Evaluating the Evaluators: Should Investors Trust Corporate Governance Metrics Ratings?
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Springer 2005
Evaluating the Evaluators: Should Investors Trust Corporate Governance Metrics Ratings? DARYL KOEHN1,* and JOE UENG2 1 Cullen Chair of Business EthicsUniversity of St. Thomas, TX 77006 Houston, USA (*Author for correspondence, phone: 713-942-5917; fax: 713-525-2110; e-mail: [email protected]); 2 Associate Professor of Finance, University of St. Thomas, TX 77006, Houston, USA
Abstract. Companies are under increasing pressure to have their corporate governance rated by an independent corporate governance metrics firm, such as Institutional Shareholder Services (ISS) or Governance Metrics International (GMI). These rating firms claim to be able to determine how effective and responsive a companyÕs board is. Institutional investors have begun using these board governance ratings when deciding which firms to include in their stock portfolios. This paper considers whether investors, many of whom claim to be socially responsible, should be relying upon board governance metrics. We find that these metrics are not good indicators of either the quality of a firmÕs earnings or of its ethics. Key words: board of directors, corporate governance, earnings quality, ethics, rating agencies
Institutional investors have been pushing firms to adopt so-called ‘‘Best Board Practices in Corporate Governance.’’ Best practices include, but are not limited to, having a majority of independent directors on the board; using only independent directors on the audit committee; enforcing board member attendance requirements, keeping former CEOs off the board, and being responsive to shareholder proposals. Much research could be cited in support of these best practices. Studies have shown that boards dominated by outside directors are more likely to get rid of ineffective CEOs (Weisbach, 1988), to hire replacement CEOs from outside the company (Borokhovich et al., 1996), to secure takeover bids better regarded by investors (Shivdasani and Zenner, 2004), to make better acquisitions (Byrd et al., 1992), and to get higher returns for shareholders in the case of takeovers (Cotter et al., 1997). Brown and Caylor (2004) found that companies with weaker boards performed more poorly, were significantly less profitable and reported earnings with a higher volatility than firms characterized as having stronger corporate governance. After reviewing the corporate governance literature, Melvin (2003) made a similar claim. Klein (2002) concluded that equity investors find earnings releases to be more believable when the companyÕs audit committee
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consists of independent directors. A study by Uzun et al. (2004) of US companies suggested that the likelihood of corporate fraud decreased as the proportion of outside independent directors on the board and its oversight committees increased. Such corporate governance research has encouraged institutional investors to believe that best board practices are likely to benefit shareholders over the long haul. Consequently, investors and stock analysts have begun to rely upon corporate go
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