Board reform versus profits: The impact of ratings on the adoption of governance practices

• Author: Timothy J. Rowley,Andrew V. Shipilov,Henrich R. Greve
• Published date: 01 April 2017
• Date: 01 April 2017
• DOI: http://doi.org/10.1002/smj.2545

Strategic Management Journal

Strat. Mgmt. J.,38: 815–833 (2017)

Published online EarlyView 22 July 2016 in WileyOnline Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2545

Received 2 October 2014;Final revision received11 May 2016

BOARD REFORM VERSUS PROFITS: THE IMPACT

OF RATINGS ON THE ADOPTION OF GOVERNANCE

PRACTICES

TIMOTHY J. ROWLEY,1ANDREW V. SHIPILOV,2*and HENRICH R. GREVE3

1Rotman School of Management, University of Toronto, Toronto, Ontario, Canada

2Strategy, INSEAD, Fontainebleau, France

3Entrepreneurship, INSEAD, Singapore, Singapore

Research summary: External stakeholders frequently attempt to inuence organizations’ adop-

tion of new practices through the creationof public ratings. Based on the insights of performance

feedback theory, we develop the theory of organizational reactions to external ratings to explain

how rms’ behaviors depend on their rating scores and their protability. A central issue in our

theory is the conict between established internal goals and goals introduced by public ratings,

with public ratings receiving lower priority than established protability goals. Our theory sug-

gests that, contrary to the expectations of the external stakeholders,rms targeted for criticism by

ratings become less likely to adopt corresponding practices when their protabilityis below aspi-

rations. These arguments aresupported in data on the diffusion of corporate governance practices

in Canada.

Managerial summary: Firms and their products arerated and ranked by external agencies rang-

ing from Consumer Reports to magazine rankings of admired, environmental, or well-governed

companies. Weinvestigate whether such ratings affect rm behaviors, and especially whether they

can incentivize poorly rated rms to improve their ranking when these rms’ protability is also

low. Using the leading corporate governance ranking in Canada, we nd that rankings could

have adverse effects: when rms have both poor governance ranking and poor protability they

are less likely to adopt governance practices, contrary to the ranking creators’ intentions. The

ndings show that there is a hierarchyof rms’ goals, where the goal of protability comes ahead

of other goals imposed by external agencies through ratings and rankings. Copyright © 2016

John Wiley & Sons, Ltd.

INTRODUCTION

There has been a proliferation of rating and rank-

ing systems to gauge and compare organizations’

adoption of certain practices, such as environmen-

tal standards (Chatterji and Toffel, 2010), corporate

governance initiatives (Shipilov, Greve, and Row-

ley, 2010), and fair employment contracts (Briscoe

Keywords: corporate governance; aspirations; perfor-

mance feedback; ratings; networks

*Correspondence to: AndrewV. Shipilov,Strategy Area, INSEAD

blvd de Constance Fontainebleau FRANCE 77300.

E-mail: shipilov@insead.edu

Copyright © 2016 John Wiley & Sons, Ltd.

and Safford, 2008). Many creators of these rankings

employ them to harness the mechanism of “reactiv-

ity” (Espeland and Sauder, 2007); i.e., the change

in behavior that occurs as a result of a subject being

measured. Publishing ratings lets the stakeholders

advocating new practices keep track of who adopts

these practices and who does not. Stakeholders also

use these ratings as tournaments by producing rank-

ings of rms with respect to their ratings. Such

stakeholders expect reactivity to inuence orga-

nizations that would not adopt specic practices

were it not for the public critique and shaming

associated with low ratings constructed to penalize

nonadopters. Given the capacity of rankings to enact

816 T. J. Rowley, A. V. Shipilov, and H. R. Greve

intended and unintended changes, reactivity to them

deserves closer scholarly attention (Espeland and

Sauder, 2007), and there is a need to understand how

organizations react to rankings, which are increas-

ingly used as an inuence strategy by external stake-

holders (Chatterji and Toffel, 2010).

