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Spotting the next Tyco
Rating firm sounds alarm on Home Depot, Lucent, Viacom and 159 other FORTUNE 500 companies.
November 3, 2005: 10:08 AM EST
By Marc Gunther, FORTUNE senior writer

NEW YORK (FORTUNE) - Is Home Depot the next Tyco?

A small corporate governance rating company that sounded early warnings about the troubles that hit Global Crossing, Tyco, and AIG now has its eye on Home Depot (Research), Lucent (Research), Wells Fargo (Research) and Viacom (Research) -- along with another 158 companies in the FORTUNE 500.

Researchers at the Corporate Library pore over their own data, charts and historical records to forecast corporate disasters -- scandals, bankruptcies, lawsuits and other threats to shareholders.

Focusing on the performance of corporate boards, the Portland, Maine, firm has in its short history anticipated a number of storms that others have missed, including those at Global Crossing, Tyco, Sprint, DPL and Kmart.

Two years before Maurice "Hank" Greenberg was forced to resign as CEO of American International Group, it downgraded the insurance giant into its "high risk" category, citing Greenberg's excessive pay and the control he apparently exercised over its board.

"We told you so," crowed Ric Marshall, the chief analyst of the Corporate Library, after the AIG scandal broke.

As the wave of corporate scandals unfolded in 2002, three research firms -- the Corporate Library, Institutional Shareholder Services (ISS) in Rockville, Md., and Governance Metrics International in New York -- moved aggressively to market governance ratings they had been compiling for years.

Today the rating business is growing fast, with institutional investors, money managers, hedge funds, regulators and insurance companies -- particularly those who write directors and officers' insurance, which protects board members and executives against shareholder lawsuits -- paying as much as $150,000 a year for their services.

But you also have to wonder just how precise these ratings are.

The Corporate Library gives subpar grades of D or F to 162 of the FORTUNE 500, including such blue chips as Wal-Mart Stores, Exxon Mobil, GE, Chevron, Citigroup and Time Warner. With that many companies tagged, the odds of picking up one or two cases to brag about are pretty good.

Junk boards?

On the one hand this is valuable stuff. "I'd dreamed of rating boards from Triple A to junk, like bonds, because boards are a risk factor that no one was paying attention to," says Nell Minow, the editor of the Corporate Library, who started the company in 1999 with longtime corporate critic Robert A.G. Monk.

ISS gave low ratings to Adelphia, WorldCom, Xerox, Parmalat, Royal Ahold and Hollinger before their problems arose. Governance Metrics International gave below-average ratings to Fannie Mae, Freddie Mac, Krispy Kreme and Interstate Bakeries.

On the other hand, it's far from an exact science.

ISS actually gave top ratings to AIG, and even raised the company's score in 2004. GE gets top ratings from the other two agencies but an F from the Corporate Library, which takes issue with the size of CEO Jeffrey Immelt's compensation and the board's composition -- too many CEOs, for one thing.

Because each rating firm uses its own methodology and information, results can differ dramatically; all are refining their models. "We all suffer from having a very short history," says Gavin Anderson, CEO of Governance Metrics.

That hasn't stopped the Corporate Library from putting its money where its mouth is: Founders Monk and Minow have seeded two small funds (assets: about $100,000 each) that buy shares of firms with better ratings and short low-rated ones.

Its own study found that companies it graded A, B, and C outperformed those graded D and F in each year since its first set of ratings came out in 2002.

ISS, meanwhile, has formed a partnership with the FTSE Group to create six investable indexes, each of which eliminates companies with the lowest governance scores.

The idea is to match or exceed the broader indexes, with lower risk. Or as the Corporate Library's Marshall puts it: "Not every tropical storm becomes a hurricane. But you ignore the storms at your peril."

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