Who's watching the watchdogs?

A new study from Stanford University questions the reliability of corporate-governance ratings.

By James Bandler and Doris Burke

June 26, 2008: 11:50 AM EDT

(Fortune Magazine) -- Since the Enron scandal, a coterie of corporate-governance firms has emerged as standard-bearers for shareholder rights. In addition to acting as quote machines, the firms - which include the Corporate Library and RiskMetrics Group's ISS Governance Services - are also big businesses that sell, among other things, ratings that say whether a company is well governed or not.

But a new study from Stanford University's law and business schools gives mostly dismal grades to four of the biggest rating services: ISS, the Corporate Library, GovernanceMetrics International (GMI), and Audit Integrity.

Statistical tests run by the Stanford academics found little or no correlation between the different services' ratings. Pfizer (PFE, Fortune 500), for instance, earned a perfect "100" from ISS in 2005, but a "D" from the Corporate Library. Lockheed Martin (LMT, Fortune 500) scored a 9.5 out of ten from GMI, but Corporate Library gave it its worst possible grade, an "F."

ISS has a separate and powerful proxy advisory service. Its ratings are posted publicly on Yahoo Finance; companies, fearing the scrutiny of shareholder activists or the wrath of the raters, sometimes do pirouettes to improve scores.

No sophisticated investment manager relies on ratings alone. But the Stanford team found very little or no statistical evidence of links between the ratings and company performance, undermining the firms' very raison d'être. Some did better than others: GMI predicted companies' restatements better than its peers. But ISS's main rankings, the study found, predicted nothing but future lawsuits. On average, its top-ranked companies were more likely to have class-action lawsuits than its lowest-rated companies.

A tool, not a talisman

The firms say other studies show their ratings can identify investment opportunities and risks. "The fact that our primary customers are investment managers suggests they are finding value in what we deliver," said Howard Sherman, CEO of GMI. Patrick McGurn, special counsel at ISS, said the study used the wrong kinds of metrics and should have looked at more than one year of ratings data - and points out that the ratings are "a tool, not a talisman," and not meant to act as a predictor of performance. The Corporate Library declined to comment; the CEO of Audit Integrity praised the study.

But the Stanford findings reinforce a growing sentiment that governance ratings are an art, not a science. "It points out that there's no grand unified theory of corporate governance," says Cary Klafter, vice president of legal and corporate affairs at Intel.

A few years ago, ISS docked Intel's score because the law firm where a member of the Intel board's nominating committee worked had done legal work for Intel (INTC, Fortune 500). Klafter called the ratings adjustment - Intel's score fell by multiples of ten, then shot back up after the director switched to a different committee - "amazingly overblown" and said it suggested the irrelevance of the number.

All this is not to say that governance doesn't matter; it may just not be easily quantifiable. "[Good] governance is a little bit like porn," says Robert Daines, one of the authors of the study and co-director of Stanford's Rock Center for Corporate Governance, referring to Supreme Court Justice Potter Stewart's famous comment about recognizing obscenity. "I can spot it when I see it, but it is hard to say what it is." Even ISS's McGurn says he hopes research like the Stanford study will lead to more attention to governance.

That is happening: Researchers at the Rock Center are trying to find a way to make hard-to-collect governance data available for free. Let a thousand ratings services bloom. 

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