[cgs-iss] epps and cereola - 2008 - do institutional shareholder services (iss) corporate governance ratings reflect a company

We use the institutional shareholder services ISS corporate governance quotient CGQ rating of a firm’s corpo-rate governance structure and analyze this rating in relation to the firm’s o

Do institutional shareholder services (ISS)

corporate governance ratings reflect a

company’s operating performance?

Ruth W Eppsa,∗, Sandra J Cereolab

aSchool of Business, Virginia Commonwealth University, Richmond, VA 23284-4000, United States

bVirginia Commonwealth University, Richmond, VA 23284-4000, United States

Received 1 August 2006; received in revised form 15 May 2007; accepted 30 June 2007

Abstract

Little is known about the relation between the actual governance rating received by a firm and the firm’s performance In this study, we examine the relation between the actual corporate gover-nance rating received by a firm and the firm’s performance during the years 2002–2004 We use the institutional shareholder services (ISS) corporate governance quotient (CGQ) rating of a firm’s corpo-rate governance structure and analyze this rating in relation to the firm’s operating performance We compare the institutional shareholder services’ CGQ rating to two measures of the firm’s operating performance, return on assets (ROA) and return on equity (ROE) Based upon our results, we do not find statistical evidence suggesting that the firms’ operating performance is related to the firms’ ISS corporate governance rating

© 2007 Elsevier Ltd All rights reserved

Keywords: Corporate governance; Firm operating performance; Governance rating; Return on assets; Return on

equity

1 Introduction

The Organization for Economic Cooperation and Development (OECD)1defines cor-porate governance as, “the way in which boards oversee the running of a company by its

∗Corresponding author Tel.: +1 804 828 7137; fax: +1 804 828 8884.

E-mail address:rwepps@vcu.edu (R.W Epps).

1 Found at http://www.oecd.org

1045-2354/$ – see front matter © 2007 Elsevier Ltd All rights reserved.

doi: 10.1016/j.cpa.2007.06.007

managers, and how board members are in turn accountable to shareholders and the com-pany.” OECD elaborates that corporate governance “has implications for company behavior towards employees, shareholders, customers and banks” Implicitly, this definition of cor-porate governance implies there is a relationship between a firm’s results of operations and the governance rating score received

In response to the corporate scandals during the period 2000 and 2001, Congress enacted the Sarbanes-Oxley Act (SOX) on July 30, 20022 The act specifically targets corporate gov-ernance reform and has created a reporting system that now makes corporate govgov-ernance more transparent to the public SOX requires firms to disclose annually the structure, compo-sition, and size of its board and whether it has adopted a code of ethics for its senior financial officers in its Form 10-K Additionally, both the New York Stock Exchange (NYSE), and the National Association of Securities Dealers (NASDAQ) have corporate governance rules regarding the role and authority of independent directors (Lander, 2004)

A corporation’s corporate governance structure is important to today’s market par-ticipants Investors view corporate governance as an important criterion when making investment decisions and are willing to absorb higher costs for corporations that are well governed and have boards of directors with a high degree of independence According to a survey conducted byMcKinsey and Company (2002), 14% of the investors in the U.S say they are willing to pay a premium for a well-governed company

The requirements of SOX are meant to address the concerns of investors and to restore investor’s confidence in the corporate governance mechanism SOX has imposed requirements on public firms to improve their governance practices, to increase director independence and to create boardroom structures that hold management accountable The overall impact of SOX along with the regulations imposed by the major U.S stock exchanges should be reflected in the improvements of the corporate decision-making process, improve-ments in the organization’s accountability system and ultimately improveimprove-ments in the firm’s overall efficiency and performance Thus, if the regulations achieve the desired results of improved corporate governance, investors should expect to see an overall increase in cor-porate governance ratings from 2002 to 2005 Additionally, investors should also be able to identify a positive relationship between the corporate governance ratings and firms overall operating performance

Although our study is not the first to examine the impact of corporate governance structure

on firm performance, our approach differs from previous studies First, we are studying one corporate governance rating system, institutional shareholder services (ISS) ISS is the most widely known and used governance rating system, rating over 5000 U.S firms and 2000 global firms This system is chosen because of the size of the database and the potential pervasive impact of the findings of the research Second, while previous research uses various components of the corporate governance rating metrics as indicators of corporate governance, we use the actual aggregate corporate governance score obtained by the firm

as our indicator of corporate governance We believe this aggregate measure is important

in the investor decision-making process because this information is more readily available for comparative firm analysis

2 http://www.sec.gov , Publication L No 107-204, 116 Stat 745.

