(FORTUNE Magazine) – In Fort Lauderdale, a struggling public company facing stiff competition was racking up big losses. Its shares had fallen by more than half, from a high near $40. In September 1998 the company's board, packed with directors who have business dealings with the company, decided to act: It repriced 230,000 options it had granted to officers and directors just three months earlier. The move--which cut the strike price from about $29.50 to just over $14 a share--handed top managers and directors a $3.5 million windfall.

No, this isn't a tale from the hoary old world of corporate governance. It took place at an Internet company called SportsLine.com, which operates the CBS SportsLine Website. Chairman and CEO Mike Levy (whose own options weren't repriced) says the board took the step because it was worried about management defections but "wouldn't do it again." SportsLine's volatile shares hit $83 late last year and, at a recent close of $42, are still well above the options' original strike price.

Internet CEOs speak constantly about creating new value by breaking old rules. That makes sense--as long as the rules are obsolete. But some old rules--painful lessons handed down from brick-and-mortar companies that hit a wall--have never been more apt than they are today; dot-coms ignore them at their peril.

The differences between dot-com boards and traditional ones are striking. Consider a recent study of 39 Internet companies by the Investor Responsibility Research Center, a nonprofit corporate-governance group. It found that dot-coms' boards are far smaller than those of typical S&P 500 companies (7.3 directors, vs. 11.9), have a smaller percentage of independent directors (about half, vs. two-thirds), and average only two or three directors on their audit and compensation committees. (What's more, only 23.1% of the surveyed dot-coms have at least one female director--less than a third the S&P 500 figure.)

Many dot-com executives view such traditional good-governance considerations as irrelevant. Internet consulting firm Razorfish, for example, has an eight-member board consisting of five company insiders and three outside directors. While he says he's seeking more independent directors, CEO Jeff Dachis, 32, defends management directors as highly motivated to maximize shareholder value. "My partner and I control 10% of the company," he notes. "What's good for me is good for all the shareholders." Dachis says dot-coms need small boards that can move fast--and must select their directors carefully. "We want aggressive, bright people who 'get it' on our board, not representatives of corporate America who are interested in protecting the status quo."

Without a doubt, dot-com prosperity helps fuel such attitudes. Asked about the need for outside directors to intervene should management screw up, Dachis responds, "Management isn't screwing up. We've created enormous shareholder value." He notes that Razorfish shares trade at four times their April 1999 IPO price.

Joe Grundfest, a former SEC commissioner and Stanford law professor who runs the university's training seminars for corporate directors, is also reassured by the dot-coms' track record--no matter how brief. "Who's complaining?" he asks. "All things being equal, an outside board is not a bad idea. But I'd rather have a bunch of smart, honest insiders than sleepy, stupid outsiders. Things are going swimmingly--you have to be careful not to overgeneralize. The largest fraud problems in the market are not at dot-coms."

Not yet, anyway. Shareholder activists see such attitudes as a prescription for disaster. "Those who don't know the past are doomed to repeat it," warns Nell Minow, until recently a principal at LENS, which invests in troubled companies and then agitates for management reforms. "There's a lot of arrogance involved. The most important lesson in corporate governance is that success is your greatest challenge. The greatest corporate-governance disasters were companies that were hugely successful."

At SportsLine, Levy is the only management director. But as of the company's October 1999 proxy statement, six of its nine other board members had recent business dealings with the company. Two came from CBS and one from Reuters--"strategic partners" and investors in SportsLine. Three more directors--including Joe Namath's agent--had consulting deals with the company. (Levy says that one of those consulting deals has expired, that a second has been "terminated," and that the Reuters executive has left Reuters but remained on the SportsLine board.)

Many big-name dot-coms have small boards. Amazon has just six directors, with two inside directors. Yahoo has six directors, including three company executives. A typical dot-com board lineup consists of two or three insiders; two representatives of venture capital firms that helped launch the company; and a couple of independent directors.

The small boards can also have a difficult time adequately staffing committees. New listing provisions by the NYSE and NASD will soon require public companies to have three independent directors, including one with financial-management expertise, on their audit committees. But many dot-coms have only two outside directors on both their audit and compensation panels, for the simple reason that they have only two independent directors on the entire board. Says an Internet company director: "There are a lot of Web companies where you look around the board and say, 'Nobody's qualified to be on the audit committee.' That's a real problem."

The lack of independent expertise is troublesome not merely for meeting the new rules but also for providing meaningful board oversight on thorny new questions--these companies are breaking the rules, remember--such as how to handle emerging revenue-recognition issues like barter transactions, and whether a fast-growing Internet company is diluting shareholders excessively by issuing too many options. A dot-com that takes a misstep on one of these fronts--and subsequently stumbles in the market--will soon be facing both SEC questions and a very old-fashioned slew of shareholder lawsuits.

--Peter Elkind

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