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Years ago, most investors assessed the merits of companies by analyzing balance sheets, P&L and cash-flow statements. Investors who analyzed corporate boardrooms and ranked them for their shareholder friendly policies were a small (and sometimes vocal) bunch of institutional investors, usually representing pension funds or Taft-Hartley plans. Management regarded them as gadflies, rogue capitalists

Years ago, most investors assessed the merits of companies by analyzing balance sheets, P&L and cash-flow statements. Investors who analyzed corporate boardrooms and ranked them for their “shareholder friendly” policies were a small (and sometimes vocal) bunch of institutional investors, usually representing pension funds or Taft-Hartley plans. Management regarded them as gadflies, rogue capitalists — or just plain-old self-interested troublemakers.

Call them what you will, but today, corporate governance analysts are legion. In fact, analysis of corporate governance policies has become so popular that the Yahoo! finance Web site actually lists a “corporate governance quotient” on its company profile pages.

The growth in popularity is not surprising given the evidence that shows executives who take their roles as fiduciaries to their shareholders seriously tend to produce higher profits and keep costs lower. (For more on corporate governance basics go to:; it's free and posts news, research and links to other interesting sites.)

Recently Registered Rep. contributing editor Ann Therese Palmer talked with two key corporate governance experts for nuances on corporate governance analysis.

Ken Bertsch, managing director of Corporate Governance for Moody's Corp.

Address: 99 Church Street, New York, N.Y. 10007.

Phone: (212) 553-7194.

Moody's Investors Service subsidiary analyzes more than 170,000 corporate, government and structured finance securities, including 10,000 corporate relationships.

Not surprisingly, Moody's views a company's corporate governance policies from a debt perspective. That makes sense, says Ken Bertsch, managing director of Corporate Governance for Moody's, because, obviously, “bondholders have suffered from bad corporate governance.” So have shareholders, of course. In general, the governance interests of long-term shareholders and bondholders overlap, says Bertsch, but there are notable differences. For example, bondholders, since they are primarily focused on a company's cash flow for timely payments on debt, are concerned about executive pay plans, since many tie compensation to stock price performance. “Stock repurchase programs are legitimate, but can be overemphasized from a bondholders' perspective,” Bertsch says. Bondholders, in a given situation, may see a need to pay down debt or re-invest in the business, rather than undertake share repurchases, which can be encouraged by executive pay programs that are heavy on stock options. “It becomes a question of whether there is an even playing field, from a compensation perspective, for management consideration of alternate uses of cash,” he says.

How does Moody's use its credit expertise? Bertsch compared Merrill Lynch and Morgan Stanley to illustrate how two firms with an identical credit rating can have different outlooks, based on corporate governance issues.

Bertsch notes that Merrill Lynch has a DoubleA3 crediting rating, a very strong rating. (TripleA is Moody's best rating, then the scale descends to DoubleA1, DoubleA2, DoubleA3.) One of the reasons for its strong credit rating comes down to strong corporate governance. “Merrill has been extraordinarily successful at changing the firm's top management,” and yet investors haven't fully appreciated it, Bertsch says. “Merrill changed the culture in a way that's fairly significant, as well as changed who's on the board.” Such discipline has helped the company be a consistent leader in the financial services industry. Even now, Merrill's board “may be an unsung board of directors,” Bertsch says. But “their grasp of the company and where it should go gives us a lot of confidence.”

Morgan Stanley has an identical credit rating, but, not surprisingly, Moody's has a negative outlook. “Morgan's capital structure organization has allowed it to maintain its high credit rating,” Bertsch explains. “But, we disagree with its decision on Discover, and we're very concerned about the recent loss of talent.” Philip Purcell, as CEO, basically practiced bad corporate governance by stacking the board with his own allies. Further, Purcell was criticized for promoting executives who were loyal to him rather than to the firm. “There were clear missteps by the board, including Purcell leaving with severance packages,” Bertsch says.

Citigroup also enjoys a strong credit rating, in fact, Moody's highest, Bertsch says. Citi's business lines generate cash. That said, “We'd had concerns about Citigroup's regulatory problems,” Bertsch explains. “There's a suggestion the culture is very aggressive. That tends to get it into trouble.” For now, Moody analysts regard Citi's corporate governance as a neutral — neither “a negative or a positive,” Bertsch says.