Thus, using the corporate governance ratings provided by the institutional shareholder

services and financial data obtained from Compustat for companies listed on the Standard

and Poor’s (S&P) 500 as of February 2006, we compare the actual ISS governance ratings from 2002 to 2004 and examine the relationship (if any) between those ratings and a firms’ operating performance

2 Literature review

A central issue to corporate governance is how to ensure accountability of senior man-agers to their stakeholders while simultaneously providing executives with the autonomy and incentives they need to produce wealth-producing strategies Much of the responsibility for providing a governance structure that aligns the interest of the managers with that of the shareholders depends on the due diligence of the board of directors A board has two primary roles, that of decision-making and that of oversight However,O’Reilly et al (1990)

suggest that boards are not effective as a monitoring device Other empirical evidence shows

that firms adjust their board structure and increase the level of board activity in response to poor performance,Vafeas (1999)

There is disagreement on how good or bad the existing governance mechanisms are in the U.S.Jensen (1993)provides evidence that the U.S corporate governance system is deeply flawed and that a major move from the corporate form to a much more highly leveraged organization is on the horizon In contrast,Easterbrook and Fischel (1991)provide a very optimistic assessment of the U.S corporate governance system

Additionally,Core et al (1999)indicate that firms with weaker governance structures have greater agency problems Corporate governance issues arise in an organization due

to the separation of ownership and management In most large corporations, there is a separation between those who control and those who own the residual claims (Fama, 1980; Demsetz and Lehn, 1985) Agency theory explains how to best address the problems of goal congruency and information asymmetry between the principals (shareholders) and agents (managers) Effective corporate governance structures help to prevent agency conflicts by acting as a monitoring device designed to align management’s goals with those of the shareholder The structure allows for compensation packages, which provide managers with an incentive to maximize the value of the firm Hence, agency theory suggests better corporate performance established through measured corporate governance will lead to lower agency costs, higher stock prices and better long-term performance as managers are better supervised because a system of accountability, i.e corporate governance, exists

In a similar manner, Himmelberg et al (1999)examine the link between managerial ownership and firm performance and find no relationship between changes in managerial ownership and firm performance.Mehran (1995)finds that firm performance is positively related to the percentage of equity held by managers and to the percentage of compensation that is equity based.Bushman et al (2004)find that strong governance systems characterized

by high ownership concentration, strong directors’ and executives’ equity-based incentives and the strong reputation of outside directors vary inversely with timeliness of earnings Other studies have examined the relation between operating performance and certain corporate governance provisions.Botosan and Plumlee (2001), using Fortune list of the

100 fastest growing companies as of September 1999 and computing the effect of expens-ing stock options on operatexpens-ing performance, find a substantial effect of expensexpens-ing stock options on operating performance Similarly, Fich and Shivdasani (2006)using Fortune

1000 companies find that firms with director stock option plans are relatively more prof-itable as measured by using operating return on assets, return on sales and asset turnover as proxies for profitability

3 Metrics for corporate governance ratings

The most commonly used services that provide metrics that rank the quality of a firm’s corporate governance system are the institutional shareholder services, Standard and Poor’s (S&P, discontinued 2005), Governance Metric International (GMI), and The Corporate Library (TCL) The ISS includes a composite of 225 variables based on 61 rating criteria across eight governance topics It rates the corporate governance of over 5200 U.S compa-nies and 2300 international compacompa-nies and provides ratings based on a percentage scale The S&P includes four categories and it provides scores on a range from 1 to 10; however, the list is not currently published The GMI includes 600 variables based on seven categories;

it provides scores based on a range from 1 to 10 and provides ratings for nearly 3400 U.S and international companies The TCL includes approximately 120 variables based on six categories, provides letter scores ranging from an A to an F and provides ratings for over

2000 U.S companies When deciding on which rating service to use, researchers and firms must be cautious as each service has its advantages and disadvantages

The ISS database appears to be the most recently developed rating service and one that

is currently the most widely used in corporate governance research literature According to

a Wall Street Journal article,Langley (2003)identified the ISS rating service as the one that carries the most clout.Brown and Caylor (2005)use the ISS database to create a summary index called “Gov-Score” and argue that this index is a broad measure of governance and one that is positively linked to both return on equity and return on assets.Van den Berghe and Levrau (2004)argue that an evaluation of corporate governance must include a wide variety of factors in order to capture the real value of the board The categories included

in the ISS database are, board characteristics, audit characteristics, charter/bylaws, anti-takeover practices, executive and director compensation, progressive practices, ownership and director education Within each of the ISS categories are various subsets resulting in a total of 225 corporate governance variables

We use the ISS database because it covers a broad range of public companies, it contains

a comprehensive list of corporate governance variables and it appears to be the most widely accepted rating system being used in current practice ISS first created its corporate gov-ernance quotient (CGQ) in July of 2002 as a product intended to improve the interaction between shareholders and companies The CGQ rating system was changed in early 2003

in anticipation of the impact of the Sarbanes-Oxley Act In September 2005, ISS released

an updated version of its CGQ rating methodology3 The current CGQ rating methodology

