Evaluating Corporate Governance: The Bondholders’ Perspective
The purpose of this global criteria report is to inform the marketplace of Fitch Ratings’ approach to evaluating and incorporating the quality of a company’s corporate governance within the overall credit ratings process. While Fitch has always taken aspects of corporate governance into account, this report formalizes a more systematic framework for reviewing governance practices that affect credit quality and builds on recently completed research. Fitch will continue to refine its analytical approaches and to reflect key trends and drivers affecting governance quality as the field evolves. Fitch’s framework is grounded in agency theory and defines corporate governance from a creditor perspective. This framework identifies and focuses on the key elements of corporate governance that are most relevant for bondholders, including:
Fitch’s methodology for evaluating the quality of a company’s practices involves leveraging governance data and information and performing contextual reviews of the qualitative factors related to a company’s governance practices. The methodology is designed to be applicable globally and, as such, can be used to evaluate a range of different corporate structures and organizational models worldwide. Fitch’s ability to perform the contextual analysis depends critically on the quality of the company’s disclosures and the information provided by the corporation. Ultimately, companies that are found to have exceptionally weak corporate governance (or disclosure practices) could face a downgrade or other negative rating action, while those with very strong practices might warrant a special or favorable mention in the credit analysis.
The topic of corporate governance is not a new one, but the recent high-profile corporate scandals and their negative fallout have placed the issue at center stage within the business and financial community. Indeed, while the separation of ownership and control that defines the modern corporation is a pivotal development in modern capital markets, it also poses a unique set of challenges in ensuring that a company’s assets are managed efficiently, prudently, and honestly. While some have had little optimism regarding the resolution of these challenges (including, notably, Adam Smith), the financial markets and regulators have developed important mechanisms for promoting stronger governance. Nevertheless, as highlighted by the experience of the past few years, dramatic breakdowns in governance have resulted in a deterioration of some companies’ value and, in a few notable cases, bankruptcy.
Fitch believes that a company’s corporate governance can have a material impact on its credit quality, particularly where governance practices are weak. Academic research shows a statistical link between the quality of governance and key financial performance measures. Additionally, the experience of recent corporate scandals – in which governance mechanisms were in many cases not strong enough to check errant management behavior – also highlights the negative credit implications of exceptionally poor corporate governance. Indeed, in several of these governance-related scandals, executive mismanagement and erroneous accounting impaired the company’s reputation and access to capital market liquidity, in some instances leading to default.
While the quality of management and company oversight has long been considered in evaluating credit risk, this report formalizes Fitch’s analytical framework for reviewing corporate governance and builds on recently completed research. The publication of this report is intended to inform the marketplace of Fitch’s more systematic approach for evaluating and incorporating a company’s governance practices within the overall credit ratings process. Fitch will continue to look at the quality of a company’s governance practices as one element in the credit ratings process. Fitch believes that this initiative will provide investors with a more refined sense of the companies whose credit quality might be affected by either exceptionally weak or exceptionally strong governance practices.
While much of the public governance debate has focused on protecting equityholders, the core of Fitch’s methodology is to evaluate the quality of a company’s governance practices from a stakeholder perspective, concentrating particularly on bondholders. From a theoretical standpoint, this involves understanding the key points of alignment and potential divergences in bondholder and equityholder interests and, in turn, articulating the key principles of corporate governance in a creditor context.
These principles (for example, board independence and effectiveness, the integrity of the audit process, and reasonable and performance-based management compensation) reflect the key governance topics and concepts that Fitch views as important to promoting sound governance. As such, the principles form the basis for Fitch’s thinking about governance quality and are the focal point of its methodology and analytical approach.
Fitch’s methodology is based on the following two key prongs of analysis:
Leveraging governance data systematically helps to identify outlier companies whose governance practices deviate significantly from the average or typical standards of their peers. One source of this data is Institutional Shareholder Services’ (ISS) Corporate Governance Quotient (CGQ), which synthesizes public information on the quality of governance practices in place at the company-specific level and evaluates companies based on a number of criteria, ranking them individually relative to an index and industry peer group. Fitch’s analysis will also consider other sources of systematic information and indicators that can help flag potential outliers.
