For more than two decades, Leslie Rahl had made her living analyzing risks, but she'd never come across one quite like this: In December 2003, Fannie Mae approached her about taking a seat on its board of directors.
Rahl was honored, and in many ways she was the perfect candidate for the now-troubled mortgage lender. A star options trader for Citibank in the 1980s, she had opened her own consulting shop, Capital Market Risk Advisors, in 1994 and was soon counseling Orange County, California, on how to handle $2 billion in derivatives losses. Fannie Mae, also a huge derivatives market player, needed a financial expert on the board to replace former Goldman, Sachs & Co. chairman Stephen Friedman, who was leaving to join George W. Bush's administration as director of the National Economic Council.
But Rahl was also a little worried. She had never been a public-company director before, and the previous few years of corporate scandals and strict new regulations had redefined the nature of board service, turning what had often been a cushy networking opportunity into a high-risk endeavor. Congress's quick response to frauds at companies like Enron Corp. and WorldCom -- the Sarbanes-Oxley Act of 2002 -- had heaped unprecedented legal and financial responsibilities on board members. Regulators, activist shareholders and trial lawyers increasingly were targeting directors for failing to question or prevent corporate misdeeds. Complicating things further for Rahl, federal regulators had just announced an examination of Fannie Mae's accounting practices following the company's disclosure of a $1.1 billion error in its third-quarter 2003 earnings statement.
So rather than accept the position right away, the risk expert embarked on several weeks of painstaking due diligence. She spoke with other Fannie Mae directors, scrutinized the company's financial statements going back several years and even asked her husband, a bankruptcy lawyer, to vet the offer from a professional perspective. After two months of checking out the company, she agreed to join its board. (Since then the accounting probe has prompted a huge earnings restatement and the resignations of Fannie's CEO and CFO.)
"It seemed, and still seems, that I could be of value on this board, and that while it would be a time-consuming exercise, it wouldn't involve an undue amount of personal liability," she says. Besides, she adds, "I find tricky issues intriguing."
Paradoxically, rules meant to promote good corporate governance are in some respects making it harder to achieve. It's more important than ever for companies to have qualified independent directors as a check against management abuses -- indeed, Sarbanes-Oxley mandates that a majority of directors be independent -- yet even squeaky-clean organizations are finding it extraordinarily difficult to attract board members.
"We are in the midst of the perfect storm," says Robert Rollo, a Los Angelesbased vice chairman of recruiting firm Highland Partners. "Recruiting directors has become exponentially more difficult that it was three or four years ago. Candidates are much, much more careful about the decisions and commitments they make, and companies are finding it hard to find people that meet all the requirements they set."
Thus companies are altering their recruiting tactics and redefining what makes an attractive board candidate. Outside CEOs are out. Academics, consultants and midlevel operating executives -- particularly women and minorities, who have always been underrepresented on boards -- are in. But even these candidates need a lot of persuading.
At stake may be nothing less than the future of good corporate governance. If companies succeed in finding and luring independent-minded directors, many boards will be transformed from old boys' clubs into duly constituted minilegislatures representing an often neglected constituency: shareholders. Boards are already asserting a new authority: Boeing Co.'s board recently ousted CEO Harry Stonecipher for allegedly having an affair with another Boeing executive; Walt Disney Co. is easing out CEO Michael Eisner over erratic performance; and insurer American International Group saw off longtime CEO Maurice (Hank) Greenberg amid investigations into nontraditional insurance transactions that authorities believe may have been improperly used to gussy up the company's finances.
RARELY HAS SO MUCH SCRUTINY BEEN APPLIED TO the boardroom, which long conjured up images of bigwigs puffing on cigars and collegially charting the course of corporate America. Enron and its ilk changed all that. Reformers asserted that CEOs and their minions were able to get away with gigantic frauds in part because they packed their boards with golfing buddies, business partners and other cronies. Although many of these directors were flat-out lied to, they also could have been more persistent about challenging aggressive accounting interpretations or financial results that seemed too good to be true.
Sarbanes-Oxley requires that the majority of a public company's board be made up of independent directors who have no material relationship with senior executives and that every board have a "financial expert" leading its audit committee. Investors, too, are paying greater attention to the quality of corporate governance, often including ratings issued by the likes of Standard & Poor's and GovernanceMetrics International among the criteria they consider when deciding whether to buy or sell a given stock.
"No board can afford to carry a passive director these days," says Roger Raber, president and CEO of the National Association of Corporate Directors. "Nominating committees have to focus on the soft issues: whether the candidate is someone who is going to challenge management, think critically, work hard and still be able to work well with his or her fellow directors."
Despite the great need for qualified directors, and their importance to restoring public faith in the corporate world, more and more talented candidates are saying no when companies come calling. One big deterrent is the heightened personal liability that public-company directors now face.
