Proxy advisory firm Institutional Shareholder Services (ISS) is well-known for the impact of its controversial voting advice. But new research has revealed the power of its corporate governance rankings, too.

Academics at King’s Business School found that the downgrading of a company’s ISS corporate governance rating can result in a 1% slide in share performance during the course of a three-day announcement window. They also concluded that the fall in value is not recovered.

The research, conducted by Paul Guest and Marco Nerino, looked at the stock performance of 3,616 US companies whose governance rating was downgraded by ISS. ISS offers ratings of corporate governance based on a scale of 1–10.

They said the findings mean that ISS’s influence extends beyond its proxy recommendations and voting outcomes—currently subject to intense debate and new regulation by financial watchdogs.

The findings contrast with earlier research in 2010, which concluded that downgrades did not affect share performance. The new examination replicated the earlier work, but took it a step further by including ratings “upgrades” and “downgrades” in their study.

Their paper concludes: “We present robust evidence that downgrades by ISS have a large negative impact on stock returns, and thus contain information content.

“The negative returns are consistent with the market revising downward its expectation of firm performance due to unexpected lower governance quality as conveyed by downgrades.”

Ratings and reputation

According to Guest, markets are using the ISS rating to make a judgment about a company’s corporate governance reputation.

“If I’m a board member, I’m going to pay attention to that,” he said.

This is important, he added, because while it is well known how much attention boards pay to proxy advice, it is unclear how much importance they currently place on ratings.

But he also pointed out that the findings could influence the current US debate over proxy advice. In August the SEC, the US financial watchdog, issued new guidance about the regulation of proxy advice following a long debate. At the beginning of November ISS launched legal action to have the new guidance set aside claiming it was “contrary to law”.

Guest says that while proxy advice has received much attention, ratings rarely crop up in the debate.

“We looked at ratings,” said Guest, “and they move share price outside the proxy season and so their power is broader than currently assumed. Ratings matter more than had been shown before.”

However, while the new research could affect the debate, it could be used by either side. For those who have argued for regulation of proxy advisers it could be ammunition to claim that ISS’s influence is greater than first thought and therefore more constraints are necessary. On the other hand, ISS could argue that the findings strengthen its claim that its advice is critical to market participants.

Critics of proxy advisers claim they are unregulated and suffer from conflicts of interest—proxies provide voting advice to investors while also providing consultancy services to investee companies.

One frequently cited anonymous source describes the battle over proxies as a “civil war of capitalism that’s playing out behind the scenes”.

‘Conflicts of interest’

The SEC guidance, published in August, received praise in some quarters. Tom Quaadman of the US Chamber of Commerce said: “For too long proxy advisory firms have exploited current SEC regulation to overwhelm public companies with voting recommendations that investors have no interest in advancing as part of the annual shareholder voting process.

“Proxy advisers have been riddled with conflicts of interest, failed to link advice with economic return, or company specific information, and lack process and transparency.”

ISS disagreed, claiming the SEC had gone beyond its authority.

According to Gary Retelny, ISS president and chief executive, the new guidance could block proxy advisers from providing their services and stymie their freedom of speech.

He said: “We believe litigation to be necessary to prevent the chill of proxy advisers’ protected speech and to ensure the timeliness and independence of the advice that shareholders rely on to make decisions with regards to the governance of their publicly traded portfolio companies.”