8 CORPORATE GOVERNANCE

C orporate governance is a hot topic. Not a day seems to go by without press

comment, a conference or the launch of a newcode, all on the subject of corporate gover-nance. Recent high-profile corporate failuresin the US and elsewhere in the world, many ofwhich were caused by, or at least exacerbatedby, governance weaknesses, have convincedan increasing number of once scepticalinvestors that governance is a separate riskclass that certainly requires attention and, inmany cases, specialist analysis.

However, there still remains much scepti-cism from many quarters, particularlyinvestors, who doubt the existence of the linkbetween good governance and performanceindicators, such as share price performance.For many practitioners and academics in thefield of corporate governance, this remainstheir search for the Holy Grail – the search forthe link between returns and governance.

For these practitioners and academics, thegood news is the discovery of an increasingamount of new evidence suggesting that theselinks do exist. In a survey completed in 2002,the management consulting firm, McKinsey & Company, obtained the opinions of institu-tional investors in developing and devel-oped markets. The study found that “theseinvestors said that they still put corporate gov-ernance on a par with financial indicatorswhen making investment decisions”. More-

over, the study also said “an overwhelm-ing majority of investors are prepared to pay a premium for companies that exhibithigh governance standards”. Similarly, in astudy (CLSA, 2002) of almost 500 companiesfrom developing economies, CLSA EmergingMarkets found a strong correlation betweencorporate governance and financial perfor-mance ratios. Its study went on to say “nearlywithout exception, stocks at the top end forcorporate governance have been strong overperformers over the past one to five years”.

But have links been found in developedmarkets, for example the US, the largestcapital market in the world? In 2001, PaulGompers and Joy Ishii of Harvard Universityand Andrew Metrick of The Wharton Schoolproduced the results of their study (Gomperset al., 2001) of 1500 US firms measuredbetween 1990 and 1999. Their study found “astriking relationship between corporate gov-ernance and stock returns” and evidence that“an investment strategy that bought firmswith the strongest shareholder rights and soldthose with the weakest would have earnedabnormal returns of 8.5 per cent per year”. InJapan, the second largest capital market, linksare also starting to be made.

However, it also true to say that, despite theincreasing volume of evidence, many compa-nies still remain unconvinced and the practi-cal adoption of good governance principles

© Blackwell Publishing Ltd 2004. 9600 Garsington Road, Oxford,OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.Volume 12 Number 1 January 2004

Corporate Governance Scoring and the Link Between CorporateGovernance and PerformanceIndicators: in search of the Holy Grail*

Nick Bradley**

*This paper was presented atthe 1st International Confer-ence on Corporate Governanceorganised by the Centre for Corporate GovernanceResearch, The BirminghamBusiness School, 9 July 2002.**Address for correspondence:Standard and Poor’s, GardenHouse. 18 Finsbury Circus,London EC2M 7NJ E-mail:nick_bradley@standardandpoors.com

IN SEARCH OF THE HOLY GRAIL 9

has been “patchy” at best, with “form oversubstance” often the norm. Whilst there havebeen many attempts to measure governancefrom a compliance perspective, there are cur-rently no global benchmarks with which tomeasure governance standards.

If many investors continue to buy the stocksof companies, irrespective of their governancestandards, there is little motive for companiesto improve. Although codes and guidelinesare essential for setting minimum standards, itis often all too easy for companies to complywith the letter, but not the spirit, of thesecodes. For example, the worst board in theworld may well comply with certain corporategovernance codes – a majority of non-employed directors, for example – but if thesesame directors are unable or unwilling todevote the appropriate time to their positions,the substance of good governance is suspect.Moreover, codes are quite correctly designedto be complied with, being minimum stan-dards setters, and are not capable of identify-ing “best in class”.

In 1997, in response to increasing concernsfrom the market about corporate governanceweaknesses in certain parts of the world, Stan-dard & Poor’s conducted market research todetermine whether investors would be inter-ested in a service that specifically calibratedthe governance standards of companies on aglobal basis. Receiving a positive response,work began in 1998 on a methodology toanalyse and calibrate the corporate gover-nance processes and practices of companies.The research, including consultations withacademics, experts and practitioners in thefield of corporate governance, continuedthrough 1999 and 2000 resulting in the launch,in 2001, of a new service (Corporate Gover-nance Scores) for investors and companies and their advisers.

