Do Corporate Governance Analysts Matter? Evidence from the Expansion of Governance Analyst Coverage

• Published date: 01 June 2019
• Date: 01 June 2019
• Author: NICO LEHMANN
• DOI: http://doi.org/10.1111/1475-679X.12254

DOI: 10.1111/1475-679X.12254

Journal of Accounting Research

Vol. 57 No. 3 June 2019

Printed in U.S.A.

Do Corporate Governance Analysts

Matter? Evidence from the

Expansion of Governance Analyst

Coverage

NICO LEHMANN

∗

Received 2 September 2015; accepted 29 July 2018

ABSTRACT

This paper examines the economic consequences of the initiation of

governance analyst coverage. Governance analysts process, enhance, and

∗University of Goettingen.

Accepted by Christian Leuz. This paper is based on one part of my dissertation at the

Georg-August University of Goettingen. I am deeply indebted to J¨

org-Markus Hitz (disser-

tation chair) for his continuous support and excellent guidance. I am very grateful to the

editor and an anonymous referee for their excellent guidance and constructive suggestions

throughout the whole review process. The paper has further benefited from the insights of Ulf

Br¨

uggemann, Hans B. Christensen, Rafael Copat (discussant), Gus DeFranco, Peter Fiechter,

Joachim Gassen (discussant), Tim Gray, Paul Guest, Liang Hao (discussant), Sebastian Kau-

manns, Olaf Korn, Urska Kosi, Philipp L¨

ow, Andrew McMartin (discussant), Partha S. Mohan-

ram, Stephanie M¨

uller-Bloch, William P. Rees, Gordon D. Richardson, Almasa Sarabi, Harm

Sch¨

utt, Hollis Skaife, Wally Smieliauskas, David Veenman,Dushyant Vyas, Aida S. Wahid, M.H.

Franco Wong, Jiang Yu (discussant), and workshop and conference participants at Humboldt

University of Berlin, Surrey Business School, University of Goettingen, University of Toronto,

2013 HU Summer School “Empirical Financial Accounting Research” in Berlin, 2014 EAA

Meeting in Tallinn, 2014 EFMA Meeting in Rome, 2015 VHB Meeting in Vienna, 2015 AAA

Meeting in Chicago, and 2016 FARS Meeting in Newport Beach. I also thank Paul Wanner

(former head of CGQ rating at ISS), Kristof Ho Tiu (vice president, governance data/product

management at ISS), and Mark Brockway (director of ISS Corporate Services) for provid-

ing the CGQ data and the clarification concerning the ISS coverage activities in the United

Kingdom between 2004 and 2005. Finally, I thank Emilienne Ronzier-Joly (client services as-

sociate at FTSE Russell) for providing index composition data on the ISS/FTSE UK stock

index. All errors are my own. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

721

CUniversity of Chicago on behalf of the Accounting Research Center,2018

722 N.LEHMANN

disseminate governance-related information to capital market participants

via, for example, governance reports and ratings. Using an exogenous shock

in the United Kingdom, I find that an increase in governance analyst cover-

age results in increased governance quality, improved liquidity, increased fi-

nancial analyst following, and improved investor breadth. These findings are

consistent with governance analysts creating value for firms via monitoring,

information dissemination/production, and investor recognition.

JEL codes: G15; G23; G24; G30; G34; M40; M41

Keywords: information intermediaries; nonfinancial governance analysts;

corporate governance ratings; ISS

1. Introduction

This paper examines the economic consequences of governance analyst

coverage. Governance analysts assess firms’ governance quality and publish

reports and ratings (e.g., Daines, Gow, and Larcker [2010]).1Over the last

decade, they have become increasingly influential in capital markets. Sur-

vey findings, for example, suggest that U.S. corporate directors rank them

as the third most important group influencing boards, after institutional

investors and financial analysts and before the plaintiffs’ bar and the media

(CBM PwC [2008]). The largest and most visible vendor of governance re-

ports and ratings is Institutional Shareholder Services (ISS). For more than

8,000 firms across 31 countries, ISS gathers information on over 200 gov-

ernance factors. Its services, which are primarily marketed to institutional

investors, cost customers up to $100,000 per year (Coffin and Collinson

[2005]).