The contextual analysis focuses in particular on the characteristics, relevance, and interplay of the company’s governance practices from a bondholder perspective. To this end, Fitch’s methodology frames the key issues for analysts to consider in this review. The purpose is to evaluate more broadly the quality of governance across all Fitch-rated companies and to reflect more nuanced factors not captured in the data analysis. Additionally, a careful review of contextual factors is particularly critical when reviewing companies flagged as possible outliers in the data analysis.
The overall objective is to analyze the quality of a company’s governance practices and, where relevant, reflect this assessment in the ratings process. While corporate governance is certainly an important element to consider, it is one of a range of factors that Fitch evaluates in performing fundamental credit analysis of individual issuers. An indication of the relationship between corporate governance and credit quality can be seen in a regression analysis of CGQ scores (one proxy for governance quality) and issuer ratings for the population of companies with both a CGQ ranking and a nationally recognized statistical rating organization rating.
The results indicate that there is, in fact, a statistically significant relationship between these variables. More specifically, stronger and weaker governance practices are associated with higher and lower credit ratings, respectively. By the same token, the somewhat low explanatory power of the regression (R2 of 12%) suggests that corporate governance is but one of the elements affecting credit quality.
In reflecting corporate governance within Fitch’s ratings process, the focus primarily will be on how weak governance practices can impair a company’s financial position, with somewhat less focus on how strong practices might help to enhance credit quality. This asymmetry is derived, in part, from the low upside return but potentially high downside risk inherent in bonds. Additionally, while strong governance will help to promote timely repayment on an obligation generally, fundamental weaknesses in a company’s governance framework can potentially dissipate corporate assets or cash flows and leave bondholders vulnerable to significant credit losses.
Corporate governance, a concept discussed in a variety of contexts, includes a range of activities and practices. Indeed, diverse definitions are used in both the marketplace and academic literature. Generally, corporate governance encompasses the processes for directing and controlling the company, the procedures for making corporate decisions, and the framework for monitoring management performance. In Fitch’s view, the Organisation for Economic Co-operation and Development’s (OECD) definition (see box below) is particularly relevant in that it takes into account the interests of a range of stakeholders in the corporate enterprise, including, importantly, creditors.
Definition of Corporate GovernanceThe Organisation for Economic Co-operation and Development defines corporate governance as follows: “Corporate governance relates to the internal means by which corporations are operated and controlled…[It] involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently.” |
Early Recognition of Principal-Agent IssuesAdam Smith, the author of “Wealth of Nations,” published in 1776, is often credited with first identifying some of the principal-agent tensions that define the modern corporation, though he expressed little hope for resolving them, as in the following excerpt: “…being the managers rather of other people’s money than of their own, it cannot be well expected that [the Directors] should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own. Negligence and profusion, therefore, always prevail.” |
Another way to conceptualize corporate governance is as a principal-agent relationship in which management (the agent) makes decisions about the disposition of the company’s assets on behalf of stakeholders (the principals). The principal-agent aspects of governance have been viewed typically from the perspective of shareholders, focusing on situations in which their interests and those of management diverge. In this view, governance practices are the mechanisms that enable shareholders to monitor and discipline the behavior and performance of management.
For the most part, public debate has ignored the important role that corporate governance plays in protecting the interests of other stakeholders, namely creditors. A starting point in broadening corporate governance to a stakeholder perspective is to understand the relationship between the key principals (in particular, equityholders and bondholders) and how it is played out by management in the governance process.
Although generally aligned, the interests of the principals can diverge at important points, particularly when they may have differing economic stakes in the company’s performance and, in turn, differing views on the strategic direction that management should take. The following two preconditions are necessary for this to occur:
Potential differences in bondholder and shareholder interests are rooted in their differing contractual structures and risk profiles. For example, the maximum potential economic return for bondholders is essentially fixed at the contractual terms of the obligation, while equityholders face a more extreme range of possible economic returns, particularly on the upside. They also differ regarding seniority in payment priority, as contractual obligations on bonds legally must be met before equityholders can receive payment. Additionally, bondholders have a more senior position in bankruptcy; accordingly, as a company approaches bankruptcy, bondholders would want to maximize recovery, while equityholders would likely favor riskier actions to revive the company’s prospects (and, therefore, the value of its equity).
