How to Be a Good Director – Everything You Wanted to Know About Corporate Governance . . . . . . But didn’t know to ask

The role of a corporate board member has never been more crucial and more confusing. What exactly are directors supposed to be doing, anyway?

By CAROL HYMOWITZ
Staff Reporter of THE WALL STREET JOURNAL

Talk to any corporate director and you are likely to hear the same refrain: Our jobs are a lot tougher these days.

They certainly should be. The Sarbanes-Oxley Act, which took effect in July 2002, and subsequent rules proposed by two stock exchanges have resulted in dozens of new rules and procedures that have added to directors’ duties. They include more regularly scheduled meetings of independent directors separate from company management, more careful oversight of accounting by the board audit committees — and more potential liability if things go awry.

But amid all the new responsibilities and higher risks, there remains unanswered a simple question: What makes a good director? Boards, after all, have learned over the past two years what not to do. Now they need to figure out what to do.

A consensus is starting to emerge, and it involves being more informed, more skeptical and more independent. But plenty of questions remain. For instance, do active CEOs, long the favorite candidates for board seats, have the time required to be good directors, or should the job go to professionals who make board work their career? How can directors get all the information they need to understand a company’s core issues? And how can they review a company’s financial performance and assess strategy without taking on the jobs of executives?

"Directors now are expected to play such a multiplicity of roles — with a lot more focus on legal and accounting issues, not to mention being available to investors," says Robert Felton, a director at McKinsey & Co. in Seattle who heads the consulting firm’s North America corporate-governance practice. "No one has thought enough about how doable this is, especially for directors who have other big jobs and responsibilities."

Details, Details

Clearly, board members themselves don’t agree on their role. Steve Reinemund, chairman and CEO of PepsiCo Inc., believes that "directors should be the CEO’s sounding board. If they get so absorbed in operating details, then they are doing management’s job and can’t provide a check and balance to management."

But Pat Gross, a director at three public companies — Capital One Financial Corp., Computer Network Technology Corp. and Mobius Management Systems — sees things a bit differently. He says that "the ultimate value of a director is to step back and see the forest from the trees. But now boards also need individuals who can roll up their sleeves and get into detail much more than they used to."

As a member of Capital One’s audit committee, for example, Mr. Gross says he must be able to question various accounting treatments.

"In the past, you could be comfortable if a financial report followed generally accepted accounting principles," he says. "But now you have to ask, ‘What are the alternative treatments and if you adopt one of these how would that affect the outcome?’"

Inquiry and Dissent

So what are the main attributes of a good director?

Most experts agree that being willing to challenge company management may be the most crucial qualification for a board seat. Directors at many companies disrupted by scandals, including Tyco International Ltd., WorldCom Inc. and Enron Corp., had stellar credentials and were well respected in their businesses and professions. They also followed most of the accepted standards for boards, such as attending meetings regularly and establishing a code of ethics. But they didn’t question enough and failed to see inquiry and dissent as one of their obligations.

That leads to a second key qualification for being a good director: a willingness to do a lot of homework.

A typical director devoted 250 hours to board-related work last year, up from 125 hours in 1999, according to the National Association of Corporate Directors in Washington. "I’m betting it’s another 20% higher than that now," says Roger Raber, president and CEO of the association.

Aware of directors’ increased workload, the directors association advocates that board members with full-time jobs hold no more than four public-company seats. They and other governance groups also recommend more educational sessions for new board members.

William George, the former chief executive officer of Medtronic Inc. and now a director at Target Corp., Novartis AG and Goldman Sachs Group Inc. — and an audit-committee member of the two latter companies — says he spends hours preparing for board meetings.

"Every time I fly to Switzerland for a Novartis meeting, I’ve got a pile of material three inches thick to read on the plane," he says. And since he became a director at Goldman Sachs in 2002, he has spent time with the chief financial officer and other members of senior management to familiarize himself with the company.

He and fellow Goldman Sachs directors also held a 2 1/2-day off-site meeting to discuss strategic issues.

"Tackling anything in depth in four or five hours isn’t really possible," Mr. George says. "When you have a couple of days, you have a chance to reflect about issues."

Lewis Kaden, a partner at the law firm Davis Polk Wardwell in New York who advises corporate boards and is a director of Bethlehem Steel Corp., echoes Mr. George’s concerns about the magnitude of the task.

Mr. Kaden thinks tougher regulation has lessened the chances of future scandals. "There’s a greater likelihood that someone will sound the alarm or ask the hard question that gets at a problem before it gets too serious," he says.

