behavior is a good and important first step.

Mike Ryan is president and COO of PROXY Governance, Inc., an independent and conflict-free proxy advisory service that competes with a number of products and services offered by RiskMetrics/ISS, but does not offer corporate governance ratings. His opinions do not necessarily reflect those of CBS Interactive or its employees or partners.