EU wants curbs – but not stops – on sovereign ratings

When the shot came, it fell short of its threatened power of penetration. The European Commission is laid out paid to regulate the credit rating industry in quite fundamental ways, but not quite so fundamentally as the commission itself had trailed in the weeks before the announcement. Credit rating agencies already have to register to do business in the European Union. If the commission's plans go ahead, they will need to do a lot more than that. The commission's plan seeks to achieve four main goals:

• Reduce investor demand: Institutional investors use credit ratings in lieu of making their own analysis. So the commission wants to eliminate many references to ratings in the Capital Requirements Directive and then require financial institution "to do their own due diligence".
  
• More transparency and frequency: Ratings of sovereign debt will need to be issued at least every six months, not once a year, as it is at present. Moreover, agencies will need to inform investors and governments of the reasons for the ratings. Ratings should only be published after close of business to avoid disrupting the market.
  
• Reduce conflicts of interest: The commission wants greater diversity of ratings and greater independence. So it proposes that borrowers rotate their ratings agencies every three years. Two ratings would be required for more complex structured products, and a big shareholder of a credit rating agency should not simultaneously be a big shareholder in another credit rating agency.
  
• Greater accountability: Ratings agencies should liable for infringements of the planned "regulation", if they did so intentionally or with gross negligence, and thus harm the investor who relied on the rating. Investors "should bring their civil liability claims before national courts", it said. "The burden of proof would rest on the credit rating agency."

The plan involves both a "directive" and a "regulation". In the parlance of the European Union, a directive is only outline legislation, which member states then "transpose", giving the law its final form. A regulation is fixed; member states have to enact it as is. The directive here concerns how investors use ratings. The regulation affects the agencies themselves.

Internal Market Commissioner Michel Barnier said: "Ratings have a direct impact on the markets and the wider economy and thus on the prosperity of European citizens. They are not just simple opinions." Indeed, they are not simple at all. "We can't let ratings increase market volatility further. My first objective is to reduce the over-reliance on ratings, while at the same time improving the quality of the rating process," he added. "Credit rating agencies should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes. I also want to see increased competition in this sector."

Barnier said, correctly, that rating agencies have made serious mistakes, too. But others of his concerns seem less clear-cut. He worried, for example, about the timing of announcements of rating changes. Why did the agencies make rating changes during the negotiations about an international aid programme for a country? Why? Because the risk profile of the borrower that changed materially, which might materially impair investors' assets.

Source document: The project website has links to the news release and related documentation.

Shaking the habit of ratings – or debt?

When addicts try to come off drugs, they often suffer symptoms of the withdrawal. They sweat more profusely and more easily. They grow paranoid, thinking everyone is out to get them. They get angry and lash out, sometimes inappropriately. The crisis in European sovereign debt feels a little like that sometimes. Now we read these words:
Ratings currently have a quasi-institutional role. We need to reduce our reliance on them.

They come from the European Commission's news release concerning plans for what the European Union calls a directive and a regulation on credit ratings. While the commission backed off its threat to demand that rating agencies withhold comments on sovereign borrowers that undertake financial restructuring, its plans are still at best something to address the symptoms without addressing the cause. Cold turkey it isn't.

Ratings do have a "quasi-institutional role", but that's because they are designed to give confidence in and achieve legitimacy for the borrowers and their ability to pay back their loans. Suspending credit ratings in a time of distress would make little sense as the suspension would be just a downgrade in disguise. One way or the other, credit ratings would still be a part of the institutional framework in which public borrowers operate. Reducing reliance on them could mean things like ensuring that legislation and regulation avoids measures that embed credit ratings in their fabric. But it's not really the borrower or the legislation that "relies" on ratings. The investors rely on them as a check on the system, as a mechanism to ensure the borrowers don't lie. Borrowers "rely" on credit ratings the way a drug addict "relies" on needles. Borrowers "need" money the way a drug addict "needs" a fix.

The solution to the sovereign debt issue in Europe is likely to involve a slow and painful adjustment to the withdrawal of money. Only when that happens will the reliance of credit ratings disappear. If the credit ratings themselves disappeared while the need was still present, borrowers would still be in a fix.

Source document: The news release outlines the commission's planned move.

Consob commissioner sees virtue in governance dualism

Luca Enriques is both a scholar and a practitioner. His seat at the University of Bologna has been empty much of the last several years that he has spent on the Italian securities commission Consob. He brings, therefore, a dual perspective to issues in corporate governance and financial regulation, and he thinks the dual tracks may be the right way forward. He told a meeting of the European Union's Corporate Governance Forum in Warsaw to cut through the red tape company law needs to head in two different directions, which some people may find contradictory.

• Protection against expropriation …: Investors in European companies need better protection from managers and dominant shareholders, who can extract economic rents at the cost of "minority" shareholders. Europe needs to extend rules on insider trading to require notification of trades by controlling shareholders as well as managers.
  
• … but with limited application: Controlling shareholders are a big and powerful force, and they would seek to block such legislation, enlisting other vested interests in their support. So Enriques suggests the new rules apply only to companies newly coming to the stock market. "A new regime, lighter in terms of strings attached to ordinary course of business, non-conflicted decisions, and specifically and effectively addressing expropriation by managers and dominant shareholders, could be one way ahead," he said.

To get around the stigma of a company listing under a lighter weight regulatory regime, he suggests that such newly listed companies would, by default, still meet the tighter rules, but could choose to opt out of them in exchange for greater minority protection.

Source document: The remarks of Enriques can be read in full in a five-page pdf file.