In January former independent directors of Enron and WorldCom dug deep into their own pockets as part of back-to-back settlements between the companies and a collection of public pension plans that sued to recover losses related to the alleged accounting frauds. Without admitting or denying guilt, the directors, whom the pension funds accused of being complicit in the deception, agreed to pay $33 million of the $222 million total of the settlements. In the case of the WorldCom directors, the $20 million they paid to resolve the claims amounted to a cool 20 percent of their personal net worth, excluding retirement assets and homes, according to the office of Alan Hevesi, New York State comptroller and trustee of the New York State Common Retirement Fund, the lead plaintiff in the case.
Another major stumbling block to luring directors: Their workload has exploded. Recruiter Rollo calculates that sitting on a board requires a minimum commitment of 250 hours per year, up from 150 hours before Sarbanes-Oxley. Someone serving on an audit committee, or on a board dealing with a crisis, could easily see that figure double. The new regulations spell out in greater detail the specific responsibilities of directors, particularly those on audit committees. More subjects need to be aired, so more meetings must be held, and they tend to run longer. And preparation time has increased accordingly.
Consequently, few candidates are willing to consider more than one or two board assignments, whereas in the past directors often juggled three, four or more. That means that companies collectively have to recruit a greater number of directors to fill the same number of seats.
Consider former Sears, Roebuck & Co. treasurer Alice Peterson, who has been approached by six companies with director openings since last summer, when she stepped down from the board of packaging concern Fleming Cos. following its emergence from bankruptcy protection. She has turned down four of them, and despite seriously considering the remaining two, she is concerned about taking on too much work -- and liability. That wasn't as big a worry when she joined the Fleming board in 1998. Being a director, she says, "is a big job, not the kind of de minimis thing that people considered it to be in yesteryear."
The increased time commitment also has struck at what has been a highly coveted source of directors: CEOs of other companies. Forced to choose between serving their own companies' shareholders and those of other firms, many are declining offers to join new boards and stepping down from those on which they sit. MCI has taken the decision into its own hands by barring chief executive Michael Capellas from sitting on outside boards, something he did frequently as CEO of Compaq Computer Corp. before its acquisition by Hewlett-Packard Co. in 2002.
Finding a director "is becoming more like an executive search, where you hunt hard in all kinds of places and then you have to court someone and try to persuade them that they are interested in taking on this commitment," says Robert Mattson Jr., a partner at San Francisco law firm Morrison & Foerster who advises companies and potential directors on legal issues surrounding board service. "It's a much more uncertain and time-consuming process than I have ever seen it before."
SO WHAT'S A COMPANY TO DO? PERHAPS THE MOST important adjustment needed to cope in this new environment is to reassess fundamentally the notion of the ideal director. Getting creative, while forgetting about the big-name CEOs, is critical. But relying on the old-boy network is a tough habit to break. Until very recently, outside CEOs were seen as ideal candidates, largely because corporate chiefs viewed them as peers. Rarely did senior executives feel comfortable opening themselves up to grilling from lower-ranked officers of different companies, for example.
There have been other limits on the candidate pool. Retired executives often were viewed as too far removed from the front lines of competition, headhunters say. And directors with experience, naturally, have been preferred over boardroom rookies, who have a higher learning curve and thus eat up more company resources.
"The pool of talent is actually deeper than it appears, because people have had such a narrow view of who was in that pool," says Stephen Mader, the Boston-based CEO of executive search firm Christian & Timbers. That perception started to change, he says, when Edward Breen was tapped as chairman of Tyco International more than two years ago and began to rebuild the company's board. "In the first round of recruiting, he took only one CEO, and everyone else was another experienced executive but without that CEO credential," says Mader. Among the seasoned operating executives now serving on Tyco's board are Bruce Gordon, president of retail markets at Verizon Communications, and Sandra Wijnberg, chief financial officer of Marsh & McLennan Cos. Mader notes that Breen "knew he needed effective directors who had the time to devote to the job more than he needed experience or prestige."
Indeed, more companies are seeking directors with relevant operating expertise instead of blindly chasing the CEO pedigree. Specifically, while searching for financial experts, many companies have also started to consider what other skills have been missing from their boards. Some have pursued candidates who have specialized retailing expertise or have overseen foreign manufacturing operations. In time, recruiters expect a wave of interest in senior human resources officers, who would be able to contribute to discussions about compensation -- an increasingly controversial topic -- and to board-level searches for senior executives.
As companies pursue such nontraditional candidates, they're increasingly willing to discount the experience factor. Among the growing ranks of executives willing to accept first-time directors is Jeffrey Rodek, executive chairman and former CEO of Hyperion Solutions Corp., a Santa Clara, Californiabased business software company, who says rookies can make up in talent and energy what they lack in experience. "It just isn't helpful to have arbitrary rules saying that unless they have been a CEO or on a board already, this person isn't a good candidate," he asserts.
