The ratings game

Citation

Daily, C.M. and Dalton, D.R. (2004), "The ratings game", Journal of Business Strategy, Vol. 25 No. 1. https://doi.org/10.1108/jbs.2004.28825aaf.002

The ratings game

Catherine M. DailyCatherine M. Daily is the David H. Jacobs Chair of Strategic Management, Kelley School of Business, Indiana University, cdaily@indiana.edu

Dan R. DaltonDan R. Dalton is Dean and Harold A. Poling Chair of Strategic Management, Kelley School of Business, Indiana University, dalton@indiana.edu

What do large corporations, college athletics teams, professional tennis players, and automobiles all have in common? Each is subject to ratings systems that distinguish the "best" from the "worst". In the corporate arena alone there are a host of ratings systems that rely on criteria ranging from firms' size (e.g. Fortune 1,000) to reputation (e.g. Fortune) to growth rates (e.g. Business Week). Of late, corporations have been thrust into yet another ratings game, one played on the basis of the overall effectiveness of firms' corporate governance systems. But this game is distinguished by the fact that many of the players would be happier sitting in the stands watching rather than playing the game.

As with children's first experience playing T-ball or soccer, many corporations are stumbling through the opening minutes of the game. The corporate equivalent of getting on base or scoring a goal happens as much by chance as by design. At issue is that firms' strategic leaders do not always know the rules of the game they are playing. Sometimes the lack of knowledge about the rules of the game is a function of not having been privy to the rules; at other times it is because the rules are a bit less than transparent.

What is clear, however, is that corporate governance ratings systems will continue to proliferate in the coming years. As such, organizational members need to inform themselves of the various corporate governance ratings agencies and the criteria that form the basis of the respective ratings systems. It is only then that firms' strategic leaders can effectively compete in this arena.

One of the frontrunners in rating firms' governance systems is Business Week. with its "best" and "worst" boards. This ranking debuted in the mid-1990s, with the latest ranking in October 2002. Relying on surveys of corporate governance experts, analyses of corporate proxy filings, and assessment of corporations' overall board performance by Business Week's editors, corporations are analyzed on the basis of director independence, director stock ownership, director quality, and board activism. These assessments result in a list of the "best boards" and "worst boards". For those truly egregious examples of poor governance practice, the most recent rankings also included a "hall of shame", a distinction no firm wishes to achieve.

Similar to Business Week's "hall of shame" is the California Public Employees' Retirement System (CalPERS) annual "hit list" of the larger firms in their investment portfolio in need of governance overhauls. They "grade" firms on the basis of their adherence to board independence, as specified in CalPERS's corporate governance standards. As with Business Week's criteria, these standards include director independence, separation of the CEO and board chairperson positions, and director expertise.

More recent entrants into the corporate governance ratings game are Institutional Shareholder Services (ISS), The Corporate Library, and Governance Metrics International (GMI). The common theme in each of these ratings systems is board independence. The challenge for firms' strategic leaders, however, is that the approach and the metrics on which each relies vary. More importantly, the criteria are often unclear.

ISS is primarily involved in proxy advisory services (many of you will remember that they were front and center in the Hewlett-Packard/Compaq proxy battle). They recently began rating the universe of firms they track (approximately 5,400 at last count), assigning each firm a corporate governance quotient (CGQ). The CGQ ranges from 0 to 100 and firms are rated individually and within the firm's industry sector. Certainly a key element of the CGQ is the independence of the board. There has been some criticism that, for a fee, corporations dissatisfied with their CGQ rating can access ISS's ratings system, make corporate governance changes based on the ISS ratings criteria, and request an "upgrade" in the CGQ based on the changes.

The Corporate Library is a research firm specializing in relationships among corporate management, corporate boards, and shareholders that also began rating corporations' governance systems in 2002 (rating over 2,000 firms). Unlike ISS, the Corporate Library does not sell access to its ratings system. This "independence" comes at a cost to rated corporations, however. Whereas strategic leaders can access the 61 specific criteria that comprise the ISS CGQ for a fee, such access is unavailable for firms rated by the Corporate Library. The Corporate Library sets out the broad categories that form the basis of their ratings system, but refer to the specific measures as "proprietary dynamic indicators". It is rather like our hypothetical little leaguers not being told that they are evaluated on the basis of runs batted in, fielding percentage, or batting average.

GMI presents yet another twist on corporate governance ratings systems. As with ISS and the Corporate Library, corporations are not charged to be rated (in fact, with both agencies, corporations have no choice in whether they are rated!), except if corporations elect what GMI calls its "comprehensive rating" (as compared to the simpler "basic rating"). Firms are rated on a one to ten scale for seven broad categories, relative to other firms in GMI's database. Interestingly, firms electing the comprehensive rating will have this information automatically included in the GMI database. According to GMI, "we will not suppress a rating". That should cause some strategic leaders pause.

Why are these ratings important to corporations? Among the reasons is the reliance of the institutional investment community on agencies such as ISS, the Corporate Library, and GMI for guidance and counsel on shareholder issues. To ignore institutional investors, the largest aggregate holders of corporate equity for US-based corporations is, at a minimum, ill-advised. Moreover, given the scrutiny accorded matters of board independence in corporate governance and rating, these are issues that all parties will want to handle with great care. Does your company handle with care?