This Article considers the role of the corporate governance industry as a voluntary regulator. The corporate governance industry influences (and in some cases effectively controls) the votes of trillions of dollars of equity, and affects the governance policies and fortunes of thousands of companies through proxy voting recommendations and governance ratings. This Article considers the increasing influence of the corporate governance industry, and argues that potential conflicts of interest within some governance firms cast doubt on the reliability of their proxy advice and governance ratings. Additionally, governance firms may be overstepping their expertise in proxy voting decisions and in governance rating, in part because of their reliance on "good governance metrics" for which there is little evidentiary support. Finally, erroneous governance metrics (and indeed, a reliance on one-size-fits-all governance checklists) promoted by influential governance advisers not only affect important shareholder voting decisions and decisions on whether to invest in or divest from a particular company, may also have a more general, harmful effect on corporate governance regulation. number of academics have argued that federal expansion into corporate governance issues has significant negative consequences. Perhaps most importantly, Sarbanes-Oxley mandates specific governance policies rather than setting broad standards, thereby eliminating some vital flexibility in corporate governance. This Article argues that corporate governance industry may have similarly harmful effects by pressuring companies to adopt a homogenized set of governance rules which may not be suited the companies respective requirements.
INTRODUCTION II. AN INTRODUCTION TO THE CORPORATE GOVERNANCE INDUSTRY A. The Development of the Corporate Governance Industry 1. The Structure of Corporate Governance Regulation 2. The Market for a Corporate Governance Industry B. The For-Profit Governance Industry: Proxy Advisers, Governance Ratings Agencies, and Governance Advisers 1. Institutional Shareholder Services 2. Governance Metrics International 3. The Corporate Library 4. Glass, Lewis & Co. 5. Proxy Governance, Inc. 6. Morningstar and Credit Ratings Agencies III. CONCERNS WITH THE CORPORATE GOVERNANCE INDUSTRY A. Conflicts of Interest 906 B. Governance Ratings Methodologies C. The Homogenization of Corporate Governance IV. REGULATION OF THE CORPORATE GOVERNANCE INDUSTRY: PRELIMINARY CONSIDERATIONS A. Conflicts B. Methodology Concerns C. The Homogenization of Corporate Law V. CONCLUSION I. INTRODUCTION
There is no specific set of corporate governance rules, standards, and principles to which every U.S. corporation must adhere. Rather, corporations are directed by a variety of sources, some public, some private, which develop and enforce governance rules. Several intertwined factors explain why we do not have a single rule set, source, and regulator of corporate governance. The first is our federalist system of government, which reserves to the states the powers not delegated to the federal government by the Constitution, (1) and among the powers traditionally reserved to the states is the ability to charter and regulate corporations and other business forms. (2) But while the states are the primary corporate regulators, state legislatures have left much of the substantive regulation of corporations to companies themselves by creating enabling rules that allow companies to fashion their own governance structures within a broad statutory framework. (3) Roberta Romano has argued that the regulation of corporations primarily by states rather than federal regulators is the "genius" of American corporate law: states compete for incorporations and are thus incented to offer corporate codes that will appeal to businesses. (4) Companies also have an incentive to self-regulate as a competitive response to limited available capital--like state regulators; companies will generally attempt to encourage investment by offering an attractive corporate governance structure. In addition, as a condition to listing their securities on a stock exchange, public companies will subject themselves to exchange listing standards. Given that investors will often not have the time and resources to undertake a sophisticated analysis of a company's governance structure, and recognizing that companies will often have competing incentives that may result in suboptimal governance structures, exchanges also regulate via listing standards that are designed to promote investor confidence by providing minimum standards for listed companies. The recognition by industry that regulators--even relatively restrained federal agencies like the Securities and Exchange Commission (SEC)--abhor a regulatory vacuum also provides another motivation for self regulation. (5)
