The forgotten investors

The expansion of the rights of equity investors in US public companies carries the potential of substantial risk for bondholders with limited or no covenant protections.

The corporate governance improvements at US corporations in recent years have benefited bondholders, including marked improvements in the quality of financial controls and the rigor and independence of board oversight by some companies. However, the balance of power at US companies appears to be undergoing a substantial shift in which shareholders are demanding and winning new rights that give them more direct and active influence over decisions that are the traditional purview of management and boards. In an environment where activists are pushing for even greater rights this concern is particularly timely because, once awarded, shareholder rights are rarely withdrawn.

It would be of less concern if these new powers belonged only to public pension funds and other long-term shareholders because such shareholders have interests that are generally aligned with bondholders in terms of building long-term value creation. Short-term investors, however, could exercise their new rights to press companies harder for short-term gains, at the cost of long-term credit quality. As noted in the June 2007 report ‘Short-term shareholder activists degrade creditworthiness of rated companies’, Moody’s is already witnessing more activism at rated issuers which is generally negative from a credit perspective.

For those bondholders with protective covenants, such as limitations on leverage or the option to put the bonds back to the issuer in the event of a change in control, the enhancement of shareholder rights should pose limited additional risk, provided the exceptions to these limitations are relatively minimal. However, it is rare for investment-grade issuers to incorporate incurrence covenants that restrict dividend distributions and other payouts and the assumption of debt in their bond indentures. In fact, speculative-grade bonds with limited covenant protection or bank loans that are ‘covenant lite’ are becoming more common. This being said, change-in-control covenants are appearing in investment-grade bond offerings with increasing frequency.

Several of the rights being demanded by shareholders, in themselves, may have some benefit to bondholders, not least because they diminish the opportunity for management to act in its own interests and not in those of shareholders. The concern, however, is the pace and scale of change, and the potential unintended consequences and harmful effects that exercise of these rights by a small minority of short-term investors, in combination, may have for bondholders.

In a separate ‘special comment’ issued earlier this month, Moody’s reported that, to date, the effects of shareholder activism on the creditworthiness of Moody’s-rated issuers has been almost universally negative, even if only to some degree, including numerous downgrades at least indirectly linked to concessions made to activists (For more details see ‘Short-term shareholder activists degrade creditworthiness of rated companies’.) These have included the adoption of a more aggressive financial policy and increases in an issuer’s dividend or share buyback program achieved through higher leverage.

For the greater good – most of the time

Moody’s believes the corporate governance reforms that followed in the wake of the 2001-2002 corporate failures have generally benefited bondholders (see  Key positive changes above).

Moody’s believes that the interests of bondholders and long-term shareholders are relatively aligned, because both benefit when companies build long-term value creation. However, there is also potential for their interests to conflict and we believe recent developments raise the specter of a greater divergence in investor interests. With their reliance on fixed returns, bondholders are generally more risk averse than common shareholders, who have theoretically unlimited upside. For example, while shareholders tend to view taking on more debt to expand a business or return proceeds to shareholders as an opportunity to increase return on their investment, bondholders tend to view additional leverage as merely increasing the risk of default.

Traditionally, management and the board act as intermediaries between these two competing interests, and are delegated authority by the shareholders to choose corporate and financial strategies that will best balance the risk of default with the benefit of increased investment. Bondholders can – and often do – protect their interests through financial incurrence covenants, but these are typically only written into the indentures of speculative-grade bonds. Liens covenants are commonplace in investment-grade indentures, but their carve-outs generally allow companies to engage in various financings that subordinate bondholders in comparison to shareholders. As a result, holders of unsecured investment-grade bonds have traditionally relied upon management and the board to protect their interests and strike an appropriate balance between generating return for shareholders and maintaining the creditworthiness of the company.

Altering a delicate balance

A series of recent and pending developments enhancing the power of shareholders has placed this balance under strain. The improvements made in the wake of the corporate failures and Sarbanes-Oxley focused on strengthening the board vis-à-vis management. We now appear to be in another phase of change focused on enhancing the power of shareholders to influence management and the board directly.

Equity investors are now pushing for a range of new powers, with an increasing degree of success.

Moody’s view this trend as a significant one that is ongoing and very unlikely to reverse itself in the foreseeable future, particularly given the broad popularity and intuitive appeal of the concept of increasing   ‘shareholder democracy.’

Directors and managers are listening. Over 350 US public companies have adopted some form of ‘majority vote’ standard for director elections.

Most of these companies have adopted this change over the last 18 months, in contrast to the decade or so it took for shareholders to force companies to dismantle some of their takeover defenses. In the latest trend, shareholders have filed ‘say on pay’ proposals at over 80 US companies thus far in 2007, asking boards to require an annual non-binding shareholder vote on executive compensation policies. In its first proxy season, the proposals have received relatively strong shareholder support, garnering majority votes in at least two cases, Blockbuster and Verizon Communications. Already, several Moody’s-rated entities, including Aflac and TIAA-CREF, have voluntarily committed to hold such a vote in the future.

