Governance and Your Debt Rating

IN EARLY 2004, Standard & Poor's Ratings Services expanded its review of governance practices at rated issuers. As the announcement noted, many corporate failures have exhibited a combination of an aggressive management culture and weak board oversight that could potentially impair creditworthiness. Strong corporate governance, on the other hand, can mitigate perceived risks in corporate strategy or management culture, thereby contributing to ratings stability.

Although issues such as ownership structure, management practices and financial disclosure policies are integral features of credit analysis, S&P's ratings process had not traditionally identified them with corporate governance. But since the expanded review was inaugurated, Standard & Poor's credit analysts and governance specialists have seen that the links between credit quality and certain elements of corporate governance can be extensive.

Equity owners' rights are relevant to credit analysis because of the complementary role a company's equity owners (public or private) play in financing activities and growth. For example, corporations with unequal common-stock voting rights could have diminished access to investment capital. Either they might command a lower stock price, or they might attract fewer investors. That could augment the role of creditors in financing the corporation's activities, which in turn could lower its credit rating.

Even an issue like executive compensation can affect a credit rating. The size of the pay package relative to corporate earnings is not really the issue for us. Rather, it is what executive compensation programs and awards indicate about the quality of board oversight. For market observers, such decisions provide a litmus test of board effectiveness.

Other governance characteristics also require analysis. For example, this year we have been scrutinizing the uptake of majority voting initiatives at publicly listed U.S. corporations. We examine the pluses and minuses these proposals could represent for a company's creditors, especially where they combine with other initiatives, such as annual elections for all board members and the removal of "poison pills." Although shareholders might welcome such measures, from a credit perspective they could have negative consequences, including emboldening activist investors (including hedge funds and private equity groups) to attempt debt-financed dividends or buyouts.

On their side, how can an issuer's board members make use of credit ratings? Directors have the duty to ensure that their corporation assumes acceptable risks and that these risks are managed appropriately. Credit ratings can provide a useful point of reference in risk management.

A rating analysis incorporates many dimensions. Key elements include corporate structure; features of the industry; management effectiveness; and the impact of regulations and public policy. These are analyzed in the context of historical performance, together with a forward-looking review of how resources are being used to competitive advantage.

While the principal users of ratings are bond investors and other creditors, shareholders and other stakeholders also take an interest in them. Consequently, for a company's directors, understanding the relationship between ratings and the market pricing of risk is a useful tool in reaching conclusions about a borrowing program's viability, or the organization's overall ability to finance a strategic initiative like an acquisition.

Yet corporate officers and directors should be careful not to manage the company to a specific rating. A good credit rating is not especially desirable for its own sake, any more than a high corporate governance rating is a management raison d'être. Rather, the board should take a pragmatic approach to the credit rating as a resource in determining strategy.