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Every number used to govern money eventually risks drifting away from what it was designed to measure. Not because anyone breaks the rules, but because once a rule has a number attached to it, people naturally learn to satisfy the number rather than the intention behind it.

This isn’t necessarily cynicism or misconduct. It is closer to a structural feature of incentives. Attach consequences to a measurement, and the measurement starts adapting to the pressure around it - often quietly, legally, and with everyone acting rationally. Economists call this Goodhart’s Law. And few areas show it more clearly - or more expensively - than corporate debt covenants and executive compensation KPIs.

This piece starts from first principles: what Goodhart’s Law actually means, how it appears in debt and compensation contracts, why even intelligent and well-intentioned people can fall into the trap, and what can be done to keep a metric meaningful when everyone has an incentive to improve it.

Part 1: A Rule Too Simple to Ignore

In 1975, British economist Charles Goodhart was examining why the Bank of England’s monetary targets kept losing their effectiveness. Whenever policymakers selected a measure of money supply and began managing the economy toward it, the relationship between that measure and the broader economic objective started to weaken.

The observation, later popularized by anthropologist Marilyn Strathern, is usually summarized as:

“When a measure becomes a target, it ceases to be a good measure.”

The mechanism is straightforward. A metric is initially chosen because it correlates with something we actually care about - a healthy company, a well-managed fund, or a creditworthy borrower. That relationship generally holds as long as nobody is specifically optimizing for the metric.

Once real consequences - a bonus, covenant breach, or credit downgrade - are tied to that number, the relationship can begin to break. There are now two ways to improve the score: improve the underlying business, or improve the number. The second is often faster and cheaper, so the incentive to take that route grows.

Finance is an especially good laboratory for this because so much of it is built around contracts tied to specific numbers. Two of the clearest examples are debt covenants and executive compensation. To understand how Goodhart’s Law operates in practice, it helps to build each one up from first principles.

Part 2: Covenant EBITDA - When the Target Redefines the Company

Start with the basics. When a company borrows money, the lender doesn’t simply hand over cash and hope for the best. The loan agreement includes covenants - financial tests the borrower must continue to meet throughout the life of the loan.

A common example is a leverage covenant, typically measured as Debt/EBITDA. A company might agree to keep Debt/EBITDA below 4.0x. Breach that limit, and the lender may be able to declare a default, demand repayment, or renegotiate the loan.

EBITDA was originally a useful shorthand for operating performance, stripping out financing structure, taxes, depreciation, amortization, and other non-cash items to make companies easier to compare. But EBITDA is a constructed measure, not a single fixed number. Loan agreements often give borrowers flexibility over what can be included or excluded for covenant purposes.

That is where “covenant EBITDA” can begin to diverge from the EBITDA an independent analyst would calculate.

The add-backs total $16.0mm - a 28% uplift over reported EBITDA. Against $280mm of net debt, that swings leverage from 4.83x on a reported basis to 3.78x on a covenant basis: the difference between a business that is close to breach and one comfortably inside its terms.

Leverage(reported) = 280 / 58.0 = 4.83x vs Leverage(covenant) = 280 / 74.0 = 3.78x

None of this is necessarily fraudulent. Each add-back can usually be justified on its own, and lawyers on both sides negotiate the definitions carefully before the loan closes. But when enough individually defensible add-backs are stacked together, the covenant ratio can look comfortably healthy even as the company’s underlying cash generation deteriorates.

The result is that the lender’s early-warning system - the very reason the covenant exists - can quietly stop working just when the warning matters most.

Part 3: The Denominator Game - EPS and ROE

The same pattern appears in executive compensation, often in an even more mechanical way. Two common metrics used in executive bonuses and long-term incentive plans are earnings per share (EPS) growth and return on equity (ROE). Both are ratios, which means they can improve in two ways: increase the numerator or reduce the denominator.

1. EPS accretion from buybacks alone

EPS = Net Income / Shares Outstanding

Suppose net income is $120mm and the company has 100mm shares. EPS is $1.20. If it buys back 10mm shares using existing cash or new debt, EPS rises to $1.33 ($120mm / 90mm) - an 11% increase with no improvement in operating performance.

