Institutional Shareholder Services Research Articles

Is Corporate Governance Relevant for Euro-Credit Spreads? Evidence from the CDS Market

In this paper, we examine the connection between the corporate governance of predominantly European companies and the evaluation of credit instruments. Since governance generally has a favourable effect on the limitation of potential agency conflicts, this influence should result in lower risk premiums. The relatively new Corporate Governance Quotient (CGQ) of Institutional Shareholder Services is used as an evaluation indicator for the quality of the firm constitution, which signals one for high numeric values relatively good governance quality. Using linear regression analysis, it will be empirically demonstrated that a negative correlation between corporate governance and credit spreads exists, which is, however, not statistically significant. In contrast, alternative non-parametric procedures revealed complex evaluation relationships, which highlight both negative and positive correlations.

Board of directors' governance challenges and earnings management

PurposeThe purpose of this paper is to examine the relationship between corporate governance and earnings management in US context and provide further insights on the effects of board of directors' characteristics on earnings management.Design/methodology/approachThe paper uses a sample of three groups of US firms; where firms with relatively high negative, firms with relatively high positive, and those with low levels of discretionary accruals in the year 2004 are examined. Descriptive statistics, univariate analysis, multivariate analysis, board of directors' characteristics, and possible relationships between corporate governance variables and earnings management proxy provide the basis for discussion.FindingsFirms with annually elected boards, small size boards, 100 percent independent nominating committees, and 100 percent independent compensation committees have more negative discretionary accruals. However, firms with 75‐90 percent independent board or firms with a board size of between nine and 12 have higher positive discretionary accruals.Research limitations/implicationsCertain board characteristics may be the important factors associated with constraining the propensity of managers to engage in earnings management.Practical implicationsResults are limited by the accuracy of the models applied to isolate discretionary accruals. Additionally, the direction diverse of discretionary accruals may differ with selecting a time series of three or more years as a base for the analysis.Originality/valueIn contrast to prior literature, where board composition is defined as an insiders‐ or outsiders‐controlled board, this paper classifies board composition into seven discrete categories, using the same seven categories employed by Institutional Shareholder Services in evaluating and assigning corporate governance quotient scores to firms. The paper's major contributions to the existing literature are its findings that income‐increasing and income‐decreasing discretionary accruals have a different relationship with corporate governance practices and its expansion of the scope of corporate governance from board independence and audit committee independence to other corporate governance characteristics. This paper provides evidence that supports US regulators' initiatives that stronger corporate governance mechanisms provide greater monitoring of the financial accounting process and may be the important factors in improving the integrity of financial reporting.

Rating the Ratings: How Good are Commercial Governance Ratings?

Proxy advisory and corporate governance rating firms play an increasingly important role in U.S. public markets. Proxy advisory firms provide voting recommendations to shareholders on proxy proposals and sometimes take an active role persuading management to change governance arrangements. Corporate governance rating firms provide indices to evaluate the effectiveness of a firm's governance and claim to be able to predict future performance, risk, and undesirable outcomes such as accounting restatements and shareholder litigation. We examine these claims for the commercial corporate governance ratings produced for 2005 by Audit Integrity, RiskMetrics (previously Institutional Shareholder Services), GovernanceMetrics International, and The Corporate Library. Our results indicate that the level of predictive validity for these ratings are well below the threshold necessary to support the bold claims made for them by these commercial firms. Moreover, we find no relation between the governance ratings provided by RiskMetrics with either their voting recommendations or the actual votes by shareholders on proxy proposals.

