Expert Perspective by Grahall’s OmniMedia Editorial Board
Margaret E. Tahyar (partner and member of the New York Financial Institutions Group at Davis Polk & Wardwell LLP) posted a blog on March 21, 2010 on the Harvard Law School Forum on Corporate Governance and Financial Regulation (“RiskMetrics’ Introduces New Governance Measurement for Proxy Voting Reports”). In her blog, Tahyar said: “RiskMetrics Group (RMG) has recently overhauled its core corporate governance yardstick… The Corporate Governance Quotient (CGQ), which for the past several years has ranked companies, both within their industry and on a broader basis, according to their overall adherence to RMG’s notions of governance best practices, is being discontinued as of June 2010. RMG is adopting a new approach as of March 2010 called Governance Risk Indicators (GRId), which will be applied to all of the 6,400 U.S. companies that it reviews. Under the GRId system governance practices will be grouped into four headings — Board Structure, Shareholder Rights, Compensation and Audit — and a color-coded risk assessment — High, Medium or Low Concern — will be applied to each category for each company. These assessments will be made on an absolute rather than a relative basis.”
Risk Metrics’s ISS division created CGQ in 2002 and it has since become well known and well recognized if not well understood. At the time, it was an important step forward in helping investors understand the organization and structure of boards, company control and their relationship to management. The methodology for CGQ was confidential and the CGQ “black box” provided companies and their investors with a number that showed how the company compared to others in that industry. Essentially, each company was “good” or “bad” compared to their peers. The rankings were perfunctory, mechanical and, other than companies on the very extremes of “good” or “bad”, the data was so highly “normalized” that everybody fell in the middle.
The challenges with CGQ’s relative ranking are perhaps best demonstrated in the way that ISS ranked Lehman Brothers just prior to its demise. In the March 2, 2010 Huffington Post article “MSCI’S Risky Bet on RiskMetrics” reporter Tamara Belinfanti says: “Exactly fourteen days before Lehman Brothers Holding, Inc. filed for bankruptcy in September 2008, ISS gave Lehman a corporate governance rating of 87.6%, meaning that Lehman’s corporate governance in ISS’ view was better than 87.6% of other diversified financial companies. ISS also doled out generous ratings to other ailing financial companies such as Washington Mutual, which was rated by ISS as being ‘better than 44.3% of S&P 500 companies and 95.6% of [b]ank companies’ just weeks before its undoing. And if that was not enough, a few days before AIG scurried to put together an emergency loan, ISS rated AIG as being ‘better than 97.9% of S&P 500 companies and 99.2% of [i]nsurance companies.’”
OOPS! Though if you accept that the near collapse of the financial system was due to over leverage and most every financial services company was “outside the safe zone”, then “relatively” maybe these numbers make sense. But looked at through a lens of reality, and with the benefit of hindsight, these ratings are absurd.
So it makes sense that RMG is making changes. Its March 10, 2010 press release (“RiskMetrics Group to Launch Governance Risk Indicators™ on March 17”, says: “RiskMetrics Group Inc. (NYSE: RISK), a leading provider of risk management and corporate governance services to the global financial community, today announced the launch of its new Governance Risk Indicators™ (GRId) on March 17, 2010. GRId assessments will provide institutional investors with a high-level benchmark of the potential risks stemming from companies’ governance practices and structures. The fully open GRId methodology is designed to reflect governance best practices in markets worldwide and draws on a robust data set.
Specifically, GRId will focus on an absolute level of concern (low, medium, high) across four independent dimensions: board, compensation/remuneration, shareholder rights and audit. The risk assessment measures the degree to which a company’s governance structures may meet, or fall short of, best practices in a particular market. The absolute measure ensures assessments are determined entirely by a company’s own governance practices.”
Well, that sounds great, but Tahyar complains that “These are for the most part changes in packaging and presentation rather than in substance. RMG has not changed its views as to what constitutes best practices, and at least in the example RMG provided, the GRId indicators used in the evaluation largely follow the corresponding CGQ factors. In other words, the new system replicates the core failing of its predecessor, based as it is on the notion that there is a single set of “best practices” that should apply to all companies. “
From Grahall’s perspective, we agree that RMG’s approach to evaluating risk is correctly criticized by Tahyar but for the wrong reasons. We see the fundamental problem with RMG’s approach to be that they base ratings on a simple premise: that more governance is better. We believe that the premise should be: “more appropriate corporate governance, based on the companies’ particular situation, is better.” It’s not a question of quantity but of suitability. For example, in start-up companies and those in a turnaround situation, the corporate governance “balance” should tilt toward the CEO. For a mature company with no serious financial challenges, then the corporate governance balance should be tilted toward the Board. It is critical to the enduring success of a company and based on its individual circumstances to have the right corporate governance structure and the right individuals driving the governance process and decisions. There is no absolute measure that says that a more corporate governance model and structure is better for every company.
But even with its imperfections, we see this change from relative to absolute measures to be a significant change in approach. With this change, RMG is basically saying that the way they measured risk was wrong, relative rankings were a failure and now absolute and objective measures are required. Best in class is not a safe approach if the class is on life support.
So now that RMG has changed its stripes from relative to absolute standards what actions should individual companies take?
If you are one of the 6000+ US companies in the RMG data base it is imperative that you review and verify your risk metrics data (instructions can be found on the RMG web site. Whether you are part of that 6000+ or not, next you can decide if you will adopt the RMG model or create your own. If RMG’s approach is “window dressing” you could create a better model that constitutes real and relevant change.
Contact Grahall’s OmniMedia Editorial Board at email@example.com.