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The Best & Worst Boards


For most of the 1990s, Walt Disney Co. (DIS) occupied a prominent place in BusinessWeek's rankings of America's worst corporate boards. Directors there were long on ties to CEO Michael D. Eisner and short on management expertise. Although performance was strong, oversight was minimal. The company's reaction to this dubious distinction? With its stock climbing and shareholders happy, it more or less ignored the issue, saying only that Disney's strong performance spoke for itself. That's how most investors seemed to regard corporate governance in the '90s as well: in theory, a laudable goal, but one with only marginal relevance in the real world.

Those days ended with a bang when the debacle at Enron Corp. exposed just how vulnerable even the largest companies were to fraud and manipulation. Across Corporate America, a governance revolution is under way. As the list of companies engulfed in scandal grows--from Enron to Tyco to WorldCom--the revolution is gaining momentum. Top executives who once blithely ignored criticism of their clubby boards are scrambling to institute reforms. Directors whose main contribution to boardroom debate had been golf scores and gossip are returning to the classroom to learn how to read a balance sheet. Compensation committees that routinely awarded massive pay packages to poorly performing CEOs are having second thoughts. And while many official reforms have already been passed following Enron's meltdown, boards are going even further, instituting sweeping changes in their composition, structure, and practices on a scale not seen since skyrocketing executive pay gave birth to the modern governance movement in the 1980s.

The depth and breadth of the changes taking place become clear in BusinessWeek's fourth ranking of the best and worst corporate boards in America, a survey we first undertook in 1996. To determine which boards were getting it right and which weren't, we polled the nation's top governance experts and conducted an in-depth analysis of dozens of boards, looking at everything from director credentials to stock ownership to attendance. This year, besides listing the best and worst boards in America, we've added three new categories: Most Improved Boards, Boards That Need Work, and a Hall of Shame.

The yearlong study provided a richly detailed view of governance in the post-Enron age, revealing a broken system undergoing radical repairs. "Enron is bringing about the most sweeping structural changes in governance that have ever occurred," says Donald P. Jacobs, former dean of Northwestern University's Kellogg School of Business and a governance watcher. "We thought there had been an enormous increase in the quality of boards, but Enron has shaken the hell out of that confidence."

That wake-up call has spurred companies to make radical improvements. Problems that were simply ignored a couple of years ago are now the subject of heated boardroom debate. Boards are being forced to grapple with tough questions: How much is enough when it comes to paying the chief executive? What's the best way to account for option grants? What kinds of ties should be banned between directors and the companies they oversee? How many boards can directors serve on without being stretched too thin? How should the audit committee be staffed and run? And how much additional consulting, if any, is acceptable for the outside accounting firm? The recent scandals have made it all too clear that the decisions boards make on these issues can have profound consequences for their companies.

Bad boards, in particular, have made extraordinary strides in confronting these questions. Spurred in many cases by scandal, crisis, or a plummeting stock price, former laggards have become ardent believers in good governance. In some cases, a revitalized board may not be enough to undo the damage, but it's a start. Long criticized for lax governance policies, Disney, Cendant (CD), Waste Management (WMI), and others have leapt ahead of rivals, implementing dramatic governance reforms in recent months that, experts say, will serve as a template for board overhauls across the nation. Computer Associates International Inc. (CA), a company notorious for having awarded a $1.1 billion pay package to top executives four years ago and which is now under investigation for its accounting practices, has recruited the Securities & Exchange Commission's former top accountant for its audit committee and prohibits directors from selling stock until they leave.

The changes at those companies warranted their inclusion on BusinessWeek's list of most-improved boards, but even the worst boards in our rankings made some positive changes. Apple Computer Inc. (AAPL) and Qwest Communications International (Q) have both prohibited their outside auditors from doing nonaudit work for the company. Even at Tyco, WorldCom, and Adelphia--where poor oversight contributed to spectacular business scandals that landed those boards in our Hall of Shame--directors are now moving to strip their fallen leaders of gargantuan severance packages.

