The street wakes up to governance.

• Author: Gallo, Donald
• Position: Investor Accountability

Investors are going to demand some reassurance that effective governance practices are in place to protect them from Enron-like outcomes. Are you ready for the analysts' newfound interest and in-depth scrutiny?

WITHOUT A DOUBT, the level of scrutiny currently focused on the governance practices of public companies has reached an all-time high. When the bad news hits, one of the first questions asked by the investment community is "Where was the board?" As evidenced by the SEC's investigation of such fallen companies as Enron, Adelphia, and WorldCom, there is a general sentiment that had the existing board of directors been more effective these scandals could have been avoided.

It may come as some surprise to find that, despite all this scrutiny, corporate governance gets little or no attention by securities analysts in their evaluations of the companies they cover. In fact, up to now, company executives have been saved the trouble of having to provide specific details about their governance practices to the analyst community. This is likely to change. While Wall Street analysts have traditionally avoided analyzing and evaluating management practices, recent events will place pressure on them to add corporate governance to their list of performance criteria when making their investment recommendations.

Ignored by the Street

We examined 70 "initiating coverage reports from nine of the top U.S. investment banks, issued in May and June 2002. It is in these initiating coverage reports that securities analysts provide some of their most comprehensive analysis. In addition to an in-depth financial analysis, they typically provide a description and evaluation of the firm's strategy and market position. In roughly half of the reports there is an explicit discussion of the top management team and their background and qualifications along with a cursory assessment, such as "management has extensive experience." However, in only eight of the 70 reports (less than 12%) was there a description given of the board of directors along with a cursory evaluation, such as "the board has several decades of experience." Moreover, not one report provided any specific information on, or evaluation of the effectiveness of, the board of directors, much less information on governance practices.

Perhaps analysts believe that corporate governance has only a second-order impact on a company's performance--that is, relative to a firm's financial health, strategy, and operating capabilities, the effectiveness of the board of directors becomes relevant only in special circumstances such as CEO succession or major corporate decisions (e.g., M&A). Recent events have proved this to be wrong. One of the primary duties of the board is to ensure the integrity of the firm's financial statements through the board audit committee. The events of Enron, Tyco, and WorldGom provide compelling evidence of the importance of these duties being fulfilled.

Moreover, investigations into the causal link between corporate governance and shareholder returns, while academically interesting, miss the point. The absence of effective governance puts the company, and hence the shareholder, at tremendous risk. So while it may be difficult to find a nice and neat correlation between the quality of governance practices and shareholder value, when the company s share price crashes because of an accounting scandal, the importance of the board is...