Is S&P's pedestal cracked? Critics say the esteemed rating agency should have spotted Enron's woes sooner. S&P's president says 'not so'. (Finance).

By now, it's a depressingly familiar litany. Everybody failed to see Enron coming. Then it was WorldCom, Tyco and others, ad infinitum, or ad nauseum, depending on your point of view. Daily headlines screamed about malfeasance and chicanery. Coming in for roastings were auditors and accountants, lawyers, analysts, bankers and boards of directors. Nearly everyone was conflicted or compromised.

But what about the rating agencies, those supposed bastions of objectivity and rigorous intellectual analysis? The Big Three--Standard & Poor's, Moody's Investors Service and Fitch--are arguably the most powerful arbiters of financial probity in the world. Billions of dollars move in response to the slightest change in their ratings.

Critics say the Big Three didn't do their jobs, particularly since they maintained investment-grade ratings on Enron until a mere three weeks before it melted down. The rating agencies were "not connected at the right level," says Armand Ursino, a vice president at JP Morgan Asset Management in New York. The rating agencies have a "gaping hole" in their bows as a result of missing Enron, and should have been "more proactive than reactive," says Ursino, who formerly worked at Fitch and Moody's.

Leo C. O'Neill, president of S&P, doesn't see it that way. Sitting in his 47th-floor office in downtown Manhattan, he acknowledges that S&P and others were "caught in the shrapnel" of the Enron explosion. But there's no way that he and his peers could have seen Enron coming, says the 63-year-old executive, who has worked at S&P for 35 years, the past 15 as CEO.

There's a lot riding on whether O'Neill can make a persuasive case. The SEC has issued a 48-page report exploring possible fundamental changes in how the Big Three function. For instance, the SEC is considering instituting more regulation on the Big Three while investigating the role of credit rating agencies in evaluating issuers of securities, entry barriers to other agencies, ways to speed flows of information and conflicts of interest in operating credit rating agencies. The SEC will review comments from people inside and outside the industry before taking any action, most likely sometime this year.

One crucial point of the SEC investigation involves considering whether more credit rating agencies should be recognized. "Of course, our view has always been that there are hundreds and hundreds of organizations that do credit analysis and ratings," says O'Neill. "There's always room for more opinion about credit and creditworthiness.

In late February, the SEC made sure there was another opinion as it granted official status to a fourth creditrating agency, Toronto-based Dominion Bond Rating Service of Canada, the first since 1991 to be so recognized. Though a relatively small agency, Dominion's ratings will bear the U.S. government's imprimatur and will be an important guide for bond investors and for companies selling debt.

From O'Neill's perspective, S&P's fortress remains impregnable. The SEC can expand the playing field by permitting new entrants, mulling more regulation and a variety of other maneuvers, but S&P will maintain its structure, its substance and its raison d'etre, he insists. That's because S&P did nothing wrong. The problem, he says, is in the eye of the beholder, not in the substance of what his agency did, or didn't do.

A problem of perception

After Enron imploded, O'Neill had his legal staff embarked on an intensive two-month investigation. They interviewed S&P analysts, obtained files such as rating committee meeting minutes, telephone logs and S&P-published reports and statements and performed a complete internal review of the rating process.

"We always have two analysts, a lead one and a subordinate," explains O'Neill. They make their recommendation to a committee of five to seven people, who vote on the recommendation. O'Neill wouldn't say how often the analysts' recommendations are overturned.

As a built-in safeguard, the analysts are checked in three different ways. The lead analyst checks the subordinate and vice versa. Also, the committee checks the analysts and a peer review is done as well.

After the two-month review, O'Neill and S&P came to one conclusion: The process worked. "There was no substantive problem here," O'Neill says.

What the agency did have was a serious perception problem, he says, because some believe that S&P has a regulatory or watchdog role. In October 2002, for example, the staff of the Senate Committee on Governmental Affairs, which held hearings on this issue, concluded that "the credit rating agencies displayed a disappointing lack of diligence in their coverage and assessment" of Enron.

