Commentary: Turn Up the Heat on Board Cronyism, Mr. Grasso

It took the collapse of Enron Corp. and the ensuing scandal to make it happen, but outside directors are hot. Korn/Ferry International, the Los Angeles-based executive recruiter, reports that searches for corporate board candidates are up by more than 30% over last year--and no one wants lapdogs. "Clients say, `Get us some independent thinkers,"' says Peter D. Crist, head of Korn/Ferry's global board practice.

The two biggest stock exchanges echo those sentiments. Enron "is a wake-up call that the independent director doesn't serve for the protection of management," New York Stock Exchange Chief Executive Dick Grasso said at a press conference on Apr. 9. Under pressure from the Securities & Exchange Commission, the NYSE and the Nasdaq Stock Market are considering new rules that will give outside directors more crucial roles at the companies that list shares on their markets. But those changes won't count for much unless the two tighten up their lax rules for defining independence.

The exchanges clearly believe that independent directors are key to making boards the first line of defense against short-term thinking and self-dealing schemes by management. The NYSE, for example, may require listed companies to allow only independent directors on the board's nominating and compensation committees, as is now the rule for audit panels. SEC Chairman Harvey L. Pitt wants the exchanges to put the audit committee, not management, in charge of hiring and firing a company's auditors.

But under the exchange's rules, outside directors may not be independent enough to merit the trust implicit in the new suggestions. The NYSE allows former employees to be counted as outside directors just three years after they leave the company. It also lets outside directors enjoy financial ties to management through consulting contracts, professional engagements, and supplier relationships. Nasdaq's rules are similar, although it puts dollar caps on directors' dealing with the company.

How much tighter should the rules be? Former employees shouldn't count as outside directors: Their loyalties inevitably run inside the company, not to shareholders. And directors who do any consulting, legal, or similar work for the company aren't truly independent, either--even if the work is done by their firm, and not them individually. By these stricter standards, 30% of audit committees, 27% of compensation panels, and 53% of nominating committees aren't fully independent, according to the Investor Responsibility Research Center, a Washington-based shareholder group.

Nasdaq is also looking at whether contributions--like Enron's hefty gifts to academic centers where some directors worked--impair independence. The answer: Yes, they do.

An independent director should have just one financial tie to the company he or she oversees: payment for board service. That should be made in stock, to tie directors to a company's long-term prosperity. Indeed, directors should not get stock options, which create an incentive to juice the stock price in the short run as they prepare to cash in options. And they should generally be barred from selling stock during their tenure. "You want the directors to be thinking like long-term investors," says Kenneth A. Bertsch, director of corporate governance for mutual fund TIAA-CREF in New York.

Once directors are truly independent, they must be empowered. On most boards, outside directors seldom meet alone, without management. The exchanges should require such meetings regularly.

Grasso says it's "obvious" that rules on directors' financial ties need tightening. But he's not so sure about barring former employees from outsiders' seats. A Nasdaq official says independence rules are under study.

Pitt turned to the exchanges as the best place to institute changes in board powers. If he wants reforms to work, he'll lean heavily on the markets to require true independence.

By Mike McNamee

With Nanette Byrnes and Louis Lavelle in New York

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