Skin in the Game for Credit Rating Agencies and Proxy Advisors: Reality Meets Theory
54 Pages Posted: 30 Mar 2016 Last revised: 2 Jan 2017
Date Written: March 29, 2016
Financial markets function most efficiently when all of the actors perform their functions scrupulously and through the exertion of optimal effort. However, human nature demonstrates that people will often underperform if they lack sufficient incentives. In the case of the individuals and entities acting as agents in the U.S. financial markets, if these players do not perform appropriately, everyone suffers. This fact was clearly demonstrated through the scandals of Enron and Worldcom, as well as the recent financial crisis. One promising mechanism for motivating these entities is giving them ‘skin in the game:’ a direct financial interest in the companies affected by their actions. Skin in the game has become ubiquitous with regard to corporate ‘inside’ agents — the managers and directors who act on the corporation’s behalf — by providing them with stock options, bonuses, and other methods of pay-for-performance. So if giving inside agents skin in the game tends to motivate them to act in the corporation’s best interest, would such a mechanism be appropriate for the ‘outside’ agents — entities that are not actually part of the corporation, but perform work on its behalf or on behalf of investors?
This Article fills a current void in the corporate scholarship by analyzing whether two particular kinds of outside agents — credit rating agencies and proxy advisory firms — should be given skin in the game. The “skin” would be a financial incentive tied to the success of the agent’s service: rating agencies would be paid with the debt instruments they rate, and proxy advisors with share-based payment. The analysis is heavily based on principal-agent literature. The article then applies theoretical insights derived from that literature and analyzes whether skin in the game would likely be beneficial with regard to proxy advisory firms and credit rating agencies. 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.
Keywords: Credit Rating Agencies; Proxy Advisory Firms; Incentives
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