This story is part of a special series by investigating shareholders' reaction to corporate corruption on Wall Street. Click here to see a full listing of stories.

There's no question, directors were part of the problem at Enron, WorldCom, Global Crossing and many other companies now charged with fraud and deception.

Can they also be part of the solution? Corporate reformers agree that any effective effort to restore investor confidence will require better oversight from directors. But the first batch of proposed reforms, most notably the new listing standards from the New York Stock Exchange, have significant shortcomings, according to shareholder rights activists and corporate governance experts. Among the most vexing issues:

  • How can directors be truly independent from the companies they serve? And does independence ensure competence?
  • Will already strained regulators have the resources to enforce new regulations regarding the independence and competence of directors?
  • Will companies be willing to commit to wholesale overhauls of their boards to meet the new requirements?
  • Among the more ambitious proposals from the NYSE is the requirement that directors meet at "regularly scheduled executive sessions in the absence of management." Under existing rules, there is no such requirement.

    The presumption is that board members will be less willing to go along with the company line if they're both independent from senior management and compelled to meet outside their direct sphere of influence. Perhaps it would also encourage board members to go public with concerns, such as those raised by Qwest Communications' ( Q) board in September 2001, when it fretted there was an accounting "credibility issue" at the firm, according to documents released this month by the House Energy and Commerce Committee. A year after that board meeting, Qwest restated $1 billion in sales. It's fair to say that shareholders might have benefited from advance knowledge of the board's concerns.

    Desired Qualities

    The Good CEO: Endangered, but Not Extinct
    Greenberg's Rules for Recognizing Risk
    Institutions Are Asleep at the Wheel
    New Rules Can't Cure Ailing Wall Street
    Fleecing the Shareholder: How They Do It
    Inside, Outside -- We Just Want an Active Board

    But even if the playing field is changed to promote independence, the paramount issue is the character and competence of the individual directors.

    "You can lead a director to executive session, but you can't make them think," said Nell Minow, founder of the Corporate Library and a shareholder right's activist. "Tell me a way to ensure board members have independence of spirit, commitment and character -- that'd be important. There's really no item in resumes or in related transaction disclosure that's going to provide that assurance."

    The NYSE's proposal, which has become the template of the reform effort, requires that companies have a simple majority of independent directors on their boards, defining independence as "no material relationship with the company, either directly or as a partner, stockholder or officer of an organization that has a relationship with the company," including investment banking, commercial, consulting, legal, accounting, charitable and familial relationships.

    Current rules require companies have a least three independent directors on their audit committee, but there are no requirements for independence of the board itself.

    Companies will have two years to comply with the NYSE proposals after they are approved by the Securities and Exchange Commission. As of Oct. 4, an SEC spokesman said the exchange hadn't sent a version of the NYSE's proposal to the Federal Register for publication. Meaning, the public comment period, the first step toward an SEC vote, is still to come. (Similar proposals for independent audit committees are key elements of the Sarbanes-Oxley Act, which overhauled rules for corporate disclosure and toughened penalties for corruption. Also, the National Association of Securities Dealers, parent of the Nasdaq, has also issued proposals that in some regard are tougher than the Big Board's.)

    "Mandating honesty is kind of a losing battle; you either are or you aren't," said Linda Selbach, proxy manager for Barclays Global Investors in San Francisco. "It all comes down to enforcement, penalties for violations and resources for detecting lack of compliance. That's going to be a hard one for the stock exchanges to really take on because of the competition between them for listings. It's going to be hard for them to speak out against member companies."

    What It's Come To

    That leaves enforcement up to the SEC, which is busy these days with other issues. While generally applauding efforts by the major exchanges to address governance issues, Selbach also wondered about the requirements that independence be certified. "That should go without saying," she said. "It's a sad comment on where we are, that we have to ask, 'Are your fingers crossed?'"

