When bond-rating agency Standard & Poor's Corp. launched a service in 1998 to assess how effectively companies are run, executives planned to concentrate on Europe, Asia and other places scattered around the world. Companies in the United States were doing fine, they surmised. Who would question how firms driving the greatest economic boom in recent memory were governed?
Then came Enron. Then Global Crossing, WorldCom, Tyco, Adelphia and the rest. George S. Dallas, director of S&P's corporate governance rating service, realized that the biggest market for his new product might well be the United States.
"Prior to Enron a lot of the interest in this area was in the emerging markets. We were fresh on the heels of the Russian crisis at the time," Dallas said in an interview from his London office. "Then, lo and behold, all these things happened in the U.S. that we didn't anticipate. We always knew we could apply this practice to a developed market but the scandals accelerated our timetable."
Now, for a fee of $50,000 to $150,000, domestic companies can hire S&P to come in and perform an extensive review of their corporate governance practices, from director independence, to executive pay and benefits, to shareholders rights and takeover defense mechanisms.
The other two dominant national rating agencies, Moody's Investors Service Inc. and Fitch Ratings Ltd., have strengthened their corporate governance units, but neither offers the stand-alone governance rating service that S&P does. More small firms, such as Institutional Shareholder Services of Rockville, rate companies on corporate governance. Unlike S&P, which sends analysts into companies to examine governance policies, the smaller raters generally rely on publicly available documents.
Governance experts say the rating agencies are beginning to address the fact that issues such as lazy boards of directors, dominant chief executives or bloated pay structures can threaten companies' success -- and investor wealth -- as seriously as excess debt or flawed business plans.
"Governance rating is an idea whose time has clearly come," said Charles M. Elson, director of the Center for Corporate Governance at the University of Delaware. "The question is, how revealing will the ratings be? How good will the metrics be? . . . But anything that creates competition in the field will help spur everyone to do a more effective rating job."
Only 10 companies have signed up for S&P's service and only one, mortgage giant Fannie Mae, chose to make its rating public. Fannie Mae's score was 9.0 out of a possible 10.
For S&P's competitors and some academic experts, the high score raised a question about S&P's approach: Why should a company get to choose whether its rating is made public? Several governance-reform advocates also wonder whether S&P can be objective when it collects fees from the companies it rates. That question has always dogged S&P, Fitch and Moody's. All three are paid by the companies whose bonds they rate.
Dallas said S&P's approach has significant benefits. He said that because the firm's governance analysts, who operate separately from bond analysts, make several visits to companies and interview directors and executives individually and collectively, they can make judgments based not just on hard facts, such as the number of "independent" board members, but on cultural issues, which are difficult to quantify.
For example, Dallas said, S&P can assess how aggressive nominally independent directors are in challenging management decisions. To get critical information, such as board meeting minutes, Dallas said S&P has to give companies the option of keeping the final rating report private.
"We are not management advocates," Dallas said. "We are independent providers of research and we stick to our conclusions. Some might like what we find, others won't. Some will say we raised valid points and ask us to come back later and see if things have changed."
Ultimately, Dallas said, the market will decide if companies can get away with not making public their governance scores. "We hope market participants will demand this information as just another element of healthy disclosure. If you like what we are doing, speak up."
Jonathan D. Roman, vice president for corporate finance at Fannie Mae, said the firm chose S&P to conduct a review because executives wanted a tailored approach that would recognize the company's public-private status. Roman described the process, which lasted from last August until January, as "long and arduous," and said S&P analysts had several conversations with company executives, including CEO Franklin D. Raines, and board members. S&P also had full access to confidential board minutes and other company documents.
"They asked board members if they felt sufficiently prepared for meetings and to what degree they were encouraged to take part in meetings. They asked how the board reached decisions," Roman said. "They were also very careful to tell us the areas in which they thought we had issues to work on."
S&P praised Fannie Mae for having a broad shareholder base with limited director and executive holdings. It also applauded the board's independence but criticized the fact that shareholders could not vote on the five directors who are presidential appointees.
Moody's and Fitch, which with S&P were criticized for not uncovering problems at Enron and other companies, take a different approach to governance. Executives of both companies said they are further incorporating governance issues into their bond ratings. Neither offers stand-alone scores.
"We are trying to build a more systematic approach to the issue," said Kenneth A. Bertsch, director of governance at Moody's. Bertsch, who previously headed the governance unit at TIAA-CREF, the mutual fund and teachers' retirement plan company, said his job consists mostly of teaching analysts how to examine board structure, particularly the quality and independence of audit committees. "We are also looking more closely at executive pay," he said. "Is their pay structure risky? Could it lead executives to take more risks than those at other companies?"
Bertsch said corporate governance questions come up most often at two critical points in the debt-rating process: when a company is first classified as "investment grade," or safe for the average investor; and when it is upgraded to Aaa, the top rating.
Robert J. Grossman, chief credit officer at Fitch, said his firm has long examined some governance issues, but only now is coming up with a range of governance structures that would support a strong debt rating. He also noted that Fitch's parent company, Fimalac, recently purchased Core Ratings, a British firm that sells governance ratings. Fitch is evaluating whether to include Core's methods in its approach to governance.
Most smaller firms offering governance ratings take a approach similar to Fitch's and Moody's, relying on public documents rather than questioning companies.
Institutional Shareholder Services, which has 750 institutional clients, covers about 8,000 U.S. companies, applying 61 governance criteria sorted into eight categories. ISS scores companies both in comparison with their relevant index and against companies with similar market capitalization.
Jill E. Lyons, executive vice president of ISS, said scores have been increasingly volatile as companies attempt to comply with Securities and Exchange requirements that audit committee members be independent, and tougher listing requirements proposed by the New York Stock Exchange and Nasdaq. "Companies are actively moving to improve their governance practices," she said.
One company emulates S&P's approach. Governance Metrics International, which like ISS serves large institutional investors, offers a governance assessment for $50,000. Previously, it used only publicly available documents. Unlike S&P, Governance Metrics does not plan to give companies the option of keeping their ratings private. "If a company wants us to come in and go into that kind of deep analysis we want to include whatever we find in our published ratings," said chief executive Gavin Anderson.