Overwhelmed by Minutiae

But he worries that as companies become larger and more global, "it is very hard for directors to get their arms around the organization enough to be able to ask intelligent questions." Moreover, few companies have figured out how to organize data for directors so they are adequately informed but not overwhelmed with minutiae.

As a result, Mr. Kaden says, "directors tend to perform better when they have to respond to a crisis than they do monitoring the day-to-day activities of their companies."

Mr. Kaden says that at Bethlehem, which filed for bankruptcy protection while he was a director, "I had a background in pensions and health care and other issues Bethlehem faced, but it was still fairly daunting to get to the bottom of critical choices."

Controlling the Flow

Still, extra hours are only part of the equation. For instance, reading through reams of reports before meetings often doesn’t yield the information directors need to perform some of their key duties, such as choosing a successor to the chief executive.

In part, that’s because CEOs still control the flow of most information to directors. A recent survey of about 150 directors by McKinsey & Co. in association with the Directorship Search Group, a search and governance consulting concern in Greenwich, Conn., found that a majority wanted less packaged information and more time for open discussions. They also said their boards would be more effective if they included as members more professional directors and large shareholders.

The survey found agreement between directors and institutional investors on a number of issues. Both groups seem to support splitting the roles of CEO and chairman. Investors more than directors believe more reforms are necessary, but both groups agree that CEO resistance and lack of director motivation are the biggest impediments to change.

Outside Meetings

To get around these challenges, directors need to be willing to meet outside of the CEO’s sphere — both with each other and with managers down the ranks. Only a few companies, however, including General Electric Co. and Home Depot Inc., require directors to visit plants and offices where they can talk with employees on their own.

Mandated private sessions of outside directors encourage franker discussion among some board members. Raymond Troubh, a director at nine companies, attended a pre-board meeting earlier this year where fellow independent directors began arguing about whether management could achieve its sales forecasts, and whether they could trust the internal data used to justify the forecasts. When the full board met the next day, the CEO and CFO were pressed for details. "Would you testify before a congressional committee that this is your best judgment?" one director asked, according to Mr. Troubh. The senior executives promised to take another look at their forecasts.

But Mr. Troubh, who has a tendency to criticize directors who are unprepared for meetings, says he has received poor marks from other board members for his outspokenness.

"I’m trying to modulate my feelings that other directors sometimes aren’t performing," he says.

Directors at U.S. companies seem to be asserting their influence more than their European and Asian counterparts, according to Korn/Ferry’s 2003 Board of Directors survey of 1,362 directors in 15 nations. Some 87% of respondents from North and South American companies now hold meetings without the CEO present, compared with just 7% of respondents at German boards, 15% of United Kingdom boards and 4% of Asia Pacific boards.

A Collegial Atmosphere

Still, as Mr. Troubh discovered, there remains a reluctance among directors everywhere to upset the collegiality of the boardroom. The best evidence for this involves the issue of excessive executive compensation — which boards have been loath to tackle. Although the popularity of stock options dimmed in the bear market and bonuses have shrunk in the economic slowdown, CEOs still command enormous pay packages regardless of performance. Last year, despite the downturn, CEO’s total direct compensation at major U.S. companies zoomed 15% to a median $3.02 million and is expected to increase again this year.

Perhaps the biggest challenge facing directors is finding new colleagues for boardroom duty. "The demands [of being a director] are higher, so some people who might have accepted a few years ago are now declining," says Mr. Gross, the Capital One director. At the same time, boards are pickier about whom they recruit. "We have to get the right mix of people for committees and the full board to be able to carry out all our roles," he says.

Before accepting a board seat, he says, he always asks himself two questions. "I ask, ‘Is there something about my background and experience that will allow me to add some value to this company, and am I going to learn something from this?’" he says. "When I’ve got two affirmative answers, the fit is usually right."

— Ms. Hymowitz, a senior editor for The Wall Street Journal in New York, served as contributing editor of this report.

Write to Carol Hymowitz at [email protected]

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Everything You Wanted to Know
About Corporate Governance . . . . . . But didn’t know to ask

By JUDITH BURNS
DOW JONES NEWSWIRES

Everybody’s talking about corporate governance these days. But how many people know what it’s all about?

How many know, for instance, what it is, who’s responsible for it and how it’s changing? How many people know the specifics of the Sarbanes-Oxley law?

So for those who haven’t been keeping up with all the ins and outs — or just want a refresher course — here’s an attempt to answer some of the crucial questions:

Q: Start with the basics: What is corporate governance?

