McGraw-Hill (pg. 2)

Despite a McGraw often being at the helm of the company, Terry is quick to point out that the company is not a family business. There is no Class A and B stock like the New York Times Co.'s (NYT). Rather, Terry sees McGraw-Hill as a publicly traded corporation professionally managed for the benefit of shareholders. He reports to an independent board of directors. That said, McGraw himself owns some 7.9 million shares out of the 314,412,208 primary shares outstanding. They are worth a little less than $200 million. (His father owns 6.4 million shares, worth a little more than $155 million.)

McGraw believes he has earned every promotion on merit alone. He says he never for a minute thought, "I've been here 25 years. I'm senior. It's my turn. It's my time. It's my thing." Instead he said to himself, "Wait a minute-no, no, no, no. Be careful now. That's an entitlement feeling, and entitlement isn't part of the vocabulary ... Everything has to be about performance."

***

In the summer of 2007, McGraw first expressed publicly the idea that S&P, a division he ran for around four years, needed fixing. The signs of impending trouble were clear to S&P's rank and file long before that. In the fall of 2006, S&P's own structured-finance specialists were concerned by the uptick in defaults on both subprime and so-called Alt-A mortgages - the very same mortgages that were the underlying assets for many of the securities that S&P had rated AAA. According to the Boca Raton Firefighters and Police Pension Fund lawsuit, E. Christopher Meyer, an associate director in S&P's Global CDO Group, wrote in an e-mail to a colleague on the evening of Dec. 15, 2006, "Ratings agencies continue to create [an] even bigger monster - the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters." He then used an emoticon signifying a wink and a smile.

By April 2007 gallows humor had become the order of the day, according to the Boca lawsuit and a congressional hearing into the ratings agency. Notable is one text-message exchange between two analysts, Rahul Dilip Shah and Shannon Mooney. "Btw, that deal is ridiculous," Shah wrote Mooney in a text.

"I know, right ... model def[initely] does not capture half the risk," she replied.

"We should not be rating it," Shah answered.

"We rate every deal," Mooney replied. "It could be structured by cows and we would rate it."

S&P went from McGraw-Hill's cash cow to a major problem in June 2007, with the announcement that two Bear-Stearns hedge funds, which had invested heavily in mortgage-backed securities, were performing poorly. In response S&P announced the first in a series of ratings downgrades on July 10 - in this case on 498 residential mortgage-backed securities totaling $5 billion. The downgrades would continue off and on for the next eight months, and they became known as "express-train downgrades" for how rapidly they occurred.

Inside S&P, tempers were flaring. State attorneys general, including Ohio's Marc Dann, were portraying the once-venerable ratings agencies as aiding and abetting fraud. Matters came to a head on Aug. 31, when McGraw abruptly fired Kathleen Corbet, S&P's president, and dressed up the announcement with the usual corporate jargon, saying she had left "to pursue other opportunities." Deven Sharma replaced her.

"She has two young teenage boys, and she decided she was going to transition and take care of the boys" is the way Sharma described Corbet's decision in a recent interview with Fortune. Reached at her home, Corbet declined to comment.

As Sharma, a former Booz Allen management consultant, initiated a five-month study to reform S&P, New York State attorney general Andrew Cuomo subpoenaed documents from S&P as part of a broader investigation into the mortgage market. From Sharma's study came the announcement, on Feb. 7, 2008, that S&P had voluntarily agreed to implement a series of 27 measures designed "to further strengthen our ratings operations and better serve capital markets around the world."

Left out of Sharma's press release was any mention of allegations, later made in the Boca Raton complaint, that in the first months of 2008, S&P employees "were shredding things like every five seconds," and that an outside shredding vendor had been hired to help process the huge volume of paper that executives in the residential mortgage-backed securities ratings department wanted destroyed. A spokesman for McGraw-Hill responds, "The lawsuit is without legal or factual merit, and our motion to dismiss is pending with the court."

Cuomo initially dismissed Sharma's initiatives as "window-dressing." Finally, on June 5, 2008, Cuomo reached a settlement with McGraw-Hill and S&P, which included what he called "landmark reforms." They required that, among other things, the ratings agencies be paid whether or not the ratings they assigned to a debt security were acceptable to the underwriter - i.e., no more negotiating for desired ratings - and that all information about a potential securitization be disclosed publicly. Although McGraw-Hill said it was "pleased" to work with Cuomo on the reforms, the company was not out of the woods.