Director Elections and the Influence of Proxy Advisors

Using a dataset of proxy recommendations and voting results for uncontested director elections from 2005 and 2006 at S&P 1500 companies, we examine how advisors make their recommendations and how these recommendations and other factors affect the shareholder vote. Of the four firms we study, Institutional Shareholder Services (ISS), Proxy Governance, Glass Lewis, and Egan Jones, ISS is widely regarded as the most influential and its recommendation is claimed to sway 20-30% of the vote. We find that the four proxy advisory firms differ systematically from each other both in their willingness to issue a withhold recommendation and in the factors that affect their recommendation. We further find that all the proxy advisors, but particularly ISS, base their recommendations largely on factors that shareholders take into account (independent of the recommendation) in casting their vote. Once these factors are controlled for, overall voting outcomes are substantially similar whether or not a proxy advisor has issued a recommendation. Our analysis demonstrates that the reported influence of ISS is substantially overstated. Our evidence is consistent with the view that proxy advisors act primarily as agents or intermediaries which aggregate information that investors find important in determining how to vote in director elections rather than as independent power centers.

Corporate governance and firm operating performance

Using a unique dataset provided by Institutional Shareholder Services (ISS), we relate 51 governance provisions to firm operating performance as proxied by return on assets and return on equity. We identify six corporate governance provisions that are significantly and positively linked to return on assets, return on equity or both using at least two of our six regressions. We examine nine governance provisions that have been recently mandated by the three major U.S. stock exchanges, and we find none of them to be significantly and positively related to firm operating performance. Our results reveal that the governance provisions recently mandated by the U.S. stock exchanges are less closely linked to firm operating performance than are those not so mandated.

Do institutional shareholder services (ISS) corporate governance ratings reflect a company's operating performance?

Little is known about the relation between the actual governance rating received by a firm and the firm's performance. In this study, we examine the relation between the actual corporate governance rating received by a firm and the firm's performance during the years 2002–2004. We use the institutional shareholder services (ISS) corporate governance quotient (CGQ) rating of a firm's corporate governance structure and analyze this rating in relation to the firm's operating performance. We compare the institutional shareholder services’ CGQ rating to two measures of the firm's operating performance, return on assets (ROA) and return on equity (ROE). Based upon our results, we do not find statistical evidence suggesting that the firms’ operating performance is related to the firms’ ISS corporate governance rating.

An Exploration of the Role of Proxy Advisors in Proxy Voting

Proxy advisors advise institutional investors on how to vote as shareholder in the companies of which shares are held in their investment portfolio. Proxy advisors have a great deal of influence. Their voting recommendations have an impact on the decisions of companies. This paper focuses on the phenomenon of proxy advisors in more detail, and on Institutional Shareholder Services (ISS) in particular. The paper looks at their influence, various aspects of their working methods and their transparency, as well as discusses questions about the conflicts of interest that present themselves in this connection. Furthermore it discusses the applicable legislation and regulations as well as the question whether the level playing field of proxy advisors and their influence are a desirable situation. Questions that need to be addressed are not only about the concentration of 'voting power' and conflicts of interest. They also concern the desirability of the shift of the influence of institutional investors to proxy advisors as a kind of 'external agencies' which are distanced from both their clients and the companies they advise on, and the way in which they arrive at their advice.

Do Governance Mechanisms Matter for Mutual Funds?

The paper finds evidence that corporate governance mechanisms matter for mutual funds, especially funds with better governance standards. Using new and unexplored mutual fund governance data, we show that corporate governance mechanisms play a role in both the investment decisions and the monitoring efforts of mutual funds. Mutual funds, in general, tend to tilt their portfolios toward firms with strong corporate governance, and this is more evident in funds with good governance practices. We further find that corporate governance also affects fund proxy voting decisions. Such voting decisions are indicative of the funds' efforts aimed at monitoring corporate activities supporting mutual fund activism. Funds with better governance tend to vote against management's, but consistent with Institutional Shareholder Services' negative recommendations on management-sponsored proposals relating to antitakeover, board quality, and director election. Overall, our evidence suggests that well-governed, while not poorly-governed, mutual funds do perform their fiduciary duties and act in the interests of their shareholders.