3 http://www.issproxy.com

factors in the evolving regulatory and dynamic market environment and aligns the ratings methodology with lower risk (as a result of SOX Section 404) and improved financial per-formance The CGQ ranges from 0 to 100% and firms are rated individually and within the firm’ industry sector

The present research examines the relation between the aggregate ISS governance rat-ing received by a company and the company’s operatrat-ing performance Individual ratrat-ing factors are not examined; the premise of the researchers is that the overall interaction of shareholders to companies and their corporate governance is based initially upon the overall corporate governance rating received by the company Why are these ratings important to corporations? Among the many reasons is the reliance of the institutional investment com-munity 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 would be quite unwise

4 Metrics for firm performance

Empirical research on corporate governance use either market-based measures or accounting-based measures to assess firm performance There is much debate as to which measures are the more reliable.Klein (1998)andCore et al (1999)use ROA as an oper-ating performance indicator Return on equity (ROE) is used byShrader et al (1997)and

Lo (2003).Brown and Caylor (2005)use return on equity and return on assets as their two operating performance measures.Barnhart et al (1994),Dowen (1995)andVafeas (1999)

use market to book value ratios as performance indicators.Lang and Stultz (1994),Mehran (1995),Yermack (1996)andHimmelberg et al (1999)use Tobin’s q as an operating

per-formance indicator.Dalton et al (1998)indicate in a meta-analytic review of corporate governance literature that there is no consensus as to which measures are more efficient The current research examines firm’s operating performance and the effect (if any) of corporate governance rating on that performance Return on assets and return on equity are the variables selected as measures of operating performance with the log of book-to-market added as an independent control variable

4.1 Return on assets

Return on assets is a measure of operating performance, which shows an investor what earnings a firm has generated from its invested capital assets ROA in the current study is defined as income before extraordinary items for the fiscal period divided by total assets for that same period Managers are directly responsible for the operations of the business and therefore the utilization of the firms’ assets Thus, ROA allows users to assess how well a firms’ corporate governance system is in securing and motivating efficient management of the firm

4.2 Return on equity

One of the primary reasons for operating a corporation is to generate income for the benefit of the common stockholders Return on equity is a measure that shows an

investor how much profit a company generates from the money invested from its share-holders ROE in the current study is defined as the income before extraordinary items available for common equity divided by the sum of the book value of equity and deferred taxes

5 Data description

The purpose of the study is to examine the corporate governance ratings of a sample of large U.S public companies from a wide range of industries Thus, firms were selected using the S&P 500, since the S&P 500 represents a list of the top 500 U.S companies in terms of market value and performance Approximately 70% of the value of the U.S equity market

is tracked by the S&P 500 (Investorwords com, 2005) Corporate governance ratings were collected from the ISS database for the study periods 2002–2004 The present sample is based on a complete set of firms on the S&P 500 with (a) December 31st year-end, (b) a

complete set of the required financial data on Compustat for each of the years—2002–2004,

and (c) ISS corporate governance quotient score (CGQ) for each of the years—2002–2004 For the year 2004 there were 359 S&P 500 firms with December 31st fiscal year-end Seventeen of these firms were dropped because they are not rated by ISS, 67 of the remaining

342 firms were eliminated due to incomplete financial data on Compustat and 2 of the

remaining 275 firms were eliminated because of the negative value of their book-to-market ratio; hence, the natural log of the control variable could not be determined The total sample size for the year 2004 consists of 273 firms

For the year 2003, there were 359 S&P 500 firms with fiscal year-end December 31st Twenty-three of these firms were dropped because they are not rated by ISS Sixty-seven

of the remaining 336 firms were eliminated due to incomplete financial data on Compustat.

Hence, the total sample size for the year 2003 consists of 269 firms

For the year 2002, there were 357 S&P 500 firms with 12/31 fiscal year-end Thirty-two

of the firms are dropped because they are not rated by ISS and 65 firms were eliminated

due to incomplete data on Compustat Additionally, 5 firms were eliminated due to negative

ratios for their book-to-market values Thus, the research sample size for the year 2002 consists of 256 firms

6 Methodology

We use the ISS company corporate governance quotient (CGQ) rating which is a com-posite of 61 rating criteria across eight categories of governance topics from the institutional shareholder services data set for the periods 2002–2004 We relate the actual CGQ rating

to two measures of the firm’s operating performance, return on assets (ROA) and return

on equity (ROE) The objective of the research is to assess whether a firm’s ISS corporate governance rating has an effect on its operating performance To this end, we compare cor-porate governance ratings of the firms to two measures of the firm’s operating performance, return on assets (ROA) and return on equity (ROE) Simultaneously, we control for other attributes that are likely to affect performance by using the control variable, natural log

of book-to-market If performance has a positive effect on governance rating, then high corporate ratings would equate to large rates of returns Thus, our hypothesis is

H1 Corporate governance rating is positively associated with firm’s performance.