If the buyback is debt-funded, higher interest expense will reduce net income. But if borrowing costs are low enough, the benefit from the lower share count can still outweigh the added interest, creating EPS accretion even when enterprise value is unchanged or has deteriorated.

2. ROE decomposition (DuPont)

ROE = (Net Income / Revenue) × (Revenue / Assets) × (Assets / Equity)

These three components are net margin, asset turnover, and leverage. Management can improve ROE through genuine operational improvements in the first two, or simply increase leverage and reduce the equity base.

For example, increasing the equity multiplier from 8x to 10x raises ROE by 25%, even if profitability and asset efficiency remain unchanged. That is why credit analysts use DuPont analysis before treating higher ROE as evidence of stronger business quality - the same ROE can reflect either a more profitable business or a more leveraged and fragile one.

In both cases, the metric rises and the bonus may vest, but the underlying question - has the business actually become more valuable or resilient? - remains unanswered. The headline number can improve while the underlying business moves in the opposite direction.

Part 4: Why This Happens Without Misconduct

It’s tempting to see this as a story about managers deliberately gaming the system. A more useful explanation is psychological - and it doesn’t require anyone to be dishonest.

Once a target becomes important and tied to rewards, attention naturally shifts toward whatever moves the measured number. Steven Kerr described this decades ago as “the folly of rewarding A while hoping for B”: organizations often reward one behavior while actually wanting another, then act surprised when people optimize for what is on the scoreboard.

Negotiated definitions make this effect even stronger. When people debate what counts as a one-time cost or a reasonable leverage add-back, it is natural for each side to argue for the interpretation that benefits them. No one needs to be acting in bad faith.

The result is gradual, collectively reasonable drift: each adjustment may be defensible on its own, yet over time, the final number can move far from what it was originally meant to represent.

Part 5: Keeping the Measure Honest

This is where the focus should shift from diagnosis to design. Metrics can never be made completely ungameable, but they can be structured so that gaming them requires either genuine operational change or enough effort to become visible. Five mechanisms do most of the work.

1. Cap and Sunset the Add-Back Schedule

Instead of allowing an open-ended list of adjustments, credit agreements can cap total add-backs at a fixed percentage of reported EBITDA - often 15–20% - and require a “non-recurring” item to lose that treatment if it appears again within the following four quarters.

This turns a subjective question - “Is this really one-time?”- into a simple, auditable test: did it occur in the previous four quarters? No fresh negotiation is needed at every measurement date.

2. Force Multi-Metric Consistency

A single ratio can be gamed in isolation. Two or three related metrics that should move together are much harder to manipulate without genuine improvement.

For example, pair EPS growth with free cash flow per share, or ROIC with WACC. Pair ROE with a minimum equity or capital-adequacy floor. If EPS rises mainly because of buybacks while net income and FCF remain flat, the divergence becomes the warning signal.

This is similar to how auditors compare covenant EBITDA with statutory EBITDA over time: the gap between related measures can reveal more than either number alone.

3. Replace Cliff-Edge Tests with Trends and Relative Benchmarks

A binary threshold - breach 4.0x and trigger a default, or miss the EPS target and lose the bonus - creates a strong incentive to manage the number around the measurement date.

Two alternatives help. First, use trailing-twelve-month or multi-quarter averages instead of a single-period snapshot, reducing the impact of one-off actions. Second, benchmark performance against peers or the wider sector, such as relative TSR or ROIC, rather than relying only on absolute targets. This makes it harder to manage the metric without considering the broader market.

4. Track the Gap, Not Just the Number

Lenders and auditors can independently calculate a metric using a stricter definition - for example, statutory EBITDA instead of covenant EBITDA, or unlevered ROE instead of reported ROE - and track the gap between the two over time.

A small, stable gap is usually unremarkable. But a gap that keeps widening quarter after quarter can signal weakening underlying performance, often before the headline ratio breaches the covenant. That is precisely the early-warning function the covenant was supposed to provide.

5. Use Equity Cures and Clawbacks as Pressure Valves, Not Loopholes

Well-designed agreements can combine strict definitions with controlled ways to deal with breaches. Equity cure rights can allow sponsors to inject capital to fix a covenant breach, but only a limited number of times over the life of the loan. Clawback provisions can allow boards to recover bonuses if the underlying results are later restated.

