orporate governance is a buzzword on the lips of commentators, investors, analysts, and government officials. In light of the failures of publicly held companies such as Enron and Global Crossing, and the uncovering of executive shenanigans at Tyco and Adelphia Communications, people are rightly questioning how rogue or unsupervised executives ran their companies into the ground. After all, the boards of directors – groups of well-compensated, well-regarded experts and business leaders themselves – were supposed to exercise oversight over executives’ activities, ratify business decisions, and generally represent the interests of the true owners of the company: shareholders.

The reaction to the breakdown in corporate governance at some of America’s largest firms is now playing out. Civil and criminal penalties await some now-disgraced executives, and lawsuits are piling up against boards. Meanwhile, groups like the New York Stock Exchange (NYSE), the National Association of Securities Dealers (NASD), the Securities and Exchange Commission (SEC), and several other groups and individuals are putting forth recommendations to set new standards for good corporate governance.

These recommendations focus primarily on mechanics and process. At issue are topics such as board independence, the leadership of the board, audit committees, and shareholder approval of equity-based pay plans. Improving performance in these areas can be an important component of restoring the shattered trust of many investors. But an examination and evaluation of some of the proposals on the table shows that there is more to good corporate governance than simply rules and standards.

Declaration of Independence

The independence of directors – individually and collectively – from the company and management is one of the fundamental pillars of good governance. Not only should directors be independent in fact – i.e. they should not work for a company or its affiliates – they should also avoid any situation that can damage the perception of their independence. Individual independence means being free of any ties to the company, especially financial ties. (Many directors held up by companies as “independent” actually perform consulting or legal work for the company.) But the definition of independence could also include the absence of other factors such as personal relationships that might cloud independent thought and action. For example, directors who run charities that receive large donations from companies and their executives, or who are related by marriage to an executive, or who are old college friends of the chief executive officer may not be truly independent.

Today, the expectation is that a majority of the board will be composed of outside, independent directors, and that not more than one or two insiders will serve on the board. Indeed, this stipulation was one of the components of the NYSE’s recent proposals on corporate governance. Within the board, there are three key committees that are expected to be composed solely of outside directors: the audit, compensation, and governance committees.

Another characteristic of board independence is that committees and the full board should be free to hire outside experts to support their deliberations. In addition, there have been calls for directors to meet in executive session – i.e. without any member of management present – at each meeting. The impetus behind all the proposals to have truly independent boards is to structurally shift power away from management and to the board, to ensure that the board is supervising management, and not the other way around.

ne way to ensure separation, some critics argue, is to separate the two positions of chief executive officer and chairman of the board. (At many companies, the same person serves both functions.) Having a non-executive chairman on the board is more along the lines of the European governance structure. Doing so would allow someone who is not a member of management to lead the board. Another possibility would be to nominate a lead director who plays some of the role of the chairman, especially in regard to setting the board agenda, chairing executive sessions, and possibly stepping into the breach in time of crisis.

The Audit Committee

The spotlight on the audit committee is hardly surprising given the spectacular demises through bankruptcy or seriously damaged corporate and personal reputations that have resulted from the “engineering” of income statements and balance sheets, and questionable financial arrangement with senior executives. But the issues that critics now want audit committees to focus on go beyond technical compliance.

The first issue is “transparency,” the ability to understand readily the nature and health of the business from the financial statements and accompanying notes and discussion. Secondly, there are the issues of the management of risk and credibility. The greatest concerns tend to focus on aggressive revenue recognition practices and off-balance sheet items that may mask an underlying financial weakness.

“The impetus behind all the proposals to have truly independent boards is to structurally shift power away from management and to the board, to ensure that the board is supervising management, and not the other way around.”

The recommendations for audit committees primarily concern the selection and management of the outside audit firm. The NYSE, for example, has proposed that the audit committee have the sole authority to select the outside auditor. Some more moderate proposals call for the chief financial officer to remain involved, while other positions favor a full partnership between the committee and management. There have also been calls for the audit committee to meet with the auditor quarterly in executive session.

s with the board, the issue of auditor independence from management is front and center, along with the elimination of any potential conflicts of interest. To that end, many critics – including former Securities and Exchange Commission Chairman Arthur Levitt – have called for auditing firms to be barred from providing consulting services to the companies that they audit. Others have called for prohibiting accounting firms from undertaking systems development contracts. In addition, the practice of auditing firms accepting internal auditing roles at firms for whom they conduct external audits has also been appropriately called into question. Other measures under discussion are designed to ensure that the auditing firm cannot become too close to management by requiring a mandatory rotation of the audit responsibility among firms after a defined period, or by having a formally established external body review and monitor the work of auditors.

The Compensation Committee

Executive pay plans, especially the use of stock grants and options, are thought to be one of the root causes of short-term myopia and financial legerdemain. To bring the use of equity-based compensation under control, the NYSE has proposed that shareholders approve equity-based compensation plans, and to limit insider stock sales and improve the speed of reporting of those sales. Others have called for companies to treat such compensation as an expense on their balance sheets. Linked with this, and also to the view that management frequently ignores shareholder proposals, is a recommendation that brokers may not vote their customers’ shares in a bloc unless they have each customer’s explicit permission.