Since the top executives set the corporate culture as well as business strategy, financial advisors should pay attention to who is at the helm and what the boardroom policies are, Bertsch says. “With some companies, it doesn't factor on the surface quite as strongly as at other companies. But governance is definitely a risk factor.”

Patrick McGurn, executive vice president of Institutional Shareholder Services (ISS).

Address: 2099 Gaither Rd., Suite 501, Rockville, Md. 20850.

Phone: (301) 556-0500.

ISS has 13 offices worldwide and 400 employees. It is the world's largest provider of proxy voting and corporate governance services. ISS, which has more than 1,500 institutional and corporate clients worldwide, analyzes proxies and issues recommendations for more than 33,000 companies across 115 markets.

When the importance of analyzing corporate governance policies is put to McGurn, he responds: “The answer is a four-letter word: R-I-S-K. Shareholders have learned the hard way that poor governance equals high levels of investment risk. The proof was there with the many red flags waving at Enron, WorldCom and Adelphia. They misread obvious warning signs at companies that melted down.”

That is not to say an investor can trade on that info. So, while researchers are finding that “some governance metrics seem to have a strong correlation with underlying company performance,” McGurn says, “unfortunately, most studies of corporate governance metrics always try to link them to market returns over the short run. You usually don't find a direct correlation [over the short run].”

With three years of data, ISS has run regression analyses to determine which factors correlate with any number of financial performance and risk measurements. “When you start looking at specific metrics and specific governance factors, you start to find a strong correlation between certain governance practices, measurements of risk and company performance,” says McGurn.

ISS' Ratings of Wall Street (5 is the top sub-score)
Company Board Audit Anti-Takeover Compensation Outperfom Vs. S&P Outperfom Vs. Industry Avg.
A.G. Edwards 3 5 3 3 70.0% 83.6%
Citicorp 2 5 4 3 52.3 84.9
Janus 2 2 2 2 25.0 67.8
Legg Mason 5 1 5 1 33.6 60.3
Merrill Lynch 4 5 1 1 25.3 68.5
Morgan Stanley 3 5 5 1 31.9 76.0
Raymond James 3 3 5 2 50.8 71.9
T. Rowe Price 1 5 3 2 29.9 74.0
Charles Schwab 2 1 4 4 18.0 66.4
Goldman Sachs 4 5 2 2 40.9 79.5
Source: Institutional Shareholders Services

Earlier this summer, ISS added several new variables to its analysis, revised others and reweighted its 60-plus factors. The rating criteria were organized into four broad categories, says McGurn, and assigned the following weights: 40 percent board factors (independence, annual elections, etc.), 30 percent compensation programs (options, insider ownership), 20 percent anti-takeover section (shareholder rights plans, poison pills, etc.), 10 percent audit (independent, fees paid). ISS also added new metrics like “related party transactions” other than just the CEO, i.e., relatives and other directors, McGurn adds. Other variables include the number of financial experts on the audit committee; performance-based compensation; individual director performance reviews; mandatory holding periods for options; mandatory holding periods for restricted stock; and how many board members are independent outsiders.

Considering securities firms as a group, McGurn notes they tend to have problems with compensation. “They use a great deal of equity for compensation purposes,” he explains. “We haven't approved a stock option plan for any of the securities firms.”

“In the post-Enron world, investors are clearly making the effort to screen their entire portfolio to find hidden risks,” McGurn says. “That's one reason why everyone needs to take this seriously. If you don't, you get Enrons and Worldcoms.”

Big Compensation, Big Troubles

In studying the pay packages of 865 U.S. firms, Moody's found a significant correlation between “abnormally high” CEO bonuses and stock option grants and the rate of defaults and large “multi-notch” downgrades. By “high pay” Moody's means CEOs are in the top 10% in bonus and option grants, when normalized for firm size, previous operating performance and certain other variables. The “normal” group constitutes the next 70% of companies — the broad middle in CEO pay by these measures. In contrast to bonus and options pay, the Moody's study found no significance in CEO salary variations.

Default and Large Downgrade Rates: 1993-2003
Default Rate %
Bonus (normal) 0.6
Bonus (high pay) 1.8
Options (normal) 0.8
Options (high pay 1.5
Downgrade Rate %
Bonus (normal) 3.1
Bonus (high pay) 5.5
Options (normal 4.4
Options (high pay) 7.5
Source: Moody's Investor Service, Global Credit Research
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