The Promise and Peril of Corporate Governance Indices

In recent years, financial economists and commercial providers of governance services have created measures of corporate governance quality that collapse into one number (a governance rating or index) the multiple dimensions of a company’s governance, measures which commercial providers market to institutional investors as aids for portfolio and proxy voting decisions. The aim of this Article is twofold: to analyze the effectiveness of corporate governance indices in predicting corporate performance and to consider the implications for public policy that follow from that assessment. We highlight methodological shortcomings of the extant research that claims to have identified a relation between particular governance measures and corporate performance. Our core conclusion is that there is no consistent relation between governance indices and measures of corporate performance. Namely, there is no one “best” measure of corporate governance:  The most effective governance system depends on context and on firms’ specific circumstances. It would therefore be difficult for an index, or any one variable, to capture nuances critical for making informed decisions. As a consequence, we conclude that governance indices are highly imperfect instruments for determining how to vote corporate proxies, let alone for making portfolio investment decisions, and that investors and policymakers should exercise caution in attempting to draw inferences regarding a firm’s quality or future stock market performance from its ranking on any particular corporate governance measure. Most important, because there is considerable variation in the relation between indices and measures of corporate performance, our analysis suggests that corporate governance is an area where a regulatory regime of ample, flexible variation across firms that eschews governance mandates is particularly desirable.