remedies through contractual terms used to create a debt instrument. Shareholders' rights, although formally dependent upon the provisions of a company's charter and bylaws, are made truly effective through the quality of the board of directors' oversight of management--the core subject matter of
corporate governance. But effective corporate governance is just as important for creditors that have as significant an interest in the existence of strong internal controls, adequate oversight of management, and appropriate incentives as equity investors, because these factors all serve to ensure the long-term stability of the enterprise.
Consequently, Standard & Poor's Ratings Services is interested in the changing ownership profiles of rated companies, the independent strength of a company's board of directors, their awareness of management's risk appetite, and attentiveness to the various constituencies that contribute to a balance
sheet--each of which will have their own preferences for power and influence over corporate decision making. Standard & Poor's overall approach to corporate governance is rooted in twin beliefs: that analysis of governance should be wholly integrated into credit ratings and that it should be viewed on a risk-adjusted basis.
That is, once governance is seen as an integral component of credit analysis, it becomes important to implement a system to prioritize governance issues. Among factors for consideration are the current rating level, the outlook or CreditWatch designation, the amount of debt outstanding, and any recommendations by the credit analyst or governance specialist for further research. Those recommendations can be triggered by events at the company, including sudden and unexplained departures from the executive suite or boardroom, resignation of the company's external auditor, new share issues, or large dividend increases. We also consider outside governance ratings, particularly when those ratings agree with each other (either positively or negatively), as starting points for forming our own opinions regarding how critical governance issues may be to the current rating level or outlook. Where
prioritized, governance issues will find greater prominence, both internally at rating committees and in our discussions with the company, and externally in assigning ratings and explaining them in our rating rationales.
As part of this analysis, each credit analyst considers a number of issues at each issuer he or she follows. For example, is there an overreliance on a key executive or excessive power exhibited by the CEO? Does the board of directors appear to have appropriate industry experience and a sufficient level of financial experience to provide meaningful oversight? Are there unexplained or unusual related-party transactions with the controlling family or influence on major corporate decisions that minimizes the role of the board's independent directors?
Four Instances Of The Importance Of Governance In Ratings
The value of the focus we have adopted is borne out by a number of trends in the credit markets that underscore the importance of governance as a rating consideration. Here are four examples:
1. Strong liquidity in today's debt markets is changing the power balance at many companies, leading to a more aggressive financial profile. The availability of relatively cheap financing has encouraged some managements to skew the balance sheet in the interests of shareholders in a way that may be less than favorable to creditors. Highly leveraged companies may feel more secure with a higher share price, particularly with improving earnings per share ratios. But if debt has been used to secure those ratios with
stock repurchases or to return cash to shareholders by special dividends, it also makes the company more vulnerable to a general market decline or increased competitiveness. The board's role at these companies is often critical: Boards must do their best to balance the interests of shareholders and creditors.
2. The increasing prevalence of management buyouts and other going-private transactions fueled by private equity. Many of these deals also result in substantially higher leverage, not all of it subordinated to existing debt, which can leave earlier investors with significantly less attractive securities. While private equity firms may argue that they are in a position to reduce the agency problems characteristic of a large publicly traded corporation, the company's debt holders may lose the oversight provided by a board mindful of the long-term interests of minority shareholders.
3. Lowered transparency and disclosure standards when companies go private are to be expected, but may nevertheless pose problems for the company's creditors as they try to obtain a true and fair view of the company's finances and business prospects. While some may regard being in a position to circumvent Sarbanes-Oxley requirements as a positive, given that the legislation has been sharply criticized for everything from increasing internal audit costs to driving away business from the U.S. altogether, the legislation's aim is to provide investors with meaningful facts and figures and reliable points of comparison. And this is essential to the effective functioning of the capital markets.
4. Increasing activism among shareholders and bondholders means small investors are gaining greater power and, in many cases, are able to influence a company's financial policy even though they hold relatively small stakes, sometimes as low as 3% or 4% of shares outstanding. Proxy fights for control, or for seats on the board of directors, have become more prevalent and more successful. Standard & Poor's is also aware of highly creative tactics alongside more familiar "shorting" strategies, including decoupling
voting rights from economic ownership and lending practices that can hasten or provide opportunities to declare default. Many of these strategies can be inimical to long-term investor interests, especially where they focus on extracting capital rather than providing for its more efficient use. A September 2006 study from professors April Klein and Emanuel Zur at Stern School of Business at New York University found that 60% of activist fund campaigns resulted in management acquiescing to their demands. These four examples of current concerns sit alongside more familiar governance issues like shareholder voting rights and executive pay issues. A credit penalty could attach to abuse of shareholder rights stemming from unequal voting rights, since restricting shareholder rights may impair access to investment
capital, either because the price shareholders are willing to pay for the stock will be lower, or because fewer members of the investment community are interested in owning such shares. If so, that will probably augment the role creditors will have to play in financing the corporation's activities. On the other hand, where such differential voting rights are thought to promote stability, these arrangements would likely be regarded as a positive from a credit perspective, even if creditors are called upon to play an
augmented role in financing the corporation.