SEC chairman sees more rules, soon, on governance and pay

Mary Schapiro thinks that investors are pretty happy with the say-on-pay rules in the US, used for the first time in the proxy season this year. The chairman of the Securities and Exchange Commission said she hoped it would lead boards to start asking themselves some penetrating questions. But say-on-pay is only the most high-profile of the measure that the SEC has had to deal with in response to the Dodd-Frank Act, and there's more to come, soon.

• Proxy voting services: The SEC staff are looking into possible rules to governance the governance agencies and their perceived conflicts of interest, where concern has grown with the introduction of say-on-pay. "I can’t guarantee our timing in light of all that we have on our plate," Schapiro told an industry workshop. "I hope we can address concerns over their role, including disclosure of conflicts of interest and the information upon which they base recommendations, by the end of the year or early in 2012."
• Four other measures: The Dodd-Frank Act requires the SEC to make rules in four further areas relating to governance and compensation matters: pay ratio, pay-for-performance, claw-backs, and employee hedging of company stock. Schapiro said she recognised that the requirements may be costly to implement. "As we move forward, however, please keep in mind that the statutory framework for these rulemakings is, in some cases, quite prescriptive," she added. "As with all other aspects of Dodd-Frank implementation, we have made outreach to stakeholders a linchpin of our rulemaking efforts. I encourage you to reach out to us as we work to complete our Dodd-Frank requirements and to address other issues of concern." Subtext: "not my fault."

While the act doesn't set a deadline for SEC rulemakings, the SEC itself has. It hopes to propose them by the end of this year or early in 2012.

Source document: The Schapiro speech gives further details of her views on the virtues of say-on-pay.

Study shows political spending, board oversight on the rise in US

This is one of those stories journalists like to call "dog bites man" – that is, it's no surprise. Such stories are rarely worth reporting. But this one is. Two think-tanks – the Investor Responsibility Research Center and the Sustainable Investment Institute – have been looking into how much money has been flowing from US corporations into the political system, and who's responsible for it. They found that the boards of 31 per cent of S&P 500 companies now explicitly oversee such spending, compared to 23 per cent in 2010. This increased oversight and transparency does not, however, translate into less spending. Companies with board oversight of political expenditures spent about 30 per cent more in 2010 than those without such explicit policies.

It's been almost two years now since the US Supreme Court ruled that companies could make unlimited campaign contributions and other donations to political parties. That made political giving an issue for board scrutiny because of its potential dimension and the resulting materiality of the cost. It also made such gifts a tool for corporate strategy.

Source document: The IRRC-Si2 report "Corporate Governance of Political Expenditures: 2011 Benchmark Report on S&P 500 Companies" is a 92-page pdf file.

Shareholders value female directors – look at the share price

Around the world, the movement to get more women on boards of directors in gaining momentum. The move comes in part of the dissatisfaction that all the things we've tried in corporate governance haven't seem to have provided any benefit. If the "problem of corporate governance" is rampant executive pay, without demonstrable downside risk for the executive and without demonstrable upside benefit for shareholders, then clearly not much has happened. The "agenda problem" of the literature is still in full force. If the "problem" is risk management, in which corporate governance is an insurance policy, then the insurer has gone bust. Again. So all the mechanisms of incentive alignment, board independence, structure, procedures and disciplines haven't done the trick. Perhaps it's time to try something else.

According to a study by three Asian-based scholars, there is some evidence that putting women on boards helps the share price. Their working paper uses data on mandatory announcements of new director appointments, and the analysis shows that on average, "shareholders value additions of female directors more than they value additions of male directors". Moreover, companies with workplace practices that promote workplace equality seem to benefit the most from boardroom gender diversity. "This suggests that appointing female directors may help resolve value-decreasing stakeholder conflicts," they conclude.

This isn't just another study. The leader of the research, Renée Adams at the University of Queensland, was author of a related study a couple of years ago that showed rather mixed messages coming for woman on boards. Simplifying a subtle argument a bit too much, they found gender-diverse boards were better at monitoring but less good at strategising.

Source document: The working paper "Does Gender Matter in the Boardroom? Evidence from the Market Reaction to Mandatory New Director Announcements," by Renée Adams and Stephen Gray of the University of Queensland and John Nowland of City University in Hong Kong, is a 55-page pdf file.

What good are independent directors?

Some good, and possibly quite a lot. A study of German companies, focused on the role that outside directors play on supervisory boards, threw up evidence that for innovation, the right outsiders can bring a lot of benefit. Three academics examined the patent applications of innovative companies to see if there was a link to the configuration of the boards. Supervisory boards can be quite distant from the business. They have no representation of senior management. Moreover, the German variety must also have half the seats in the hands of members of the ordinary workforce. So logically, you might think, such boards would serve a narrow, compliance function. That's not the place to expect to see new ideas getting knocked around, leading to the occasional stunning breakthrough. But this study shows a rather different story. Based on panel data of the largest German companies the econometric analysis they found a "robust and significant positive influence of external executives on innovative firm performance", as measured by patent applications. When the outside directors came from innovative companies patenting activities were higher. When people from non-innovative companies dominate, the opposite occurs. "The results indicate that outside board memberships can serve as a channel for scarce specific knowledge and expertise," they conclude. It's a conclusion a lot of directors would like to believe, too.

Source document: The research paper "Outside Directors on the Board and Innovative Firm Performance," by Benjamin Balsmeier , Achim Buchwald and Joel Stiebale of Nottingham University Business School, is a 50-page pdf file.