The following model is used to investigate the above hypothesis:

ROEit = β0+ β1 CoISSit + β2 log BMit + ε (Model 1A) ROAit = β0+ β1CoISSit + β2 log BMit + ε (Model 1B) where CoISSit is the company i’s ISS corporate governance quotient (rating) in year t, ROE it

the company i’s return on equity in year t, ROA it the company i’s, return on assets in year

t, log BM it the natural log of book-to-market for company i in year t, We investigated H1

using ordinary least squares (OLS) regression for each of the years, 2002–2004

7 Analysis and results

Figs 1–3show the histogram of ISS corporate governance ratings for the sample firms in 2002–2004 The figures show a slight insignificant increase in the governance ratings with

a mean value of 52.099 in 2002 to a mean value rating of 52.672 in 2003 for the sample firms A more significant increase in the governance ratings is shown in the 2004 histogram

inFig 3, where the mean of the governance rating is 55.472 and the bars indicate a greater percentage of firms are in the upper percentiles

Tables 1–3 show the results of the regressions of the operating performance metrics, return on equity and the return on assets on the firms’ ISS corporate governance rating

Fig 1 Distribution of ISS corporate governance ratings in year 2002 histogram distribution of ISS corporate governance ratings (Co ISS) in 2002 for the S&P 500 firms in the sample Normal curve is superimposed.

Fig 2 Distribution of ISS corporate governance ratings in year 2003 histogram distribution of ISS corporate governance ratings (Co ISS) in 2003 for the S&P 500 firms in the sample Normal curve is superimposed.

(Co ISS) along with the control variable, natural log book-to-market Panel A ofTable 1

shows that the regression results for(Model 1A)for the return on equity in the year 2002

is significant at p < 0.001 with an adjusted R2 of 0.25 Both the intercept and the control variable, log of book-to-market, are significant at the 0.05 level and 0.01, respectively However, the result for the corporate governance rating variable is not significant

Fig 3 Distribution of ISS corporate governance ratings in year 2004 histogram distribution of ISS corporate governance ratings (Co ISS) in 2004 for the S&P 500 firms in the sample Normal curve is superimposed.

Table 1

Linear regression results for firms’ governance ratings in year 2002

Panel A: ROE Statistical results

Model R R2 Adjusted R2 S.E of the estimate Durbin-Watson Model summary a , c

ANOVA a , c

Model 1

Performance measure Intercept Co ISS rating Log book-to-market Adj R2 Operating performance measure

Return on

equity

( −2.330) ** (0.250) ( −9.290) ***

Panel B: ROA Statistical results

Model R R2 Adjusted R2 S.E of the estimate Durbin-Watson Model summary b , c

ANOVAb,c

Model 1

Performance measure Intercept Co ISS rating Log book-to-market Adj R2 Operating performance measure

Return on

assets

( −0.668) (0.830) ( −4.105) ***

Panel A: ROE statistical results (256 S&P Firms), Panel B: ROA statistical results (256 S&P Firms).

a Dependent variable: Return on Equity.

b Dependent variable: Return on Assets.

c Predictors: (Constant), Natural Log Book-to-Mkt, Co ISS.

*** Indicates significance at 0.01 level, ** Significance at 0.05 level, *Significance at 0.10 level, Student t-statistics

in parenthesis.

Similarly, the statistical results for the return on assets shown in Panel B ofTable 1 (Model 1B) for the firms in year 2002 indicate that the model is significant at p < 001 with an adjusted R2of 0.056 The control variable, log of book-to-market, is significant

at the 0.01 level and the intercept is not significant Similar to the ROE results above, we

Table 2

Linear regression results for firms’ governance ratings in year 2003

Panel A: ROE Statistical results

Model R R2 Adjusted R2 S.E of the estimate Durbin-Watson Model summary a , c

ANOVA a , c

Model 1

Performance measure Intercept Co ISS rating Log book-to-market Adj R2 Operating performance measure

( −0.813) (1.974) ** ( −4.918) ***

Panel B: ROA Statistical results

Model R R2 Adjusted R2 S.E of the estimate Durbin-Watson Model summaryb,c

ANOVAb,c

Model 1

Performance measure Intercept Co ISS rating Log book-to-market Adj R2 Operating performance measure

Return on

assets

(2.657) *** ( −0.327) ( −4.665) ***

Panel A: ROE statistical results (269 S&P Firms), Panel B: ROA statistical results (269 S&P Firms).

a Dependent variable: Return on Equity ROE.

b Dependent variable: Return on Assets.

c Predictors: (constant), Natural Log Book-to-Mkt, Co ISS.

*** Indicates significance at 0.01 level, ** Significance at 0.05 level, *Significance at 0.10 level, Student t-statistics

in parenthesis.