Scorecards on Governance: Are Banks Up to Par?

Bank Director focuses on one recent bank-exclusive rating study and the bigger picture on whether such scorecards hold real meaning for directors, investors, and the public.

Suddenly, it seems, everyone’s interested in the quality of corporate governance. Recent fraud and accounting scandals and three years of down markets have investors, and even Congress, taking a closer look at what constitutes good governanceu00e2u20ac”and seeking to penalize companies that fall short of those standards.

One of the more noteworthy trends is the movement by a wide array of players to rate governance practices. In recent months, investment banks, credit rating agencies, and investor advocates have introduced various forms of numerical report cards on specific companies’ board structures and behaviors, which are aimed at giving investors a heads up on who’s with the program, and who isn’t.

As a recent report from Prudential Securities senior analyst Mike Mayo demonstrates, banks aren’t immune to the trend. Mayo’s 94-page tome lays out a case for good governance and points to some glaring flaws in the practices of the 33 large and mid-sized banks he follows. It also rank orders the banks in terms of their adherence to the collection of best practices Mayo used as the basis for his study.

Such ratings are well intentionedu00e2u20ac”and, many would argue, overdueu00e2u20ac”because they help investors determine whether a company’s governance structure provides the risk controls and responsiveness needed to produce superior earnings, or at least not to implode.

They’re also a response to investor demands. A spring survey of 200 institutional investors by McKinsey & Co. found that governance has moved to the “heart of investment decisions,” with over 60% of respondents saying that poor governance practices could lead them to avoid certain stocks. “Governance used to be theoretical; now it’s real,” says Patrick McGurn, a vice president at Institutional Shareholder Services. “Investors are hungry for this information, and they’ll stop buying your securities if they’re concerned about your governance.”

But critics say the field of corporate governance is too subjective for such black-and-white comparisons. “A lot of what goes on in governance isn’t an exact science,” says Roger Raber, president of the National Association of Corporate Directors. “We’re seeing more ratings, and I get concerned about the experience and credibility of organizations that establish these systems and the benchmarks that they use.”

Mayo’s report takes a methodical approach, first identifying three crucial categoriesu00e2u20ac”board independence, accountability, and audit functionsu00e2u20ac”and then, using guidance from various governance sources, examining recent proxy disclosures to rate banks on how well they adhere to accepted best practices in those areas.

His overall conclusion: Bank boards aren’t performing up to snuff. Most are too big, too old, and too male. The average board has 16 directors. Ninety percent are men, mostly current or retired CEOs who have put in 10 years of board duty with their institution, with an average age of 60.

Moreover, many bank boards are rife with insiders; three-fourths have staggered elections, which makes them less-responsive to shareholders; and nearly half boast at least one interlocking relationship, where an inside director sits on the board of a company that has an executive on the bank’s board. One-fifth of bank directors sit on what are deemed by best practices to be too many other boards, and one-quarter have a financial relationship with the company.

There also appears to be potential for conflict on the audit side. Mayo found that 71% of all fees paid by the banks to external auditors were for non-audit services, which includes but is not limited to consulting, and that nearly half of the audit committees have at least one member who has a financial relationship with the bank.

The good news: 56% of all board compensation comes in the form of stock or options, which, he says, “aligns the interests of directors with those of shareholders.”

All this matters, Mayo argues, because the stocks of companies with good governance practices fetch an average premium of 13%u00e2u20ac”a factor that is likely to increase with investors’ growing awareness of governance. But perhaps the strongest pro-governance argument is “the central position banks play in our economy,” he says. “Without trust and confidence in our banking system, our economy could not perform at a strong, sustainable level.”

While Mayo’s general findings are interesting, what is really intriguing are the specifics. Mayo identifies best- practice areas in each of the study’s three major categories, citing reports by good-governance advocates as its foundation.

Under board independence, for instance, he gives black marks for having more than two insiders on the board (McKinsey & Co. standard) and for not having a “substantial majority” of independent directors (Business Round Table and New York Stock Exchange guidelines). Accountability measures include board sizeu00e2u20ac”less than 16 is best, according to the Business Round Tableu00e2u20ac”and director stock compensation and ownership: the more of each, the better, according to the California Public Employees Retirment System and the National Association of Corporate Directors.

The report goes on to assign individual banks grades of between “1” and “4” in each area. Those scores are tallied and averaged to produce a numerical “report card” for each institution (See Figure 1).