Finding the right candidate, unfortunately, is only part of the battle. The real challenge lies in persuading a prospective director that the experience will be worth all the time, effort and potential legal headaches involved.
An increasingly popular tool for both locating and wooing prospective directors is the headhunter. The NACD calculates that 43 percent of all successful public-company board member searches last year were done through recruiters, up from just 15 percent in 2001. Highland Partners' Rollo, for example, recently helped find three new directors for retailing giant Safeway: Janet Grove, the CEO of Federated Merchandising Group and vice chairwoman of Federated Department Stores; Mohan Gyani, the retired former CEO of AT&T Wireless Mobility Services; and Raymond Viault, a retired vice chairman of General Mills.
ExSears treasurer Peterson has noticed the change. When she was approached for her first board seat, in 1996, at 360 Communications Co., CEO Dennis Foster made the call. "He told me, 'I've heard from three or four bankers that you're smart and would make a good board member,'" she recalls. These days, she says, that approach is much more likely to come from a headhunter or from the nominating committee of the board. "I think I'm on some kind of recruiter hot list," Peterson quips.
Hyperion's Rodek began using an executive search firm in 2002, when he recruited John Riccitiello, thenchief operating officer of Electronic Arts and now a private equity investor, to his board. A headhunter also led Rodek to Terry Carlitz, who joined Hyperion's board in 2003 after stepping down as chief financial officer of Saba Software. Carlitz, who served on Saba's board and has held key operating positions at such technology companies as Apple Computer, wasn't interested in another senior executive job, but she was contemplating a new career -- as a professional director. Rodek concedes that he probably wouldn't have found her using the old, tried-and-true recruiting methods.
"I decided that turning to a recruiter would get independence in fact and, just as important these days, in appearance," he explains. "And it would help us discover talented people who weren't already in our network."
As the amount and intensity of the due diligence that prospective directors must perform grow exponentially, companies find they must be as open as possible with candidates. Before joining Hyperion's board Carlitz conducted a host of one-on-one interviews with directors and executives, requested and pored over reams of documents and had her own attorney review details of the directors' and officers' insurance policy that Hyperion offered. Although she was already familiar with the company's business -- while at Apple in the late 1980s, she tested one of Hyperion's early products -- Carlitz wanted to ensure that she felt comfortable with its operational outlook, financial reporting, governance and culture.
"I really insist on meeting or having a conference call with every board member and every senior executive who will interact with or report to the board," says Carlitz, who is also a director of two other companies, Advent Software and Photon Dynamics, which provides test and inspection systems for makers of flat-panel video displays. "The first clue I get is whether the company encourages its executives to talk openly to the board members." Carlitz says that some companies that have approached her about taking a board seat made available only a "select subset" of people for interviews while declining access to others. That's a big red flag. "Anything less than full disclosure is a nonstarter," she says.
Charles King, head of the global board services practice at recruiter Korn/Ferry International, recalls one example of extreme due diligence he encountered while searching for a director to serve on the audit committee of a large-cap company. A candidate insisted not only on reviewing financial statements and talking with senior executives and directors but also on meeting with the company's internal and outside auditors and reviewing audit committee meeting minutes for the previous two years. The company obliged, and after scrutinizing the documents, the candidate accepted the position. (King declines to identify the company because of client-confidentiality issues.)
"The perceived risks of sitting on boards are much higher, so companies just have to put up with this," King says. "Nothing will kill the process more quickly than a company that gives the appearance of withholding information."
Not surprisingly, board candidates are also more discriminating about directors' and officers' insurance, which generally indemnifies people serving in those roles against damages awarded in lawsuits against the corporation. In the current climate adequate D&O coverage is nonnegotiable. And the particulars of policies -- just how much is considered "adequate" -- can be a bone of contention. That's especially true as both insurance companies and corporations, mindful of the recent scandals, are gravitating toward policies with more exclusions and getting tougher in interpreting the wording of those policies.
For instance, insurers typically limit their liability in cases where someone has been determined to be guilty of malfeasance or fraud "in fact." More and more, insurers are either inserting new language defining "in fact" in very broad terms or simply choosing to interpret the phrase that way -- for example, when an e-mail is uncovered that seems to signal that an executive or director is acknowledging wrongdoing. Companies and board members are battling back by insisting on language that defines "in fact" more narrowly, such as a court or regulatory decision.
The issue of an underwriter's ability to rescind coverage is a particularly hot potato. An insurer may argue, for example, that a company supplied fraudulent financial data when applying for coverage and withdraw the coverage on the grounds that the policy would have been denied had the insurer known the truth. Clauses may be written into policies that provide for directors and officers who were not involved in the fraud to retain their coverage in such cases. These "severability" clauses are increasingly in demand.
