A rating agency perspective on US corporate governance
Kenneth A Bertsch and Mark Watson
Moody’s Investors Service
A key problem in any consideration of corporate governance is what is often called the ‘agency problem’: the risk that managers of the enterprise will make decisions in their own interests or for expedience, rather than in the interests of the company’s shareholders. This concern is of particular importance in the context of widely diversified ownership, as is typical for large, publicly held US corporations.
Most governance mechanisms are therefore principally arranged to address the accountability of a firm’s senior managers and board of directors to shareholders. Debtholders also have a strong interest in proper accountability structures, however. At its extreme, poor corporate governance structures can endanger the viability of the enterprise and ultimately can leave debtholder contract claims significantly diminished, as several recent, high-profile corporate failures have illustrated.
Nevertheless, debtholders also face a danger, in our view, if ‘good corporate governance’ is interpreted to mean complete alignment of managers with short-term shareholders. Differences may be resolved in the longer term, but in the short term, efforts to pump up share price can come at the expense of creditors. We believe good credit analysis should involve an understanding of incentives and structures that might lead to short-term share-price focus.
Shareholder versus bondholder concerns
Fundamental credit analysis incorporates an evaluation of franchise strength, financial statement analysis and management quality. From our perspective, corporate governance is an important element of management quality. That is, to the extent that both shareholders and creditors are assured that the proper incentives and systems of accountability are in place, they can have greater confidence in the present management of the company.
In theory, both interests can also be more confident that, should management fail to meet emerging challenges, the responsible decision-makers will be removed, either through action by the independent board of directors, or through outside pressures – up to and including a hostile takeover.
Although there is substantial overlap between creditor and shareholder interests in these areas of management performance, there are also important potential conflicts. Perhaps nowhere is this more evident than in the effort over the last 15 years – particularly in the United States – to solve the agency problem through the use of executive stock option awards. A question we address is whether excessive use of such awards at times may endanger the enterprise by encouraging executives to ‘swing for the fences’, and occasionally even to shade the truth about corporate performance. Of course, risk taking is a vital component of good long-term management, but so is judgement.
In addition, creditors and shareholders frequently have different views on the appropriate level of risk to be undertaken by the firm. Creditors cannot benefit from any resultant upside performance, of course, and instead are only exposed to downside risks.
Profiling good governance
In considering corporate governance, Moody’s confronts two primary questions. First, what aspects of corporate governance are relevant from a creditor’s perspective? Second, how should creditors assess the quality of governance in these areas, and how should that factor into the credit decision?
Our corporate governance analysis encompasses several components, discussed below.
Quality of the board of directors
Our presumption is that a board of directors which effectively promotes and protects the long-term interests of shareholders will, by and large, also mitigate risk for creditors, by assuring proper oversight of management. Conversely, a board that fails in basic oversight of key areas – such as conflicts of interest, management succession, risk management, internal controls, financial reporting or strategic planning – poses an inherent credit risk.
Our analysis encompasses the following:
• issues of board and committee independence, experience, diversity and leadership;
• a general review of committee charters and processes, and of areas of explicit board responsibility;
• processes for board and director evaluations;
• director training; and
• director compensation and related policies, such as share ownership guidelines.
Audit committee and key audit/ accountability functions
We examine separately the effectiveness of the audit committee because of its relevance to the reliability of financial reporting. We review the audit committee charter, as well as the board’s expectations of the committee in the areas of financial accountability, risk assessment, internal controls and ethics policies, and processes.
Critical audit committee practices include control of the relationship with the independent external auditor (and assurance of auditor independence), as well as oversight of internal audit.
Conflicts of interest
We highlight significant disclosed director and executive conflicts of interest, and assess how those conflicts are managed.
Executive compensation and management development and evaluation
We focus particularly on chief executive officer (CEO) incentive structures, particularly those which are likely to have an adverse affect on risk appetite and which therefore pose dangers to long-term debtholder interests. We also consider executive succession planning and management development, a key area of board responsibility.
Shareholder rights
We examine shareholder rights and takeover defences compared with general national and industry practices.
Ownership
We are particularly concerned with the presence of a majority or large minority holder at a publicly traded company, as well as the implications this has for the governance of the corporation and for the interests of creditors. We also consider implications of director and management holdings, and of executive share ownership requirements.
Governance transparency
Requirements for governance transparency have expanded substantially in recent years, so we are increasingly focused on this area, particularly with regard to notable positive or negative departures from standard practices.
Evaluating the internal dynamics of the board
Moody’s places particular importance on the independence and effectiveness of the board of directors. We also recognise that these qualities are difficult to judge from outside the boardroom.
We start our evaluation with comparisons against external metrics, with an eye towards highlighting any significant departure from generally recommended best practices. In identifying these best practices, we consider stock market listing standards, along with recommendations put forth by both national and international organisations such as the National Association of Corporate Directors, the Council of Institutional Investors, the Conference Board, the International Corporate Governance Network and the Organisation for Economic Cooperation and Development.
