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MSCI'S Risky Bet on RiskMetrics

Ironically, the success of MSCI's acquisition hinges on the bet that once again ISS has miscalled it, and that contrary to ISS' ratings, the management of MSCI actually knows what it is doing.
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Last week, MSCI, Inc., a provider of investment support tools, agreed to acquire RiskMetrics Group Inc., the leading provider of risk management services, corporate governance ratings and proxy advisory services, in a deal valued at approximately $1.55 billion. While markets and analysts responded positively to the news, this exuberance may be short-lived thanks to RiskMetrics' wholly-owned subsidiary, ISS. ISS is incompetent and it is only a matter of time before markets and regulators realize.

ISS or Institutional Shareholder Services is a ticking time bomb waiting to explode. ISS sells proxy voting advice services to institutional investors, issues corporate governance ratings on publicly traded companies, and operates with minimal accountability and transparency. A significant portion of institutional investors, including some 80% of mutual funds and 68% of pension funds, rely on ISS' advice and corporate governance ratings, but the MSCI deal and the recent financial crisis call into serious doubt whether investors should be following ISS' judgment in the first place.

Exactly fourteen days before Lehman Brothers Holding, Inc. filed for bankruptcy in September 2008, ISS gave Lehman a corporate governance rating of 87.6%, meaning that Lehman's corporate governance in ISS' view was better than 87.6% of other diversified financial companies. ISS also doled out generous ratings to other ailing financial companies such as Washington Mutual, which was rated by ISS as being "better than 44.3% of S&P 500 companies and 95.6% of [b]ank companies" just weeks before it's undoing. And if that was not enough, a few days before AIG scurried to put together an emergency loan, ISS rated AIG as being "better than 97.9% of S&P 500 companies and 99.2% of [i]nsurance companies."

ISS defends its corporate governance ratings (known as the "CGQ") as a "dynamic corporate governance tool that helps investors manage investment risk and drive value" and ISS touts its CGQ as a tool that helps investors "identify the worst corporate offenders." Well, if this is true, several questions come to mind. First, why did the CGQ fail the market in this last financial crisis? Second, in light of the obvious fallacies in ISS' CGQ, should investors place any stock in them as a reliable measure of a company's corporate governance? And third, if the CGQ does indeed help investors identify the "worst corporate offenders", why did RiskMetrics, ISS' parent, agree to be bought by MSCI, who according to ISS has a CGQ of 2.5%? This means that in ISS'/RiskMetrics' view, MSCI is in the bottom 2.5% of all S&P 400 companies in terms of corporate governance, or to use their own words, MSCI is one of the "worst corporate offenders." By agreeing to take MSCI stock as consideration for the merger, RiskMetrics' action belies the reliability of its own corporate governance ratings system.

The evidence is clear -- there is serious reason to doubt ISS' ratings and investors would do well to stop relying on ISS' view of corporate governance.

Moreover, ISS has also been repeatedly criticized for being riddled with conflict of interest problems, using faulty analysis in coming up with its voting recommendations, making errors, mistakes and/or omissions that impact its proxy voting advice, hiring relatively unskilled employees to conduct its analysis, being "blatantly opportunistic" in peddling its services, and merely following the fad of the time instead of truly developing well-thought out, sound corporate governance policies. In fact in 2003, ISS acknowledged that sometimes its advice was less than stellar, and with regard to a particular incident acknowledged that it had "screwed up...[and] was embarrassed by the [revealed] operational misstep." Of course while after-the-fact apologies may serve some therapeutic purpose, the problem is that when mutual funds and other institutional investors follow ISS' recommendations en masse and those recommendations turn out to be faulty, it is not ISS that is left holding the bag. Instead it is the underlying portfolio companies affected by the recommendations and the long-term shareholders of those companies.

Thus for MSCI, while the RiskMetrics acquisition promises to result in significant cost synergies, the deal also promises to expose MSCI's corporate structure to substantial risk unless they can figure out what to do with ISS. ISS' ratings and advice are unreliable and it is only a matter of time before investors lose confidence.

Ironically, the success of MSCI's acquisition hinges on the bet that once again ISS has miscalled it, and that contrary to ISS' ratings, the management of MSCI actually knows what it is doing.

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