Initial research has examined reactivity to rank-

ings, illustrating variations in how organizations

respond to their positions (e.g., Espeland and

Sauder, 2007) and collectively offering divergent

ndings. In a study of rms’ responses to the ratings

of their environmental practices, Chatterji and Tof-

fel (2010) nd that lower rated rms tend to adopt

practices and behaviors that improve ratings more

than higher rated rms. This nding is consistent

with the expectations of stakeholders producing

rating systems. However, Elsbach and Kramer’s

(1996) investigation of how business schools

respond to BusinessWeek rankings indicates that

poorly ranked schools seek to discredit the ranking

system rather than take steps to improve their

rankings. Similar ndings are reported in a study

of law school administrators’ responses to their

rankings (Sauder and Espeland, 2009). It is difcult

to conclude from these two studies that schools at

the bottom of the rankings will all pursue actions to

improve their positions, as is the case in Chatterji

and Toffel’s (2010) examination of environmental

practice ratings. Indeed, logical extension leads to

the opposite conclusion— schools at the bottom

of the rankings are the least likely to adopt the

practices that might enhance their positions.

Our goal is to reconcile these differences using

the insights from the behavioral theory of the rm

(Cyert and March, 1963), performance feedback

theory and research on the impact of governance

practices (Daines, Gow, and Larcker, 2010). As

research on performance feedback suggests (e.g.,

Greve, 2003b), rms allocate resources to adopt

practices in response to the gaps between their

performance and aspiration levels. Firms cannot

address all performance indicators at the same time,

so they pick which goals they attend to and which

they ignore. Meeting nancial aspirations, such

as protability, is the principal goal of organiza-

tions and all other goals will be secondary, espe-

cially when the achievement of other goals requires

diversion of resources from improving protability

(Greve, 2008). Reacting to an externally imposed

goal, such as the position on a governance rating,

will be less important for the rm than reacting to

its nancial performance shortfalls. Our principal

prediction and nding is that rms with both poor

protability and poor performance on the exter-

nal ratings will be the least likely to adopt the

rating-consistent practices. Thus, the rms’ reactiv-

ity to a low position on the external ratings will be

conditioned upon their nancial performance.

Overall, our study describes organizational pro-

cesses that predict some rms’ persistent rejection

of practices promulgated through rating mecha-

nisms and explains the heterogeneity of practice

adoption that is often observed despite stakeholder

pressures. Weattempt to settle the debate on the ef-

cacy of the rating systems (e.g., Chatterji and Toffel,

2010; Sauder and Espeland, 2009) by showing that

the mixed ndings could be driven by the adverse

effects of ratings on the adoptions of poorly rated

rms. That is, public ratings may prevent poorly

rated rms that also exhibit poor nancial perfor-

mance from adopting the practices promoted by the

ratings’ creators. Restated, ratings could be poor

inuence strategies: if stakeholders want a particu-

lar unprotable company to adopt a set of practices

with uncertain links to performance, the strategy of

publicly shaming this company through ratings may

backre. Consequently, to the extent a study sample

is dominated by poorly rated rms that also have

poor nancial performance, one would see more

resistance to the adoption of rating-consistent prac-

tices relative to studies mostly based on highly rated

rms or rms with superior nancial performance.

We also contribute to performance feedback the-

ory, which has focused on studying rms’ reactions

to commonly agreed goals, such as protability,

but has overlooked both how new goals emerge in

the organizations’ environment and how organiza-

tions set their aspirations levels differently depend-

ing on differences in goals (Gavetti etal., 2012;

Shinkle, 2012). Specically, given the tensions

between stakeholders, raters, and rms regarding

the ambiguous impact of ratings-consistent prac-

tices on the rms’ outcomes (Daines et al., 2010),

the evaluation of the rm’s success on the rating

will have a signicantly greater social comparison

component than the evaluation of the rm’ssuccess

based on protability.

RATINGS, RANKINGS,

AND REACTIVITY

The past 40 years have seen a proliferation of

quantitative performance measures. The spread of

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J.,38: 815–833 (2017)

DOI: 10.1002/smj