And it's not just the laggards. Even good boards have undertaken reforms or demonstrated stern resolve in dealing with management. Both Home Depot Inc. (HD) and General Electric Co. (GE) are expensing options, and GE CEO Jeffrey R. Immelt has vowed to add more directors without ties to the company. The GE board's latest changes and unrivaled record of creating shareholder value were enough to land it on our best boards list for the fourth time, despite recent revelations about the retirement perks it awarded former CEO John F. Welch in 1996. At Apria Healthcare Group Inc. (AHG), the board demonstrated why it, too, is consistently named one of the nation's best: Within 24 hours of learning that the wife of CEO Philip L. Carter had been hired for a company job, an infuriated board in February accepted his resignation and rescinded her offer of employment. It was able to act decisively because it had done its governance homework: A succession plan was in place, and the independent directors met regularly without management present to discuss Carter's performance, which until then had been universally lauded. "It just destroyed our whole trust in him," explained board member Richard H. Koppes. "We couldn't believe what he had done." Carter maintains that the turnaround he was hired for was complete, and that he left voluntarily.

While governance progress has been made throughout Corporate America, pockets of resistance remain. At Xerox Corp. (XRX), CEO Anne M. Mulcahy has made several changes to the board since the bungled succession of Paul A. Allaire two years ago. But problems remain: Three of the eight directors sit on too many boards, director Vernon Jordan's law firm still provides legal services to the company, and two members of the audit committee had attendance problems last year--this while the SEC was sifting Xerox' books to determine if the company used accounting tricks to boost revenue and earnings. Xerox says the board has been instrumental in leading the company's turnaround and is continuing to improve. At American International Group (AIG), CEO Maurice R. Greenberg vigorously defends the half-dozen directors who sit with him on the board of a private company that got $77 million in AIG business last year and another that rewards top AIG execs with generous bonuses--a situation he describes as beneficial to shareholders.

At Apple, Steven P. Jobs owns just two shares of the company he founded nearly three decades ago. Even worse, the CEO of Micro Warehouse Inc., Jerome B. York, sits on Apple's compensation committee--even though Micro Warehouse accounted for nearly 3% of Apple's net sales in 2001. In the past two years, the board has awarded Jobs 27.5 million stock options and a $90 million jet, though it has saved on salary because Jobs has worked for $1 a year since his return to Apple in 1997. Apple declined to comment, but shareholders are aghast. "This is the old boys' network at its worst," says James C. Voye, international representative for the International Brotherhood of Electrical Workers pension fund, which launched an unsuccessful campaign for an independent compensation committee. "How do shareholders have any faith that these insiders aren't stuffing their pockets?"

But for boards that are reforming, the changes are likely to be profound. The remade boards will include fewer company executives and other insiders--and more independent directors. Board practices, such as executive sessions of outside directors, will give independent majorities more power. As a result, the whole tenor of board deliberations will change. Historically content to rubber-stamp management, the new board will become a true partner, with members meeting frequently with executives to confer on strategy and consulting with one another to evaluate management performance. And the job itself will become more difficult, requiring more time and more technical knowhow, especially for audit-committee members. "Boards of directors will be rolling up their sleeves and becoming much more closely involved with management decision-making," says Jeffrey A. Sonnenfeld, associate dean of the Yale School of Management.

There are already signs that boards are starting to demand more of their directors. Headhunters report spiking demand for independent directors--curmudgeons who will act as watchdogs, not lapdogs. Director "boot camps" and training seminars, such as those run by the Kellogg School and the University of Georgia's Terry College of Business, report standing-room-only crowds. Governance gurus who advise companies on revamping their boards, such as Harvard's Jay W. Lorsch and Ira M. Millstein of the law firm Weil, Gotshal & Manges LLP, are so busy they're turning away work. Directors say they're ready to embrace even some of the more radical reform ideas, including expensing stock options, increasing the audit committee's responsibility for risk, and appointing a "lead" independent director. At many companies, the workload is heavier than ever. At Lucent Technologies (LU), for example, which has been hammered by the telecom meltdown, the chairman communicates with directors once a week, and the audit committee convenes every month. "In the post-Enron days, governance has become critical," says Sanjay Kumar, CEO of Computer Associates.

That's in stark contrast to most of the 1990s, when corporate governance hardly seemed to matter: The buoyant stock market rewarded both good and bad boards. But when the bubble burst, that changed. Suddenly, the importance of governance was clear. In a time of crisis, a vigorous board that has done its job can help companies minimize the damage. A look back at BusinessWeek's inaugural ranking of best and worst boards in 1996 tells the story. For three years after the list appeared, the stocks of companies with the best boards outperformed those with the worst by 2 to 1. But as the economy slowed starting in 2000, the Best Boards companies retained much more of their value, returning 51.7%, vs. -12.9% for the Worst Boards companies. Ralph V. Whitworth, the director who nurtured Waste Management Inc. through its accounting crisis and engineered governance turnarounds there and at Apria Healthcare, says investors in well-governed companies are buying a form of insurance. "A good board does not ensure that a company is never going to find itself in a crisis," says Whitworth. "The real test is what they do in reaction to a crisis."