On July 30, Connecticut attorney general Richard Blumenthal took his best shot - suing S&P, Moody's (MCO), and Fitch for giving better credit ratings to corporations than to municipalities and other public entities. The lower ratings forced issuers to either buy bond insurance to get a higher rating or pay a higher interest rate to investors to compensate them for the supposedly higher risk. Either way, the lower ratings cost Connecticut taxpayers.

A few weeks later the Teamsters piled on after their pension fund, which owns more than 10,000 shares of McGraw-Hill (MHP, Fortune 500), became concerned that McGraw was peddling ratings for increased profits. In a letter dated Aug. 18, 2008, Maya Saxena, a Florida lawyer representing the Teamsters Allied Benefit Funds, claimed that the officers and directors "encouraged employees to issue false ratings on securities in order to satisfy Wall Street expectations." She further claimed that the board members "breached their fiduciary duties" by failing to supervise and monitor the "adequacy" of internal controls and allowing "misleading statements and filings" to be disseminated. Saxena demanded that the board investigate and "bring forward all appropriate legal action" against anyone "found to have committed or participated in the wrongdoing."

Six weeks later Floyd Abrams, the noted First Amendment attorney and a longtime partner at Cahill Gordon, responded to Saxena, informing her that the McGraw-Hill board had "undertaken a review" of the matters described in her letter. Following that review, Abrams wrote, the board determined not to pursue any legal action against any of the company's officers or directors and found that Saxena's letter "provides no basis ... to accede to your demands."

The Teamsters disagreed with Abrams, and on Jan. 8 the pension fund sued as individuals Terry McGraw and his father, former CEO Harold McGraw Jr., plus the McGraw-Hill board of directors, in U.S. District Court in New York City. The suit alleged that the McGraws and the rest of the board had "sold the Company's integrity for a steady and increasing stream of fees on these transactions." (Harold McGraw Jr. was subsequently dropped as a defendant in the lawsuit because of his advanced age of 91.)

The complaint also quoted Richard Gugliada, another former S&P managing director, as saying that S&P was involved in a "market share war where criteria were relaxed" but that McGraw-Hill management "mandated" that S&P executives "find a way to issue positive" ratings.

"I knew it was wrong at the time," the complaint quotes Gugliada as saying. "It was either that or skip the business. That wasn't my mandate. My mandate was to find a way. Find the way." (Reached at his home on Staten Island, Gugliada declined to be interviewed.)

The case is still pending. During the company's Jan. 27 earnings call, Terry McGraw labeled the Teamsters' suit as "totally without merit"; he told Fortune that his lawyers have told him "the risk is very low" and "nobody likes to get sued," but "we'll get through it." Cahill Gordon filed a motion to dismiss the case on March 27.

***

Warren Buffett once observed, "It takes 20 years to build a reputation and five minutes to lose it. If you think about that, you will do things differently." The challenge now for Terry McGraw is rebuilding his company's reputation. Although McGraw-Hill declined to make its new S&P ombudsman, Ray Groves, available for an interview, Steven Weiss, a spokesman for the company, emphasized repeatedly that the voluntary reforms that S&P has implemented, including the appointment of Groves, are all part of a concerted effort to begin to ensure the highest standards, quality, and transparency at S&P.

Asked whether it is fair to criticize McGraw-Hill for its role in the credit crisis, McGraw says, "It's a yes and no on that one." He believes it is fair to criticize the methodology S&P used when rating CDOs, but he believes it a stretch to say, "Well, your assumptions didn't work, so you're complicit or you're incompetent ... That's a little over the top."

Despite McGraw's best efforts to appear to be responding to McGraw-Hill's role in the financial crisis, the hits just keep on coming. In an April 6 letter to Fed chairman Ben Bernanke, Connecticut's Richard Blumenthal urged Bernanke to "reassess and revamp" a policy that would reward S&P for rating securities issued in the future under the umbrella of the Fed's Term Asset-Backed Securities Loan Facility, known as TALF. "The policy handsomely rewards failure," Blumenthal wrote. "Indeed, it enables [S&P, Moody's, and Fitch] to profit from their own self-enriching malfeasance."

Clearly the time has come for Terry McGraw and the other CEOs who had a hand in causing this financial crisis to restore credibility to the capital markets. And that may require a little more of an overhaul than changing a few business practices and appointing an ombudsman. It may require no longer negotiating ratings with the underwriters who have traditionally paid S&P's fees. 

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