Rating management behavior and ethics: a proposal to upgrade the corporate governance rating criteria.

• Author: Vo, Thuy-Nga T.

1. INTRODUCTION II. CORPORATE GOVERNANCE RATINGS A. Growth of Governance Rating Agencies B. Governance Rating Process 1. Rating Scales 2. Rating Criteria C. Influence of Governance Ratings 1. Wide Range of Clients and Users 2. Deep Impact on Governance Practices III. DISCONNECT BETWEEN GOVERNANCE RATING CRITERIA AND CORPORATE PERFORMANCE A. The Lack of Correlation Between Rating Criteria and Corporate Financial Performance B. The Lack of Correlation Between Rating Criteria and Management Behavior and Ethics IV. CONNECTING GOVERNANCE RATING CRITERIA TO CORPORATE PERFORMANCE A. Management Behavior and Ethics Affect Financial Performance B. Employees as a Source of Information About Management Behavior and Ethics C. Benefits of Employee Assessments as a Corporate Governance Rating Criterion D. Conducting Employee Assessments V. CONCLUSION I. INTRODUCTION

   Corporate governance rating agencies currently do not, but should, include in their rating criteria an employee assessment of managerial behavior and ethics. Governance rating agencies strive to distinguish themselves from their competitors by establishing governance rating criteria that are indicative of whether directors and officers are serving shareholder interests instead of management prerogatives. Adding a rating criterion that is based on a company's implementation of, and the results from, periodic assessments of managerial behavior and ethics would provide insight into whether the company's directors and officers are performing their responsibilities to advance shareholder interests.

   Governance rating agencies are for-profit providers of corporate governance ratings. These governance rating agencies have experienced tremendous growth in size as well as influence during the past decade. There is a wide range of users and uses for the corporate governance ratings. Some of the users include investors, insurance companies, financial and securities analysts, lawyers, accountants, financial institutions, and the rated companies themselves. These users utilize the data compiled and the ratings assigned by governance rating agencies to make investment and voting decisions, determine premiums, prepare financial and stock reports, provide governance advice, determine credit risk, and benchmark governance practices. Knowing that there is a broad base of clients for and users of corporate governance ratings, public companies pay close attention to the governance ratings assigned to their companies by governance rating agencies. The rated companies strive to adopt governance practices advocated by governance rating agencies in order to garner favorable governance ratings.

   Governance rating agencies develop rating criteria that mirror disclosure obligations and operational measures required under law or for listing on stock markets. Rating agencies also establish standards of governance that extend beyond legal and listing requirements or dominant corporate practices to include governance mechanisms that may not be prevalent but that are perceived by rating agencies to be conducive to enhancing directors' and officers' performance of their responsibilities to advance shareholder interests.

   Empirical evidence has not established a strong correlation between corporate financial profitability and the structural mechanisms relied upon by rating agencies in their rating systems. The rating criteria also do not provide assurance that officers and directors of the corporation are performing their respective responsibilities of management and oversight. The lack of strong linkage between governance rating criteria and corporate performance, financial or otherwise, may be due to the rating agencies' focus on observable, structural mechanisms as indicators of corporate conduct. Structural mechanisms such as board composition and charter provisions neither indicate the board's fulfillment of its responsibility to monitor managerial performance nor ensure management's fulfillment of its responsibility to apply fundamental business precepts. Missing from the current governance rating criteria is an evaluation of the actual conduct and decision-making of the management group, an evaluation that would provide necessary data for the board to perform its oversight responsibility and enhance shareholder value.

   Assessment of management's business standards and conduct can be implemented through a company-wide survey of employees, the internal stakeholders with daily and direct access to the actual conduct and decision-making of the management group. Employee assessments can provide valuable information to the board in carrying out its fiduciary duty to monitor management performance. Employee assessments can also provide information that is of interest to investors, customers, and other stakeholders, but which is currently unavailable, about management's affinity for ethical behavior or inclination for ethical lapses.

   Part II of this Article examines the governance rating industry, focusing on three prominent rating agencies, their rating scales and criteria, and their influence in the corporate governance arena. Part III discusses the lack of correlation between governance rating criteria and corporate performance, on both financial and nonfinancial dimensions. Part IV demonstrates that management behavior and ethics affect shareholder value. Investors, customers, and other stakeholders are interested in information about management's actual decision-making process and behaviors. With insider access and opportunity to witness managerial conduct on a routine basis, employees constitute a unique source of nonpublic information about the realities of the company's governance. This Article proposes that corporate governance rating agencies include an employee assessment of managerial behavior and ethics as part of the rating agencies' governance rating criteria. A rating criterion that focuses on management's behavior and ethics may correlate more closely with the corporation's performance on both financial and nonfinancial measures.

   This Article concludes that governance rating agencies should utilize their strong influence in the realm of corporate governance to motivate companies to conduct employee assessments of management's behavior and ethics. By utilizing public companies' implementation of, and results from, employee assessments of managerial conduct as a rating criterion, governance rating agencies can employ their authority in the corporate governance arena to improve the transparency of managerial behavior and ethics, which in turn can enhance corporate integrity and financial performance. Employee assessments can provide information that is of interest to the investing public and potential employees, thereby attracting investors, customers, and employees to the company. In addition, the employee assessments of managerial behavior and ethics will provide the board with information to enhance the board's performance of its oversight function and to promote management's business ethics and corporate integrity. As we have learned from the notable corporate events of the past decade, companies can collapse because of poor managerial behavior and ethics. Employees constitute a unique source of information about management conduct, and gathering and evaluating that information for the use of the board and the stakeholders may ultimately act to preserve the company's financial performance and existence.

2. CORPORATE GOVERNANCE RATINGS

   1. Growth of Governance Rating Agencies

      The growth in number, size, and influence of corporate governance rating agencies may be attributed to the rise of institutional investors, the implementation of regulatory requirements governing the voting of proxies by investment advisers and money managers, and the continual revelation of financial scandals and governance weaknesses since the beginning of this millennium. (1) Corporate governance rating agencies' services include compiling, comparing, and assigning scores on various governance practices deemed significant in determining company performance and shareholder value. (2) These private, profit-making rating agencies also provide research services, advise on proxy voting, and consult with clients on corporate governance matters. (3)

      The largest and most influential corporate governance rating agency is Institutional Shareholder Services (ISS), (4) which launched its corporate governance research and advisory business in 1985 (5) and began to rate companies' governance in 2002. (6) The rise of ISS' role in the corporate governance arena is evident in the growth of its market value, from $40 million in 2001 to $550 million in 2006. (7) ISS has more than 3300 clients worldwide. (8) As it owes its growth to the rise in number and activism of institutional investors, (9) ISS has committed to conducting "its entire business in the best interests of its institutional clients." (10)

      ISS rates more than 8000 companies in 31 countries. (11) ISS charges a subscription fee ranging from $10,000 to $17,000 per year for access to its governance ratings of companies. (12) In addition to providing governance rating services, ISS also performs research and provides advice regarding proxy issues in order to assist shareholders cast their votes. (13)

      Another well-known name in the governance rating industry is GovernanceMetrics International (GMI), which was formed in 2000 as a corporate governance research and rating agency. (14) GMI counts among its clients the large pension funds TIAA-CREF and the New York State Retirement Fund, (15) in addition to other pension funds, investment managers, banks, insurance companies, credit rating agencies, regulatory agencies, public companies, lawyers, accountants, and consulting firms. (16)

      GMI rates over 4100 companies throughout the world, (17) and the subscription fee to view the governance ratings issued by GMI starts at $18,000 per year. (18) In addition to...