Even the best boards could take a page from Whitworth's playbook. When he was called in to Waste Management in the wake of the accounting scandal in 1998, a serious illness on the part of the CEO brought in to fix things forced Whitworth to take charge. He demanded the resignations of three top executives who had sold stock just months before an earnings miss. With two other board members, he set up shop at the Houston headquarters, meeting with a crisis team every day at 5 p.m. for 90 consecutive days, as an army of 1,200 accountants scoured the company's books--all while recruiting a new CEO and resetting company strategy. "It's a great success story and one of the most dramatic turnarounds in governance," says Kenneth A. Bertsch, director of corporate governance at TIAA CREF, the huge teachers' pension fund and a governance gadfly. "It's when you have a company crisis that something has to happen, or the company can just go down."

If Corporate America succeeds in remaking governance, one of the greatest ironies will be that we have Enron to thank for it. When the unquestioning faith Enron's board placed in the company's management was revealed as a colossal blunder, faith in other once-revered executives also began to falter. Almost on cue, the giants began falling--Tyco, WorldCom, Global Crossing--confirming suspicions that the blight of greed and hubris that brought down Enron was more widespread.

Enron, and the corporate disasters that followed, forced many companies to get serious about governance. There are signs, especially, that boards are finally starting to grapple with the most egregious governance failure of the 20th century: astronomical executive pay. At E*Trade Group Inc. (ET), CEO Christos M. Cotsakos returned $21 million in pay after shareholder anger over his $80 million pay package boiled over. And in July, the head of the compensation committee, who had business ties to Cotsakos, resigned. At Dollar General Corp. (DG), CEO Cal Turner Jr. returned $6.8 million he received as the result of financial results that were later restated. "Boards have decided they're in a position where they can take a hard line," says Paul Hodgson, a senior research associate with the governance Web site The Corporate Library. "And if they don't take a hard line, they're going to get in trouble with shareholders."

Pressure from shareholders was responsible for many of the governance changes of the past year. Companies that once ignored criticism of their weak boards from disgruntled investors could no longer do so. And few boards had weaker governance than Disney's (DIS).

Under pressure from his board--particularly Stanley P. Gold, who manages the Disney family fortune--and institutional investors unhappy with the company's lackluster performance, CEO Michael Eisner recruited governance guru Millstein as an adviser and in April announced a series of changes. Post-Enron, Disney was among the first companies to prohibit its external auditors from providing consulting services, a reform originally proposed in a 2002 shareholder resolution that Disney opposed. Robert A.M. Stern, whose architectural firm was paid $76,000 for its work on a Disney resort last year, and former U.S. Senator George J. Mitchell, who had a $50,000 consulting contract in addition to his law firm's $1.3 million in Disney billings, have severed their business ties to the company. And the company came clean about four directors whose family members had previously undisclosed Disney jobs. "The goal is to end up with a board and a set of governance rules that go a long way toward growing investor confidence," says Robert A. Iger, Disney's president and chief operating officer. "We think we've taken some giant leaps forward, and we expect it to continue."

While the changes are significant, Disney's efforts show just how hard it is to turn a bad board around. Half of the 16 Disney directors still have ties to the company. Nine own less than $150,000 in stock, including five whose stakes are less than Disney's new $100,000 minimum. And the compensation committee--which has made Eisner one of the few CEOs in history to earn more than $1 billion over the course of his career--is rife with directors who have ties to Disney or Eisner, including Reveta F. Bowers, who runs a school once attended by Eisner's children. The board's independence is likely to be tested in future months as Eisner and Gold continue to clash. "Times change," says Charles M. Elson, director of the University of Delaware's Center for Corporate Governance. "But it doesn't happen overnight."

At Disney and at other companies, the factors driving governance reform are numerous, but they all boil down to self-preservation. Some boards are undertaking reforms, such as adding independent directors, because they will soon be required to under New York Stock Exchange rules. Others are hoping that reforms will persuade Congress not to take action. For most companies, soaring insurance rates for directors and officers is also a factor.

Perhaps the most important driver of change is the markets. Increasingly, institutional investors are flocking to stocks of companies perceived as being well governed and punishing stocks of companies seen as having lax oversight. No company knows this better than Cendant Corp., which has been revamping governance since its 1998 accounting scandal. Among the most recent changes: Executive stock options will now require shareholder approval, and severance deals for departing executives will be severely curtailed. "I think the real impetus [for reform] will not be the NYSE, the President, or Congress--it will be the reality of the marketplace," says Henry R. Silverman, Cendant's CEO.

