King's College London

New research into how the market responds to changes in governance ratings issued by Institutional Shareholder Services (ISS) demonstrates that investors take governance ratings seriously, and that they are more worried about the implications of bad governance than they are encouraged by evidence of improved governance.

Paul Guest, Professor of Corporate Finance and Marco Nerino of King’s Business School studied the share price performance of 3,616 individual US firms that had seen a change in their ISS governance rating. They found that large governance ratings downgrades are associated with negative returns of -1.14 per cent over the three days surrounding the announcement, but that upgrades did not result in a significant market reaction.

The team’s study of the ratings issued by other providers also showed a negative return where downgrades are issued by governance analysts who do not provide a proxy advisory service. This is important because it suggests that investors value the substantive information and analysis behind the governance re-rating and are not simply trying to anticipate the share price impact of a negative proxy vote.

The research found that governance downgrades had a negative impact when they were not associated with a change in governance that the company had reported to the market. This suggests that governance downgrades provide investors with proprietary information to support their decision-making.

Guest and Nerino point out that; “in both the US and Europe there has been a lot of discussion on governance advisory firms. This has mostly focussed on their proxy voting recommendations, which some argue are disproportionately influential.  But our research shows that their influence is not simply about their voting recommendations; the evidence suggests that investors value the substance of their governance assessments.”

The research also investigated why only governance ratings downgrades, and not upgrades, had an impact on share price performance. Its findings suggest that investors are indeed more focussed on the downside risks of governance, and assess its potential economic cost on a firm-by-firm basis. They found that a downgrade had a different impact on a firm depending on its:

• cash flow – higher cash flow gives management teams access to more resources which can potentially be misspent
• market to book value ratio – this is used as an indication of a company’s growth prospects and therefore its scope to make investments that add to shareholder value
• leverage – higher leverage and more borrowing constrain a management team’s discretion over how they use revenues

The authors add; “we examined whether the reason that governance upgrades had no positive impact on share price performance was because the companies had already leaked the good news to the market, or because investors were suspicious of good news because the ratings providers might provide other services to the companies involved.  But we found no evidence of good news leaking ahead of announcements, and even smaller companies that weren’t likely to be clients of the ratings provider weren’t rewarded with a boost in share price when their governance ratings were upgraded.”

“Whether they are right or wrong to do so, investors seem to be using governance ratings to put a price on weak governance.”