After WorldCom, Enron, and the other turn-of-the-millennium financial scandals, this loose structure of federal/state/exchange and self regulation was regarded by many to be an unreliable motivator of adequate corporate governance. The Sarbanes-Oxley Act of 2002 was one response to this perceived failure, and has since been the subject of considerable academic interest, not least because it federalized several areas of corporate law that had been left to the states or simply to the discretion of the board and management. Another response, which has received relatively little attention, is the increasing role of what this Article refers to as the "corporate governance industry": governance advisers, governance rating firms, and proxy advisers (sometimes operating as business units of a single company). (6)
The corporate governance industry plays a major corporate governance policymaking role, and, because of its influence with institutional investors, effectively acts as a voluntary corporate regulator. Some executives believe that corporate governance industry market leader Institutional Shareholder Services (ISS) may control a third or more of the shareholder votes. (7) According to a recent interview reported in the Washington Post, John M. Connolly, president and chief executive of ISS, acknowledges that 15%-20% of ISS clients use a service that automatically votes according to ISS recommendations, although clients can override it. (8) As a measure of influence, consider that ISS has over 1700 institutional clients, and the clients' assets under management exceed $25 trillion. (9) ISS claims to advise "24 of the top 25" and "81 of the top 100" mutual funds, all "25 of the top 25" asset managers, and "17 of the top 25" public pension funds. (10) ISS advice has been cited as a decisive factor in a number of major corporate events, including the approval of the Hewlett-Packard/Compaq merger and the shareholder vote that ousted Michael Eisner from his role of chairman at Walt Disney Co. (11) Another measure of the growing importance of the industry is the fact that, just five years ago, market leader ISS was acquired for around $40 million. (12) On November 1, 2006, RiskMetrics acquired ISS for an estimated $550 million. (13)
The influence of ISS and other proxy advisers may increase even more with passage of rules by the New York Stock Exchange (NYSE), scheduled to take effect in January 2008, (14) which would eliminate broker discretionary voting in director elections. (15) According to Wachtell, Lipton, Rosen & Katz attorneys David Katz and Laura McIntosh, "an estimated 70 to 80 percent of all public companies' shares are held in 'street name' ... by brokers ... [and] depositories ..." on behalf of beneficial owners, (16) and under NYSE rules brokers are given discretionary voting power over such shares only for "routine matters"; (17) if the rules under consideration are enacted, uncontested elections would be considered "non-routine." Katz and McIntosh argue that "[i]f, in the aftermath of NYSE rule changes as proposed, issuers indeed are unable to contact or obtain voting instructions from large numbers of individual shareholders, the effect will be a massive shift of voting power from brokers to institutions, and, therefore, to proxy advisory services such as ISS, Glass, Lewis & Co., and Proxy Governance." (18) As an indication of how this shifts power to the corporate governance industry, Katz and McIntosh note that a 2002 study found that "ISS recommended that shareholders vote against over 78 percent of the proposals that the authors estimated to have been determined by broker discretionary votes." (19) While the general purpose of the new rule would be to increase shareholder power with respect to director elections, (20) the influence of the corporate governance industry generally, and proxy advisers particularly, has prompted the NYSE to propose a formal SEC investigation into the role of these firms in the proxy process. (21)
Given the industry's tremendous influence over corporate governance and, more directly, the proxy voting mechanism that shapes corporate governance decision-making, it is imperative to scrutinize the manner in which this influence is exercised. It is also crucial to scrutinize the assumptions underlying the advice. Some observers, including Rep. Richard Baker (R-Louisiana), have raised concerns over potential conflicts of interest within some governance firms that cast doubt on the reliability of their proxy advice and governance ratings. (22) ISS, for example, sells advice on proxy voting and sells corporate governance ratings, but it also provides advice to companies on how to improve their ratings. (23) Because of ISS' market power, Rep. Baker has argued that "conflicts of interest and a lack of competition in the industry could lead firms to provide biased advice," (24) and a study is currently being undertaken by the Government Accountability Office at his request. (25)
Additionally, governance firms may be overstepping their expertise in proxy voting decisions, (26) and in...