A: Corporate governance is a hefty-sounding phrase that really just means oversight of a company’s management — making sure the business is run well and investors are treated fairly.

When it works as it’s supposed to, a board of directors looks attentively over the shoulders of executives who smartly handle the day-to-day business decisions, and shareholders get a full accounting of the company’s operations and finances. But lately, this model has failed in some rather spectacular smash-ups, with executives acting like imperial monarchs — operating unchecked by boards, bankrupting their companies and leaving shareholders with nearly worthless stock. Governance issues have made headlines since scandals erupted at Enron Corp., Tyco International Ltd., WorldCom Inc. and other firms.

"Corporate governance has been the hot topic," says Charles King, managing director and head of global board services for Korn/Ferry International, a Los Angeles-based executive-search firm. While the subject may seem mystifying, he says, at heart "it’s really about setting and maintaining high standards."

Q: Does corporate governance matter to investors?

A: For investors, "poor governance is a substantial risk factor," says Patrick McGurn, senior vice president and special counsel at Institutional Shareholder Services, a proxy-advisory firm in Rockville, Md.

Good corporate governance doesn’t guarantee superior performance, but a 2002 study by consultants McKinsey & Co. found institutional investors are willing to pay a 14% premium, on average, for shares of well-governed U.S. companies. McKinsey defined good corporate governance as having a board with a majority of outsiders who are truly independent of the company and its managers, who have significant holdings of the company’s stock, and who are paid chiefly in company stock or its equivalent. Formal evaluation of directors and responsiveness to investor requests for information are other hallmarks of well-governed companies, according to McKinsey.

Credit-rating agencies are beginning to factor corporate governance into their evaluations, too. And firms that sell liability insurance for corporate officers and directors are adjusting premiums to reward companies with good governance and punish those with bad governance.

Q: Who are the major players in corporate governance?

A: Board members, senior management, outside auditors, states, federal regulatory agencies such as the Securities and Exchange Commission, criminal prosecutors, legislators and the courts all play a role.

Q: Let’s start with board members. What is their responsibility?

A: The board’s most important job is hiring, firing and setting compensation for a company’s chief executive, who runs the company day-to-day. "The board of directors hires the CEO, not vice versa," SEC Chairman William Donaldson said at a recent Senate hearing.

Boards also are expected to oversee management, corporate strategy and the company’s financial reports to shareholders. In the U.S., boards typically have about a dozen members, often with the company’s CEO serving as chairman, and meet regularly throughout the year. Usually they have separate audit, compensation and nominating committees, though some now combine their nominating and governance committees.

Directors rely heavily on outsiders, including the company’s outside auditor. Even the most dedicated board members are unlikely to detect fraud at a company without assistance from accounting experts.

Q: What’s the main criticism of boards?

A: Well-run corporations have boards that are independent and strong. But in too many cases, board members have been hand-picked by the very parties they are supposed to oversee: the chief executives. Often in such cases, the boards approve whatever the CEOs ask for — particularly big pay packages that aren’t tied to performance.

On average, CEO pay rose 279% from 1990 to 2002, far more than the 166% rise in the Standard & Poor’s 500-stock index over the same period, according to a joint study by the Institute for Policy Studies in Washington and the Boston-based independent research group United for a Fair Economy.

The best predictor of CEO overpay is the number of CEOs on a compensation committee, says Nell Minow, editor of the Corporate Library, a research firm in Portland, Maine, that tracks corporate governance.

Defenders of CEO pay levels say they are driven by the same market forces that have sent salaries for professional athletes soaring, for example. The salaries may seem excessive, but corporate boards and ball clubs are willing to pony up because they don’t want to lose talent to the competition, Fannie Mae Chairman and CEO Franklin Raines said at a recent forum of the Business Roundtable, a lobbying group of chief executives. Mr. Raines is chairman of a corporate-governance task force for the roundtable.

Another criticism of corporate boards is that they too closely control the process of selecting future directors. Nominating committees recommend candidates for inclusion on corporate proxy ballots. The full board has the final say in selecting nominees. Then the shareholders vote on the candidates. But some shareholders complain they have too little input. The SEC has proposed rules that would require companies to disclose how they screen candidates and deal with shareholder-nominated candidates.

Q: What about the other watchdogs, such as the SEC and law enforcement? What do they do?

A: The SEC requires public companies to file quarterly and annual financial reports using generally accepted accounting principles.