Some boards, it seems, never change. Long regarded as governance slackers, they still seem oblivious to the atmosphere of reform. At Tyson Foods Inc. (TJN), for example, there are 10 insiders on the 15-member board, including founder Don Tyson's son, making it one of the most insider-dominated boards around--and earning the company a place on BusinessWeek's Worst Boards list. Five of the insiders are Tyson consultants, and seven have extensive side deals with the company--everything from leasing farms to providing aircraft, wastewater-treatment plants, and office space. Two of those seven sit on the compensation committee that awarded CEO John H. Tyson a $2.1 million bonus for negotiating the acquisition of meatpacker IBP--a deal the company tried, unsuccessfully, to back out of. And after a federal indictment in Tennessee accused the company of conspiring since 1994 to smuggle illegal immigrants into the U.S. from Mexico to work in its poultry-processing plants, the company fired several managers allegedly involved in the scheme, but the board took no action against the CEO.

Tyson denies the conspiracy charge and says the CEO's bonus was earned in light of the "huge number of man-hours" involved in the IBP acquisition and its "unqualified success." But governance experts say boards like Tyson's are a throwback to when directors saw board seats as a way to land clients for their companies or consulting contracts for themselves. "It's an incestuous board with a capital I," says Patrick McGurn, corporate-programs director at proxy adviser Institutional Shareholder Services Inc. "They may not all share the name, but they all share the same affinity for the Tyson family."

To be sure, the governance revolution has not taken root everywhere. And even where it has, constant vigilance is necessary to make sure the sense of purpose survives. Computer Associates, a Most Improved board, hired Harvard governance expert Jay W. Lorsch to advise it on reform, designated a lead independent director, and bolstered its audit committee with Walter P. Schuetze, the former chief accountant of the SEC's enforcement division. But in July, it disclosed that it paid Texas billionaire Sam Wyly $10 million to call off his proxy battle--a payment governance experts denounce as "greenmail" and an improper use of corporate funds. Lorsch, who was named to the CA board in March, says every director was behind the payment, which was viewed as a practical way to avoid the cost and distraction of a proxy fight. "It does not fall within my definition of greenmail," says Lorsch. "From our point of view, it was the right thing to do."

Also defending their governance practices were many of the companies that appeared on BusinessWeek's Worst Boards list and in the Hall of Shame. Dillard's Inc., which fared poorly in the rankings due to its six inside or affiliated directors, said the current and former company employees brought "a wealth of insight and experience" as well as "character and integrity" to the board. Adelphia blamed its problems on the Rigas family, which, it said, provided the board with "inadequate, incomplete, misleading, or simply false information." And the company that started the governance revolution? It says it's not to blame for the failures that brought it down. "The board and its structure were more than adequate," wrote W. Neil Eggleston, an attorney representing the old Enron board, in a response to BusinessWeek. "Enron's management and outside advisers were the problem at Enron."

While extraordinary changes have been made, the governance revolution is far from over. Some changes proposed in Enron's wake--including certification of financial statements by CEOs, a ban on loans to officers and directors, and faster reporting of insider stock transactions--are in place. But others are still under discussion, including expensing of options, separation of the roles of chairman and CEO, and an outright ban on company side deals with directors.

Other changes that aren't on most boards' radar screens yet, should be. Shareholders need more power to choose and replace directors. They need two candidates for every seat, and a simple majority of votes cast should decide the election. They also need access to the information that will let them make an informed choice. Disclosure of board roll-call votes on issues such as executive pay would go a long way toward helping shareholders decide which candidates deserve their vote. And shareholder resolutions should be easier to pass. Supermajority voting requirements should be eliminated. Resolutions should be binding.

As executives and board members watched the Enron drama and its sequels unfold, many came away with a renewed sense of purpose. Now, the reforms they've implemented promise not only to remake the corporation but also to sound the death knell for the imperial CEO. Almost overnight, boards that were at the CEO's beck and call are more independent, skeptical, and determined than ever to hold top executives accountable. As revolutions go, not a bad start.

Corrections and Clarifications

``The best & worst boards'' (Cover Story, Oct. 7) incorrectly reported that the Microsoft Corp. board lacks a nominating committee. The board created a committee in August and disclosed it on Sept. 19. The article also incorrectly stated that the Tyson Foods Inc. compensation committee includes two directors with business ties to the company.

By Louis Lavelle in New York


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