Is Rating Firms While Selling Them Consulting a Conflict?

responsibility.JPG(Editor's Note: The is the second in a four part series. Read the first part here.)

A few years ago, James P. Melican was helping prepare International Paper Co. for an upcoming annual meeting. Then the paper giant's executive vice president, Melican worked with other top officials and directors as they pored over ratings of the firm prepared by proxy service firm, Institutional Shareholder Services, itemizing the company's strengths and weaknesses.

"Just as we were doing this, the doorbell rang and it was an ISS salesman. He was trying to sell us consulting services," Melican told me. He is now chairman of ProxyGovernance, a proxy service firm that offers recommendations about firms to institutional investors but pointedly does not provide ratings or consulting to the firms its studies.

Therein lies an essential contradiction, if not out-right conflict of interest, with some proxy service firms. If companies such as ISS, now owned by RiskMetrics, rate companies, should they be simultaneously trying to peddle consulting services? Accounting firms got caught in the same game nearly a decade ago and were forced to spin off their consulting arms.

"They seem to be saying, 'I'll give you bad grade but if you pay me, I'll tell you how to get a good grade,'" says Robert Daines, a Stanford law professor who co-authored a recent and scathing report on ratings offered by proxy service firms. His report surveyed some 15,000 ratings of 6,827 companies from 2005 to 2007.

Besides ISS, the Stanford study reviewed corporate governance ratings by Audit Integrity, Governance Metrics International, and The Corporate Library. Its conclusions questioned the relevance and reliability of all of the firms' ratings which factor in such things as the number of shareholders' lawsuits, the firm's "Q" ratings or market value to book value, executive compensation, and anti-takeover provisions, among others.

While some raters tried to stick with quantitative measures, The Corporate Library used ratings which reflected "subjective judgment and expertise," the report says. By contrast, Audit Integrity uses 200 accounting and governance metrics along with 3,500 other variables to identify "fraudulent patterns" of behavior, the report says.

On some occasions, the Stanford researchers found that the numbers used by the raters were basically random ones and did little to predict any outcomes such as whether the firm would be profitable or whether it was progressing towards good governance practices. "If this were the drug industry, the FDA wouldn't let them sell over the counter using these numbers," Daines says.

Some proxy service firms shy away from ratings. Glass Lewis, based in San Francisco, for instance, doesn't offer them. "We see our service as offering opinions," says Robert McCormick, the firm's chief policy officer. Nor does the firm do any consulting. "We don't do any work for issuers," says McCormick, whose firm is now owned by the Ontario Teachers Pension Plan which has been active in pushing strong governance practices in the firms in which it invests.

Next: How RiskMetrics justifies its ratings and consulting.

(Image by mamamusings via Flickr, CC 2.0)