Do you think that corporate governance could be a reliable indicator of the quality of company management, supervision and transparency, i.e. an instrument of value generation for investors? Which indicator is in your opinion the best proxy for a company corporate governance performance and which one is the most used by rating agencies according to your experience? (Aldo Bonati, Milan, Italy)

I am not sure corporate governance is a direct indicator of management quality. It is rather an indicator of the quality of the processes that govern the hiring, remuneration and overall monitoring of managers. Of course, better governance should be conducive of better management. In terms of best indicators, I believe that this is where the rating exercise is probably even more complicated than credit rating: there are so many dimensions to take into consideration. It is also the case that a “box ticking” approach, where there is a list of variables to be checked, is particularly unsatisfactory in the case of corporate governance (although quite popular).

Let me give you an example. In general, it is thought that managerial entrenchment is a bad thing: managers should promote shareholders interests first. But suppose there is a company that has a large investor who is also one of the main suppliers for that company. Presumably this large shareholder would like managers conducting business with his other company, even if those products might not be the most competitive ones. It could be best that in those situations, managers are given quite a significant degree of autonomy. A box-ticking approach would give a “minus 1” twice to that company: one for having not too responsive managers to shareholders pressure, one for having a large shareholder with motives that could be detrimental to the rest of the shareholders. But sometimes I believe those two minus ones don’t add up to minus 2, they could rather nullify each other.

The point I am trying to make is that in matters of corporate governance, most of the time, whether a process is good or bad is highly dependent on circumstances. This is the basis of the “comply or explain” approach pioneered by the UK where companies are expected to comply to a set of principles but they can opt out provided they have genuine reasons for doing so and then must state them in their annual accounts. This is an interesting model, a credible alternative to SOX (editor’s note: the Sarbanes-Oxley Act passed in the United States in 2002).

I am always baffled by the fact that the rating industry is composed by so few firms. I would expect new firms to have challenged the incumbents after scandals like Enron, Tyco, or Parmalat in Europe. Is regulation the reason, or is there some deeper economic reason for this? (Volker Piessland, Frankfurt, Germany)

There are some deep economic reason for this, indeed. The main asset of a rating agency is its reputation, as exemplified by the fall of Arthur Andersen. Once one of the biggest, it fell to nothing when its reputation got destroyed. Reputation is much harder and longer to acquire than what it takes to losing it. In economic terms, the need to develop a reputation constitutes one of the most formidable barrier to entry that there can be in a market. Regulators have been keen to foster entry in this market. It just does not happen because it takes time to get a rating firm whose opinion is highly valued by the market participants.

If so many investors depend on rating agencies for choosing securities, shouldn't these agencies be forced to participate to investor losses when a well rated firm goes bankrupt?

This is a deep question: how should rating agencies make a living? Should they be paid by the firms they rate, as now, or by the investors who follow their advice? In the latter scenario there would be then a basis to make a case when it goes wrong as investors could argue they bought some misleading advice. But in the current model, I don’t see why investors should get compensated from the rating agencies in those cases, given that they are in no contractual relationship with them.

Agencies like S&P rate individual securities. Corporate governance ratings, instead, are a comprehensive assessment of a company. Wouldn't their use help identify problems earlier and more frequently? (Quin Li, Hong Kong)

This is a bit of a matter of definition. There has been for a long time talks of developing equity ratings (as opposed to bond ratings). In some ways, corporate governance ratings, which assess how shareholders’ interests are looked after, can be viewed as some sort of equity ratings, therefore not too far from a rating of an individual security. I think that your question highlights that there is no such a thing as a rating of an individual security. Even in the case of bonds, the likelihood of default cannot be assessed ignoring the other (possibly more senior) securities, nor the overall financial situation of a company. For instance, corporate governance risk also plays a role in that perspective.

