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Corporate Governance – The Role of the Organisation A Rating


									Corporate Governance: Impact on Credit Ratings
Daniel R. Kastholm, CFA Managing Director

Latin America Corporates
June 2009

Purpose of Corporate Governance
What are we trying to protect? Corporate Governance are checks and balances that are put in place to ensure … (circle the appropriate answer)
A) Equity shareholder(s) interests are protected from personal interests of management.
B) Debt and equity investors are protected from personal interests of management. C) Company‟s interests are protected from personal interests of management. D) All investor‟s interests are protected from personal interests of management AND any of the stakeholders. E) All of the above.

Corporate Governance and Credit Analysis
> Public debate on Corporate Governance focuses on relationship between shareholders and management > Shareholders often manage corporations to serve their own interests at the expense of the bondholders > Fitch focuses on corporate governance practices for the interests of bondholders > Generally, there is broad alignment in shareholder and bondholder interests, but important divergences can occur …

Bondholders vs Shareholders Perspective
> Shareholders favor:
– Debt financed acquisitions/investments – High dividends – Share repurchases

> Bondholders favor:
– Equity financed acquisitions/investments – Low dividends

– Debt repayment (consistent levels of debt)

Role of Shareholder Structure
> Private Sector Entity
– Large number non-controlling Shareholders – 1 shareholder with 100% ownership (or with minorities)

> Public Sector Entity
– Government controlling shareholder

– Government controlling shareholder with minorities

> Corporate Governance applies/benefits all shareholder structures
– Each creates challenges to implement and enforce

– Often difficult to analyze

Majority-Controlled Companies – CG Challenges
> Related party transactions may be difficult to assess
– Family controlled companies, family members at key executive roles – Commercial relationships held outside the company – Owners compensations, family reliance on dividends

– Minorities limited power to challenge controlling partner

> Parallels with publicly controlled entities
– Political appointments to management – Conflicts of interests between shareholder, regulator, and company – State or municipal need for cash – Level of regulatory independence, profits vs prices

Publicly Controlled Entities – Good Governance
> Good Governance starts at the top – the state or municipal level
– – – Lack of checks at municipal level weakens corporate governance Concentration of power leads to political favors for personal gain Examples: awarding contracts/jobs/lower tariffs/divert funds

> Public policies need to balance interests of all parties
– – – – Provide good service, best available rate Maximize profits and preserve corporate sustainability Transparent/defined rules, live by the rules Company is ultimately for the „People‟

Complex and Opaque Holding Structures
> Complex structures easier to mask corporate malpractices

> Strength of accountability between the parent and sub.

> Independent oversight and control structure from parent

> Regulatory arbitrage - meeting minimums or higher standards

Corporate Governance in Latin America
> The „new‟ debate … not so „new‟ in Latin America
– – Closely held by wealth family groups Inefficient government owned entities

> Progress in some markets …
– – 2002 Sarbanes-Oxley Act (“Sarbox”) increased standards, scared some Amendments to Brazilian Corporate Law, Bovespa‟s Novo Mercado

> Corporate Governance still lacking in the region
– – Accepting risks that jeopardize corporation, recent derivative losses Lack of disclosure

Role In The Rating Process
> Corporate Governance is one of many areas we analyze when rating a private or public sector company > Assess the controls and look for “warning signs” that something could go wrong with the company > Analysis overlaps with analysis of risk management and enterprise risk management > Assess management oversight and its influence on management behavior

Corporate Governance – 5 Key Components
> Board Independence > Board Quality > Board & Management Compensation > Related Party Transactions > Integrity of Financial Information

Impact on Credit Ratings
> Strong corporate governance practices are viewed positively but generally do not necessarily mean a higher rating > Weak corporate governance practices are viewed negatively and may result in lower credit rating despite a strong financial profile > Rating upgrades are possible if improvements in CG occur in an entity penalized for poor corporate governance practices > Public sector entities that have good corporate governance and more independence, more be rated on a stand alone basis

Concluding Observations
> Benefits of Good Corporate Governance Obvious
– Higher share price premiums, lower rates and cost of capital


Improves management behavior and resource allocation
Reduce risks of misuse of financial resources and affiliate dealings

> Corporate Governance impacts credit ratings
– Poor practices can result in lower ratings

> Sound Corporate Governance policies not enough
– – Good implementation Adherence to policy


Most important, develop and maintain long-term track records

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Board Independence - Analysis
> Independence
– –

Real Independence

> Quality (Expertise)
Particular business, products

– – – –

Finance, accounting

> Commitment and efficiency
Board size Board members outside professional positions

> Former CEO
Good business knowledge or out of date Potential conflict of interest re pro management

Board Quality - Analysis
> Inherently difficult to assess board quality – no/limited access > Management meeting probing and related discussion:
– How assertive is the Board in evaluating management decisions – What key questions did the Board pose to management – What are their biggest concerns – How are Board members selected – How broad is the pool of candidates – What is the CEO‟s role in the nomination process – How large of a transaction can occur without board approval

Board & Management Compensation - Analysis
> Who decides how CEO and other key executives are paid and how much > Is compensation of management within reasonable bounds
– Relation to peers – Aligned with the company‟s performance – Short-term only

> Board members‟ fees

Related Party Transactions - Analysis
> Certainty that executives and majority shareholders are not using related party transactions to divert company‟s wealth for personal enrichment or political gain > Links between the company and its customers, suppliers and bankers > The terms of the company‟s transactions with key management > Good disclosure is important to get a sense of the nature, purpose and terms of identified related party transactions

Integrity of Financial Information - Analysis
> Transparency of financial information
– – Transparent disclosure revealing the story of the business in the period Rules-based, box-ticking accounting information prepared to meet legal requirement

> Financial control environment
– Entrenched in business culture or designed to meet rules

> Integrity of audit process
– Board/Audit Committee should govern the internal control and audit process to promote the objectivity and integrity of financial reporting

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