Both reduce the incentive to manipulate the metric. A genuine breach can be fixed properly rather than hidden, while an inflated bonus can be recovered later. Gaming the number becomes less attractive because it is no longer a one-way win.

Part 6: Closing

Goodhart’s Law isn’t a flaw in financial contracts. It is an unavoidable consequence of reducing something as complex as “Is this business healthy?” to one negotiable number. That number will naturally be influenced by whoever has the most at stake in how it looks, and that influence often won’t appear as misconduct while it is happening.

The answer isn’t to find a metric that can never be gamed - no such metric exists. It is to design contracts with that reality in mind: limit adjustments, make multiple metrics corroborate each other, measure trends rather than snapshots, and track the gap between the reported number and a stricter version underneath it.

Done consistently, a covenant or compensation plan stops being a number management simply needs to hit and returns to its original purpose:

an early-warning system, not a target.

Picture a university where students hire their own examiners, pay them directly, and get to pick a new examiner if the first one grades too harshly. You'd assume the grades coming out of that system are, at best, generous. At worst, meaningless.

That, in essence, is how the global credit rating industry has worked for the last fifty years. And despite a financial crisis that was substantially caused by this exact arrangement, it's still how the industry works today.

Part 1: START WITH THE BASICS: WHAT A CREDIT RATING ACTUALLY IS

Strip away the jargon and a credit rating is a simple thing: a letter grade - AAA down to D - that estimates how likely a borrower is to pay back what it owes. Governments get rated. Corporations get rated. So do the complex bundles of loans that banks package and sell to investors.

These letters matter enormously, for a reason most people outside finance don't fully appreciate. A rating isn't just a helpful guide for investors doing their own homework - it's often a legal gatekeeper. Many pension funds, insurance companies, and money-market funds are only permitted, by their own charters or by regulation, to hold debt above a certain rating threshold. A single downgrade - say, from BBB- to BB+ - can force forced selling by every institutional investor no longer allowed to hold the paper. That one notch can move billions of dollars, not because anything about the underlying company changed overnight, but because the label attached to it did.

So who hands out these labels? Three companies, essentially. Moody's and S&P Global each control something like 40% of the global ratings market, and Fitch holds most of the rest - together the "Big Three" account for roughly 90-95% of credit ratings issued worldwide. This is not a crowded, competitive marketplace. It's closer to a regulated oligopoly wearing the costume of a market.

That oligopoly exists partly by regulatory design. In the US, an agency needs to be designated a Nationally Recognized Statistical Rating Organization (NRSRO) by the SEC before its ratings can be used to satisfy the regulatory requirements described above - and under global bank capital rules like Basel III, the rating on a bond determines how much capital a bank has to hold against it. A AAA bond eats up almost no regulatory capital; a junk bond eats up a lot. This is the detail that turns credit ratings from "useful opinion" into "regulatory input" - a distinction that matters a great deal for everything that follows.

Part 2: THE TWIST NOBODY BUDGETS FOR: WHO ACTUALLY PAYS

Here's where it gets interesting, and where most primers on credit ratings stop short of the uncomfortable part.

You'd reasonably assume that if a rating exists to protect investors, investors would be the ones paying for it - the way you pay a home inspector before you buy a house, not the seller. That was, in fact, how the industry worked for most of the 20th century. Investors paid for subscriptions to rating reports, and rating agencies had every incentive to be right, because their entire business was selling accurate information.

That changed in the 1970s. Photocopiers had made it trivially easy for a single subscriber to duplicate a rating report and pass it around for free, which quietly gutted the investor-pays subscription business. Around the same time, regulators began requiring public debt to carry a rating from a recognized agency, which meant every issuer suddenly needed one, guaranteed customer. The industry pivoted to a new model almost overnight: issuers would now pay for their own ratings.

Think about what that flips. The rating agency's paying customer is no longer the party trying to find safe, honest information - it's the party trying to borrow money as cheaply as possible. The examiner is now paid by the student. And once you see this shift, entire chapters of financial history start to read differently.