Standard & Poor’s started its corporate governance ratings in 2001 by selecting listed firms in emerging markets, and in 2002 extended it to include 1,500 firms worldwide. Market rumors have it that many of these threatened to switch to another agency if the rating was not made voluntary. If this account is correct, wouldn’t it imply that many companies are indeed adopting bad corporate governance practices? (Reginald Howing, London, UK)

This is really what my article is about: the impact of voluntary disclosure on the market for ratings. I had exactly the same intuition as yours: if companies can hide a bad rating, then voluntary disclosure (as opposed to compulsory) helps them to get away with bad governance. There is an issue though: some companies will get good ratings and will reveal those. Therefore, one could expect that in a mature market, investors would realize that a firm without a rating is probably a firm that got a bad rating. In fact, if all companies were rated, surely not revealing any rating would tell the market that this company is hiding something fishy.

The failure to show a good rating would then constitute bad news about a company. Companies would then have to decide between the lesser of two evils: revealing its relatively poor rating or not doing so, both being bad news. If the rating is only moderately bad, it would then be best for that company to reveal it as markets would think things are even worse if no rating is revealed. Interestingly, this effect can work to the advantage of rating agencies, here S&P, as the option of no disclosure can increase the willingness to pay for S&P’s services.

The Parmalat and Enron scandals have exposed the inadequacy of standard ratings as a protection to investors. Would corporate governance ratings, possibly compulsory, help reduce this inadequacy? (Nick Stellone, New York, NY, USA)

Well, that’s the hope. As I said earlier I am not even sure that those ratings have to be compulsory. Even on a voluntary basis, the inability or unwillingness of a company to reveal a corporate governance rating would send a bad signal to investors. Companies might be worried of investors staying away from their stock, and that may provide enough incentives for them to implement necessary changes in corporate governance.

In your opinion, is there a serious case for suspecting the existence of collusion between rating agencies and firms? (Howard Seinstein, San Francisco, CA, USA)

I guess your question refer to what happened in auditing, where the issue of conflict of interest became prevalent. Whether the same bad incentives could perturb the working of the rating market, in particular in matters of corporate governance remains to be seen. But it is true that one could already think about rotating mechanisms, whereby a firm would have to rotate the agencies that provide its ratings. That would need enough competition. Notice also that companies can get and usually get ratings from more than one agency. This is already a limit to kind of opportunistic behavior you have in mind.

Firms often cite the need to preserve discretion as a reason not to disclose information. But if information is disclosed to a rating agency it should still remain confidential. Therefore, shouldn't regulators make ratings a more general form of investor protection than it currently is? (Per Edumdsson, Goteborg, Sweden)

I personally believe that the need to preserve discretion, not to disclose proprietary information, is a no issue when it comes to ratings, in particular in matters of corporate governance. Take the UK as an example. The Code wants companies to have separation of Chairman and CEO, to have independent, non executive directors, to have remuneration, compensation and hiring committees and so on… all those recommendations are principles of best practices mainly about internal processes. Other codes (e.g. Austria) discourage dual class of shares. In the US, most of pressure is against anti-takeover protection… Why discretion in those matters? I can’t think of a cost of revealing that you are doing things well.

Corporate governance rules and practices differ widely across countries. How can a rating be both objective and take into accounts such variety of national elements? (Andres Epelbaum, Mexico)

Some of those scores (e.g. S&P’s) explicitly take differences in legal environments across countries. A poison pill in the US is certainly not the same as in Russia. This point also highlights that the value added by rating agencies that adopt a “box-ticking” approach is much less than those who instead conduct a case by case analysis. This is where the market should go.

Would corporate governance rating be more useful for large firms, which are already under the scrutiny of analysts, press, and institutional investors, or for smaller firms - which often complain of the difficulty to attract analyst coverage?

In my article, I argue that ratings are most useful in situation where there is most uncertainty about the quality of corporate governance of a given company. As you rightly point out this is generally not the case for big firms, operating in countries where transparency standards and overall regulation are of pretty high quality.