Looking Beyond the Numbers - Governance Concerns in Scoring Process
Since the Enron debacle, the credit rating agencies have determined that there is more to sound financials than just numbers. News stories divulging tales of outrageous executive compensation packages or unethical self dealings have sounded an alarm for many investors and for the agencies that provide ratings. “I think everyone has really had a wake-up call in terms of what they need to delve into,” said executive vice president Kent Wideman of Dominion Bond Rating Service.
Some credit rating agencies provide corporate governance scores, some do not. However, all recognized rating agencies – Moody’s Standard & Poor’s, Fitch Ratings and Dominion – have introduced or renewed their focus on corporate governance in the scoring process for public companies.
Given the subjective nature of governance issues, there is much at stake for corporations when credit ratings depend on positive reviews from the agencies. Experts at the rating agencies speculate that companies with poor governance practices will see an increase in their cost of funds and a dramatic change in their access to credit, which appears to be agencies’ support for a link between corporate governance practices and credit default risk.
According to Clifford Griep, chief credit officer for Standard & Poor’s, his agency is currently reviewing more than 40 companies that have exhibited governance-related risk characteristics. Currently, all of the rating agencies are educating customers to help assuage corporate fears and explain any changes to rating methods. In addition, S&P and Moody’s are offering consulting services designed to bring public companies up to speed on corporate risk management.
The rating agencies say that the rating process is largely transparent. However, advocacy groups such as the Association for Financial Professionals have raised questions regarding the level of openness in rating methodologies.
AFP president and chief executive officer Jim Kaitz urged the Securities and Exchange Commission and the nationally recognized statistical rating organizations to bring more sunshine into the scoring process when he testified before the US House Financial Services Committee Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises on 14 September 2004 “Restoring issuer and investor confidence in the credit ratings process is critical to global capital markets,” Kaitz said.
According to the Business Sector Advisory Group, part of the Organisation for Economic Co-operation and Development, sound corporate governance encompasses four primary principles: fairness, transparency, accountability and responsibility. However, among the rating agencies, the exact definition of good governance varies from one company to the next. “We try to extract those governance factors that are most relevant to creditworthiness,” said S&P’s Griep.
In recent years, Moody’s, Standard & Poor’s and Fitch Ratings have publicly outlined their governance rating methods. Corporate governance methods for Dominion Bond Rating Service are not publicly available. Whether the policy is formalized in writing or informally shared through issuer’s analysts, all rating agencies say they apply a keen eye to board independence, board practices, audit integrity, and executive compensation.
The Sarbanes-Oxley Act mandates that all public companies must adhere to certain strictures of good corporate behavior. These include CEO- and CFO-certified financial statements, proof of independent audit, and independent board members, among other things. According to the rating agencies, there are numerous other factors that should be considered when reviewing debt issuer information.
The road to rating executive management practices has been a long one. While corporate governance problems gained visibility in recent years, Dominion has been reviewing these practices for decades in Canada. Likewise, S&P and Fitch have been developing global “corporate governance screens” since 2000. These screens are used to compare large numbers of companies against one another in countries such as Russia, Thailand, Malaysia, Singapore and Indonesia.
Screens were first developed in response to a call for greater transparency in developing markets where bribery and corruption are common. The results from the first transparency and disclosure studies were released in 2003 and 2004.
Today, each rating agency has developed its own methodology for addressing corporate governance concerns among American companies. The emphasis on corporate governance and the number of corporate governance specialists at each agency varies widely, from 10 staff members at the largest rating agencies to one member at the smallest.
Moody’s wraps corporate governance into its risk management overview, according to Ken Bertsch, senior vice president and director, corporate governance. “We’re not scoring on corporate governance at this time. We’re doing a very in-depth risk management review,” Bertsch said. Moody’s corporate governance assessment emphasizes board independence and management accountability to the board, board and executive compensation arrangements, management succession plans, public disclosures, legal and regulatory structures, ownership structures, governance transparency, and shareholder voting rights.
S&P assigns scores from 10 (very strong practices) to one (very weak practices) to the four individual components that contribute to overall sound governance. “The dimensions are pretty straightforward,” Griep said. According to 2002 and 2004 reports, these elements include: ownership structure and influence of external stakeholders, investor rights and relations, financial transparency and information disclosure, and board structure and process.
Fitch, on the other hand, uses a rating tool that ranks companies based on criteria such as board independence and quality, presence of related-party transactions, integrity of the audit process, executive compensation, and different ownership structures (in particular majority-controlled and family-owned companies), according to Fitch’s governance expert, Kim Olson.
Dominion has no written policy, but the company has included corporate governance factors in its rating process for nearly 30 years – long before it entered into American markets, according to Wideman. As the newest nationally recognized statistical rating organization approved by the SEC, Dominion has been rating US companies for less than one year.
Certain types of companies are under a close watch, according to the rating agencies. For instance, experts from all the rating agencies concurred that closely held, family-owned companies may become havens for risky business. “They’re a host of examples over the past year where failings of governance have come to light and have contributed in some way to the allowance of management practices that have been detrimental to the firm’s investor constituencies,” Griep said.
The impact of poor management practices can be devastating. “In many cases they’ve had an impact on equity price. In some cases they impacted creditworthiness. Ultimately they’ve contributed to loss of confidence,” Griep said.
On the flip side, Moody’s Bertsch noted that majority ownership can be a good thing. “Warren Buffet is a controlling shareholder in Berkshire Hathaway, and that’s a positive. Another good example would be Pepsi America, the bottling company for PepsiCo,” Bertsch said. “The worst case right now has to be Hollinger International. Adelphia would be another example. The insiders took gross advantage of minority shareholders, which is very bad for creditors.”
In both bases, he said, there was a lack of openness. Both Hollinger and Adelphia have dual-class stock structures. Even with the renewed interest in good governance, all agencies concurred that red flags are the exception rather than the norm among debt issuing companies.
According to all agencies interviewed for this article, board oversight remains the number one building block for good corporate governance.
Copyright 2005 by the Association for Financial Professionals (AFP). Reproduction of this material is prohibited without prior permission by AFP. All rights reserved in all countries.