Under Mayo’s formula, KeyCorp ranks as the best-governed large bank, followed by Bank of Hawaii Corp., Union Planters Corp., National City Corp., and Wells Fargo & Co. The lowest-rated bank in the study is Hibernia Corp.,
followed by SunTrust Banks Inc., FleetBoston Financial Corp., City National Corp., and Comerica Inc.

Eyes upon us

This is but one of many recent efforts to numerically rate the quality of governance practices. In the past year, credit rating agencies Standard & Poors, Moody’s Investors Service, and ISS, adviser to big pension fund and money managers, have launched more weighty ratings. So, too, have investment banks and some business magazines.
For boards and managements, the implications of all this are staggeringu00e2u20ac”and not only because of the potential impact on stock prices. A company with a poor governance score also could see credit ratings fall and D&O insurance premiums rise, raising expenses and hurting earnings.

At least for now, insurers are not yet employing such scores, says John Keogh, president of National Union Fire Insurance Co., a large D&O policy issuer. He says that other factors, including management’s track record and a company’s industry, are more important considerations. But Keogh also thinks that could soon change. “If some independent third party did an evaluation with metrics we thought were appropriate, it would certainly be helpful,” he says.

Directors also could find themselves on the hot seat come proxy season: Already, McGurn says, institutional investors are using such ratings to help determine which directors to vote for during annual elections and where to target shareholder activism campaigns.

For all that, the ratings wave is far from universally accepted. Charles Elson, director of the University of Delaware’s corporate governance center, says he likes the idea of trying to better assess board performance. But he also argues that much of governance is subjective and questions the metrics that are used as baselines for such studies.

Mayo’s report, for instance, asserts that a key measure of board independence is a separation of the chairman and CEO rolesu00e2u20ac”something advocated by CalPERS. Institutions with such structures, including Comerica and Wachovia Corp., received top scores on his scale, while the majority that combine the two posts got low ratings.

Yet Elson notes that there is conflicting academic evidence on the value of such structures. He argues that separating the two roles can create “dual power centers,” which “can be damaging, because it’s more difficult for management to run the company.”

Similar problems emerge with insider participation. Mayo’s study gives demerits to companies with more than two insiders on the board. But while studies support the notion that boards dominated by independents will more readily replace ineffective CEOs and consider takeover offers, Marc Zenner, author of a recent governance study for Salomon Smith Barney, says, overall, research “has not found any direct link between board composition and … financial performance or shareholder value.” Indeed, the evidence shows that “percentages of independent directors greater than 50% [do not] add incremental value,” he adds.

A 1989 study by Harvard Business School Professor Jay Lorsch went even further, arguing that having a handful of executives on the board can give directors a more comprehensive view of the company and ease succession planning by providing a chance to see prospective candidates at work.

Searching for meaning

These findings underline the difficulty of employing “scientific” evaluations to corporate governance structures. Richard Frankel, a business professor at MIT, notes that in medical trials, researchers “control” their studies by choosing which patients get a medicine and which get a placebo. In studies of corporate governance, however, the “patient”u00e2u20ac”in this case, the firmu00e2u20ac”selects its own “medication,” and firms that are “sicker” may choose more aggressive governance methods to right themselves. “If we find no difference between firms with outside directors and those with no outside directors, it may be that outside directors do nothing, or that they have helped bring their firms to parity” with other companies, Frankel says.

Concludes Nell Minow, editor of The Corporate Library, (www.thecorporatelibrary.com), an online governance watchdog: “It’s impossible for outsiders to evaluate the effectiveness of the board based on structural indicators.”

Despite such misgivings, Minow’s site is among those intent on rating boards, assigning them grades of “A” through “F,” based on three criteria: how well CEO pay is linked to performance, the transparency of financial reporting, and adherence to corporate strategy. “The key is to assess not what the board looks like or what it says it does,” Minow says, “[but] to look at what it actually does.”

A similar philosophy underpins ISS’s recently launched Corporate Governance Quotient, a system that assesses 51 different governance areas, from charter and bylaw provisions to executive compensation and director education, to produce a rating between 1 and 100. (For more details, see www.isscgq.com.) Those scores are then prominently displayed at the front of the firm’s proxy analyses, which are followed religiously by many institutional investors.