Due to these cumulative differences, bondholders prefer corporate actions that maximize the certainty of full and timely repayment on their obligations. On the other hand, equityholders prefer actions that maximize the present value of their investment. Therefore, despite their longer contractual investment horizon, equityholders might seek to maximize short-term returns through actions that could undermine the interests of bondholders. These actions might include increasing dividends, which diverts financial resources away from productive uses and coverage of future debt payments; increasing leverage, which can strain the company’s financial position and impair its ability to service existing debt; and investing in riskier projects, which can increase the uncertainty of future cash flows needed to service debt payments.
In light of these differences, equityholders and bondholders might then seem to have a fundamentally adversarial relationship within the corporation. This, in turn, would suggest that the conventional views on good corporate governance – with the primary focus on protecting shareholder interests – is inappropriate and irrelevant to bondholders. Accordingly, it is natural to ask: what mechanisms have kept these potential conflicts in check?
Potential conflicts in the principal-to-principal relationship tend to be mitigated by a combination of common interests, market discipline, and contracting. Although there are important differences in the risk profiles of bondholders and equityholders (particularly concerning short-term decisions), the two principals generally have common interests regarding the long-term management of the company. Equityholders and bondholders both prefer to invest in companies that are prudently managed, that create economic value through rational investment, and that achieve stable ongoing financial performance. Likewise, as highlighted by recent governance meltdowns, equityholders are not the only ones harmed by corporate excess, executive fraud, malfeasance, and weak monitoring of management behavior. Bondholders incur losses, as well.
Financial markets also provide an important discipline on shareholder preferences. Although shareholders might reap short-term gains from a one-off action that hurts bondholders, a company’s longer term performance likely will benefit from continual access to credit markets. Therefore, bond investors can punish self-interested behavior by raising a company’s risk premium and limiting its access to competitive funding markets.
Additionally, the credit ratings process readily communicates to market participants any material changes to a company’s credit standing. Indeed, companies that rely on public debt markets for funding face strong incentives to avoid actions that could negatively affect their credit ratings. Furthermore, participation in certain markets might require that a company have robust credit quality. For example, U.S. regulations (specifically, Rule 2a-7) limit money market funds to purchasing commercial paper only if the commercial paper is highly rated. Participation in other markets, whether by regulation or market convention, can entail similar restrictions on credit quality.
Contracting also can help keep the principal-to-principal relationship in check, particularly when financial and negative covenants are in place. Financial covenants protect bondholders by requiring the financial management of the company to meet specified trigger ratios. Negative covenants might in some cases help curb actions that could harm bondholders by giving the creditor control over mergers and acquisitions, future investments, additional borrowings, and payment of dividends, among other examples. Bondholders are better able to impose covenants on non-investment-grade issuers typically. For higher rated companies, there could be some room for bondholders to piggyback on loan covenants obtained by commercial lenders, though this protection can be limited since most loans are refinanced or repaid earlier than bonds.
While a combination of market and legal mechanisms helps discipline the relationship between bondholders and equityholders, the potential for rifts in this relationship to occur is an important factor in governance analysis. Therefore, Fitch’s stakeholder approach to assessing corporate governance focuses on the overall quality of the company’s governance practices, with an analytical overlay to consider the principal-to-principal relationship and hone in on the bondholders’ perspective.
Fitch’s framework is grounded in the key principles of corporate governance that serve to protect the interests of bondholders. These principles reflect the key governance topics and concepts that Fitch views as important and, as such, are the focal point of both the quantitative data and contextual factors that Fitch will evaluate in its review of a company’s governance practices.
