Has the ratings party run its course

Written by YRK Reddy | Updated: Oct 1 2005, 05:30am hrs
Standard & Poors has recently announced that it is getting out of the business of rating on corporate governance in the US. It competed well by quickly developing a corporate governance score (CGS) service and emerged as the leader. The rating model was based mainly on the assumptions implicit in the OECD principles on corporate governance.

Since its announcement of the service in 2000, several companies around the world subjected themselves to this rating, many from the emerging markets, particularly Russia. It launched its services in the US in 2002 and the first company that announced its CGS publicly was the Washington-based Federal National Mortgage Association (Fannie Mae), the USs largest housing finance company, that scored nine out of 10. Andria Esposito, managing director for governance services at Standard & Poors, New York, reportedly commented at that time: Fannie Mae is not only demonstrating its own strong governance practices, but is also showing leadership in the US with regard to providing greater openness and disclosure about its corporate governance standards.

Subsequent to the dramatic ratings and announcements, Fannie Mae was caught in a vortex of scandals related to accounting, compensation, and other governance issues. Standard & Poors lowered the score to seven and then to six. Finally, it has announced withdrawal of the score, as well as the service itself, for the US companies. Some have speculated on additional considerations beh-ind the decision, such as poor revenues in this line of business in the US due to the preoccupation with the Sarbanes-Oxley legislation, which may have crowded out the luxury of corporate governance ratings.

It may be a matter of time before many companies and agencies give up corporate governance rating for reasons of weak validity or cost-effectiveness. About 30 months back, I had cautioned through this paper that corporate governance ratings at this point are akin to partying hurriedly in a bikini. First, the ratings do not yet have a clear objective in relation to capital markets. This is unlike in credit rating, for which there are clear objectives for the rating agencies, the rated companies and the public dealing with such companies.

Second, the knowledge, database and incisive research are scant in respect of corporate governanceit is still a minefield of assumptions and assertions. Under-standably, many rating agencies are still learning. Credit ratings, on the other hand, have solid database and valid models, if objectively applied. For instance, statistical analysis shows that the lower the rating and the longer the holding period, the higher the default rates in respect of credit instruments.

Shortly after the Enron crisis, The Economist, somewhat prop-hetically, had noted that the Securities and Exchange Commi-ssion hearings in the US had focused partly on the criticism that the rating agencies are venturing into territories for which they are ill-equipped and where they are able to add little or no value.

Indian industry had enthusiastically taken to corporate governance ratings nearly three years before. The stock exchange regulator at that time had also commended such ratings. However, the industry is yet to reconcile with the wide variations in market expectations and the ratings, the diverse approaches amongst rating agencies that result in diverse impressions and the expectations of value addition due to such ratings, compared to the scant benefits in the end.

But there is no need to throw the baby out with the bathwater. Companies have another option in this respect. They can do a genuine health check to improve themselves, instead of going to town flashing vague numbers. If the validity and benefits of the rating system are in doubt, they must try the former. Companies can check on where they stand vis-a-vis international best practices in corporate governance and prepare plans for action for Board development.

They may do this internally or use a scorecard approach, as deve-loped by the Academy of Corp-orate Governance. Alternatively, investors in particular may look to agencies like GovernanceMetrics International in the US, which do their rating based on research of over 3,200 companies and provide their input on a subscription basis, as opposed to the consultancy or engagement basis of many others.