Recent Technical Papers on Corporate Governance

During 2004, the Social Science Research Network (SSRN) posted nearly 200 draft and pre-published articles examining aspects of corporate governance on its website. This cluster of new work exceeded by scale that on the telecom collapse, the stock bubble, the overvalued dollar, and the Irish economic renaissance. The question is whether it is evidence that social science research follows what gets media attention, or whether it forms an organic whole attempting to advance towards a solution to the governance crisis. We develop an overview of that part of year 2004’s corporate governance research that answers partially that question. Articles were evaluated on six factors: intent, hypothesis, sources, methodology, relevance and importance, on a score between zero and one for each factor, providing for a score between zero and six for each article. The articles were then clustered into four categories: 1) the role of the board in explaining the corporate governance crisis 2) the relationship of executive and director compensation and corporate governance 3) the effect of governance indices on firm performance 4) the market for corporate control. In order to test for the “organic whole” of this stream of literature we evaluated each cluster using the factors as common metrics. In our judgment, a small number of articles (30% of those with scores of six) made contributions to understanding and thus improving governance in 2004. In the first set of articles Uzun et al. found less fraud if boards are smaller and have a lower percentage of non-independent inside directors; public firms having independent directors on nominating and audit committees experience lower levels of fraud (those in the sample tested [1978-2001 period] were not subject to the current requirements of the Sarbanes-Oxley Act of 2002 [SOX] of an independent director to chair the audit committee; thus the results are somewhat dated). Agrawal and Chadha found that boards having independent directors with financial expertise (on the board or audit committee) were less likely to experience a “shock” (defined by the authors as a significant accounting restatement). Brown and Caylor found that seven of the metrics utilized by Institutional Shareholder Services (ISS), principally those related to director performance and senior management stock options, had an effect on firm performance. On the second set, Shi found that CEO compensation structure was related to the type of risk (general, industry, and firm specific) that management can be held accountable for. Kadan and Yang found a relationship between executive stock options and earnings management. Datta et al. argue that there is a relationship between managerial stock ownership and corporate debt maturity (shorter debt maturity subjects the firm to greater monitoring by the debt capital markets). Cohen et al. found that subsequent to the passage of the Sarbanes-Oxley Act of 2002 (SOX), firms increased the fixed portion of executive compensation packages to compensate CEOs for the additional liability imposed on them by SOX. Moreover, CEO’s in the post-SOX environment were less likely to invest in RD well governed firms recognize write-offs earlier. On the fourth cluster of articles, Qiu found that when public pension ownership in a firm is high, corporate (post merger) performance in stronger. Wang found that block and higher institutional stock ownership (a governance mechanism) reduces corporate fraud and increases fraud detection. Bebchuk et al. find that the entrenchment index (developed from six ISS corporate governance variables) improves firm performance. Bebchuk et al. argue that internal barriers developed by management with the approval of the board constrain outside market governance forces. We also note two governance articles developed in 2004 that are based more on the extensive prior research by authors, rather than new empirical research. We refer to these as Type II articles in this paper. One article of interest by Jensen et al. posits a refinement of executive compensation that they believe will result in an improved performance metric to evaluate management. Shareholder value related to management performance should be measured by changes in earnings, incorporating cost of capital, rather than being measured solely by share price. The authors argue for the creation of bonus banks that allow for negative bonuses, thus holding management accountable for poor performance. Romano found that the development of SOX and derivative governance reforms was not grounded in empirical research. Romano argues that policy makers developed SOX rapidly in response to pressure from the public and media that was amplified by an election cycle. In our view, the articles by Jensen et al. and Romano provide the greatest contribution to our understanding of corporate governance. We believe that while many of the Type I (based on empirical research) articles provide answers to individual corporate governance factors (or sets of factors), they address only partial elements of a multivariate equation, rather than an organic whole, that would offer a solution to strengthen corporate governance.

Corporate Governance and Firm Operating Performance

Using a unique dataset provided by Institutional Shareholder Services (ISS), we relate 51 governance provisions to firm operating performance as proxied by return on assets and return on equity. We show that seven (six) governance provisions are significantly and positively related to return on assets (equity) using at least two of three econometric approaches. We identify 10 corporate governance provisions that are positively linked to return on assets, return on equity or both using at least two of our three econometric approaches. Nine of the corporate governance provisions we examine have recently been mandated by the three major U.S. stock exchanges but only one of them, nominating committee is comprised solely of independent outside directors, is significantly and positively related to firm operating performance. Our results reveal that the corporate governance reforms recently mandated by the three major U.S. stock exchanges are not more closely linked to firm operating performance than are those not so mandated.