When corporate fraud occurs, enforcement can come from multiple sources, including the SEC, state and federal prosecutors, and class-action lawsuits by private plaintiffs. The SEC can bring civil suits against companies and individuals who commit fraud, and impose fines and bar individuals from serving as corporate officers or directors. But the SEC doesn’t have criminal authority, so it can’t put anyone behind bars. That requires action by criminal authorities.

Criminal prosecutors who once shunned securities cases are now eager to go after corporate wrongdoers. Manhattan District Attorney Robert Morgenthau brought charges against Tyco International’s former CEO, L. Dennis Kozlowski, and former chief financial officer, Mark Swartz, accusing them of looting $600 million in corporate assets and using the money to cover personal expenses and award themselves lavish, unauthorized pay packages. Both defendants have pleaded not guilty.

Q: What is Sarbanes-Oxley?

A: Amid public outcry over corporate-accounting scandals, Congress enacted the Sarbanes-Oxley Act of 2002, which imposed weighty new responsibilities on corporate executives and boards.

Under the law, chief executives and chief financial officers of all public companies must attest that quarterly and annual reports fairly present the company’s financial condition. Executives who willfully certify false results face fines of as much as $5 million and as many as 20 years in prison. Audit committees are required to establish a system for employees to lodge confidential complaints about wrongdoing, and the company’s lawyers must report their concerns to higher-ups.

The law greatly expanded the role of directors who sit on corporate audit committees, making them responsible for the hiring, firing and oversight of outside auditors. If companies don’t follow the rules, they risk being delisted from the stock exchanges.

A five-member accounting oversight board was created with the power to examine audit firms and discipline wrongdoing. Board member Charles Niemeier says that in the past, when management hired the outside audit firm, auditors believed they were working for management, not the company and its shareholders. Mr. Niemeier predicts the change in law will lead to "really good audit committees" at U.S. public companies.

Sarbanes-Oxley also mandated that audit-committee members have no ties to the company, and called for firms to disclose in future annual reports whether they have a "financial expert" on their audit committee. Congress left the definition of "financial expert" to the SEC, which set a standard requiring significant understanding of accounting and financial statements.

"The law’s effect will be to make board members be more inquisitive," SEC Commissioner Paul Atkins said in remarks at a corporate-governance conference in Berlin in June. He expects directors will raise tougher questions with management, which he views as a step in the right direction.

Q: What role do investors play in corporate governance?

A: Goldman, Sachs & Co. Managing Director Abby Joseph Cohen thinks shareholders are pushing companies in the right direction as much as regulators are.

"People who own securities are properly infuriated," Ms. Cohen said at a recent governance conference sponsored by Georgetown University’s Capital Markets Research Center. As a result, she said, corporate executives are getting serious about governance reforms: "This has become a priority for them now."

Institutional investors that have huge portfolios can be very effective in demanding governance changes. TIAA-CREF, the New York-based investment company that manages pension plans for teachers, colleges, universities and research institutions, believes it has a responsibility to push for better corporate governance as well as stock performance.

Wisconsin’s state-employee pension fund and other state pension funds also have been leading the charge. The Louisiana Teachers Retirement System brought legal pressure to bear on Siebel Systems Inc., resulting in a settlement in August in which the software company agreed to make changes in its board and to disclose how it sets executive compensation, which has been criticized as excessive.

In a case brought against some officers and directors of Sprint Corp. by labor unions and pension funds, Sprint settled by agreeing to governance changes that require at least two-thirds of its board members to be independent. Sprint also will designate a lead independent director with authority equivalent to that of the chairman of the board, and require that all shareholder proposals be reviewed by an independent board committee.

Some governance experts think market-driven changes will far outweigh what Congress has done. Already, the Business Roundtable says 80% of its member companies have boards dominated by independent members. By year-end, the group says, 55% of member firms will have an independent chairman of the board, an independent lead director or a presiding outside director.

Q: What about stock exchanges? Do they have a say in all this?

A: Absolutely. The New York Stock Exchange and Nasdaq Stock Market are expected to put governance changes in place shortly that will call for listed companies to have boards with a majority of independent directors who meet regularly without management. Once approved by the SEC, changes would take effect starting next year.

The SEC has already approved one change proposed by the NYSE and Nasdaq — requiring companies to get shareholder approval for stock-compensation plans. That took effect this summer. The SEC held off on approving other governance changes, giving the NYSE and Nasdaq time to refine and harmonize proposals.

The SEC also is pushing the exchanges to improve their own governance practices.

