Getting Credit for Governance

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Recent research relates the importance of corporate governance not to stockholders but rather to another important stakeholder: bondholders. Ever since spectacular failures occurred at previously well-regarded companies, the spotlight has shone on corporate governance activities as the means of preventing fraud and aligning management with shareholders' interests. After all, in the spate of bankruptcies that began with Enron Corp. in 2001, shareholders were left with billiondollar losses in market capitalization in a short period of time.

Bondholders suffered as well. In 2002, Worldcom Inc. famously went from having a coveted investment-grade long-term credit rating to bankruptcy in less than three months. It stands to reason that if better corporate governance would prevent such fraud as has been alleged at Worldcom, then credit rating agencies, notably Standard & Poor's (S&P),Moody's Investor Service and Fitch, the three organizations approved by the U.S. government, would factor those variables into credit ratings.

"The Effects of Corporate Governance on Firms' Credit Ratings," a working paper under review at the Journal of Accounting & Economics, confirms the link between governance and credit ratings. In fact, the paper states that "a hypothetical firm that possesses desirable governance characteristics from the bondholders' viewpoint nearly doubles its likelihood of receiving an investment-grade rating." That should get boards to take notice.

The study reveals how perceptions of corporate governance practices by the capital markets affect the company's cost of capital. Credit ratings are judgments on the risk of default. As such, if a company has a higher credit rating, it is deemed more likely to make its debt payments and generally pays a lower interest rate on the bonds it issues.

A key characteristic is whether a company's debt receives a rating high enough to be considered "investment grade," or whether it has to pay the higher interest rates associated with speculative bonds (such as high-yield or junk bonds). Because some investors are barred from holding speculative securities, the spread is large between investment- grade and speculative bond yields. Thus, if corporate governance affects the ability of a company to maintain an investment-grade credit rating, it could impact a company's cost of capital.

How great would the impact be? "The median firm in our sample had $934 million of outstanding debt," says co-author Daniel W. Collins, the Henry B. Tippie Research Chair in Accounting at the University of Iowa's Henry B. Tippie College of Business. "And the spread between investment grade and speculative grade on 10-year bonds during this time frame was about 800 basis points." That translates into a hypothetical savings of $74 million per year.

Collins, along with Hollis Ashbaugh and Ryan LaFond, an assistant professor of accounting and information systems and a doctoral candidate, respectively, at the University of Wisconsin, Madison, examined S&P ratings on representative longterm credit for 906 companies in 2002. There is generally a high equivalence among ratings by the three agencies.

Governance data across 16 variables, including board size and composition, directors' backgrounds, auditors' nonaudit fees and stock ownership, were taken mostly from the Corporate Library's Board Analyst database for the same year. The database is primarily a compilation of information made public through Securities and Exchange Commission filings. Several governance variables came from earlier academic studies, including one that distilled 24 variables related to takeover defenses, director protections, voting rights and other restrictions on shareholder rights into a single variable measuring the strength of shareholder rights with regard to corporate control.

Further, the authors compiled financial data for the companies in the study. "It was important in our study to include traditional variables that are used to predict ratings, things like leverage, ROA, capital intensity and other traditional accounting measures," says Collins. "We wanted to see if governance [variables] had incremental ability to predict ratings over and above these traditional measures of creditworthiness." Holding these measures constant, the study indeed finds "compelling evidence that a variety of governance mech- anisms do help explain credit ratings."

Rating agencies acknowledge that corporate governance is relevant. "As far back as we have been doing ratings, we have incorporated a lot of the elements that today are called ‘corporate governance,' " says Solomon Samson, managing director and chief rating officer for corporate credits at S&P. But the proprietary nature of the analysis has resulted in companies being uninformed about the specifics of how governance affects credit ratings.

The study sheds some light on that process. In particular, the research found seven significant variables that influence credit ratings. Credit ratings improve under the following conditions:

• Fewer shareholders own at least 5% of the company. There is a risk that a concentration of ownership could allow large block holders to influence management on their behalf, for instance, calling for targeted share repurchases or special dividends.
• Weaker shareholder rights with regard to corporate control. Factors such as staggered terms for directors and golden parachutes for executives increase the company's takeover resistance and give more power to management as opposed to shareholders. That can be good for bondholders because buyouts often lead to bond losses, whether due to increased leverage or the introduction of other uncertainties.
• More transparency in financial disclosures. As analysts get a clearer picture of the company's condition, they factor less uncertainty into their ratings.
• A higher percentage of the board's directors are deemed to be independent. Independence is commonly seen as a proxy for a board's willingness and ability to oversee management.
• Less CEO power on the board, reflected by whether the CEO is also chairman of the board or sits on other committees. CEOs have been known to dominate board proceedings, so reducing CEO influence is another proxy for the board's willingness and ability to oversee management.
• More stock ownership among directors. When directors have "skin in the game" in the sense of owning the company's stock, they are thought to be better aligned with the interests of other shareholders.
• Greater director experience and expertise, as measured by the number of appointments to other boards.

In addition, several variables commonly associated with better corporate governance were found not to have much influence on ratings. Notably, having audit, compensation and/or nominating committee members consist entirely of independent directors had no effect on the likelihood of receiving an investment-grade rating. These criteria are part of the reforms enacted by the New York Stock Exchange and NASDAQ. Likewise, several elements of the Sarbanes- Oxley Act of 2002 — limiting a public auditor from performing nonaudit work for the business, for instance, or having a financial expert on the audit committee — were not significantly correlated with higher credit ratings. It seems that not all of the factors that regulators are scrutinizing are relevant in the determination of a business's credit rating.

Indeed, S&P confirms that credit analysts don't explicitly factor all corporate governance variables into ratings unless red flags emerge over whether the board is providing adequate checks and balances to management. "How often the board meets, how often the audit committee meets — things of that sort do speak to board oversight, but to us those aren't really critical issues," says S&P's Samson. Variables that capture a board's mechanics don't provide insight into a board's inner workings, he says.

If circumstances arise where governance comes into question, say, if there is a contentious proxy fight or a shareholder lawsuit is filed, S&P credit analysts will consult additional governance expertise. S&P has a separate group of analysts who assess corporate governance practices. But, says S&P's Samson, "We wouldn't just be opining about whether this company has good or bad corporate governance. We would be thinking about what that corporate governance means for the ratings."

The interests of bondholders and shareholders can diverge. The research paper finds that companies with stronger shareholder rights have lower credit ratings, so "governance mechanisms that benefit shareholders may do so at the expense of bondholders." Clearly, both groups of stakeholders prefer long-term prosperity. But some management moves, particularly ones that involve mergers, benefit shareholders at the expense of bondholders. However, when times get really tough, bondholders might prefer a bankruptcy in which they gain control of assets, leaving shareholders with nothing.

There is a growing body of research that focuses on corporate governance and the interests of shareholders. But even fervent governance activists admit that the results of these studies have been ambiguous in the aggregate, which gives cynical boards fodder to dismiss this activism as meddling. Perhaps a more compelling reason to push for governance reform is simply to point out that by changing their approaches to corporate governance, companies may be able to keep their credit ratings high — and thereby lower their cost of capital.

For more information, contact Daniel W. Collins at daniel-collins@uiowa.edu or Hollis Ashbaugh at hashbaugh@bus.wisc.edu.

— Larry Yu

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