"In the past, board candidates just asked about the amount of coverage," says Keith Crow, a partner at law firm Kirkland & Ellis in Chicago. "Now they need to know more details."
Also growing in popularity among directors is so-called side-A coverage, which treats independent board members separately from inside directors and other company officers. Such policies can help address conflicts of interest between shareholders and management. And independent directors are negotiating other specialized coverage, including provisions protecting innocent directors or officers from being held liable for the misrepresentations of others.
Providing all this D&O coverage, recruiters and company executives agree, will probably continue to cost companies more in premiums. Law firm Foley & Lardner concluded in a study issued last summer that public companies with less than $1 billion in revenue paid about $329,000 for D&O insurance in 2001, $639,000 in 2002 and $850,000 in 2003. A survey of 2,455 companies by the Tillinghast unit of consulting firm Towers Perrin, however, shows that D&O premiums rose about 30 percent per year from 2001 to 2003 but fell 10 percent in 2004 as insurers upped their capacity in response to mounting demand.
Although providing D&O coverage is a must, one increasingly popular option for making directors -- particularly first-timers -- more comfortable with the job is to offer them access to educational programs or seminars. These are sprouting up nationwide and can involve anything from a daylong orientation on the basics of being a director to crash courses in specific businesses to several days at Ivy League business schools.
Mary Ann Jorgenson, a Cleveland-based partner for law firm Squire, Sanders & Dempsey, recently advised a client about joining the board of a big consumer products company. "Finally, he said he would only join if he had a tour of all the operations first, so he could understand how they worked," she says. The CEO, who hadn't visited all the sites himself, not only agreed but decided to go along. Says Jorgenson, "The guy joined the board."
Even Leslie Rahl, who brought a wealth of risk management expertise to Fannie Mae, benefited from some tutoring in the ways of the boardroom. The mortgage giant agreed to foot a $6,250 bill for her to attend a three-day Harvard seminar to learn more about how to be an effective director. "For someone who is used to digging deep into issues and problems, it is a challenge to step back and understand that a director's role is to ask questions, not necessarily to have all the answers themselves," Rahl says. "That's one of the things that the course helped me understand."
Compensation also is a lure. Directors' pay has soared by at least 50 percent in the past five years, estimates Highland's Rollo. Cash compensation can easily reach $150,000 at the biggest companies, with options or restricted stock potentially doubling that sum, he says. Even a company with less than $2 billion in sales should be prepared to pay directors more than $50,000 in cash and an equivalent amount in stock-based compensation.
IT MAY BE COLD COMFORT FOR COMPANIES THAT are struggling to cope with a shortage of qualified directors, but corporate governance is likely to emerge much stronger from this painful transformation. Consider that many companies have been able to extract value from the time-consuming, expensive process of complying with other aspects of Sarbanes-Oxley. The internal-controls certification mandated under the law's dreaded Section 404, for example, has cost untold millions to implement but also has provided some corporations with an opportunity to reexamine and improve on long-standing business practices. Similarly, many of those involved in the battle to assemble boards in a post-Enron world argue that all the headaches will be worth it because boards will become stronger, more diverse and better structured.
"Boards are being forced to get out of the rut they have been in for decades," says Rollo. Historically, companies have made an effort to lure nontraditional candidates only when trying to boost diversity by hiring women and minorities. Now their goal is improving governance and pleasing shareholders.
Even the reluctance of qualified candidates to join more than one or two boards may ultimately be a plus. "If you can just persuade that person, they are yours and nearly all yours," notes Hyperion's Rodek. "They aren't going to let much else distract them from being a great board member for you."
Moreover, the good news behind candidates' taking so much time to evaluate the risks and make up their minds is that those who do make the commitment will take it seriously. When those people also happen to possess expertise that's relevant to the company, that devotion becomes all the more valuable.
Consider Rahl and Fannie Mae. Who better to serve on the mortgage lender's board at a time when its capital markets and risk management practices are coming under harsh scrutiny than an expert in those fields? "Clearly, I had no idea of the full magnitude of the events that would unfold," Rahl says today, referring to the accounting controversy that since December has prompted the resignations of CFO Timothy Howard and CEO Franklin Raines, a restatement of earnings back to 2001 that is still under way and the conclusion by regulators that Fannie Mae is undercapitalized to the tune of $3 billion. Still, she doesn't regret her decision to join the board, even though her workload has expanded to include serving on a new compliance committee charged with helping to clean up the company's accounting.
"If you are careful and cautious, you can afford to take the risk of being a director without its being viewed as a reckless activity," says Carlitz, the former tech executive who recently joined Hyperion's board. "It seemed serendipitous to me that my background and availability to take on these roles corresponded so closely with a growing need on the part of companies for people like me."