Q: Are the new laws and pressure having an effect on corporate governance?

A: Board members are responding to the pressure, putting more effort and time into the job. In the 1970s, directors typically spent about 40 hours a year on board-related work, says SEC Commissioner Harvey Goldschmid. Last year, Korn/Ferry estimates, directors at Fortune 1000 companies spent about 190 hours on board service, and it projects that those hours could rise to 250 or 300 this year, largely due to audit-committee meetings.

"Boards are being much more diligent than they ever have before," says the ISS’s Mr. McGurn.

Deloitte & Touche LLP, one of the Big Four accounting firms, found that 39 of 66 clients now hold audit-committee meetings six or more times a year, up from just 11 that did so previously. Only 10% of audit committees at the companies surveyed met for less than one hour, compared with about 50% before adoption of the new law, according to Deloitte & Touche.

Pay is rising along with the workload for board members. Korn/Ferry’s Mr. King says companies are paying an extra $5,000 a year for audit-committee members and $10,000 a year more for audit-committee chairmen. Directors at Fortune 1000 firms were paid an annual average of $89,000 in 2002. Some also receive hiring and retention bonuses.

Stock compensation or ownership can help align directors’ interests with those of shareholders, governance experts say. Some recommend that directors hold at least $150,000 of stock or options in the company if they serve on its board.

Demand for financial experts to sit on corporate audit committees is up sharply. Korn/Ferry’s Mr. King says 60% of the firm’s searches for directors now target financial experts, up from 10% before Congress adopted Sarbanes-Oxley. Governance experts say the shift should help investors, since firms with financially savvy boards are less likely to restate financial reports than those with boards that lack accounting and finance expertise.

CEOs now serve on less than two outside boards, on average, according to Korn/Ferry. That’s down from four a decade ago.

Given the increasing obligations of directors, companies will have to turn to other, less traditional sources of talent, experts agree. Going forward, SEC Chairman Donaldson says, "not every company can have a CEO on its board."

Professionals who do nothing but serve on boards aren’t gaining favor, though. Executive-search firms say corporations don’t want professional directors, preferring to recruit candidates who have experience running a company, either as a chief executive, chief operating officer or head of a major corporate division.

Q: Are further changes likely?

A: Yes. Earlier this year, a panel of the Conference Board, a business-research group in New York, recommended changes to improve corporate governance. At the top of the list: splitting the role of chairman of the board from that of chief executive — preferably with the chairman’s position filled by an independent director. Chairmen have far more than a ceremonial role, as they set board agendas, manage meetings and control the flow of information to the board.

Separation of the CEO and chairman functions is common in Britain, and the idea is gaining support in the U.S. McKinsey & Co. found 70% of directors it surveyed at Fortune 500 companies favor splitting the two roles. Ms. Minow of the Corporate Library estimates about one-third of U.S. firms have split the functions already.

Supporters argue that separating the roles will provide more independence and greater accountability to shareholders. But skeptics note that both Enron and WorldCom had nonexecutive chairmen. And they worry that splitting the two roles could create conflict in the boardroom.

In another controversial move, the SEC is proposing new rules to make it easier for shareholders to nominate candidates to a board and to have the nominees’ names appear on corporate proxy ballots. Access to corporate proxy ballots allows shareholders to save the time and expense of traditional proxy contests. Proxy-access reforms, which are favored by labor unions and other institutional investors, could be in place starting in 2004, if approved by the SEC.

Business groups oppose giving disgruntled shareholders easy access to ballots, fearing that it could create chaos in the boardroom. Pfizer Inc. Chairman and CEO Henry McKinnell recently said he worries the proposal could inject "the worst of American politics" into corporate boardrooms.

But supporters say the SEC’s proposed approach will give shareholders a safety valve for use only in the worst cases. The SEC is contemplating proxy access only when a company has demonstrated governance problems, such as having a significant percentage of shareholders withhold votes for one or more directors. Other signs of unrest, such as a majority of shareholders voting for proxy access, could trigger the process the SEC has proposed.

Candidates would have to be backed by 5% of long-term shareholders to be nominated, and would be elected only with the approval of a majority of shareholders. The SEC also will insist that shareholder-backed candidates undergo the same vetting as any other candidate, and meet all independence requirements.

Ms. Minow, of the Corporate Library, says anyone who can gather that critical mass of support "deserves to be on the board."

— Ms. Burns is a reporter for Dow Jones Newswires in Washington.

Write to Judith Burns at [email protected]