A company Corporate Governance Score(CGS) reflects Standard and Poor’s assessmentof a company’s corporate governance prac-tices and policies and the extent to which theseserve the interests of the company’s financialstakeholders, with an emphasis on sharehold-ers’ interests. The assessment can be done ona public or confidential basis and involves theanalysis of public and non-public informationas well as meetings with directors and seniormanagement.

A Corporate Governance Score (‘CGS’) isassigned on a scale from CGS-10 (highest) toCGS-1 (lowest).

Standard & Poor’s analyses four key com-ponents when evaluating a company’s cor-porate governance standards. The first isOwnership Structure & Influence, where thetransparency of the ownership structure and

the influence, whether positive, negative or neutral, of major shareholders or blockholders is analysed. In the second component,Shareholder Rights and Stakeholder Relations, thequality of the interaction of the company with its financial stakeholders (for example,shareholder meeting procedures) and therights afforded to financial stakeholders (andwhether economic and legal rights are pro-portionate) are evaluated. The impact of anyanti-takeover provisions that might thwart an otherwise legitimate takeover attempt orentrench an unsatisfactory management arealso taken into consideration. In the third component, Financial Transparency and Informa-tion Disclosure, the quality, accessibility andtimeliness of financial (including the integrityand independence of the audit process) andoperational disclosures to financial stake-holders are measured. The analysis includesevaluations of a company’s public filings,annual reports and web sites. Finally, theanalysis looks at Board Structure & Process andevaluates the structure and effectiveness of theboard of directors, the role and independenceof non-employed directors, risk management,strategy setting and remuneration and succes-sion issues.

In these definitions, “financial stakeholders”include both a company’s shareholders andcreditors. This reflects the premise that thequality of a company’s governance processcan affect its ability both to honour contractualfinancial obligations to creditors and to max-imise the value of a company’s equity and dis-tributions for its shareholders.

It is important to note that different modelsof corporate governance around the worldreflect the nature of local legal and regulatorysystems, as well as differing approaches toeconomic management. The Anglo-Saxonsystem focuses primarily on the shareholder,while others, such as the German system, areoften perceived as achieving a greater balanceof interests between shareholders and otherexternal stakeholders (including creditors,employees, the community, the environment,etc.). By addressing the interests of both cred-itors and shareholders, the CGS recognises theimportance of stakeholders’ rights beyond therights of the shareholder. Hence, this systemcan be applied generally in many countriesaround the world, operating with differinggeneral approaches to corporate governance.However, it should be noted that Standard & Poor’s Corporate Governance Scores aredesigned specifically for financial stakehold-ers, primarily shareholders.

Although a Governance Score reflects Standard & Poor’s assessment of an individ-ual company’s corporate governance practices

© Blackwell Publishing Ltd 2004 Volume 12 Number 1 January 2004

10 CORPORATE GOVERNANCE

and policies and focuses on the internal gov-ernance structure and processes at an individ-ual company, consideration of a country’slegal, regulatory and market environment isalso an important element in the overall analy-sis of the risks associated with the governancepractices of an individual company. Forexample, two companies with the same CGS,but domiciled in countries with contrastinglegal, regulatory and market standards, pres-ent different risk profiles. In the event of deterioration in governance standards at aparticular company, investors and stakehold-ers are likely to receive better protection in acountry with stronger and better-enforcedlaws and regulations.

In the final analysis, Standard & Poor’s Governance Services takes the view thatmarket solutions are crucial to the long-termimplementation and adoption of substantivegovernance improvements – if investors arerewarded for investing in those companies

with good governance, by better equity per-formance, then companies whose cost ofcapital will be lower will be motivated to make these improvement. Is governance just acurrent fashion accessory for the current bearmarket or will governance continue to be part of the financial landscape when sharesrecover? We will see!

References

CLSA (2002) Emerging Markets, Make me holy . . .but not yet! February.

Gompers, P., Ishii, J. and Metrick, A. (2001) Corpo-rate Governance and Equity Prices, July.

McKinsey & Company (2002) Global InvestorOpinion, July.

Nick Bradley is a Managing Director and co-founder of Standard & Poor’s GovernanceServices group based in London.

Volume 12 Number 1 January 2004 © Blackwell Publishing Ltd 2004

“Public Companies need to do more to communicate the corporate governance and inter-nal control changes they’ve been making in the wake of corporate scandals and new regulations.” Dominic Jones, Blunn and Company.