The basic elements of sound governance generally serve the interests of all stakeholders. Therefore, the governance principles that are critical to bondholders overlap to a large extent with the traditional market paradigm of best practice (which tends to focus primarily on the interests of equityholders). However, there also are principles within this traditional paradigm with less clear-cut benefit to bondholders.
Fitch regards the following principles as core elements of sound governance from a bondholder perspective.
Assessing a company’s governance practices begins with its board of directors. An independent, active, and committed board of directors is an essential element of a robust governance framework. A board that is not committed to fulfilling its fiduciary responsibilities can open the door for ineffective, incompetent, and, in some cases, unscrupulous management behavior.
Board of DirectorsA board of directors has several key responsibilities, including:
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This is not to say that the relationship between the directors and senior executives should be adversarial or confrontational; on the contrary, it is vital that the board and management have strong chemistry and can work well together in steering the company toward its performance objectives. Nevertheless, key executives must be held accountable for their actions, particularly those that create potential conflicts of interest or affect the company’s risk profile.
A director is defined as independent when his or her seat on the board is the sole connection to the company. While in many instances senior executives (for example, the chief executive officer [CEO] or chief financial officer) appropriately serve as board members, the marketplace increasingly expects the board to be composed primarily of independent directors. Although the concept of independence seems straightforward, the challenge lies in identifying and understanding the myriad personal and professional relationships that can exist between the board member and the company or its key executives.
Although difficult to gauge from a third-party analytical perspective, another element of assessing board quality is how active and committed a company’s directors are in performing their fiduciary duties. Gaining a broad sense of a board’s quality and effectiveness involves the contextual analysis of more qualitative factors, including the background and professional experience of the directors, the flow of information between management and the board, and the nature of the issues and questions raised at board meetings.
Transactions between senior management or major shareholders and the company – or related-party transactions – merit closer review in governance analysis. Related-party transactions give rise to potential conflicts of interest for the related party. More specifically, the related party may be faced with a competing set of incentives that is separate from the financial performance of the company. In fact, in some cases, the primary motivation of a related-party transaction is to enrich the executive or related party at the expense of the corporation. Several recent governance scandals involved individual executives using such transactions to extract wealth from the company for personal gain.
This issue illustrates the often important interplay of different elements of a company’s governance framework. For example, a lax or insider-dominated board might neglect to examine carefully transactions that create potential conflicts of interest between management and the company. Therefore, the presence of related-party transactions, which in and of themselves could be a potential vulnerability, might also signal more fundamental weaknesses in the overall governance structure of the company.
Good quality financial reporting is a hallmark of robust governance. Viable and accurate accounting statements are critical in informing the investment decisions of equityholders and bondholders alike by providing a view of the company’s financial position and fundamental risks. Likewise, publishing intentionally inaccurate or misleading accounting statements is symptomatic of deeper flaws in a company’s governance framework. The public exposure of techniques that subvert the spirit of accepted accounting standards or, worse yet, are designed to mask fraudulent activity can undermine investor confidence and destroy a company’s value.
Governance of the audit process is an important safeguard in protecting the integrity of a company’s financial reporting. It is the responsibility of the audit committee to promote a sound internal control environment and to monitor the work of the external and internal auditors, particularly in cases where the accounting guidance permits considerable discretion in the choice of treatment or where key aspects of the company’s statements are not subject to an external audit. In this regard, having independent and financially knowledgeable directors on the audit committee can help to promote dispassionate and critical oversight of the company’s accounting practices.
Additionally, it is important for the audit committee to ensure that the company’s audit is conducted independently and objectively. For example, the committee should carefully monitor any potential conflicts of interests that might arise between the company and the audit firm, such as the auditor providing consulting or other remunerative services not directly related to the performance of the audit. Reasonable and Performance-Based Management Compensation
Remuneration of executive management poses a governance concern, particularly if it exceeds market norms and standards. Excessive compensation is a direct drain on the company’s financial resources. More fundamentally, it suggests a lack of financial discipline and accountability that might pervade the culture and operations of the company more generally. Extraordinary pay packages should call into question the vigilance and independence of the board in monitoring management behavior.