Part 3: THE STRESS TEST THE SYSTEM FAILED

The clearest evidence of what this conflict produces arrived in 2007 and 2008. In the run-up to the crisis, somewhere around 80-95% of a typical subprime mortgage-backed security was carved into slices carrying the highest possible AAA grade - the same grade assigned to the safest government debt on earth. Investment banks paid handsomely for these gold-star ratings because AAA-labeled paper could be sold to pension funds, insurers, and conservative money managers who were contractually barred from touching anything riskier.

Then reality caught up. By the time the dust settled, more than 90% of the AAA ratings handed out on mortgage-backed securities issued in 2006 and 2007 had been downgraded to junk. Some deals were wiped out completely - one subprime issuer saw every single one of its 75 AAA-rated securities from 2006 eventually collapse to junk status. The U.S. Financial Crisis Inquiry Commission, tasked with the official autopsy, put it about as bluntly as a government report ever does: the crisis, in its words, could not have happened without the rating agencies.

This wasn't primarily a case of agencies being duped by clever bankers, though that happened too. It was, in large part, a business model working exactly as its incentives suggested it would. The agencies were being paid by the very banks assembling these mortgage bonds, and there was always another rating agency willing to be more generous if one got too cautious - a dynamic known in the industry as rating shopping.

An issuer could quietly solicit a preliminary opinion from two or three agencies, see which one produced the friendliest grade, and only pay for (and publish) that one. The agency that said no simply never got hired again. In a market with only three real players, that's not a subtle disincentive - it's existential.

It also helps to understand "why" AAA was so achievable in the first place. Mortgage bonds aren't rated as one lump sum - they're sliced into layers called tranches, arranged in a "waterfall" where the top tranche gets paid first and absorbs losses last, while the bottom tranche absorbs losses first and gets paid last, if at all. This is called subordination, and it's the mechanism banks used to manufacture AAA ratings out of distinctly non-AAA mortgages: pile enough risky loans together, carve out a thin top slice protected by all the losses below it, and the rating models said that top slice was nearly bulletproof. The models were right about the mechanics of subordination in normal times and catastrophically wrong about how correlated mortgage defaults would become when a nationwide housing bust hit every tranche at once. Add the fact that the agencies bore essentially no legal liability for getting a rating wrong, and you have a textbook case of moral hazard - the incentive to take on more risk when someone else, or something else, absorbs the downside. 

Part 4: THE REFORM THAT WASN'T

Here's the part of the story that should bother you more than 2008 itself: this is still how it works.

Dodd-Frank, the sprawling 2010 reform law written explicitly in response to the crisis, took direct aim at the ratings industry. It created a dedicated SEC Office of Credit Ratings. It mandated formal studies into alternatives to the issuer-pays model - including a genuinely interesting proposal where a neutral board would randomly assign which agency rated which deal, removing the issuer's ability to shop for a friendly grade. Congress even gave the SEC explicit authority to implement that random-assignment system by rule, without needing to come back for further legislation.

The SEC studied it. The GAO studied it. Regulators held a public roundtable in 2013 to debate the merits. And then, by the SEC's own later admission, the agency simply never acted. No business model was ever recommended. The random-assignment system was never implemented. More than a decade on, issuer-pays remains the dominant compensation structure across the industry, largely unchanged in its basic architecture from the model blamed for the worst financial crisis in eighty years.

Why did reform stall? Partly because the alternatives have real flaws of their own - the SEC's own analysis found that even random assignment might not fully kill rating shopping, since issuers could still hire additional agencies for supplementary opinions. Partly because the Big Three, having survived the crisis with their market position essentially intact, had every incentive to lobby quietly and wait the reform momentum out. And partly because - this is the uncomfortable structural point - regulators themselves have leaned on credit ratings for decades to set capital requirements and eligible-investment rules. The system is now load-bearing. Ripping out issuer-pays without a workable replacement risks a bigger mess than leaving a flawed thing standing.

Part 5: WHY THIS ISN'T JUST A 2008 STORY

It's tempting to file this under "historical curiosity" - a scandal that got its punishment in the form of collapsed banks and a decade of regulatory hand-wringing. But the same structural conflict is quietly present every time you read a headline about a country's sovereign rating being cut, or a corporation issuing a fresh bond.

