Professors give corporate governance ratings a failing grade

PHILADELPHIA — Three Wharton School accounting professors are critical of corporate governance scorecards and ratings.

"This sort of check-box approach to corporate governance doesn't work," according to a new study by David F. Larcker, Ernst & Young professor of accounting, and Irem Tuna and Scott Richardson, both assistant professors of accounting.

"Lots of people are coming up with governance scorecards," Mr. Larcker said in a Wharton statement about the study. "They're coming up with best practices and selling this stuff. As far as we can tell, there's no evidence that those scorecards map into better corporate performance or better behavior by managers."

In a working paper titled "Does Corporate Governance Really Matter?" the three criticize "consultants and ratings services that use formulas — which they typically refuse to reveal — to boil down a company's corporate governance to a single number or grade."

"Not only are typical governance indicators based on shaky empirical foundations, they even can yield perverse results," according to the Wharton statement about the paper. Dell Inc.'s stock returned 32% over the last two years, compared with 22% for the Dow Jones Total Stock Market index, they noted. "But some corporate-governance raters have criticized (Dell), claiming insiders dominate its board. The list of top-performing firms that have been dinged in these sorts of ratings includes" Wal-Mart Stores Inc. and Southwest Airlines Co.

Ms. Tuna, in the statement, contrasts Dell with the now-infamous Enron Corp., which got good scores from some raters. Enron had implemented purported good governance practices, such as a separate chairman and chief executive officer and a board stocked with high-profile outsiders. Yet these safeguards didn't prevent executive misconduct.

The three academics disapprove of the California Public Employees' Retirement System's zero-tolerance campaign this year. The fund withheld proxy votes for any corporate director who was a member of the audit committee that approved allowing the auditor to do non-audit work. As a result, CalPERS, which oversees $166 billion in assets, opposed directors at more than 2,700 companies, they noted.

That check-box approach branded Warren Buffett "an undesirable board member," they wrote, resulting in CalPERS and other institutions withholding votes on Mr. Buffett's election to the board of Coca-Cola Co., Atlanta. Mr. Buffett, however, won re-election.

"Companies and their situations are too diverse," according to Mr. Larcker, Ms. Tuna and Mr. Richardson.

"The recipe book is big, and there's a different recipe for each company," Mr. Richardson noted in the statement.

The three academics tried to create a magic formula of their own. "But no matter how they sliced and diced governance data — consisting of more than 30 individual measures on more than 2,100 public companies — they couldn't find one," according to the statement.

Despite their paper's provocative title, the three think corporate governance matters. But "after puzzling over reams of company numbers, they are not confident that anyone can measure whether one firm's governance is better than another's, at least not by using typical metrics," according to the statement.

"Our overall conclusion is that the typical structural indicators of corporate governance used in academic research and institutional rating services have a very limited ability to explain managerial decisions and firm valuation," the three said in their paper. By structural indicators, they are referring to whether a company has a lot of insiders on its board or whether a board's chairman is also the company's chief executive officer.

"In theory, these facts point to ‘bad' governance because they suggest that managers control a firm and can enrich themselves, with impunity, at the expense of outside shareholders," according to the statement.

"We set the study up to err on the side of, ‘The relationship between governance measures and good performance is there,'" Ms. Tuna said in the statement. "And we can't even find it when we do that. We biased the analysis in favor of finding something. The structural indicators just don't seem to have that much ability to explain whether companies have to do accounting restatements, whether they're selling at a higher multiple, whether they're manipulating earnings and things like that."

The authors believe that in theory, better-governed firms should perform better. But they believe "it's difficult to use strictly numerical tools to assess what really drives managers' conduct."

"We believe that if we had some psychological way to go in and assess people — ‘Is this a good person or a bad person? Do they have high ethics or low ethics?' — that that would be extremely useful," Mr. Larcker said in the statement. "Maybe we could develop a psychological map. But virtually all the work done on this by consultants and the preponderance of work by academics uses measures that are a level removed from that."

"In the absence of effective measurement tools, investors who are trying to assess firms' governance have to do it the old-fashioned way," the authors believe. "That is, they have to do their homework, examining companies one at a time."

Mr. Larcker, Ms. Tuna and Mr. Richardson evaluated the sorts of indicators perceived by many investors as important in determining a company's external valuation by the market or debt rating agencies.

Among the indicators, the "appointment of a non-executive director as a lead director is expected to create an additional monitoring benefit on incumbent management," they noted.

But "no matter how they parsed the data," the authors "didn't uncover any strong, consistent relationship," the Wharton statement noted. "In many cases, they even saw the opposite of what one might expect, finding for example, that companies with big boards report smaller abnormal accounting accruals."

"This is inconsistent with prior literature that suggests big boards are ‘bad,' " the authors pointed out in their paper.

The professors' advice to companies concerned about their governance: "Don't do anything rash just to appease a ratings service.".

"A lot of well-known people and consulting companies seem to be espousing, ‘Here are the best practices. Trust me,'" says Mr. Larcker in the statement. "Our message is that there's not much evidence to back up those bold claims and simply benchmarking your governance to best practices isn't going to be that useful."