While determining whether management compensation is excessive is not necessarily straightforward, there are a few key underlying principles that the company should observe. The relationship between the executive’s compensation and the company’s performance expectations should be established clearly up front and communicated openly to the market. Additionally, executives should not receive markedly higher compensation relative to compensation for their counterparts at better-performing companies.
While observance of the principles detailed above provides clear benefits to bondholders, certain other elements of corporate governance have a more ambiguous impact. In particular, although the use of both stock ownership as incentive and limitations on takeover defenses are generally viewed as beneficial to equityholders, these governance principles might not necessarily further the interests of bondholders in all cases. However, a contextual review of how the company incorporates these principles in its governance framework can help to illustrate the net impact on bondholders.
One view in the market is that the principal-agent tension at the root of many governance problems might be resolved effectively by aligning ownership and control – namely, turning management into owners by granting them (or requiring them to purchase) equity in the company. In this view, executive and director equity ownership (including the use of stock options) serves as financial incentive to base decision-making on promoting the positive performance of the company.
Equity ownership can have either a positive or a negative impact on bondholder interests. On one hand, bondholders are likely to benefit if equity ownership truly motivates executives and directors to work harder to promote the long-term value of the company. On the other hand, if executives are looking to liquidate their equity holdings in the near term, they might be driven to take inefficient or ill-advised actions that undermine the company’s long-term stability and value creation. In addition, pressures on executive management (and directors for that matter) to meet earnings expectations and other short-term performance measures could lead them to support aggressive steps to prop up the company’s stated returns, through serial acquisitions, accounting manipulation, or other cosmetic devices that are unsustainable over the long term.
One possible way to deter such undesirable shortterm actions is to incorporate features in the equity instruments that make the executive’s or director’s stake more long term – for example, by restricting the liquidity or exercise terms.
As with the issue of executive/director stock ownership, takeover defenses’ (for example, “poison pills” that dilute the interests of potential acquirers and, therefore, make the target’s stock less attractive) impact on bondholders depends in part on the circumstances of their use. On one hand, incumbent management can misuse “poison pills” and other anti-takeover mechanisms to entrench its position, insulating it from the disciplining forces of the market for corporate control. Bondholders certainly are not well served by inefficient managers who seek protection behind takeover defenses.
On the other hand, bondholders do not necessarily benefit under all takeover scenarios. Whereas equityholders will only approve an acquisition or a merger if it serves their own economic interests, bondholders generally do not have any influence on the merger decision. In fact, if a merger is funded through or results in a significant increase in the company’s leverage, then, all else being equal, bondholders will be worse off as a result of the transaction. To some extent, they can protect their interests either through covenants or, though rare in bonds, through change-in-control provisions. Barring these provisions, bondholders are not in a position to protect their interests during a merger process. Therefore, the overall impact of anti-takeover mechanisms on bondholders will depend, to some degree, on the resulting credit profile (particularly the leverage and cash flow position) of the merged entity.
The principles described above form a basis for thinking about the quality of corporate governance from a bondholder perspective. Fitch’s methodology, in turn, provides analytical tools for assessing how individual companies apply these principles, as well as the practices underlying them.
The ultimate purpose of Fitch’s methodology is to analyze the quality of a company’s governance practices and, where relevant, reflect this assessment in the ratings process. Fitch’s methodology is based on two key prongs of analysis: leveraging data and information on the quality of governance practices across companies; and performing contextual reviews of the qualitative attributes and nuances of a company’s approach to corporate governance. In reflecting corporate governance within Fitch’s ratings process, the focus will be primarily on how weak governance practices can impair a company’s financial position and potentially lead to a downgrade or other negative rating action.
Fitch’s approach begins with harnessing information on the governance practices of individual companies. The information and data that companies report (for example, in annual reports and other corporate filings) can be of considerable value in assessing the quality of their governance practices. Depending on the robustness of the given disclosure practices, these reports can shed light, for example, on the independence and background of directors, the size and frequency of board meetings, the level of executive compensation, the use and structure of related-party transactions, stock ownership by executives and directors, policies concerning auditor rotation, and shareholder voting requirements.
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