These critics were expecting too much, in O'Neill's view. "I don't think any ratings company had any idea about Enron," he says. "People thought we got inside information. Unfortunately, we didn't get information about the fraudulent things that were going on.

"Our job is not to uncover corporate malfeasance," he adds. "We don't have subpoena powers; we don't have punitive powers. We were duped like everyone else was duped."

In that case, one wonders why investors pay so much attention to the agencies. Ratings have become an increasingly critical part of the global capital markets, giving S&P more power. Some companies, fearing S&P's wrath and possible downgrades, declined to comment about the ratings situation for the record. "S&P is hugely influential on Wall Street," says one corporate spokesperson, who insisted on anonymity.

S&P's defenders believe critics are trying to turn the rating agencies into scapegoats for corporate implosions. "Standard & Poor's analysis is only as good as the information provided to them from a company," says George D. Martin, vice president and treasurer of Anthem, an Indiana health benefits company. "You can't forecast fraud."

But what of the whole conflict of interest issue? The agencies get fees from the companies they rate, critics argue. Though S&P won't disclose how how much Enron paid it for its ratings, it says fees vary from $5,000 to $1.5 million.

O'Neill brushes the criticism aside, insisting the SEC has no problem with this arrangement. He also notes that S&P has lowered numerous ratings of companies that pay fees. And S&P analysts don't get any financial benefit from upgrading or downgrading a company. Further, he adds, no smoking gun" has ever been unearthed about the fees affecting the ratings.

So the whole problem, O'Neill insists, is perception. "I think we ought to be very proactive in assuring that our value proposition in the marketplace is understood--what it is we do, how we do it, what our value is and why investors rely on us," he says.

Ursino argues that the agencies should be "opening the black box" and explaining the ratings process. This, Ursino says, would be one way for them to avoid getting caught in a "circular firing squad."

S&P has, in fact, begun adapting the way it does things. It has accelerated its disclosure process, moved ahead on the governance issue and launched a core earnings initiative, which is an analytical tool to measure corporate profits in a better way, O'Neill says. S&P is also trying to become more transparent about its ratings, rationales and methodologies. "Let's make sure the substance, the process around our ratings, is working," O'Neill says.

Will it be enough? O'Neill obviously hopes S&P and others can reform themselves enough to avoid heavy-handed regulatory moves.

As to his personal career, O'Neill will turn 65 in two years, but he's vague about retiring. "When we get there, we'll see where we are," he says. One could say the same about the future of the ratings business. A

RELATED ARTICLE: S&P Response to Enron's Meltdown 

8.13.01 S&P Rating / Affirms BBB+/Stable.

8.14.01 Enron Events / Jeffrey Skilling resigns as president. S&P leaves rating unchanged.

10.16.01 Enron Events / Enron reports a $618 million third-quarter loss and discloses a $1.2 billion reduction in shareholder equity.

S&P Rating / Affirms BBB+ rating, based on expectation Enron would restore balance sheet.

10.23.01 Enron Events / The SEC begins an informal inquiry into investment partnerships formerly run by Enron's chief financial officer.

10.25.01 S&P Rating / Affirms BBB+ rating, but revises the outlook to negative.

11.01.01 Enron Events / SEC upgrades inquiry into formal investigation. S&P Rating Lowers rating to BBB and places ratings on Credit Watch Negative.

11.09.01 Enron Events / Enron tries to merge with Dynegy.

S&P Rating / Lowers rating to BBB-. This is the lowest rating that is still investment grade. Rating is contingent upon merger with Dynegy.

11.28.01 Enron Events / Enron-Dynegy merger is imperiled. S&P Rating I Lowers rating to B-, which is below investment grade.

11.30.01 Enron Events / Merger fails.

S&P Rating / Lowers rating to CC.

12.02.01 Enron Events / Enron files for Chapter 11 reorganiztion.

12.03.01 S&P Rating / Lowers rating to D. This is S&P's lowest rating.

Sources: S&P, Washington Post, CNN.com, Hunt-Scanlon.com