Corporate Culture and the Problem of Executive Compensation

In this commentary on Bebchuk and Fried s Pay Without Performance, the former SEC Chairman begins by declaring, “I have problems with exorbitant executive pay precisely because I care about markets and private enterprise. These huge pay checks… undermine corporate governance and send a signal that boards are willing to spend shareholders' money lavishly and with too little oversight.” The author calls for a number of regulatory reforms, including expensing of stock options, broader and more complete disclosure of compensation, greater independence of directors, and empowerment of shareholders. At the same time, he notes that corrective market forces are already at work in the form of companies like Institutional Shareholder Services that monitor corporate governance and decision-making.

Evaluating the Evaluators: Should Investors Trust Corporate Governance Metrics Ratings?

Companies are under increasing pressure to have their corporate governance rated by an independent corporate governance metrics firm, such as Institutional Shareholder Services (ISS) or Governance Metrics International (GMI). These rating firms claim to be able to determine how effective and responsive a company’s board is. Institutional investors have begun using these board governance ratings when deciding which firms to include in their stock portfolios. This paper considers whether investors, many of whom claim to be socially responsible, should be relying upon board governance metrics. We find that these metrics are not good indicators of either the quality of a firm’s earnings or of its ethics.

Interview: Robert A G Monks

Born into a moneyed New England family, Robert A G Monks graduated from Harvard Law School, founded corporate governance consulting firm Institutional Shareholder Services and the investment fund Lens and served in the Reagan administration. But over recent years Monks has become an unlikely activist, leading the growing clamour for greater rights for shareholders. Along the way he has managed to write best‐selling books including The New Global Investors: How Shareholders Can Unlock Sustainable Prosperity Worldwide and has just had his first novel published. Interview by Stuart Crainer.

Symposium on Corporate Elections

This paper contains the edited transcripts of the Symposium on Corporate Elections held at Harvard Law School in October 2003. The symposium brought together SEC officials, CEOs, directors, institutional investors, money managers, shareholder activists, lawyers, judges, academics, and others to discuss the subject from a wide range of perspectives. The symposium included the following six sessions:1. The Basic Pros and Cons of Shareholder Access.Martin Lipton and Steven Rosenblum, Wachtell, Lipton, Rosen & Katz, Lucian Bebchuk, Harvard Law School2. The Board/Management Perspective.Richard Breeden, Richard C. Breeden & Co. John Castellani, The Business Roundtable James Rogers, Cinergy Inc. Ralph Whitworth, Apria Healthcare Group3. The Perspective of Institutional Investors.Orin Kramer, Kramer Spellman Robert Pozen, Harvard Law School Michael Price, MFP Investors Sarah Teslik, Council for Institutional Investors4. The Perspective of Shareholder Activists and Advisers.Jaime Heard, Institutional Shareholder Services Robert Monks, Lens Governance Advisors Damon Silvers, AFL-CIO John Wilcox, Georgeson Shareholders5. Legal Problems in Designing a Shareholder Access Rule.John Coffee, Columbia Law School Joseph Grundfest, Stanford Law School Robert Todd Lang, Weil, Gotshal & Manges Charles Nathan, Latham & Watkins Leo Strine, Delaware Chancery Court6. Concluding Remarks.Robert Clark, Harvard Law School Floyd Norris, The New York Times Harvey Goldschmid, U.S. Securities and Exchange CommissionEach session started with opening presentations by the panelists, followed by a discussion among the panelists and between the panelists and other participants in the symposium.