Simultaneously, Moody’s believes a number of new and proposed regulatory changes may further increase the potency of these new shareholder powers (see   New and proposed regulatory changes below).

Taken together, Moody’s believes these changes, if all become a reality, could represent the broadest and fastest acceleration of shareholder rights the US has seen in recent history.

Open to abuse

We believe several of the specific rights being demanded by shareholders may, in themselves, have some benefit to bondholders. For example, a non-binding vote on executive pay may create pressure on boards to rethink executive pay and, over time, reduce outlier CEO pay, which we have seen as having some correlation to enhanced credit risk. (This correlation is studied further in ‘CEO compensation and credit risk’ from July 2005.)

Similarly, majority vote mechanisms may pressure directors to feel more accountable and make them more vigilant. Indeed, taken together, these new powers could diminish the overall concern that disinterested management acts in its own interests, and not those of the broad shareholder group (the so-called principal-agent problem).

Long-term investors, such as public and union pension funds, are doing much of the slow, painstaking work of pressuring the SEC for new rules and pushing shareholder resolutions through one company at a time. Generally, these investors have a long-term perspective, and would use the new powers sparingly and only when extreme circumstances demand strong measures.

However, Moody’s is concerned that short-term investors, including some who appear most interested in reaping a quick return of assets to shareholders, are recognizing their usefulness. Activist investors finding a mixture of the short slate proxy fight – combined with the power of convincing proxy advisors and other institutional holders to rally to their cause – can place tremendous pressure on boards and management to meet some or all of their demands. The short slate rule, first adopted in 1992, allows a shareholder to nominate fewer directors than would make up a majority of the board and then fill in the remaining slots with the company’s nominees.

The new rights and regulatory changes that are noted above may indeed enhance the power of these short-term investors.

To the extent that shareholders use their new powers to oust unethical or incompetent directors or managers, bondholders and shareholders will share common interests and will both benefit. However, we are concerned a more common scenario may be that just a small minority of shareholders, with a short-term focus, will use their power to pressure companies in a direction that may not be favorable, in totality, for long-term shareholders and bondholders in terms of enhancing value creation.

For example, management and boards are being subjected to greater pressure from shareholders to increase returns on equity through a leveraged buyout, debt-financed business investment, or simply borrow funds or sell assets and then return proceeds directly to shareholders through dividends or share purchases. This pressure is more telling today, because companies have been dismantling their takeover defenses in recent years in response to investor pressure to do so. Since 2000, the number of companies in the S&P 500 with a ‘classified board’ (directors who are elected in staggered classes) has fallen to less than 200 from 281. According to Institutional Shareholder Services, over the same period, the number of companies with an active ‘poison pill’ – a mechanism that, if triggered, substantially dilutes the value of shares that a hostile bidder has already acquired – has dropped to 175 from 276. Both of these defenses are relatively potent and provide boards with some latitude to fend off hostile bidders or shareholders using the threat of a putting the company into play as leverage to elicit return of assets to shareholders.

In the most dramatic cases, management and the board of an investment-grade company will enter into a leveraged buyout, yielding a high premium for shareholders but a sharp increase in credit risk for bondholders without protective covenants. In such situations, even long-term investors, such as public pension funds, find it hard to stand in the way, given potential upside in the short term. As a result, there appears to be no counterbalance in the market to the upswing in short-term investors using new powers to leverage and force companies to make major strategic or financial changes.

Bondholders carry the burden

With limited, if any, protections, bondholders may pay a price for greater shareholder democracy. Covenants protecting against subordinating liens and increased leverage can provide substantial protection for bondholders from any potential increase in credit risk due to expanded shareholder rights, but a substantial proportion of bondholders do not enjoy these protections. It is rare for investment-grade indentures to include financial covenants.

Change-in-control clauses are becoming the chosen panacea for bondholder protection, but they are not foolproof. Strong covenant protection for speculative-grade bonds is no longer automatic  either, with the current buyers’ market for bonds driving a new trend toward more limited or ‘covenant-lite’ protections.

Moody’s believes several of the rights being demanded by shareholders, in themselves, may have some benefit to bondholders. The concern, however, is the sheer pace and scale of change, and the likelihood that short-term investors will be the ones using these powers routinely, not long-term investors. Moody’s has seen little analysis by investors or policymakers on how the various rights would work together or of the unintended consequences that the rights may bring about. We also recognize that shareholder rights are rarely withdrawn, once awarded. Hence, Moody’s believes it is time for investors and policymakers to analyze carefully the potential harm to bondholders of significantly enhancing shareholder power.