Professor Robert Daines weighs in on the usefulness of proxy advisory firms for large corporations in a piece for the Financial Post.

Good corporate governance is booming business for powerful proxy advisory firms — companies like RiskMetrics/Institutional Shareholder Services (ISS), and Glass, Lewis & Co., who influence key shareholder votes with their governance ratings on companies and recommendations on how shareholders should vote at annual meetings or on special issues such as takeover bids. But for public companies and investors who follow their recommendations, new research suggests the advice may not be as useful as the advisors’ reputation might suggest.

Proxy firms are among those cashing in on the policy push to bolster the health of companies and the welfare of shareholders and the public markets in general. Generally, when they talk, giant investing pools of capital listen.

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“I’m suspicious they know what they are doing,” said Robert Daines, law professor at the Rock Centre for Governance at Stanford University in California.

Prof. Daines has studied the commercial governance ratings of proxy firms for years, including their bold claims that their ratings identify the worst corporate offenders, and how they identify problems before firms implode. In a report, “Rating the ratings: How good are commercial governance ratings?” Prof. Daines and two U.S.-based academics concluded such “exaggerated” claims don’t add up under scrutiny.

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“We found no evidence that their advice helps shareholders,” Prof. Daines told the Financial Post. “We found no evidence that the firms they believed to have ‘good governance’ actually had higher returns, market valuations, fewer lawsuits, or other outcomes that shareholders would like.” In fact, he added, “there was some evidence that the firms they considered to be well governed did worse on this score.”

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In fact, so obsessed have companies become with their governance ratings, according to Prof. Daines, that boards of public companies list proxy advisors as the third-most influential force they deal with behind institutional investors and analysts. A low governance rating, he said, is an important red flag that prompts directors to increase their monitoring, the same way they do when a company misses a quarterly analysts’ earnings estimate.

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In his study, Prof. Daines and his colleagues reviewed the association between the ratings producing by the rating firms and performance of the companies they measured. “We find that these governance ratings have either limited or no success in predicting firm performance or other outcomes of interest to other shareholders,” the report concluded. In the cases where they did find a statistical link, “the substantive economic association is small.”

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The conflicting evidence suggests the governance firms are applying a “one-size fits all approach,” Prof. Daines argued. These firms are populated with like-minded people who have strong beliefs about corporate governance but who may not have sufficient expertise in specific industries to assess deals and back up their recommendations, he said.

“The governance ratings we studied were no better than random number of generators when it came to predicting most of what shareholders cared about,” he said, adding compared to accounting firms, governance raters “did quite poorly.”

The bottom line: regulators should scrutinize advisers “for the accuracy of the data and recommendations” they peddle, he urged. “Just because ISS says it’s not good, doesn’t actually mean it’s wrong.”

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