The best & worst boards of 2002: let there be light; good governance? Gurus are searching for answers, but they are sure those companies that go beyond the letter of the law will be the first to win back investors. (Governance).

Try asking corporate governance experts to name a best board these days and you'll find these formerly loquacious gurus have clammed up.

"Not a chance," responds Elizabeth Saunders, chairman and co-founder of investor relations firm Ashton & Partners, when asked to select a best board. "The minute I do, they'll be investigated by the SEC."

"We like you, at the moment are gun-shy," reports Bill Patterson, director of the office of investment for the AFL-CIO, who says the organization has had to rethink its method of evaluating boards.

"Best board? I would pick Enron's--next year," quips Sandy Smith, corporate attorney with Morris Manning & Martin and executive-in-residence for corporate governance at Dartmouth College.

It became clear, after interviews with more than a dozen experts, that the parade of scandals has left the corporate governance community speechless. Even those whose own bottom lines depend on evaluating board effectiveness, and whose methods of evaluation have been tried and tested, have returned to the drawing board. "Before Enron, we would have weighed very heavily the kind of experience a board had," says Kevin LaCroix, president of Genesis Professional Liability Managers, an underwriting management subsidiary of Stamford, Conn.-based Genesis Insurance Company that provides directors' and officers' liability coverage. Enron was as blue chip a board as you re ever going to End," he notes, "so this has been a sobering set of events for us."

Even CE's established hallmarks of good governance, used for the past nine years to choose its list of Best and Worst Boards (this year's list-less format being a onetime departure) are shown to be little more than window dressing when blue-chip directors fall down on the job. Case in point: Enron's board made CE's list of Best Boards in 2000, not to mention the lists of a number of other prominent business magazines.

So where does that leave investors and other stakeholders? If the criteria that can be evaluated from the outside --board size, outsider/insider ratio, potential conflicts of interest and director stock ownership, among others -- don't mean that much, how is anyone to know, without actually sitting in the boardroom during meetings, which boards need fixing?

The answer lies in scrutinizing the information that is quantifiable. LaCroix says Genesis has downplayed the importance of board credentials in its underwriting criteria and has instead gotten "much more hard-nosed" about objective financial. For one thing, controls must be firmly in place regarding insider trading, in line with the SEC's "Rule 10b5-1," which establishes when an executive can be held liable for such transactions. The company's compliance officer should be strictly enforcing blackout periods; Genesis recommends no trading the last one or two months of every quarter. "If a company has these kinds of controls in place, they're less likely to have insider trading at sensitive times that plaintiff lawyers can later allege occurred because of knowledge of inside information," says LaCroix.

Genesis also examines policies on corporate disclosure. Companies that give projections need written guidelines specifying what they're going to discuss and what kinds of questions won't be addressed. And all communication should be funneled through one person in charge of corporate disclosure -- a sophisticated, well-trained, high-ranking executive. LaCroix cautions against relying too heavily on outside help from investor relations firms, saying they should not make statements about projections or estimates on behalf of the company.

While not required by law, periodic disclosure of risk factors is also favored. So are companies that take advantage of the safe harbor under federal law, which exempts them from liability for forward-looking statements when they're accompanied by meaningful cautionary language. "If we see companies not using safe harbors," says LaCroix, "it could persuade us not to get involved with them." Companies would also be wise to have all their public statements reviewed by counsel in advance of disclosure. And when there is bad news to tell, "get the truth out immediately," says LaCroix. "Often it's the spin, not the disclosure, that causes the company problems."

Most of these are not legal requirements. But in the coming months, it will be critical for companies not only to follow the rules, but go a step beyond them, proactively adopting practices that have not yet become law. Investors are already seeking companies that are one step ahead. A survey by McKinsey & Co. of 200-plus institutional investors responsible for $9 trillion in assets under management found that more than three-quarters of fund managers said they would pay 12 to 14 percent more for businesses with strong governance policies.

Five hallmarks of a better board

All CEOs are quickly learning the intricacies of the corporate-reform bill known as the Sarbanes Oxley Act, which President Bush signed into law in July. But experts have other ideas about going a step or two further. "We're going to see a lot of corporations having to distinguish themselves as having greater integrity than others," says Larry Mitchell,] law professor at Georgetown University, author of Corporate Irresponsibility America's Newest Export and director of the International Institute for Corporate Governance and Accountability.