What about the hot-button issue of CEO compensation?
In our view, even the largest payday for a CEO is unlikely to affect a corporation's financial profile, so the focus for Standard & Poor's is not the size of the compensation relative to overall corporate earnings.
Rather, executive compensation programs provide a bellwether of the quality of board oversight. The actions of a board's compensation committee (or private company equivalent) provide critical insight into the ability of directors to make rational, proportionate, and defensible decisions. Where the CEO is a
major owner or manifests a dominant personality, then the level and type of compensation the board awards is a manifestation of their own authority and power to hold the corporation's most influential individual to account. That, in turn, is an indicator of how directors make evaluations across the gamut of
corporate actions they have to decide. Standard & Poor's analysts consider these and similar topics in the credit rating process. This exercise provides a useful and efficient way to leverage credit analysts' deep knowledge of the issuers they followto arrive at a fuller understanding of their governance practices and the relationship to credit quality.
Therefore, as appropriate, credit analysts will complete additional research, sometimes with Standard & Poor's governance specialists. This can involve additional meetings with senior management and, in some cases, members of the board of directors.
Instances Of How Governance Issues Affect Ratings
Over the past year and a half, this analytical process contributed to a number of cases in which a rating or outlook has changed:
UnitedHealth Group Inc. (A/Negative/A-1)
Allegations of backdating of stock option awards led to the departure of UnitedHealth's CEO and significant management distraction. Standard & Poor's revised the company's outlook to negative from stable and, in doing so, wrote that "the uncertainty of heightened media, accounting restatements, investor, and regulatory scrutiny remains. We will also assess, over time, the effectiveness of additional board actions, announced Oct. 15, to enhance UnitedHealth's governance."
Cablevision Systems Corp. (BB/Watch Neg/B-1)
At times, Cablevision's troubled relationship with its owners has been an important factor in the credit rating. We wrote that the firm's "history of family disputes, high executive compensation, and recent moves by the controlling shareholders to enact a debt-financed dividend support Standard & Poor's view that corporate governance remains a concern, and this is incorporated in the current rating."
Molson Coors Brewing Co. (BBB/Stable/A-2)
The balance between Coors and Molson family members has been a rating concern. We wrote, "Credit-related corporate governance concerns exist, centered on both executive compensation and board structureà With respect to the board, we note the delicate balance of directors from the Coors and Molson families via the Coors Trust and Pentland Trust (five Coors family members and five from the
Molson family). The potential for inter- and intra-family disputes is a meaningful credit concern, strengthened by the company's voting trust agreements. The Coors Trust and Pentland Trust together control more than two-thirds of the company's Class A common and exchangeable stock. Under current
arrangements, there is no mechanism for resolving deadlocks if these two stockholders do not agree to vote in favor of matters submitted to a stockholder vote, other than the election of directors. Thus, the
voting trustees will be required to vote all shares held against the matter. A longer track record will be required for us to gain greater comfort with the effectiveness of current procedures."
News Corp. (BBB/Stable/--)
The Murdoch family's role in the firm's corporate governance has been a meaningful credit issue for some time. We wrote, "Given News Corp.'s track record, its current ownership profile, and the competitiveness of the entertainment industry, Standard & Poor's believes that this balance between family control and outside owners has been broadly positive for creditors. The role of the board's independent directors in succession planning will be a key driver of how we view News Corp.'s corporate governance because CEO Rupert Murdoch has stated his desire that one of his children should succeed him at the company."
Assured Guaranty Corp. (AAA/Stable/--)
Our opinion of corporate governance practices of Assured Guaranty has been, on balance, a support to the overall rating. We wrote, "Standard & Poor's has a positive view of Assured Guaranty's corporate governance practices. This is based on the high level of engagement of the board of directors, the
relatively small size of the company and its business, and the growing emphasis on risk management on and off the board."
These examples illustrate how matters like family control can be viewed both positively and negatively in the context of a credit rating and, depending on the rating level, may lead either to a lowering of the rating or a change in outlook on that rating. Conversely, these issues can provide support for the extant rating level. We are continuing to develop our analytical methodology for incorporating governance issues into our credit rating criteria. As part of that exercise, we frequently seek comment and involvement from external governance specialists, as well as incorporate the wealth of knowledge and experience that Standard & Poor's own teams of credit analysts bring to this area. Considering the ever-growing importance of corporate governance issues to creditors, we could do no less.