Friday, 15 June 2018

Article Preview: “Can Credit Rating Agencies Play a Greater Role in Corporate Governance Disclosure?” – Corporate Governance: The International Journal of Business in Society

In the first of a few brief posts today, we shall be looking at a forthcoming article by this author on the credit rating agencies and their potential involvement with a push to increase corporate governance disclosure rates in the EU. The article was invited as part of a special edition for the Corporate Governance: The International Journal of Business in Society Journal, and will be published very shortly.

The article is concerned with the European Commission’s (EC) efforts to increase the effectiveness of corporate governance disclosures, which is a system they have established which aims to construct a ‘comply or explain’ system of corporate governance reporting. The system was set up by the EC in 2014, and would take the form of what are called ‘corporate governance statements’. Since this system has been established, it has only witnessed limited success because, as was mentioned in a commissioned report for the EC, there has been a lack of ‘informative disclosure’ from companies caught by the regulatory endeavour. The EC acknowledged this in 2011 and since then have been formulating measures to help alleviate the problem, but there are a number of issues at play. The commissioned report noted that, as far as investors were concerned, only a quarter of reporting companies were producing information regarding their compliance with stated corporate governance regulations as ‘sufficiently good’.

Essentially, the program dictates that companies who are caught by the regulation (it differs by size and status i.e. public companies) must declare in a separate statement alongside their annual reports which national corporate governance regime they are following, and how they are complying with that stated regime. Taking influence from other jurisdictions that have applied a similar philosophy previously (like the UK), the EC wanted to allow for flexibility so companies are allowed to miss their obligations (if it is reasonable for them do so, on account of aspects such as applicability related to size or industry etc.) but they must subsequently explain why then have chosen not to comply. In attempting to increase the effectiveness of the regime, the EC has decided that a regulatory amendment is in order, and not a private one. That regulatory amendment takes the form of the national regulators (the ‘competent authorities’) taking a more active role in the monitoring of responses and the enforcement of the regime. The article discusses how that, according to some in the literature, ‘the market is not particularly concerned about non-compliance’, which adds to a viewpoint that there are very few deterrents within the current regulatory regime. This argument is based on the concept that, for investors, it is likely a ‘comply or perform’ dynamic, rather than a ‘comply or explain’ dynamic on account of investors tending to focus on the financial performance of a given company in respect of its organisational behaviour. For example, the suggestion is that if a firm is performing well, then it must be being governed well. We know that this is not the case, because a company may be performing well for many reasons other than good governance, and indeed it may be the case that the company is performing well because it is not being governed well. We know this dynamic to be short-termism, which is something the EC is trying to reduce on a systemic scale. However, the question for the article is whether the approach is increasing the regulatory framework is optimal or not.

There are issues with the call to increase the regulatory framework. Though it is often the case here in financial Regulation Matters that giving more power to the market is rarely called for, on this occasion the increase in regulation is littered with potential inefficiencies. One inefficiency that the literature has found is that the cost to the national regulators will increase, whilst the perception or the care from investors will not. If that dynamic comes to bear, then it is unlikely that companies will respond by increasing their disclosure rates. It is probably more likely that a ‘box-ticking’ exercise will ensue that will cost regulators but not benefit the marketplace. It is for this reason that the article suggests, but only suggests, that a different approach may be required.

That approach is to work with the credit rating agencies more and push for a slight alteration in their methodologies. Any regular reader of Financial Regulation Matters will know that this author is particularly critical of the credit rating agencies, and this article does not suggest that the rating agencies are the most optimal option as they stand. However, theoretically, they do have a potential role to play. For the agencies, methodologically speaking, ‘governance’ is one of the key factors in developing a credit rating. If a CRA is concerned with whether a borrower can repay a loan on time and in full, then how that borrower is governed will naturally be of importance to the designation of that particular rating. To digress, in a forthcoming book by this author entitled The Role of Credit Rating Agencies in Responsible Finance, the focus will be on examining the incorporation of ‘ESG’ principles into credit ratings – Environmental, Social, and Governance – although, for the rating agencies, they are incredibly clear that, for them (and for investors too), ‘Governance’ is the primary factor. So, if governance is a key factor for the agencies, what does that mean for the EC’s push for an increase in governance disclosure rates?

The article suggests that if the CRAs were to adapt their methodologies slightly so that, now, a credit rating included the quality of a company’s CG Statement disclosure, then there would be a market-based deterrent. Furthermore, this deterrent would be much more powerful than anything the state could provide, mostly because of how it would be received. Leaving aside whether it is positive or not for one moment, the marketplace is intrinsically linked to the CRAs and their ratings, and as such a negative rating carries serious weight for companies. You can often see press releases from companies (and states) and annual reports mentioning the need to improve a credit rating or protect a credit rating, and that is because investors use credit ratings. The reason why they use these ratings is another matter and has been discussed here in the blog, but the fact that they do means that companies would be incredibly attuned to the rating process. If the CRAs were to include the quality of governance disclosure within their rating, and also make that incorporation transparent for investors, there exists a real opportunity to develop a meaningful deterrent. The result would be a system whereby not only would poor disclosure be punished, but good rates of quality CG disclosure would be rewarded, which is a situation the EC covet. However, there are potential issues because of how the CRA industry is set up, and the ‘issuer-pays’ remuneration system is the largest issue of them all. If this system was put in place, then there is a potential that the issuer-pays dynamic would be leveraged so that the CRAs favoured the issuer when deciding the quality of the CG statements. For those who may read this and suggest there are safeguards in place to prevent that, this author would suggest that those safeguards – reputational pressure, competition, transparency – have always been in place and have been proven to have failed on a number of occasions in the past. But, there is a potential if the EC and the CRAs were to consider it.

Ultimately, however, the article suggests a regime that may work, but whether that gets adopted or not is another question entirely. Why would the CRAs increase their workload when they are recording massive revenues anyway? Is there an appetite from the EC to incorporate financial third-parties? To answer the first question, the CRAs may adopt this program as it would increase their shattered reputation in the eyes of investors and the financial arena, but we know here in the blog that they are not subject to reputational pressures. To answer the second question, the EC has shown that they favour the regulatory approach rather than a private approach, and that may be because of the damage the rating agencies caused in the Eurozone Crisis after the Financial Crisis – perhaps those wounds are (understandably) not healed yet. Nevertheless, there are options available to the EC and the marketplace to add a level of effectiveness to the CG Statement regime that is currently missing.


Keywords – Credit Rating Agencies, EU, Corporate Governance, Business, @finregmatters

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