Sovereign ratings are a particularly sharp version of the same tension. Rating agencies assess government creditworthiness while simultaneously courting relationships with those same governments' debt offices, their central banks, and the investment banks that structure sovereign bond sales. A downgrade can genuinely move a country's borrowing costs and, by extension, its fiscal room to maneuver - which means the agency doing the grading is never fully insulated from the politics of the grade it hands out.

And at the level of ordinary corporate debt, the same quiet incentive persists on every single issuance: the agency wants the repeat business, the issuer wants the friendliest defensible grade, and the investor relying on that letter to make a decision is not the one writing the check.

Part 6: SO WHAT WOULD ACTUALLY FIX THIS?

None of this means credit ratings are useless - they aggregate real analytical work, and most of the time issuer-pays ratings are directionally accurate. The problem isn't that the system fails constantly; it's that it fails predictably at the worst possible moments, precisely when the incentive to be lenient is strongest - during a boom, when issuance volume (and fee revenue) is highest and everyone least wants to hear "no."

The GAO, tasked by Dodd-Frank with actually cataloguing the alternatives, came back with a shortlist. It's worth walking through each one properly, because they fail and succeed in genuinely different ways - this is where the interesting trade-offs live.

a. Random assignment model. A neutral body - not the issuer - decides which NRSRO rates a given deal. This is the model Dodd-Frank explicitly authorized the SEC to implement without further legislation, and it kills rating shopping in its purest form. But the SEC's own 2012 study found the flaw baked in: an issuer can still privately commission an unofficial second opinion from a non-assigned agency and use it as leverage even if it never becomes the official rating.

b. Investor - pays model. Flips the money flow back to the pre-1970s structure - the institutions relying on the rating fund it directly. This already exists: Egan-Jones Ratings, an NRSRO since 2007, runs largely on subscriber fees. But a 2023 academic study found the opposite conflict re-emerging - more optimistic ratings and slower downgrades for bonds more heavily held by its own paying subscribers. Flip the direction of the money and the conflict doesn't disappear; it relocates.

c. Designation model. The agency is still picked and paid the way it is today, but securities holders - not the issuer - designate which agency receives the fee. It keeps issuer-side funding while giving investors the power to reward or punish a track record, though it requires dispersed bondholders to coordinate, something they're historically poor at.

d. Platform or utility-style ratings. The most structurally radical option: a non-profit or public utility issues a baseline rating funded by industry-wide fees, similar to how an exchange or clearinghouse operates as shared infrastructure rather than a for-profit gatekeeper. It most cleanly removes the profit motive - but nobody has built one at scale to find out what new problems that creates.

Notice the pattern across all four: every fix solves the "specific" conflict it targets and introduces a "different" one somewhere else. That's not an argument for inaction - the issuer-pays model's failure mode is the best-documented and most catastrophic of the bunch, which is exactly why it's the one Congress singled out. But it explains, more honestly than "regulatory capture" alone, why a fifteen-year-old mandate to fix this has produced studies, roundtables, and no rule.

What would move the needle without waiting for Washington to pick a single model: mandatory dual ratings from differently-compensated agencies on structured products, pairing one issuer-paid rating with one subscriber-paid or platform rating so the two conflicts at least point in opposite directions rather than the same one; hard liability for rating agencies when a rating is later shown to have ignored known, documented deterioration, closing the "just an opinion" legal shield that has historically protected agencies from lawsuits; and regulators gradually stripping ratings out of hard-coded capital rules - something Dodd-Frank also mandated and only partially delivered - so a single letter grade stops being the sole gatekeeper for how much capital an institution must hold.

None of these needs a single perfect model to be chosen. They need the two-decade-old political will to actually legislate a functioning fix, rather than fund a well-documented shelf of studies about one.

The next time a headline tells you a company or a country just got upgraded or downgraded, it's worth asking the same question you'd ask of any grade: not just what the score is, but who's paying the person holding the red pen - and whether the fix on the table quietly hands the pen to someone with a different, but equally real, reason to be generous.