Does BBR render CGR and CGI DOA?
By Hoffer Kaback

A re corporate governance “indices” valuable … or mean- ingless? Do so-called gover- nance “ best pr actices” lead to better corporate performance … or are they not worth a John Nance Garner bucketful of warm p—? Should direc- tors cut their consciences (and practices) to fit this year’s governance fashions … or should they stand tall and refuse to do so? The commercial rating ser- vices answer these three ques- tions by claiming that their p r o p r i e t a r y f o r m u l a e f o r weighting governance prac- tices yield a valuable tool for investors. (And, plainly, their s u b s t a n t i a l c u s to m e r b a s e votes with its pocketbook on this assertion.) Very different answers are g ive n i n a n O c to b e r 2 0 0 7 paper by Professors Sanjai Bhag at, Br ian B olton, and Roberta Romano (BBR). Ti- tled “The Promise and Peril of Corporate Governance Indices,” it was written for the European Corporate Governance Institute (and can be down- loaded at BBR’s principal points include: 1. Those who sell governance ratings and evaluation services to investors as- sert that earlier academic studies dem- onstrate a causal, statistically significant connection between governance indices and corporate performance. 2. BBR’s analysis shows, on the con- trary, that there is “no consistent relation between the academic and related com- mercial governance indices and mea- sures of corporate performance.” 3. Regulators should not mandate specific governance practices but should encour age flexibilit y. In other (my) words: Corporate governance indices (CGI) and corporate governance ratings (CGR) are bunk. 4. The single characteristic of outside board members’ stock ownership is a better proxy for good governance than CGI/CGR insofar as such ownership re- lates to (a) future accounting earnings and (b) firing the CEO after bad performance. 5. Indices that weight indi- vidual governance practices overlook the issue of interac- tion among practices and that practices may be substitutes (rather than complements). 6. There are differences be- tween relating governance to (a) stock returns and (b) ac- counting earnings. 7 . “ C o m p l y o r e x p l a i n” r e g u l a t o r y r e g i m e s ( a s i n Canada) create an unhealthy and inappropriate incentive for companies to conform to governance checklist-ism; better would be disclosure without comparisons to a purported standard. 8. Purchasers of CGR services may not themselves even believe that such ratings have predictive or analytical value; they may instead be engaged in CYA activity as fiduciaries. 9. BBR’s two key policy conclusions are: a) regulation regarding governance practices should not be “checklist”-ori- ented but instead disclosure-driven; and b) investors should grasp that CGR and CGI do not and cannot predict stock price movement. Now to comments and criticism: • Virtually every BBR citation appears to be to an ar ticle from an academic journal. Why such “purity”? There are numerous pieces, written by academics and nonacademics alike but published in nonacademic journals and periodi- cals, that contribute not insignificantly to governance literature and thinking. But in BBR, governance analysis appears to exist only in strictly formal academic journals — a space not necessarily co- extensive with the real world. • BBR’s inferences about directors’ stock ownership are, in my view, mis- guided. Among many other things, BBR fails to consider that directors own a fair amount of stock these days not necessar- ily because they desire to or because they are convinced that doing so is a superb investment but because the companies on whose boards they sit require them to (if they want to be directors); and those companies so compel them because of pressure over the last 15 years from the chefs de cuisine in the “eat your own cooking” governance kitchen. Were all U.S. directors required to wear maroon ties to board meetings, then one could correlate that to corporate performance. BBR’s conclusions about directors’ stock ownership may reflect that directors at some companies have been compelled to hold more dollar value of stock than have directors at other companies. • Wi l l B B R re n d e r C G R a n d C G I henceforward “dead on arrival”? For many years now, several commentators (and the Business Roundtable) have criticized the checklist mindset, empha- sizing instead that the essence of gover- nance lies in each director’s character and ability. To the extent, however, that the CYA mentality remains operative in the institutional investor world, BBR will have the same little effect that these far earlier anti-checklist analyses had. For, clearly, the purchase of checklist- based CGRs is itself an act of checklist- ing. The CYA-oriented investor buys the CGR and checks the “buy a CGR” box. For such an investor, CGR and CGI will not be DOA; they will endure. ■ The author can be contacted at hkaback@ quiddities directors & boardssecond quarter 2008 Hoffer Kaback is president of Gloucester Capital Corp. and has served on several boards. Does BBR render CGR and CGI DOA? Or, no matter what the evidence, is it all CYA? By Hoffer KaBacK We help mitigate enterprise risk so directors can lead with confidence. 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