In addition to drawing comparisons against these standards, we may also draw more targeted comparisons with the boards of other companies within the industry peer group.
Ultimately, however, our judgements about the board of directors come down to our evaluations of the people on it – their experience, their influence, their special and private interests (and any potential conflicts therein), and their history with the company. Dynamics of relationships between these individuals and with senior managers are also critical.
All these assessments, we recognise, rely in good part on relatively subjective judgements.
Among some of the more objective data points that can be used to assess board independence and effectiveness are answers to questions such as the following:
• Do the directors have financial or familial relationships with company executives that may compromise their independence?
• Are there significant links between the company (or its executives) and corporate, charitable and/or educational institutions managed by outside directors?
• Have the directors created appropriate committees, with memberships of qualified individuals, sufficiently frequent meetings, good attendance and appropriate charters and procedures?
• What have directors done to assert authority in their proper sphere, such as in controlling the relationship with the internal auditor, external auditor and compensation consultant?
Among some of the ‘softer’ issues which also provide important insights are questions such as the following:
• How do the CEO and board relate to each other?
• Does the CEO feel accountable to the board and seek directors’ fully informed judgements?
• At what point does board collegiality give way to director and board passivity? Alternatively, at what point does appropriate director questioning and probing becomes meddlesome micro-management which undermines the executive team?
After collecting information from public sources, we seek to interview the firm’s chief governance officer (generally the general counsel and/or corporate secretary), the CEO and an independent member of the board. Among the questions that we ask are the following:
• How does the company identify and choose director nominees? What skills would you look for in seeking new directors? Does the nominating/corporate governance committee typically use a search firm? Do you expect much change on the board in the near future (larger, smaller, turnover)?
• Please describe board and committee evaluation processes. What would you expect the 2003 board and/or committee performance evaluations would highlight as the key areas for improvement? Is there any element involving individual director evaluation? How does the board evaluate whether directors are too busy?
• We would like a clear understanding of the board’s definition of an ‘independent’ director. What mechanisms are in place to manage any potential director conflicts of interest?
• How does the audit committee ensure that the external auditor in practice feels accountable to the committee and not to management? What constitutes audit committee involvement in selecting the lead partner on the audit? What is encompassed within the non-audit work performed by the external audit firm? How frequently does the company undertake a serious ‘due diligence’ review of the audit firm engagement?
In addition to publicly available information and the additional insights gleaned through such questionnaires, we typically seek corporate governance guidelines and board and committee charters, as well as ethics and business conduct codes, which some companies do not make public. We also find it useful to examine the board and committee calendar and attendance records, because director absenteeism or lack of key committee meetings (particularly the audit committee) may indicate a lack of proper diligence.
Compensation and incentives
Director compensation practice is another important area of focus, although most US companies fall within relatively narrow ranges of peer groups based on company size and industry. Director pay which is far in excess of peers – as well as company loans or loan guarantees to directors, or consulting or other arrangements – could compromise the independence of directors.
We are also concerned about pay arrangements that would result in a significant financial impact on a director should he choose to resign. Directors have a job to do on boards, but they are also lending their credibility, and they should not be financially tied to their service as director.
Finally, pay which may reward short-term focus on share price is of concern. Compensation schemes that rely heavily on stock options or other relatively risky pay elements may also merit evaluation if they potentially encourage risk taking that could be excessive from a creditor standpoint.
On the other hand, expectations for director qualifications, time commitment and diligence are clearly rising. Arguably, the perceived liability exposure for directors has also increased; many directors certainly believe this to be the case, although another point of view suggests that directors in practice face little risk compared with executives or audit firms.
Another area we consider is executive pay arrangements that provide significant short-term incentives, particularly those related to equity valuations, which can be volatile and erratic. Such arrangements may pose excessive risk from the creditor standpoint. This situation is particularly true if there is a failure to tie compensation or executive stock ownership to the longer-term success of the enterprise. Large grants of standard stock options – especially if the vesting periods are short and/or stockholding requirements are lacking – may encourage excessive risk taking and even aggressive or potentially misleading financial reporting.
Exploring the link to credit
We do not believe that there is a single clear formula of good governance which is verifiable and adequate. Context is important, including the legal and cultural environment, industry characteristics, ownership patterns, company growth stages and assorted other factors. Such factors are also important determinants of a firm’s overall credit health.
Moody’s therefore has a distinct advantage in approaching the assessment of corporate governance because we can build on the foundation laid as part of our fundamental credit analysis.
In reviewing corporate governance, we seek to satisfy ourselves that basic structures of accountability and oversight are functioning adequately. Inadequate governance oversight poses a credit risk, in our view. We believe a more in-depth examination of corporate governance as a distinct credit concern not only provides additional, valuable information to investors, who are increasingly concerned about this issue, but also further informs and enriches our own credit analysis.
For more on corporate governance from the rating agency perspective, see Moody’s Methodology “US and Canadian Corporate Governance Assessment”, published August 2003 and available at www.moodys.com.