Complying with the SEC’s new proxy voting rules

In late January 2003, the Securities and Exchange Commission (SEC) adopted new rules for investment advisers under the Investment Advisers Act of 1940 (Advisers Act) requiring them to adopt and disclose to clients proxy voting policies and procedures. Concurrently, the SEC adopted new rules for registered investment companies (funds) under the Investment Company Act of 1940 (1940 Act) requiring them to disclose their proxy voting policies and procedures to their shareholders and to file their voting records with the SEC. The compliance dates for the new Rules are approaching fast. The Rules should have a significant impact on disclosure of proxy voting by advisers and funds. In a recent survey it conducted, Institutional Shareholder Services (ISS) noted that, of the approximately 3,700 fund groups that will be affected by the Rules, only eleven funds publicly disclose their proxy voting policies on their public websites. Of the eleven funds, seven disclose their proxy voting records and none discloses its policies with respect to conflicts of interest.

The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy

This article argues that effective staggered boards (ESBs) provide a powerful antitakeover defense, more powerful than is commonly recognized. We develop a theoretical account of how ESBs impede hostile bids by forcing bidders both to wait at least one year to gain control and to win two elections far apart in time rather than a one-time referendum on their offer. We then test our theory using a new data set of hostile bids during 1996-2000. We find that in this period:1) Not a single hostile bidder won a ballot box victory against an ESB;2) An ESB nearly doubled the odds of remaining independent for an average target in our data set;3) Shareholders of targets that remained independent were made worse off compared with accepting the bid;4) ESBs did not provide significant countervailing benefits in terms of increased premiums to offset the costs of remaining independent;5) Overall, during 1996-2000, ESBs reduced the returns to shareholders of hostile bid targets on the order of 8-10%; and6) Most ESBs were adopted before the developments in takeover jurisprudence that made ESBs.In view of these findings, we argue that courts should not permit managers of a target with an ESB to continue maintaining a pill after they lose one election conducted over an acquisition offer. This approach, we suggest, would best implement the basic proportionality principles underlying takeover doctrine.The Stanford Law Review is planning to publish a symposium with responses and reactions to this article. Participants will include Steve Bainbridge (UCLA), Mark Gordon (Wachtell, Lipton), Patrick McGurn (Institutional Shareholder Services), Lynn Stout (UCLA), and Leo Strine (Delaware Chancery Court). We are now in the process of writing for the symposium a paper that will respond to these five commentators and will further develop our analysis of staggered boards. Accordingly, comments or reactions on the article would be most welcome.

Mutual Fund Voting of Portfolio Shares: Why Not Disclose?

U.S. mutual funds control nearly one-third of U.S. equity voting power, yet they exercise their voting/governance power in obscurity. No rules (private or public) compel disclosure of the methods, policies and practices of mutual fund voting of portfolio shares. Why not disclose? Mutual funds are financial intermediaries that make diversification, asset allocation and risk management available to individual investors. As financial intermediaries, they are heavily regulated. Federal law specifies the governance structure and diversification levels of publicly-sold mutual funds, and mandates detailed information about fund investment policies, risk profiles, securities holdings and fees charged. Absent, however, is any mandate to disclose voting of portfolio shares and other corporate governance activities. Mutual funds have become the swing vote in U.S. corporate governance. Operating within fund families or in coordination with proxy service firms, principally Institutional Shareholder Services, mutual funds have lately been pivotal in shareholder voting. But mutual fund voting of portfolio shares is regulated only if the fund seeks control or concentrates its holdings in any one issuer. In the 1970s the SEC twice considered mandating disclosure of mutual fund voting policies and practices, but each time abandoned the project. The article outlines a proposal for the mandatory disclosure by mutual funds of their voting and governance activities. It considers possible arguments against such a regime. Perhaps existing price disclosure and redemption liquidity, combined with apparent apathy of mutual fund investors, render voting disclosure unnecessary. Perhaps greater transparency would undermine the current effectiveness of behind-the-scenes mutual fund voting/governance activities. Or perhaps it would create perverse incentives for mutual fund managers to politicize the voting function. These concerns, however, are belied by the handful of funds that disclose their voting policies and activities. On inspection, transparency - touted by the mutual fund industry with respect to portfolio companies - offers many potential benefits at relatively low cost.