1) Seek real independence. In addition to a majority of independents on boards, and all-independent audit committees, the New York Stock Exchange has proposed that compensation and nominating committees, too, be comprised of directors with no relationship to the CEO or the company. The NYSE also recommends mandating that non-management directors meet at regularly scheduled sessions, sans CEO and his or her entourage.

2) Build a more aggressive audit committee. This committee, which most represents shareholders, is the board's last line of defense against fraud; a weak one can spell disaster even if the board's other committees are on target. The Sarbanes-Okley Act arms audit committees with the authority to engage independent counsel and advisers as needed. But the AFL-CIO's Patterson says the new legislation, while an important step, doesn't go as far as it should. At press time, the organization was debating ways that companies might enact even stronger provisions than those currently mandated. "We're trying to figure out what the next level of accountability should look like," explains Patterson.

3) Put more skin in the game. Shareholder activists have already blamed greedy executives with excessive options for padding earnings to pump up share prices for short-term gains. That has now become a director issue as well; if board members are not motivated to think long term, they may turn a blind eye to financial "tweaking." The answer, say some experts, is to mandate share ownership -- not what's handed to them as compensation, but their own stock purchases. Ashton & Partners' Saunders says the topic came up at a recent National Association of Corporate Directors conference. Most directors were opposed, but CEOs were very much in favor of "having board members put their own skin in the game.

4) Separate the CEO and chairman titles. This has long been a hot-button topic in the U.S. Most American companies question the benefits of following this popular European trend, and critics say having an independent chairman would give a complete outsider too much power. But those in favor say it's impossible to have a truly independent board with the CEO sitting at the head of the table. Even Robert Nardelli, chairman and CEO of The Home Depot, who is opposed to splitting up the roles, acknowledged recently that having both titles is "a tremendous responsibility" and that you have to be able to be pretty self-critical of the CEO when you're chairman and CEO."

LaCroix notes that a division of titles would score high marks on his firm's governance test. Not many companies are doing it now, he admits, "but it's something you'll hear more about in coming months."

5) Create regular director evaluations. When it comes to director tenure, some experts say too long a stint leads to complacency and sloppy governance, while others say directors must have sufficient time to learn the business. So how can a CEO and his or her board know when it's time to show a director the door?

One solution is regular evaluations. Directors should rank themselves and one another confidentially. In some cases, boards and CEOs are seeking out independent evaluation and experts say that corporate America may be headed toward a more formal board certification process model. "Boards are saying, 'We need a checkup, we need someone to validate that we're functioning well,"' says Edward Lawler, professor of business at the Marshall School at the University of Southern California and co-author of Corporate Boards; New Strategies for Adding Value at the Top.

As an example, Lawler points to Motorola. The company has had its share of problems, but its board members regularly assess their effectiveness through surveys and outside diagnostics. A small number of companies have instituted term limits, including Computer Associates, which caps its director service at eight years. In July, New York Stock Exchange CEO Richard Grasso, one of the directors required to step down from CA'S board, praised the company's term limits and said they "ensure a continual injection of fresh, independent thinking."

Five hallmarks of a rotten board

There are a number of less tangible, systemic problems that can undermine boards. Since they're usually invisible to investors, employees and others, CEOs and directors are responsible for spotting them.

1) Control freak CEOs. The CEO already has a tremendous amount of power; the chairman title gives him or her even more. "Assuming the CEO is bright and charismatic, he or she can really control any board," says Lawler. The chief can limit the information the board gets, control meeting agendas and directly or indirectly influence membership. "You can't judge how much control they have by looking at procedures and processes, he says. CEOs must select board members with the courage to challenge and demand information when they think they're being boxed out.

2) Insiders masquerading as outsiders. These directors look independent to the shareholder community; they don't work for the company nor do they do material business with it. Yet their loyalties are with the CEO, for one reason or another. Their directorship may be a quid pro quo for service to their own board or they may have taken the job for the prestige or the contacts. Or they may simply admire the CEO and don't want to disturb the camaraderie. Whatever the reason, experts say, some CEOs have outsider directors tucked safely in their inside pockets. For those who suspect this problem on a particular board, Pat McGurn, vice president and director of corporate programs at Institutional Shareholder Services, suggests scanning for serial directors, who serve many different boards. A report recently published by the University of Michigan Business School looked at the degrees of separation between Fortune 1,000 board directors. "They found those boards are every bit as incestuous as Hollywood," McGurn says, "and no one has ever claimed Hollywood is a diverse crowd."

