WHAT'S YOUR “CGQ” IQ? WHAT EVERY CORPORATE EXECUTIVE SHOULD KNOW ABOUT THE CORPORATE GOVERNANCE QUOTIENT
As a corporate executive or director you might find yourself wondering what, if anything, to do about your company’s Corporate Governance Quotient (CGQ) computed and published by Institutional Shareholder Services: should you pat yourself on the back as a good governance leader for a high CGQ, or take drastic action to remedy a low CGQ, lest you be viewed as being “soft” on corporate governance matters? Despite its widespread publication, you might be uncertain as to the CGQ’s origin, components and practical impact. This article attempts to cut through some of the CGQ clutter by discussing the CGQ’s background and role and providing you with practical strategies for dealing with your company’s CGQ ratings.
Corporate Watchdogs and the CGQ’s Creation
Corporate governance and corporate ethics have waxed and waned as subjects of great public interest, but have taken on an added (and seemingly lasting) prominence in the wake of the scandals at Enron and WorldCom, the Sarbanes-Oxley Act of 2002 and the recent option backdating investigations. In parallel with these developments, we have seen the increasing influence of institutional shareholders, shareholder activists and “corporate watchdogs,” such as Institutional Shareholder Services (ISS), which analyzes proxies and issues research and vote recommendations for numerous companies across worldwide markets.[1]
In its corporate watchdog role, ISS determined that investors view governance as an important issue in making investment decisions as well as in proxy voting and identifying targets for proxy season campaigns.[2] To meet the demand for a tool that monitors and compares the corporate governance structures of America’s publicly-traded companies, ISS developed the Corporate Governance Quotient.[3]
The CGQ is a relative measure, meaning that companies are compared and given percentile ratings.[4] Each company has two CGQ ratings: a market CGQ, which compares the company to the relative market index (e.g. S&P 500, Mid-Cap 400, Small-Cap 600, etc.), and an industry CGQ, which compares the company to its industry peer group (e.g. healthcare equipment and services, software and services companies, retailing companies, etc.).[5]
The CGQ’s Components
To generate your company’s CGQ, ISS analyzes your company’s public disclosure documents, company websites and other public sources to gather data points in eight core components: (1) board structure and composition, (2) audit issues, (3) charter and bylaw provisions, (4) laws of the state of incorporation, (5) executive and director compensation, (6) progressive practices, (7) director and officer stock ownership, and (8) director education.[6] The score for each core topic reflects a set of key governance variables.[7] The current list comprises over 60 of these sub-issues, and some variables are analyzed in combination with other provisions.[8] For example, a company that has a board with a majority of independent directors and all-independent key board committees (audit, nominating and compensation) receives higher ratings for each of these attributes in combination than it would if it had either one of them in isolation.[9] Other factors that negatively affect your company’s CGQ include anti-takeover measures, staggered boards and having an executive as chairman of the board.[10]
The CGQ methodology is updated periodically to reflect the most current corporate governance trends.[11] In November 2006, the CGQ was updated to add ratings criteria for majority voting, financial restatement, options backdating and director withhold recommendations. Additionally, the ratings criteria for board structure and the separation of the chairman and chief executive officer positions were updated to reflect cases where companies have taken intermediate steps to modify their corporate governance structure. Finally, the ratings factor for options expensing was removed to reflect that it is no longer a differentiator for companies in the CGQ model, following the implementation of FAS 123(R).[12]
Finding and Analyzing Your Company’s CGQ
Your CGQ ratings appear on the front page of your ISS proxy analysis along with information that provides some context for the ratings.[13] Additionally, your company’s CGQ can be found at Yahoo! Finance on your company’s “Profile” page.
