A New Early-Warning System for Investors

Wayward CEOs had barely finished their perp walks before a handful of number-crunching companies began vying to provide definitive rankings of how well corporations are governed. To date, though, no clear leader has emerged.

Into this fray now steps Standard & Poor's. On Oct. 15, S&P announced the U.S. launch of its own corporate rating service--an early warning system for Enron (ENRNQ )-style meltdowns in the making. S&P, like BusinessWeek a division of The McGraw-Hill Companies (MHP ), believes it has a better way. While its rivals plan to sell ratings to investors, S&P will apply the same model it uses for its debt ratings--selling the service to companies instead. The idea is that a good score will help companies attract investors.

But success will be far from a slam dunk. With new governance rules already on tap from the New York Stock Exchange and the Sarbanes-Oxley Act, many companies may view a rating as redundant. Positive rankings may be suspect because S&P will be paid by the companies it ranks. And since it will be up to those companies to decide whether to disclose their rankings, it's unlikely that lousy scores will be publicized, at least initially. Says Patrick McGurn, vice-president for proxy adviser Institutional Shareholder Services, which provides a similar service: "The fear is that it's the proverbial tree that falls in the forest and no one hears it."

S&P will use securities filings, interviews with management and directors, and nonpublic information such as board minutes to generate scores for shareholder rights, disclosure practices, and board processes. The 1-to-10 ratings could cost up to $100,000.

Some governance advocates maintain that giving a client the publishing option will work in S&P's favor. Companies will have nothing to lose and everything to gain by seeking a ranking. Institutional investors, meanwhile, say they'll pressure companies to obtain a rating and make it public. Says Andrew A. Davis, president of Davis Selected Advisors, which manages $40 billion: "For larger companies the pressure to bring these ratings to the fore will be unbearable."

In recent months, a stampede of companies have been developing their own rankings. ISS began ranking the Russell 3000 in June and now provides ratings, free to subscribers, on 9,000 companies. Using publicly available data and company input, ISS ranks on 62 data points--everything from audit fees to insiders who have side deals with the company. The Corporate Library, Investor Responsibility Research Center, and Governance Metrics International plan to launch similar services.

S&P says its access to company insiders and internal documents will make for a more nuanced rating. But some critics believe the client relationship may taint the scores. "Could [the rating] be influenced by the fact that they're being paid by the company?" says Peter R. Gleason, research director at the National Association of Corporate Directors. "I think that is a question."

Some also wonder why companies will spring for a governance rating that, unlike some bond ratings, are not required by law. But clearly S&P hopes its grades become a kind of Good Housekeeping Seal of Approval that companies can't pass up. And it is counting on investors, burned time and again, to insist on it.

By Louis Lavelle in New York, with Amy Borrus in Washington

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