In contrast to the best-practices approach employed by Mayo, McGurn says ISS has sought to base its CGQ ratings on bottom-line impact. It began by examining various studies to come up with an initial ratings scheme, then ran the proposed criteria by an advisory panel of investors and corporate leaders, who suggested numerous changes. That formula was beta tested on a small group of companies, and economic analyses were used to give more weight to factors that showed stronger correlations with financial performance.

The data for the ratings come mostly from public filings, but companies can submit additional information to ISS. They also get the chance to review ISS’s information for factual errors before the score is included in a proxy analysis, and to get a copy of the score when it’s released.

McGurn concedes that in some governance areas, measurements can be “too rough to find a direct correlation with financial performance.” But he also argues that the scores can highlight potential red flags: Recent tests show that, before their bankruptcy filings, Enron scored a 60 on ISS’s scale, while WorldCom’s rating was below 50 and Adelphia’s less than 20.

What does all this mean for banks? Unlike, say, boards of technology or manufacturing companies, bank boards have been subjected to intense regulator scrutiny for the better part of two decades. The industry’s CAMELS ratings, once a source of consternation for the industry, now look like something of a blessingu00e2u20ac”especially the “M” in the acronym, which stands for management.

“The whole point of effective corporate governance is to reduce risk, and that’s been the focus of bank regulators for the past 15 years,” says Robert Clarke, comptroller of the currency from 1985 to 1992, and now a senior partner at Bracewell & Patterson in Houston. As a result, he says, bank boards have “done a much better job with governance than other corporations, if for no other reason, than because they’ve had to.”

The results of Mayo’s study don’t necessarily support that notion: Even top-rated KeyCorp got a score of just 3.1 out of 4, while 21 of the 33 banks registered a 2.5 or lower.

Four months after issuing the report, Mayo concedes that more work is needed. Rating board performance is “more art than science,” he says, and while the study is a “good starting pointu00e2u20ac”something that helps with the mosaic of evaluating corporate governance practices,” it is not an end point itself.

Still, one can’t help wondering if the scores will edge even lower on Mayo’s next go-around. Since the report’s release, he notes, governance faux pas have been exposed at several of his big banks. Citigroup, a middling player in the rankings, has revealed a “long laundry list of issues”u00e2u20ac”including allegations of business tie-ins between its commercial and investment-banking units, and interlocking directorships “that negatively impact our view of its corporate governance,” Mayo says. Morgan Chase failed to adhere to its dividend payout policy, and Fleet’s board, already a bottom dweller on Mayo’s list, didn’t enhance its reputation when it more than doubled outgoing CEO Terrence Murray’s retirement package to $5.8 million annually.

The irony, says Mayo, is “that some of the worst corporate governance actions are precisely those items which a survey does not cover.”

What appears clear is that some banks pay closer attention to governance issues than others. While number-one KeyCorp was docked in the audit category (83% of fees paid to auditor Ernst & Young were for nonaudit services), it registered top scores in both board independence and accountability.

The Cleveland company’s directors conduct biannual self-assessments, all members of key committees are required to be independent, and independent directors, that is, those with no material relationship to the company, meet in executive session three times a year, sans management. About 50% of KeyCorp directors’ compensation comes in the form of stock options, and the board is both proactive and responsive: It recently voted to reduce its size from 18 members to 16, and it submitted to shareholders a proposal to replace the current staggered board terms with annual electionsu00e2u20ac”even though the board itself opposed the move, asserting that board stability was crucial to long-term strategic planning.

While corporate governance might not be the sole reason for it, KeyCorp’s share price on Oct. 17 stood at $25, giving it a price-earnings ratio of 19, a healthy premium compared to P/Es of 15 for rival Bank One Corp., 11 for Bank of America, and 13 for Citigroup.

This is admittedly a new area, with plenty of kinks remaining to be worked out. But for all the inherent problems in rating governance practices, directors should be able to use such studies to their advantage and proactively head off trouble, says Ron Glancz, head of the financial institutions practice at Venable Baetjer Howard & Civiletti in Washington, D.C.

Glancz notes that bank boards, like those in other industries, “are facing more scrutiny and potential liability than they did in the past,” and can use such benchmarking as a way to proactively head off trouble. Boards “don’t need to be way out front of their peers” in terms of governance, he adds. “But you want to be near them, or someone will start asking questions.”

That’s good advice. With all the attention being given to how boards do their jobs, Mayo says, “it’s almost inevitable that future valuations reflect perceptions of corporate governance.” Bank directors would be wise to take heed.