Reforming governance: companies must go beyond rules to focus on issues of character.

Governance headlines in 2004 were sadly similar to those of recent years, with more than a few stories of boards forced to remove their CEOs under clouds of disgrace. From Marsh & McLennan, Fannie Mae and Computer Associates in the U.S. to Royal Dutch/Shell and Parmalat abroad, boards claimed to have been ambushed by the massive fraud of those close to the top.

The investigations that follow major white-collar improprieties invariably show that people at the top could have learned about them but insulated themselves, or denied the bad news when corrective action could have been taken. Why? We might think of the state of awareness as a continuum ranging from individuals "in the know" to those "in the dark"--the victims, for instance. In between are individuals who have partial knowledge or a vague understanding. Why don't they act? There are several factors.

First, and most obviously, is the image of the company. For six years, Fortune ranked Enron as the most innovative company in the nation. Leading consulting firms and academics held Enron up as the prototype of the "New Economy." Arthur Andersen was their accounting firm. CEO Ken Lay was a personal friend to President Bush. With such a reputation, suspicious activity was easier to dismiss.

The second factor is somewhat paradoxical. There is virtually no significant transaction today that does not involve dozens of specialists and dozens of organizations. Many of the major deals that have come unglued involved bankers, investment bankers, auditors, equity investors, lessees, vendors, lawyers for the lessee, lawyers for the lessor, the banks and so on. We use these specialists to reduce the risk of doing business. But, in practice, having so many players creates a structure in which it's easy to conceal fraud.

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Third, there is a phenomenon of "anesthetization" that occurs when fiduciaries guarding against wrongdoing develop a set of routines over time that they follow in a mindless way, ignoring the signs of trouble that the routine was designed to detect.

There are six steps we recommend for CEOs and their boards to pursue in 2005:

1. Create a climate of trust and candor. Often, boards are "managed" by executives who see them as obstacles rather than as trusted business partners. Critical information should be shared with directors in time for them to read and digest the facts. Polarizing factions and in-groups should be discouraged.

2. Foster a culture of open dissent. Dissent is not the same thing as disloyalty. One prominent director warned that "no one wants to be seen as the skunk in the lawn party." Safeguarded channels for whistle-blowers in management should supplement new Sarbanes-Oxley protections and audit committee solicitation of concerns.

3. Mix up the roles. Managers and corporate directors must avoid getting trapped into rigid typecast positions. To stimulate debate and avoid the stereotypes of being the "fire-the-bastards" person, or the "harmonizer" or the "governance whiner," people should take turns as enthusiasts and devil's advocates. This can challenge blind obedience to authority and break the group's tendency to avoid reality testing.

4. Ensure individual accountability. To escape the quicksand of bystander apathy, managers and directors can be required to report on strategic and operational issues. These tasks should involve the collection of external data, interviews with customers, anonymous "mystery shopper" visits and the cultivation of links to outside parties critical to the company's future.

5. Let the board assess leadership talent. At top companies, the board is actively involved in assessing talent. At Procter & Gamble, The Home Depot and General Electric, the board regularly visits facilities and meets with managers and customers to learn and to observe operations and talent firsthand. Directors at P & G often come in early to board meetings to meet with and coach emerging leaders.

6. Evaluate the board's performance. It is impossible to learn without feedback. Yet many in top management and half of all boards do not provide performance appraisals. Everyone else in the enterprise can be assessed, but somehow the more senior players find excuses to not collect this often discomforting information.

The Securities and Exchange Commission is encouraging more direct nominations of directors from shareholders, bypassing board nominating committees. While shareholder activists and CEOs battle over the legal definitions of the triggering events that should lead to such direct nominations, the criteria for identifying more diligent directors has been left on the sidelines. To improve the quality of directors, we suggest the following:

* Seek knowledge rather than names. An overenthusiasm for "branded" names has led to a pathological fixation on fame. Corrupt CEOs love to hide under the reflected glory of star-studded boards, knowing that investors will be impressed and the directors themselves likely will be too busy to ask tough questions.

* Focus on character more than independence. Many shareholder activists are pushing for supermajorities of independent outside directors with the ultimate goal of having the CEO be the only insider. That's not necessarily wise. One of the most courageous voices on the Enron board was a renowned scientist, Charles LeMaistre. But today, LeMaistre would be suspect because his institute, MD Anderson Cancer Center, received Enron funding.

Similarly, having some inside directors who know the business can help inform the outside directors by reducing the filtering of knowledge through the CEO.

* Ruthlessly purge those with hidden agendas. Boards and management committees should not resemble city council meetings. Sometimes unrevealed conflicts are not even financial but rather political and personal. Forest products, pharmaceutical and media firms are especially exposed to public issue advocacy groups. Board candidates who are primarily anchored in single-issue causes are not likely to be legitimate representatives of a broader group of shareholders.

* Find people with passionate interest in the business. Sadly, many people seek board posts for the vanity and power but have little interest in the industry or culture of the enterprise they have joined. Sometimes directors will even admit they do not fully understand the acronyms on the charts in PowerPoint presentations.

* Avoid joiners who collect boards like trophies. Until the forceful reform efforts of shareholder activists a decade ago, it was common to find directors serving on more than a dozen boards and frequently attending fewer than 75 percent of the meetings. With a single board post now easily requiring 200 hours a year of preparation and meetings, four boards is becoming a common limit for otherwise employed directors.

* Don't accept arbitrary retirement ages. Enterprises such as Corning, Delta and Boeing have wisely sought energetic elder statespersons, like Jamie Houghton, Jerry Grinstein and Harry Stonecipher, to lead them through troubled times.

For reformers, the situation today is akin to that of the dog who finally caught the car it has chased for years. Now that we have a climate that will embrace reform, what do we do with it? It's time to shift the debate from rules and procedure, to focus now on what we really know about people and their character.

Robert P. Gandossy leads Hewitt Associates' talent practice. Jeffrey Sonnenfeld is Associate Dean at the Yale School of Management. They are co-editors of the book, Leadership and Governance From the Inside Out.