Aligning the Interests of Credit Rating Agencies, Proxy Advisors, and Investors

Asaf Eckstein is Adjunct Professor at Bar-Ilan University Law School, and academic fellow at the Raymond Ackerman Chair for Corporate Governance, Bar-Ilan School of Business. This post is based on a recent article authored by Professor Eckstein.

The concept of skin in the game represents a powerful mechanism for motivating agents to perform at their best. It is an incentive-based compensation that ties agents’ pay to their performance. In this author’s view, just as skin in the game has been beneficial in the context of inside agents (directors and managers), so may it be put to use with certain outside agents, like credit rating agencies and proxy advisory firms, for the benefit of investors.

But before employing such a mechanism, corporations, investors and policy makers must understand the factors which will influence its effectiveness. My article, Skin in the Game: Aligning the Interests of Credit Rating Agencies, Proxy Advisors, and Investors, which has recently been made publicly available on SSRN, lays the groundwork for an analysis of when skin in the game may be beneficial with regard to any given outside agent and with regard to rating agencies and proxy advisors in particular. The analysis is heavily based on principal-agent literature.

There are myriad considerations which must be analyzed before deciding to give a particular agent skin in the game. The most important among those factors are the relative observability of the agent’s input. i.e., the agent’s behavior and level of effort, and output, i.e., the agent’s contribution to the principal’s goals and welfare. Within my article’s context, rating agencies are agents that supposed to act on behalf of investors—both potential bond investors who want to know the risks in buying a bond and existing investors who frequently review the ratings over the bond’s lifetime. Therefore, the “output” of these agents is their contribution of trustworthy information for the protection of investors. The “output” of proxy advisors is the value of their recommendations to investors who hold shares of corporations affected by the advisors’ recommendations, and this value is theoretically measured as the total contribution to the firm value, i.e., by the effect of good recommendations on the price of firm shares.

Observability of the agent’s input and output determine the appropriate trade-off between the cost of monitoring an agent’s behavior and the cost of providing the agent incentives (skin in the game) to act in the principal’s best interest. The starting point and most critical component in analyzing that trade-off, as described in the classic agency literature, is that when an agent’s input is relatively observable, a monitoring mechanism is typically best way to control the agent’s actions. In contrast, when information about the agent’s work is difficult to interpret or costly to obtain, the agent’s input is hidden from the principal and a moral hazard problem arises. As explain in my article, both credit rating agencies and proxy advisory firms deal with complex services, operate within uncertain environments, and exhibit a lack of transparency; their behavior is relatively unobservable.

Principals typically respond to such a moral hazard by using the agent’s output to make inferences about the level of effort that the agent chose to exert, and then by compensating the agent using an output-contingent compensation scheme. Such a scheme incentivizes the agent to put forth additional effort and increases the likelihood of good output. As a practical matter, such a mechanism for rating agencies has been proposed by Yair Listokin and Benjamin Taibleson who suggested to pay the rating agencies with the debt they rate; Such a mechanism for proxy advisors is now being developed by the author together with his co-author Sharon Hannes.

Finally, agency research traditionally cautions that when at least one of two major conditions exists, then it may be appropriate to reduce any outcome-contingent incentives, such as skin in the game. The first condition is an agent’s risk-aversion and any uncertainty regarding outcomes of the agent’s action. Within this article’s context, it is important to note that the leading proxy advisory firms help many institutional investors determine how to vote their clients’ shares on literally thousands of proxy questions posed each and every year, and credit rating agencies rate tens of thousands of securities. Such a diversification takes away some of the risks related a single public firm. Still, however, such a diversification does not alleviate the (systematic) risk related to the entire market.

The second condition is the relative measurability of the agent’s output. The more accurately a principal can measure an agent’s success, the more effective a skin in the game mechanism will be. Therefore, whatever metric is chosen by the principal to serve this purpose should produce a measurement that strongly correlates with the agent’s actual effort. For purposes of the article, that metric will be referred to as the “performance measure.” Basing significant incentives on non-measurable outputs may distort an agent’s incentives and lead to an overall reduction of the agent’s effort. This is because in such a situation, it is impossible to accurately assess the value of the agent’s output, and consequently impossible to compensate the agent based on its output. The second condition is more widely discussed in my article.

Here, it is enough to note that credit rating agencies’ output—reflected by the accurate information provided to investors regards the creditworthiness of a borrower—can be observed in a fairly exact manner, whereas proxy advisors’ output—reflected by the merit of their recommendations to investors regarding how to vote—remains relatively unobservable. A credit rating agency’s performance can be generally defined as its success or failure in predicting the debtor’s ability to pay back the debt and the probability of default. In hindsight, whether the rating agency was correct can typically be answered with a simple, unqualified “yes” or no.”

In contrast, proxy advisory firms’ output—performing advisory services on behalf of institutional investors—is far less measurable. First and foremost, there is a difficulty to define what is considered to be a good advice. There is no consensus between market observers and academics regarding the correct manner in which to resolve some of the most significant corporate governance issues—issues regarding which proxy advisory firms give voting recommendations.

Relatedly, the performance of a proxy advisor is influenced by many outside factors. An assessment of a proxy advisor’s performance must capture the extent to which the advisor’s recommendations affected voting, and in turn whether the vote added to or detracted from shareholder value. However, despite significant academic effort to determine the true impact of voting recommendations on voting outcomes, this impact has remained woefully unclear. Although a positive correlation between proxy advisor recommendation and voting outcomes has been identified by some literature, this correlation is not necessarily causal. Considering the aforementioned points regarding the measurability of credit rating agencies’ and proxy advisory firms’ outputs, that factor would militate in favor of adopting a skin in the game scheme with regard to credit rating agencies, but would require us to adopt such a scheme with a cautious manner (i.e., giving the agents a relatively small stake in the principal corporations) with regard to proxy advisory firms.

Numerous other factors beyond observability (some of which, however, are related to observability) will come to bear on the ultimate decision of whether to give an agent skin in the game. These factors include the agent’s market power, the number and type of agents simultaneously working for the same principal and goals, and potential negative effects of skin in the game. The article does not seek to establish a precise formula for weighing these factors; it merely seeks to highlight the considerations that a principal or a policymaker should undertake when making that decision. It concludes that skin in the game would likely be beneficial when dealing with rating agencies, but should be employed cautiously when dealing with proxy advisory firms.

The full article is available for download here.

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