Crashing the Boards

By Jyoti Thottam

When hotel giant Marriott International needed a new board member last year, it nominated investment banker George Munoz, 51, an amiable, meticulous Texan who runs a private investment firm in Washington. It isn't hard to see why Munoz got the nod: he went to the right school (Harvard Law, class of '78), he knows the right people (Marriott CEO Bill Marriott is a friend), and he has managed multibillion-dollar portfolios. But Munoz doesn't simply fit the profile of the traditional corporate director: he's an expert on Latin America, where Marriott hopes to expand aggressively, and he's a CPA who can truly read a financial statement--what's on the lines and what's between them.

Balance sheet? CPA? Regional expert? Since when do such things really matter in the boardroom? Since Enron and Tyco and WorldCom. Munoz is one of a new breed of director that just might change corporate governance permanently and for the better. The corporate scandals of the past few years have inspired a flurry of strict new government and industry rules on board composition and responsibility. These rules could do much to dismantle the old-boy, do-little director network--in other words, to make directors work for their money.

This has not been welcome news for many of the old boys (or girls) or for many of the executives who had hoped to succeed them in sinecures. Paul Lapides, director of the Corporate Governance Center at Kennesaw State University in Atlanta, estimates that 15% of sitting directors of U.S. public companies will give up their seats over the next 18 months--triple the usual rate of turnover. Recruiting firms say the number of director searches they have been asked to conduct has already shot up--20% to 50% over the number a year ago--and that several hundred director seats will be added in the next two years by S&P 500 companies alone. Despite all the talk of no one wanting to be a director these days, "none of those seats will go empty," says Sarah Teslik, executive director of the Council of Institutional Investors, an association of pension funds. "It is still the most sought-after job in America. You're playing with the big boys."

But now the job will include demands and risks that many candidates among the ranks of traditional recruits--current and retired top executives, say--aren't willing to accept. Congress, the New York Stock Exchange and NASDAQ all answered calls for reform last year with their respective rule changes. The most substantial changes involve audit committees and outside directors (those without significant financial or family relationships to a company). To help avoid an Enron-like scenario, in which an audit committee doesn't adequately vet auditors' reports, the chairman of that committee must be a financial expert: either a CFO of a public company or someone who has audited one. Three powerful board committees--audit, compensation and nominating (which finds new directors and senior managers)--must now be made up entirely of outside directors. And even the definition of outside has changed: recent employees are barred.

Most corporate boards will not be able to meet these new standards without shuffling or adding directors. IBM, for instance, may have to replace American Express CEO Kenneth Chenault as a member of its compensation committee because AmEx is a $4 billion customer of IBM's.

So who will fill the void? There is "a huge reluctance from the traditional pool of candidates," especially current CEOs of public companies, says Julie Daum, head of the U.S. board practice at executive-search firm Spencer Stuart. While board members will not be held personally liable for corporate misdeeds, litigation targeting directors (and the embarrassing publicity it brings) is a growing possibility as shareholders and their lawyers test the breadth of the new rules. Many companies are being forced to widen their searches for directors. This means reaching out to people who have never before served on a board, executives below CEO level, and specialists (in finance, technology, cross-border trade) instead of generalists.

This is a massive shift and an opportunity to create the kind of engaged, critical and creative board that every company should have had in the first place. Search firms are aggressively steering nominating committees into new territory. Peter Crist, vice chairman of Korn/Ferry International, goes so far as to call the prototypical director, the distinguished elder statesman sitting on four or five boards, "an anachronism." The new ideal, Crist says, is a CFO 45 to 50 years old and very often a first-time director.

In reaching beyond CEOs, who are overwhelmingly white and male, boards are tapping a rich new source of talent. "This is going to be the largest short-term opportunity we've seen," says Carl Brooks, president of the Executive Leadership Council, an organization of African-American businessmen. Of its 283 members, all of whom serve within three levels of the CEO position at their companies, only one-quarter serve on a board. But after years of only spotty interest from boards and recruiters, the organization now gets inquiries every week. Similarly, 16% of corporate officers of the 500 largest public companies in the U.S. are women, but women account for only 12% of those companies' board members, according to Catalyst, an advocacy group for women in business. "It's perfectly clear that there is a pool of people there to tap," says Sheila Wellington, Catalyst's president. And in finance, that pool is only getting deeper, with women making up the majority of new graduates in accounting.

But will more diverse boards necessarily perform better? They should, because homogeneity among directors often leads to a boardroom culture that "avoids conflict, avoids impoliteness and as a result does not permit hard questioning," says Rakesh Khurana, a professor at Harvard Business School who studies CEO behavior.

Anna Cabral, president of the Hispanic Association on Corporate Responsibility, in Washington, argues that board performance will improve as long as minority recruiting is part of a larger move to choose directors based on skills rather than title. Before last year, Cabral says, she got perhaps one phone call a month from someone looking for a Hispanic director, and the wish was almost always for a well-known figure with board experience at a marquee company. Now the calls come every week, and the primary desire is for expertise in, say, finance or marketing.

"Increasingly, it is the expertise that's sought," says Ira Hall, a former treasurer of Texaco who recently joined the board of Reynolds & Reynolds, a software company serving the automotive-retail industry. "All the better if it's a black person or a woman."

The flip side: many CEOs in particular are not disposed to listen to someone they don't consider a peer. "There's still a pecking order in the boardroom," says the Council of Institutional Investors' Teslik. It will be up to new directors to breach that barrier. Munoz, for his part, says he would not join any board that seemed resistant to change. "It's not that difficult to tell whether someone is sincere about wanting to include you in the decision-making process," he says.

Even the most welcome new directors are wary of the liabilities they may face under corporate-governance reforms. "The real problem with the old system is that it was relatively easy to pass the buck," says Krishna Palepu, a professor at Harvard Business School who has studied the functioning of audit committees. "Now that's much more difficult." Hall says he would decline to serve as any board's financial expert (a new rule requires audit committees to disclose whether they have one), despite his years in investment banking and corporate finance. "That's an invitation to a lawsuit," he says. In fact, some insurers are scaling back their coverage of directors to limit their own exposure to lawsuits.

The perception of risk is greatest at technology companies. It was far easier to recruit outside directors before the tech-sector collapse, "when there was a huge upside in the stock," says Bobbie Kilberg, president of the Northern Virginia Technology Council, a regional trade group of 1,600 tech firms. These days, potential directors are less willing to sit on the board of any company whose product or service they don't understand. Kilberg says she recently agreed to join a local bank's board but turned down a small software firm. "It just wasn't worth it," she says. Robert Edwards, CFO of Imation, a maker of magnetic and optical data-storage discs based in Oakdale, Minn., joined the board of glass manufacturer Apogee Enterprises in October. It is his first stint on the board of a company other than his own, and he says, "One of the key requirements for me was, Do I understand the business that they're involved in?"

Palepu says he is optimistic that as companies are forced to find financial experts for their audit committees, they will also start to think more carefully and creatively about all their board seats. Instead of fixating on CEOs, they will tap the likes of venture capitalists, retired partners in accounting firms and retired investment bankers. Rising pay will help generate interest. Until recently, outside directors of publicly traded companies typically received $45,000 to $150,000 a year in cash and stock, based largely on the size of the company and the number of committees a director joined. As directors take on more responsibility, pay is increasing as much as 20%--and more for the chair of an audit committee.

If that seems excessive, keep in mind that part of the new, hoped-for culture of the boardroom will be that directors will no longer sit on more boards than they can serve well. Companies won't stand for it, and if most board members finally do earn their pay, investors, too, will be well rewarded.