To attempt to ensure that your company’s CGQ is calculated using accurate information, ISS encourages you to use https://ga.issproxy.com/ to verify the data that ISS compares to its CGQ criteria and to submit any material changes related to your company’s corporate governance structure, policies and procedures.[14]
ISS also provides a fee-based CGQ benchmarking service, which allows you to perform sensitivity analyses to assess the impact of various proposed changes to your company’s governance profile.[15] Using this benchmarking service, your company is also able to compare its governance structure and policies with peer companies and applicable market index and industry groups.[16]
The Role of the CGQ
While many CGQ components are aligned with ISS voting policies on specific issues (such as majority voting), ISS does not currently use your company’s CGQ as a sole determining factor in making any voting recommendations. ISS may consider your CGQ in assessing your company’s governance structure or profile in connection with voting recommendations on certain matters, such as director nominees, cumulative voting, separation of the chairman of the board and chief executive officer positions, majority vote shareholder proposals, mergers, corporate restructurings, changes in capital structure and proxy contests.[17] Although the relationship between ISS voting policies and your company’s CGQ could change in the future, it is important for you to keep the current relationship in mind when assessing your company’s CGQ and considering any corrective action. In other words, in most instances your company can simply consider the CGQ in the same light as any other third party analysis of corporate performance.
The CGQ is not without its critics, many of whom question whether the CGQ should be the definitive measuring stick for corporate governance quality. In particular, the CGQ has been criticized for what may be perceived as a conflict of interest concerning its creator, doubt surrounding ISS’s qualification to unilaterally define good corporate governance, skepticism over its impact on investment decisions and its relativist nature as a shifting benchmark.
The conflict of interest criticism centers on “ISS’s growing business of selling services to the same corporations it scrutinizes.”[18] For instance, if your company has a low CGQ, you can ask ISS to help your company improve its CGQ in exchange for a substantial fee. Ironically, some critics have likened “ISS to the big accounting firms of a few years ago, which sold consulting services to corporations while at the same time auditing their books,” a practice which has been frowned upon by the recent corporate governance movement.[19]
To be fair, ISS keeps its corporate services sales division separate from its research division and your company is ultimately responsible for implementing measures which will improve its CGQ.[20] However, ISS’s practice of selling services to boost a measure of its own design and publication lends itself to some skepticism.
Some critics also question why ISS’s conceptual model of good corporate governance should be the model that is imposed on all companies. For instance, some companies feel that the ISS model is more concerned about being “politically correct” than it is about generating shareholder returns.[21]
While ISS claims that investors view governance as an important issue in making investment decisions, it is not clear that a low CGQ score has a large impact on individual investment decisions. To be more precise, it seems unlikely that investors would be unwilling to invest in a profitable company simply because that company’s CGQ is low relative to its industry peers and the market. While corporate governance may or may not be a cause of individual investment decisions, recent studies have found a correlation between good corporate governance and investment returns, suggesting that “corporate boards that are more concerned about shareholder rights are also better guardians of shareholder money.”[22] Additionally, ISS continues to refine the CGQ methodology to try to reflect best practices and good financial performance metrics.[23]
Also, it is important to emphasize the relative nature of the CGQ, meaning that positive changes made by your company to increase its CGQ ratings will be counteracted by positive changes made by other companies in your respective market and industry. As a result, you must be mindful of placing too much emphasis on boosting your company’s CGQ ratings. In order to improve your company’s CGQ ratings, you might be tempted to encourage your company’s board of directors to remove important takeover defense measures, as some of the key governance components that can negatively impact your company’s CGQ include a shareholder rights plan, or “poison pill,” that has not been subject to shareholder approval, a classified or staggered board and blank check preferred stock. By removing these defensive measures, your company might weaken its ability to resist takeover proposals which are unfavorable to its shareholders, while at the same time having no guarantee that such changes will reap the anticipated benefits of improving its CGQ.
Practical Strategies for Dealing with Your Company’s CGQ
While the CGQ is a useful tool in understanding how your company’s governance mechanisms rate in comparison to your industry and market peers, the CGQ should not be the sole determinant for executives and directors trying to craft a good corporate governance structure. To balance the usefulness of the CGQ as a tool for comparing your company’s governance structure to its peers with the aforementioned criticisms and concerns about placing too much emphasis on the CGQ, you should consider the following approach in managing your company’s CGQ:
(1) Remember the Role of the CGQ. You need to be mindful of the fact that the CGQ is not currently driving the vast majority of ordinary course voting recommendations from ISS (nor, anecdotally, voting decisions by subscribers or individuals). Corporate changes at your company designed to address CGQ issues should be viewed through an investor relations lens, and not with a focus on proxy voting impact.