Although a rich academic literature examines financial analysts, empiri-

cal evidence on (nonfinancial) governance analysts is scarce, with little in-

sight into whether and how they create value for investors. Daines, Gow,

and Larcker [2010], for example, investigate the predictive power of three

commercial governance ratings and provide inconclusive or weak evidence

for a positive economic role. Similarly, cross-country evidence by Hitz and

Lehmann [2015] suggests that governance ratings are not incrementally in-

formative, beyond the publicly available information the ratings aggregate.

Thus, the economic role of governance analysts remains an open question.

Empirical evidence on the role of governance analysts is also limited in at

least two ways. First, papers typically focus on only one summary measure—

commercially available governance ratings—when assessing the value of

governance analysts. This approach neglects the usefulness of other services

1My definition of governance analysts excludes proxy voting advice. The economic roles of

vendors of governance ratings versus proxy voting services differ. The former provide detailed

information on the firm’s governance structure (Daines, Gow, and Larcker [2010], Hitz and

Lehmann [2015]), while the latter facilitate investor votes at annual meetings (Ertimur, Ferri,

and Oesch [2013], Calluzzo and Dudley [2018], Hitz and Lehmann [2018]). Governance

rating services end up being an input to proxy advisory, rather than a comparable service.

DO CORPORATE GOVERNANCE ANALYSTS MATTER?723

provided by the analysts such as reports, customized rating tools, and in-

sights from interaction with firms’ management. Second, the literature ex-

amines associations between governance ratings and economic outcomes,

which are prone to endogeneity concerns. My study aims to overcome these

limitations by investigating the economic effects of governance analyst cov-

erage, with coverage encompassing all information production by these an-

alysts. I do so by exploiting a plausibly exogenous shock to ISS coverage.

This allows for a tighter identification of causal effects.

From 2004 to 2005, ISS coverage of U.K. firms increased by almost 150%,

from 212 to 524 firms. No comparable coverage increase occurred in any

of the other countries in which ISS then did business. The reason behind

this increase was a “joint indices project” with the Financial Times Stock Ex-

change (FTSE). At the end of 2004, ISS and FTSE started to develop several

governance-related indices, with one of these designated for the U.K. stock

market. To construct the index and supply a sufficient governance-rated

firm base, ISS beefed up its U.K. coverage. Thus, the coverage increase

was exogenous to the preferences of individual ISS analysts and firms that

gained coverage. In comparison, the day-to-day decision of ISS analysts to

cover firms depends on observable and unobservable firm characteristics,

such as the firm’s membership in a stock index or institutional ownership;

it is endogenous by nature. Because these characteristics are likely related

to potential economic outcomes of governance analyst coverage, OLS anal-

yses of the day-to-day coverage decisions are likely to be biased.

My identification strategy is based on a standard difference-in-differences

(DiD) research design with one treatment group, two control groups, and

firm and year fixed effects. The treated group encompasses U.K. firms that

ISS started covering in 2005, as the result of the joint indices project. The

control group is U.K. firms that were either continuously covered or con-

tinuously not covered by ISS throughout the sample period between 2004

and 2006.

I test three nonmutually exclusive channels through which governance

analysts may create firm value: (1) promoting external monitoring by disci-

plining firms’ management through information revelation in governance

reports and ratings (monitoring), (2) improving firms’ information environ-

ments by helping disseminate publicly available governance information or

uncovering new information (information dissemination and production), and

(3) increasing firms’ investor recognition by alleviating the risk for profes-

sional investors of breaches of their fiduciary duties (investor recognition).

To proxy for changes in monitoring, I use a summary measure com-

prising CEO/chairman duality, board independence, and key committee

independence (channel 1). The idea is that the disciplining role of infor-

mation revelation pressures the firm’s executives and board members to

remedy governance deficiencies. To assess changes in the information en-

vironment, I focus on two well-researched dimensions: changes in liquid-

ity, due to decreasing information asymmetry (measured by a proxy com-

prising zero share return days, bid-ask spreads, and trading volume), and