United States: Adapting to RiskMetrics Group’s New Governance Risk Indicators System

In early February 2010, the highly-influential proxy advisory firm RiskMetrics Group ("RMG") announced it would no longer evaluate companies based upon its Corporate Governance Quotient ("CGQ"), but would instead use a new yardstick, called Governance Risk Indicators ("GRId"). GRId is intended to be more closely aligned with the principles underlying RMG's proxy voting policy.¹ On March 10, 2010, RMG released a detailed 188-page report explaining the GRId criteria and scoring methodology, which is being incorporated in proxy research reports now, beginning as of March 17, 2010.² GRId is intended to be both more transparent and more comprehensive than CGQ.

In comparison to the CGQ score, which was based upon a relative ranking of the corporate governance of peer companies in any given industry group against RMG's standards, the GRId system is intended to operate on an absolute basis so that companies are judged only on their own governance practices as compared with what RMG perceives as local best practices. Accordingly, a company's evaluation will no longer be impacted by actions of competitors. In addition, as opposed to the single CGQ score RMG previously awarded, GRId will provide four distinct "level of concern" indicators – one for each of the following governance areas: the board, compensation/remuneration, shareholder rights, and audit. Scores will take into account market practices based upon the location of the company, as well as applicable legal requirements in the relevant jurisdiction. Each indicator score, centered on RMG's assessed level of concern, will take the form of a low, medium, or high risk rating.

To calculate the scores, GRId will take into account the answers to between 59 and 95 questions tailored to particular markets and grouped into subsections under each of the four governance categories described above. Each question will be scored between -5 and 5, with 0 being a neutral score representing RMG's view of local governance standards and higher scores exceeding such standards. After RMG has determined a numerical score, RMG will assign a weight to that score, considering local best practices and legal requirements. The weighting reflects RMG's views of the importance of the particular factor being measured. A company may be able to effect meaningful improvements on its score by focusing on the most highly weighted items. RMG will total the scores for each subsection and section and normalize them in relation to the highest and lowest possible scores in that category for the relevant market. The normalized scores will be published as a low, medium, or high "concern level," as mentioned above. Detailed charts listing all the values for the scores for each market are available on the RMG website.³

Companies should familiarize themselves with the new GRId criteria and methodology and review their corporate governance practices, particularly in light of recent changes to the proxy voting system. RMG's evaluation of a particular company may change significantly under the new system even if the company does not modify its existing corporate governance practices.

A noteworthy feature of GRId's scoring and methodology is enhanced transparency. Not only do companies have access to all of the questions GRId will use in making evaluations, but companies will be able to freely access a data verification site where they can verify the accuracy of the data upon which RMG will base its score. RMG intends to update the data verification site on a monthly basis. Given GRId's increased transparency, companies should regularly verify the accuracy of all data on the verification site, particularly in the first year when RMG will be updating the information with respect to many companies. RMG generally updates information based on publicly available information and may not be aware of changes in a company's corporate governance policies that have not been publicly disclosed. Further, because RMG has made it possible for companies to make suggestions for improvements to the GRId system, companies should actively evaluate RMG's methodology and discuss their concerns with RMG.

Because the GRId system evaluates companies on a stand-alone basis and not in relation to their peers, as the CGQ did, companies will no longer need to focus on the governance practices of other peer companies for purposes of improving RMG grading. As a best practices measure, however, companies may still want to consider peer-group governance practices, since equity analysts and investors may still continue to compare companies within industries. Although RMG has significantly expanded its evaluation criteria and will take into account what it perceives as local market best practices, it appears that the change in methodology will not lead to major changes in RMG's overall views on corporate practices. Thus, evaluations will still be based on a set of best practices as determined by RMG. Because the standards for evaluation have not changed yet companies will no longer be evaluated in relation to their peers, this could create major changes in evaluations for companies with governance practices that are not favored by RMG but are widespread across an industry. This could result in RMG making a recommendation that shareholders vote against a company's director nominee in circumstances where RMG would not previously have made such a recommendation.

While it is always advisable for companies to engage in periodic reviews of their corporate governance practices, it is particularly advisable to do so now in order to consider how those practices will be viewed under the GRId system. Companies may want to discuss at the board or committee level those practices that are of greater concern under the new GRId system. Similarly, companies that are in the process of going public should take a fresh look at their corporate governance practices. Ultimately, any decision as to whether to amend a company's governance practices should be based upon consideration of what is relevant and appropriate for that company and not upon third-party guidance or a desire to obtain a particular GRId rating.

Footnotes

1 See A Look at RiskMetrics Group's Policy Update for the 2010 Proxy Season, for a discussion of RMG's most recent policy updates.

2 See http://www.riskmetrics.com/press/20100303_grid .

3 See http://www.riskmetrics.com/sites/default/files/ISS_GRId_Tech_Doc_20100310.pdf .

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