Supervision At Moody's Needs Improvement

| About: Moody's Corporation (MCO)
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Moody's Corp. (NYSE:MCO) could better safeguard itself from the business conduct failures that the Securities and Exchange Commission discovered in its second annual review of nine ratings agencies. The New York firm needs to take more steps to prevent its senior managers from abusing their powers.

Without specifying names, the U.S. regulator said on Nov. 15 that ratings agencies in the country experienced problems such as the failure to follow policies, keep records, and disclose conflicts of interest. Moody's and Standard & Poor's Corp. accounted for around 83% of all credit ratings, the SEC said. (This article is the second of a two-part series that already discussed corporate governance problems at The McGraw-Hill Companies (MHP), of which S&P is a part.) Each of the larger agencies did not appear to follow their policies in determining certain credit ratings, the SEC found, among other things. The regulator also said all the agencies could strengthen their internal supervisory controls.

The SEC noted that Moody's has 128 credit analyst supervisors and 1,124 credit analysts, in contrast with S&P's 244 supervisors and 1,172 credit analysts. The regulator also examined the function of board supervision at ratings agencies, and implied in its report that directors should be "generally involved" in oversight, make records of their recommendations to managers, and follow corporate codes of conduct. The SEC did not specify to what extent Moody's board had fulfilled such duties.

Moody's says in documentation on its website that each employee must certify adherence on a periodic basis to a business conduct code that "sets forth the guiding principles that we expect each employee and corporate director to follow in order to preserve the integrity of our business." It remains unclear whether Moody's directors must regularly certify adherence to this code, or are merely expected to follow it.

Meanwhile, Moody's policies continue to limit the extent to which shareholders can have a say in the composition of its board. In 2006, investors asked Moody's at its annual shareholder meeting to implement the practice of electing directors each year. But as of the company's most recent proxy filing this year, Moody's requires that investors elect a group of its directors every three years. An investor again submitted a proposal to Moody's this spring, citing research that those using such board structures are associated with problems including lower firm valuation, lower sensitivity of compensation to performance, and lower sensitivity of CEO turnover to firm performance. The board countered that its structure allowed for depth of knowledge among the directors and increased stability, among other things.

Moody's board has approved executive compensation plans that suggest an imbalance of power is taking place among the higher ups. For example, Moody's chairman and CEO Raymond W. McDaniel earned $11.9 million in total compensation during 2011, more than four times the median pay for the other named executive officers at the company. In addition, long-term incentive grants for Mr. McDaniel are 50% performance-based shares and 50% time-based market-priced stock options. To be effective, all equity awards granted for long-term incentives should include performance-vesting features. Moreover, market-priced stock options may provide rewards due to a rising market alone, regardless of individual performance.

In part due to these concerns as well as others, such as recent regulatory fallout related to the financial crisis, Moody's is rated "D" on its environmental, social and governance (ESG) risk overall. The ratings agency has an AGR ® score of 33, indicating higher accounting and governance risk than 67% of comparable companies.

Even under scrutiny such as the SEC's recent annual report, Moody's has shown the willingness to continue with practices that many corporate governance experts consider flawed. If the SEC had enough authority to announce the results of its examination more precisely, the ratings agencies might have more incentive to make improvements beyond what the regulator recommended last year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a financial reporter at GMI. The reporter has no business relationship with any company whose stock is mentioned in this article. Nobody paid GMI to write this article on his or her behalf.