Conflicts of Interest, Low-Quality Ratings, and Meaningful Reform of Credit and Corporate Governance Ratings

Corporate governance ratings have become an important component of proxy voting and shareholder control. Corporate governance ratings, however, are different from other ratings in that they measure relatively intangible components of corporate performance and are not easily modeled. Furthermore, existing empirical work has not been able to identify robust linkages between corporate governance ratings and value creation within firms; there is little evidence that corporate governance ratings create significant shareholder value or increase the quality of corporate governance practices. We develop a new interpretation of corporate governance ratings that sees ratings as a means of expanding or redistributing the aggregate economic rents that accrue to incentive-conflicted management, institutional investors, and rating agencies, and we argue that this could explain the popularity of corporate governance ratings among institutional investors and managers. If important conflicts of interest lie between institutional investors and their clients, the ultimate investors, then institutional investors may demand meaningless ratings as a means of increasing their rents and avoiding accountability. Because of the market power that can be exercised within the existing manager-rating agency-institutional investor alliances fuelled by those rents, competitive pressures alone will not be sufficient to overturn these bad equilibria. Hence, without appropriate regulatory interventions, the perverse incentives that encourage rent-seeking via low-quality corporate governance ratings will persist.

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