Corporate directors and officers have yet another reason to take a careful look at their compensation practices: Executive pay could affect the company’s credit ratings.
In addition to institutional investors, who have been increasingly outspoken on executive compensation practices in recent months, ratings agencies are now acknowledging that pay practices are one of many factors being used to ascertain credit risk. Two of the major ratings agencies have told Compliance Week that executive pay is a factor in assigning ratings, and that unexplained, outsized pay packages may raise a red flag.
The pay-risk correlation was highlighted in a Special Comment paper issued last week by Moody’s Investors Service, which concluded that excessive CEO compensation packages are associated with higher levels of credit risk.
Based on its study of data from non-financial U.S. corporations with senior unsecured bond ratings of “B3” or higher from 1993-2003, Moody’s concluded, “a connection exists between CEO compensation and overall credit risk.” The connection, it turns out, is to downgrades and default rates. “Firms where CEO pay is substantially greater than expected based on firm size, past performance, and other variables experience higher default rates and more frequent large downgrades than do other similarly rated companies.” The report noted that variations in salaries do not appear to be predictive of credit risk.
The Moody’s research doesn’t explain why higher compensation may be associated with higher credit risk, but offers three possible explanations. First, excessive compensation may be indicative of weak management oversight. Second, large pay packages that are highly sensitive to stock price or operating performance may induce greater risk taking by managers that may be consistent with stockholders’ objectives, but not with bondholders’ objectives. And third, large incentive-pay packages may lead managers to focus on accounting results, which Moody’s says “may, at best, divert management attention from the underlying business or, at worst, create an environment that ultimately leads to fraud.”
Bertsch
“From a credit standpoint, all three explanations would be of concern,” said Kenneth Bertsch, managing director for corporate governance analysis at Moody’s.
Affecting Discussions
According to Bertsch, the rating agency is using the data from the Special Comment paper as part of its overall efforts to judge companies’ governance quality. For larger issuers, Bertsch said, Moody’s reviews such information annually.
“We’ve been asking companies more about executive pay, this [data] will help us refine our questions,” said Bertsch. “For current companies caught by this red flag, it will effect our discussions with them on corporate governance and on executive pay.”
“Our own research indicates similar findings,” agreed Dan Konigsburg, director of Governance Services at Standard & Poor's, who said his firm also screens for outsized executive pay. “Executive pay is a clear window into how well a board provides oversight over management,” said Konigsburg.
AGENCY VIEWS
Moody's Investors Services
The excerpt below is from, "CEO Compensation and Credit Risk," by Moody's Investors Services, July 2005:
After controlling for a variety of firm characteristics, including industry effects and long-term ratings, we find that large, positive, unexplained bonus and option awards are predictive of both default and large rating downgrades. Variations in salaries, however, do not appear to be predictive of credit risk.
Although the analysis does not directly address the reasons why large bonuses or option grants are associated with
greater credit risk, possible explanations can be inferred from the academic literature on CEO compensation, managerial
incentives, and board control.
High levels of unexplained compensation may indicate that board oversight is lax and, as a result, management has
insufficient pressure to deliver good financial performance.
Large performance-based compensation packages, in particular, may induce managers to:
Deliver strong short-term financial results and obscure longer-term structural problems.
Pursue high risk strategies with very strong positive, but also very adverse, potential payoffs.
Standard & Poor's
The excerpt below is from, "The Evolving Role of Corporate Governance In Credit Rating Analysis," by Standard & Poor's, Oct. 2002:
It is clear that weak corporate governance can undermine creditworthiness in several ways and should serve as a red flag or warning indicator to credit analysts. Alternatively, strong corporate governance, demonstrated in part by the presence of an active, independent board that participates in determining and monitoring the control environment, while not a guarantee of creditworthiness, can serve to support the credibility of financial disclosure and, more broadly, management.
Recent examples of poor corporate governance, which contributed to impaired creditworthiness, include:
Uncontrolled dominant ownership influence that applied company resources to personal or unrelated use.
Uncontrolled executive compensation programs.
Management incentives that compromised long-term stability for short-term gain.
Inadequate oversight of the integrity of financial disclosure, which resulted in heightened funding and liquidity risk...
...Similarly, relatively little attention has been paid to the compensation of directors and senior management teams. These issues are focused on more extensively in Governance Services' corporate governance scores and will receive more scrutiny in the ratings process as well. This can be a qualitative area of analysis, and it can be difficult to determine objectively if a given level of compensation is excessive or will result in a company strategy that is overly aggressive or mainly focused on short-term performance. As board practices change in the wake of management and accounting abuses—and directors take on a more active role in the company direction and oversight—more weight to the role of the board of directors could be warranted from the perspective of credit rating.
While Bertsch was careful to note that the link between CEO compensation and expected credit risk “needs to be evaluated on a case-by-case basis,” he said, “It does factor into the credit rating.”
Bertsch said Moody’s looks for “pay that’s out of the norm on the high side and is not well-explained.”
“For most of those companies caught with this red flag, there’s no real problem, and we can work through the reason why the pay is elevated,” said Bertsch. “On the other hand, for the minority where this is reflecting something, where it is meaningful, there could be a substantial credit event down the road.” In some cases, he said Moody’s may notch a rating or knock a company’s rating down one grade to reflect more risk. “We have to take this as a risk factor and shade the ratings appropriately,” he said.
As an example, Bertsch noted that one company flagged in the historical study was The Gap. Bertsch said the company was flagged based on policies it had in place a few years back. “They had a combination of poor performance and high pay that put them in the outlier group. The fact that they were flagged fits with our picture of them as being fairly undisciplined in their governance a few years ago,” says Bertsch, noting that the company has since made substantial changes in its governance, executive team and executive compensation. “They have much more solid governance now that we believe backs up the turnaround they’ve experienced. They’ve been more solid in the last couple of years.”
Enron and Covanta Energy were also among those companies caught by Moody’s model that ultimately defaulted. Both companies were also marked as providing high unexplained compensation in six of the seven years prior to their default in 2001.
Avoiding Red Flags
Other red flags S&P’s Konigsburg noted are large, unexplained changes to the size of bonus pay or grants in options or restricted stock, particularly where the long-term trend of performance has been negative, as well as unexplained changes to a compensation policy, such as changes to performance targets that aren’t explained.
Konigsburg
Said Konigsburg, “We look at [high executive compensation] on case-by-case basis and when we think the risks are higher, it will form a part of the credit discussion when we assign the rating. If we believe it's necessary, we'll comment on it.”
For example, last year, Konigsburg noted that S&P felt Cendant had governance issues that demanded a closer look. “We met with management, a number of the directors and we made constant comments, both positive and negative. Some of the critical comments we had were on executive compensation.” (See related document above, right).
Both Bertsch and Konigsburg offered some advice as to what boards should be doing to keep companies from being flagged as risky.
“Pay should be set independently without any influence by the CEO and it should be strongly connected with the performance of the company,” said Konigsburg. “There are lots of ways to do it. We don’t prescribe any one way, but companies need to convince us that there is goodwill behind the process.”
“Companies need to be aware of whether their executive pay is rational, and whether they maybe perceived as an outlier. If their compensation is out of the norm, they should explain it in the proxy,” adds Bertsch from Moody’s. “Boards need to understand what they’re incentivizing. If they award a large pay package, they need to understand what behavior it made lead to. If a company has high pay hinged on meeting a certain number, it may not be surprising that there are a lot of actions around meeting that number, both legitimate and not legitimate.”
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