(2) Consider Your Company’s Exposure to Shareholder Proposals. If your company has been the subject of shareholder proposals (such as those to redeem your company’s poison pill or eliminate your classified board) in the past, or anticipates that such proposals are reasonably likely, then taking steps to improve your company’s CGQ could build some political capital and decrease the number of similar proposals.
(3) Consider Your Industry. If your industry peers have similar corporate governance structures and market CGQs, then it seems to be of little value to try to boost your market CGQ. On the other hand, if your industry peers have better industry CGQs then you may wish to take measures to improve your company’s industry CGQ.
(4) Remember the Relativity. If you make a change in your company’s corporate governance structure in hopes of boosting your company’s CGQ, you are not guaranteed that your company’s CGQ ratings will improve because other companies might also make similar changes.
(5) Verify Your Company’s Data. Regardless of where your company’s CGQ ratings fall (or their relative importance) they should, at least, be based on accurate data. Therefore, you should use https://ga.issproxy.com/ to verify your data and submit any material changes related to your company’s corporate governance structure, policies and procedures.
By following this approach to CGQ management, you can ensure that your company appropriately considers and addresses corporate governance issues without overreacting to the CGQ benchmark.
For further discussion of these developments and other SEC regulations, please contact a member of Oppenheimer's Securities Group.
[1] Morton A. Pierce et al., Taking a Hard Look at Poison Pills: Criticism of Shareholder Rights Plans Gains Momentum, 234 N.Y.L.J. 9 (2005).
[2] See ISS Corporate Governance Quotient, About the Ratings, (“ISS CGQ”), available at http://www.isscgq.com/CGQratings.htm (last visited Dec. 10, 2006).
[3] Id.
[4] Jill E. Lyons, Rating Corporate Governance: Update on Enhanced CGQ Methodology (“Methodology”), at 4 (June 21, 2005).
[5] Id.
[6] ISS Corporate Services, Inc., Corporate Governance Quotient: Benchmark Your Corporate Governance Against Your Peers (“Benchmarking”) at 2, available at http://www.isscorporateservices.com/pdf/CorpCGQ.pdf (last visited Dec. 10, 2006); Lyons, supra note 4, at 8.
[7] See ISS CGQ, supra note 2.
[8] See Lyons, supra note 4, at 8; ISS CGQ, supra note 2. Prior to the November 2006 updates, there were 63 sub-issues.
[9] ISS CGQ, supra note 2.
[10] Id.
[11] Institutional Shareholder Services, 2006 CGQ Methodology Update (“2006 Update”), available at http://www.issproxy.com/cgq_methodology/update.jsp (last visited Dec. 10, 2006).
[12] Id.
[13] See ISS CGQ,supra note 2.
[14] See Benchmarking, supra note 6, at 4.
[15] See Benchmarking, supra note 6, at 1.
[16] Id. at 1, 3.
[17] ISS 2006 US Proxy Voting Guidelines Summary at 7, 10–12, 16, 18–19, 21, 23, 44, 46 available at http://www.issproxy.com/pdf/US2006SummaryGuidelines.pdf (last visited Dec. 10, 2006).
[18] Dean Starkman, A Proxy Adviser’s Two Sides: Some Question Work of ISS for Companies It Scrutinizes, Wash. Post, Jan. 23, 2006, at D1.
[19] Id.
[20] Id.
[21] See Starkman, supra note 18, at D1.
[22] Jay W. Eisenhofer and Gregg S. Levin, Does Corporate Governance Matter to Investment Returns?, Corporate Accountability Report, Vol. 3, No. 57 (Sept. 23, 2005) at 1.
[23] Institutional Shareholder Services, Explaining the CGQ Methodology Change Process, at 3 (June 21, 2005), available at http://www.issproxy.com/pdf/CGQevolvingmethodologyWP.pdf; 2006 Update, supra note 11.
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