Do Corporate Governance Ratings Change Investor Expectations? Evidence from Announcements by Institutional Shareholder Services

Paul M. Guest is Professor of Corporate Finance and Marco Nerino is a PhD student, both at King’s Business School at King’s College London. This post is based on their paper, forthcoming in the Review of Finance.Related research from the Program on Corporate Governance Learning and the Disappearing Association between Governance and Returns by Lucian Bebchuk, Alma Cohen, and Charles C. Y. Wang (discussed on the Forum here) and What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen, and Allen Ferrell.

Corporate governance analysts are important information intermediaries in financial markets. They provide a wide range of services including data, analysis, ratings, proxy recommendations, and consulting. Academics, practitioners, and regulators have predominantly focused on proxy recommendations and their influence over firm governance choices and investor decisions. Therefore, our understanding of the determinants and effects of the other services provided by governance analysts is limited. An important and unresolved question is whether their governance ratings provide price relevant information. Understanding the importance to the market of the information provided by governance analysts is key to understanding how influential they actually are. In our paper Do Corporate Governance Ratings change Investor Expectations? Evidence from Announcements by Institutional Shareholder Services, forthcoming in the Review of Finance, we revisit this question, using an event study approach to establish whether governance ratings are price-relevant for security markets.

We focus our main analysis on 18,911 rating change announcements by Institutional Shareholder Services (ISS), the most influential (and sole surviving governance focused) rating firm in the U.S. over the past 20 years. To strengthen the reliability of our results, we remove confounding events, employ different counterfactuals and multiple event windows, and control for cross-correlation due to event clustering.

We find that rating downgrades by ISS cause negative announcement returns of –1.14%. Thus, rating information is highly relevant for financial markets. We examine whether the information content reflects the underlying corporate governance quality of the firm. We find that announcement returns are lower for downgraded firms with higher potential agency costs. Since the cost of weaker governance is higher in such firms, this is consistent with the market revising downward its expectation of future firm performance due to the unexpected lower governance quality communicated by downgrades.

Given that proxy advice has been shown to also affect stock prices, we examine whether the rating announcements returns are driven by subsequent ISS proxy recommendations. We find that the negative returns are not caused by higher expectations of an ISS proxy recommendation against management. In particular, we show that the correlation between downgrades and subsequent proxy recommendations against management is small, and that the negative returns are not driven by downgrades that occur closer to the proxy season.

We investigate whether the information content of ISS downgrade announcements contains proprietary analysis and thus independent information content. Alternatively, investors may underreact to individual prior changes in governance data, and rating changes may merely draw users to look at previously available governance data more closely. To distinguish between these possibilities, we disentangle governance rating changes from governance changes using the underlying governance inputs that ISS uses for its rating estimation. We find that the information content is independent and cannot be explained solely by having drawn the market’s attention to prior governance changes, since the negative returns hold for firms with no governance change and correlate highly with the proprietary information content of the downgrade.

The key conclusion that ratings contain price-relevant information contrasts with the insignificant price impact documented by the only prior event study of Daines, Gow, and Larcker (2010). We replicate their analysis and successfully reconcile the difference in findings by pooling upgrades and downgrades together, which produces an insignificant price effect. The replication analysis extends to other governance analysts as well as ISS, and thus demonstrates that price relevance is not just specific to ISS.

Our motivation to draw a distinction between rating upgrades and downgrades derives from the presence of asymmetric announcement price effects in the credit rating and analyst forecast revision literatures. The study tests different explanations for why upgrades are not price informative, but none is strongly supported by the data.

The study’s findings are relevant to the ongoing regulatory debate on governance analyst firms within Congress, the SEC, and European Union. This debate has focused on proxy recommendations rather than ratings. By showing that ISS also impact prices via rating announcements, the study demonstrates a greater influence and importance than previously assumed. The findings suggest that even in the absence of a proxy advisory service, ISS would wield considerable influence and thus the substantive issues at the heart of the debate would remain.

The complete article is available for download here.


Daines, R., Gow, I. and Larcker, D. (2010) Rating the ratings: How good are commercial governance ratings? Journal of Financial Economics 98, 439–461.

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