Of course, most of these recommendations are already recognized as the hallmarks of at least the skeletal framework of good governance, and are practiced by many boards. Many large and not-so-large companies have implemented these practices and live them. What is missing from much of the current dialogue is the flesh on the bones of that skeleton that truly makes boards strong advocates for the shareholder.

Flesh and Bones

At the heart of good governance are the character and competence of the directors, the way the directors work as a board, and the board’s partnership with management. Openness and trust among the board and with management provide the underpinning. Most boards already know that they, not management, have the power and that they can and should exercise it as required to ensure that shareholders receive a good return on their investment. And most directors realize that effective governance is not about structure and process, but about character, courage, and competence – qualities that rules and regulations cannot legislate.

The question then becomes how directors can and should fulfill their responsibilities as fiduciaries for the shareholders. Each director has to accept ownership for her knowledge of the business, although not without management’s ongoing assistance. Effective directing requires that each director understand the key drivers of value in the business, along with the company’s competitive position and the areas of significant risk. Armed with that understanding, directors are equipped to provide the constructive challenge that will fortify the strategy and help with the oversight of its implementation.

Each director must have an untarnished reputation for unassailable integrity, along with an area of competence that can help the board and management in decision-making. The courage to resist “group-think,” to ask tough questions, to take a lone position, and to require outside experts and advisors to the board, as needed, is also a prerequisite. And yes, all directors should be squeaky clean, in fact and in perception, when it comes to their independence.

Selecting the leadership of the company is where integrity and trust begins. The chairman of the board must set the tone with clearly stated expectations for uncompromising integrity. The chairman has to “walk the talk” and must be forceful in communications to the organization. Management must have in place a comprehensive set of policies and programs that reach every employee to reinforce the requirement for ethical behavior. And those policies and programs, and the results, should be shared with the board at least annually.

emarkably, in the discussions of corporate governance since the Enron and Global Crossing implosions, while much has been said about the use of stock grants and options in the compensation of executives, there has been relatively little said about the compensation committee’s role in providing appropriate rewards and incentives for performance. The critical task is to ensure that the compensation of senior executives is firmly linked to the key deliverables for successful implementation of the strategy, to the company’s competitive position, and to the sustained growth of shareholder value. Stock grants and options may well be a key component of the compensation plan and certainly link management to shareholder objectives. (This stock link to shareholder objectives is also essential for the directors.)

“What is missing from much of the current dialogue is the flesh on the bones of that skeleton that truly makes boards strong advocates for the shareholder.”

Every member of the board, not just the audit committee, should know the major accounting practices of the company and ensure that the positions being taken adequately reflect the nature of the business and its inherent risks. The board has to be unrelenting in ensuring that the management is focused on the quality of the earnings in all its work, undiminished by its accounting practices. Technical adherence and accuracy may well not be the total equation. With the audit committee taking the lead, the board and the outside auditors have to ensure that the financial reporting for the outside world is clear and accurately represents the performance of the company in a way that can be easily understood, but without revealing too much to the competition. And it must recognize that more complex businesses might require that the users of the reports may need more than a passing knowledge of the areas important to the success of the company.

Crisis management must also be on the board agenda. Internal and external risks that threaten the corporation have to be anticipated. Despite all prevention, a crisis can still occur without warning. So plans for dealing with crises of different kinds have to be laid out. The health of the enterprise, its employees, and its community is paramount. The board role is to ensure that management has adequate plans in place.

A strong board will be composed of truly independent outsiders, with one or, at the most, two insiders. It will work in a constructive partnership with management, but will be decisive if management fails in any of its commitments. Its directors will be compensated primarily in stock and with the addition of their individual stock purchases, will be linked, along with management, to all shareholder objectives. The board will not approve the application of the firm’s resources to financial arrangements for senior executives that are clearly in the executives’ interest rather than that of the shareholders. Finally, a strong board will conduct a periodic evaluation of its performance from the encompassing perspective of sustained enhancement of shareholder value.

o many boards already fulfill all of these responsibilities, and more. And the investing public and oversight institutions have to be wary of expecting that imposing corporate governance rules and regulations will be a panacea for preventing greed, unethical behavior, and criminal acts. Executives with those bents are a distinct minority, and they may well work their way around any prohibition. As we all know so well, behavior cannot be legislated, and an overreaction to the absence in those few of a moral compass lacking a true north would be misguided.

American boards have set the standards in corporate governance best practice and over the past two decades have continued to raise the bar. Without question, all directors have had forceful recent reminders of the nature of their roles and responsibilities and many boards, in response, have done more than a superficial assessment of how they are working. These reminders may well provide the impetus to have the boards who have yet to do so adopt those best practices. The challenge is to keep a watchful eye open for further substantive opportunities for raising the bar again.

PATRICIA BARRON is clinical associate professor of information systems, entrepreneurship, and innovation at NYU Stern.