3) Rubber-stamp directors. Nobody likes to sound incompetent, least of all CEOs. And experts say that's what motivated some of Enron's best directors to keep mum when they didn't understand the details of its complex financial transactions. Self-censorship still goes on. Ashton & Partners' Saunders reports that at the NASD conference, several directors admitted they "didn't have the kind of board atmosphere where they'd feel comfortable asking a question they didn't already know the answer to."

Self-censured directors are a dear sign of a CEO who either dislikes being challenged--in itself a red flag--or one who doesn't know how to collaborate with the board. Most experts say it's the CEO's responsibility to create the right atmosphere. "They need to encourage directors to engage in strategic debate and provide active and careful oversight of management," says Patricia Crawford, professor at the Tuck School of Business at Dartmouth and executive director at the Center for Corporate Governance.

4) They look good, but they're asleep. When Enron imploded, the first board member to whom the outraged world turned was Robert Jaedicke, head of Enron's audit committee for more than a decade, who they figured, as a former accounting professor at Stanford, should have known better. It's not clear why Jaedicke failed to catch the misdeeds of Enron's senior management, though critics point to his 70-something age as one likely factor. But the lesson is that credentials don't make the director. Those who boast an impressive background, but who don't take the time to learn about the company or the industry won't be worth their weight in Cracker Jacks. This category includes directors who don't read their board agendas or meeting materials until they get on the plane; those who spend more time worrying about what will be served for lunch than the CFO's report; and those who actually fall asleep at the table. If board members are not willing to pay attention, the best guidelines and rules won't help. "On an airpla ne you have an automatic pilot and all this automated guidance," says Dartmouth's Smith, "but you still have to look out the window."

But CEOs can find ways to wake up dozing directors. Bernie Marcus, co-founder of Home Depot, established a rule for directors years ago: They were required to visit 18 stores a year and spend two hours in each speaking with employees and customers. "It's a totally different level of work" than WorldCom's four-meeting-per-year requirement, says Paul Lapides, director of the corporate governance center at Kennesaw State University Marcus essentially said to potential directors: "If you're not willing to give us the time, don't be on our boards."

5) Boards who listen to CEOs who stretch the truth. Most agree that asking the right questions in a board meeting can help root out misinformation, particularly when things look good on the surface. WorldCom's directors should have been asking why margins were so high relative to its industry, says Georgetown's Larry Mitchell. "If they had asked the question, they would have been able to evaluate the quality of Ebbers' answers and they would have known he was lying."

But realistically, if senior management is bent on concealing information, there is no board that can't be hoodwinked. "There are only so many board meetings a year, only so much time an independent director can spend focusing on the activities of a company," says Charles King, managing director and head of global board services for search firm Korn Ferry International.

This unpleasant realization is discouraging talented, would-be directors from serving. King reports that while director searches are up 26 percent post-Enron as more directors resign -- and are likely to increase if boards are required to have a majority of independents--new hires are harder than ever to recruit. CEOs of public companies are much more reluctant to take board positions, in part because of the scrutiny and in part because they're busy keeping their own companies afloat during hard times, says King. As a result, he is placing fewer CEOs on boards, instead finding qualified CFOs and others with strong financial acumen.

Widening the board pool to include people of different races and genders, as well as policy makers and academics, is applauded by most corporate governance experts. Such diversity could help break up the club mentality. "We have a psychological tendency to identify with people like us," says Mitchell.

It remains to be seen, however, whether lower-level, younger and inexperienced directors are likely to challenge fishy numbers put forth by an older, seasoned executive. Or, for that matter, whether they will be willing to oust a CEO who is cooking the books. At the end of the day, experts agree, restoring investor confidence will depend on CEOs having zero tolerance for dishonesty. That means there may be only one important decision the board makes, says Lawler, "and that's who is going to be the CEO."