    Selbach's also criticizes the NYSE's proposal for exempting "controlled companies" -- those with more than 50% of voting power held by an individual, group or other company. Additionally, while giving shareholders an increased say in executive compensation, she noted with some disappointment that the Big Board's proposal exempts "employee-inducement awards and options; plans relating to mergers and acquisitions; and tax qualified and excess benefits plans."

    Some shareholder rights groups see other conspicuous omission in existing proposals to reform corporate boards, namely a contingency to allow shareholders "ballot access" to elect dissident board members. A group called the Committee of Concerned Shareholders has co-sponsored a petition for changes to SEC Rule 14a-8(i) that would allow investors to have far greater say in the electing of directors. An SEC spokesman declined to comment on the petition, and few governance experts believe it's going to get any easier to elect an alternative slate of directors going forward.

    Meanwhile, Patrick McGurn, vice president and special counsel at Institutional Shareholder Services, a provider of proxy voting and corporate governance services, is concerned about the unintended consequences of the reform effort.

    Who Decides?

    The ISS estimates 26.5% of U.S. companies will have to alter the makeup of their boards to meet the NYSE's requirement for a majority of independent members, McGurn said. Also, he said 28% of audit committees, 32% of compensation committees and 74% of nominating committees will need changing to meet new requirements for total independence. Nominating committees require the most significant change, "because how can you have independence on boards when CEOs and other insiders are playing a role in selection of directors in the first place?" he wondered.

    Along with firms such as Tyco ( TYC) that have made changes "under duress," a number of companies have recently announced board makeovers in an effort to meet new independence requirements even before they become mandated by regulators, McGurn noted. Among them are: Bank One ( ONE - Get Report), Cendant ( CD), Cinergy ( CIN), CIT Group ( CIT - Get Report), Citigroup ( C - Get Report), FleetBoston Financial ( FBF), Heidrick & Struggle ( HSII), Hot Topic ( HOTT) and Liberate Technologies ( LBRT).

    Additionally, McGurn speculated that many people who serve on boards are going to cut back on their commitments, because of the increased demands on directors. Just last week, Citigroup chieftain Sandy Weill resigned his directorships from the board of AT&T ( T) and said he would not stand for re-election for United Technologies' board, in order to avoid potential conflicts. "Weill's interlocks are something that the stock exchange and many investors don't include in their definition of nonindependence, so it's raising the bar a bit," McGurn commented.

    Elsewhere, Apple ( AAPL) CEO Steve Jobs resigned from the board of Gap ( GPS) citing a need to "focus on other priorities."

    Presumably, both executives' day jobs prohibit them from meeting the heightened expectations now placed on board members. (Martha Stewart's resignation from the Board of the NYSE was a bit more complicated, given the questions about her sale of ImClone stock.)

    "I'm not going to pretend it's not going to be more difficult to land good directors at a time when the candidate pool is going to be sorely tested," McGurn said. "It's going to become more difficult."


    At the Business Leadership conference at the Greenbrier Resort in West Virginia last week, more than a few CEOs complained about having their attention diverted by these new regulations, although savvy and practically astute corporations are embracing the proposed changes as necessary and inevitable. Even some much maligned boards, such as at Disney ( DIS) and Computer Associates ( CA), have made efforts to eliminate conflicts and reduce executives' compensation.

    Certainly, no tears are being shed for corporations and/or board members. There is a dramatic need to improve the independence and quality of boards, which is something even credit rating agencies are now focusing on more.

    "We believe that governance weaknesses can provide an early warning of credit problems that may otherwise be invisible in advance of financial stress," and vice versa for good practices, according to Debra Perry, senior managing director of Moody's Corporate Finance Group. Last week, Moody's announced the hiring of Kenneth A. Bertsch, formerly of giant pension fund manager at TIAA-CREF, as its new director of corporate governance.

    Obviously, the bar for corporate governance was ratcheted down dramatically in the 1990s, as scandals at Tyco and Adelphia Communications demonstrate. The process of taking it up a few rungs has begun, but there's a long, long way to go before shareholders, and those who claim to speak for them, will be satisfied that directors are above board and above reproach.