Moody’s analyses executive pay for credit risk
06/08/2007
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Boards and management may be unaware that their credit rating from Moody’s could take into account risk associated with executive compensation.  Contrarily, some of the things Moody’s are wary about are advocated as good practice in Australia and the UK, and increasingly now in the US and Canada.  This includes using Total Shareholder Return (TSR) and Earnings Per Share (EPS) growth as performance metrics for long term incentives (LTIs).


Several Moody’s publications note the risks. One of the more interesting is the rating service’s research report on the credit implications of executive pay structures.  It issued this report to “provide a broader context” for executive compensation risks in its corporate governance assessments.

The rating agency sees three areas of executive remuneration that pose special credit risks: the use of stock options, the employment of earnings per share growth as an executive incentive performance metric, and the use of total shareholder return as an executive incentive performance metric.

Use of any of these three can encourage a company to buy back shares rather than keep the cash within the firm, thereby increasing its risk of nonpayment to creditors. Indeed, these have been among the several criticisms against the extensive use of share buybacks in Australia.  This still holds true even though issuing options rather than paying out cash compensation can increase cash-flow in the near term because, according to Moody’s, options and share-price metrics can move executives to much higher levels of cash-squandering.


The rating agency also favours using multiple performance metrics — it has a particular taste for operating cash flow and free cash flow — rather than relying on a single measuring rod for incentive payouts.  Guerdon Associates is sympathetic to some of these sentiments, although we acknowledge the circumstances of each company needs to be taken into account.


While this approach can lead to complexity, a pay structure focused “on just one dimension of success is more likely to be gamed,” according to the Moody’s report.
In its report, Moody’s says it keeps a close watch on the difference between chief executive compensation and the pay of other top executives.  Too hefty a divergence could signal the existence of an “imperial CEO” and a company too dependent on a single person. While a company that pays its chief executive officer twice what it pays its next highest earning manager would be adhering to the norm, the company would get a rater’s attention if it paid the CEO five times more, according to Moody’s. (Guerdon Associates has reported on issues of internal pay equity for executives before – see HERE and HERE).


The research showed that there was a link between excessive bonuses and higher incidences of default or severe ratings downgrades, which can have significant effects on the company’s cost of capital.  While it was not established that excessive CEO compensation causes the increased levels of credit risk, the relationship is strong both economically and statistically.

But it should be kept in mind that Moody’s research is primarily interested with the needs of its clients, i.e. bondholders.  They are not interested in the needs of shareholders.  And this is exemplified clearly in their research when Moody’s poses an explanation for their findings. They say that typical pay-for-performance schemes that are too overly focused on share price or earnings may induce greater risk taking by managers, which might not be ideal for bondholders.  Hence, a lower credit rating may ensue.  This is due to the fact that the company exposes bondholders to the risk of default, if their risky projects fail.  On the other hand, they are also limited in sharing any possible success of the project, since the most gain they can make is to receive the yield from the loan – unlike shareholders, who would be able to reap all the benefits of a successful project.  Hence, there is the conflict between shareholders and bondholders predicted under agency theory.

The authors observe that an “excessive” compensation policy could also “be indicative of weak management oversight” by the board of directors.  Alternatively, the authors also postulated that it could be indicative of managers seeking only to perform in the specific accounting measures that are related to their performance plans, which may be detrimental to the firm itself.

See the Moody’s report HERE.

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