(MONEY Magazine) – On a chilly April morning in Manhattan, nearly a dozen top investors gathered in the office of Christopher Davis, a portfolio manager at mutual fund company Davis Selected Advisors, to vent their frustration with the state of corporate America--and to see what they could do about it.

There was Vanguard founder Jack Bogle, who arranged the meeting. There was Legg Mason's Bill Miller, the fund superstar who has beaten Standard & Poor's 500-stock index for 11 straight years. Pension giants TIAA-CREF and Barclays Global Investors sent emissaries. Value manager Wally Weitz flew in from Nebraska. "There were two or three trillion dollars represented in that room," Weitz marvels.

For two hours these money machers aired their gripes, and there sure was plenty to gripe about. Ever since Enron's house of lies collapsed late last year, revelations of corporate abuses haven't let up. Allegations of accounting fraud at Global Crossing and Tyco. Huge personal loans to WorldCom's chief executive. Alleged misuse of corporate funds by the founding family at Adelphia Communications. A $77 million pay package for the CEO of barely profitable E-Trade. Insider trading charges at ImClone. "Grossly bad behavior," says Bogle, fuming at me-first management.

The outrages and the resulting crisis in investor confidence have prompted an unprecedented effort by regulators, shareholder activists, elected officials and business leaders to bolster corporate governance--the checks and balances that are supposed to make publicly traded companies accountable to shareholders. The New York Stock Exchange, for instance, is considering new standards aimed at, among other things, increasing the independence of boards of directors and giving shareholders more say in how companies dole out stock options to top executives. As for those high-powered managers who gathered in Chris Davis' offices, they're now drafting and debating a list of best practices, a kind of governance manifesto that they'd wield like a club to pressure uncooperative holdings to change their unfriendly ways. Says Davis: "We need to become much more vocal with our companies."

Some might argue that the only meaningful measure of shareholder friendliness is how much the stock goes up. Given recent events, that view seems painfully shortsighted. Indeed, there is evidence that, in the long run, companies that look out for shareholders make better investments. A 2001 National Bureau of Economic Research analysis of 1,500 stocks concludes that a portfolio of the companies with the fewest restrictions on shareholder rights earned 23% a year (annualized) between 1990 and 1999 vs. 14% for companies with the most restrictions. Good governance also can help safeguard against the risks of fraud and mismanagement, says Linda Selbach, head of governance for Barclays Global, which manages $790 billion: "You can be more confident in the future of a company that has good corporate governance."

For investors who lack the resources of a Barclays or the expertise of a Chris Davis, we've crafted a series of tests to help you assess any public company's corporate practices, focusing on three hot-button topics: board independence, overuse of stock options and manipulation of accounting rules to make earnings look good. We've also done some of the work for you. With the help of the proxy data service Investor Responsibility Research Center (IRRC), we've run the 50 biggest stocks through our good-governance criteria. We review some of the results here; complete data are posted on our website, www.money.com.

Board stiffs: How to spot weakness

Investors rely on directors to represent their interests and oversee the top execs. "They are stewards of our capital," says Neuberger Berman Guardian co-manager Rick White. A board stacked with management and chums, however, may be too reluctant to attack mediocre performance and too eager to lard the CEO's pay package. That's why many professional investors prefer boards with a healthy majority of directors who are independent of the company. Bogle says he'd like to see requirements for an independent board chairman (now the chairman is usually the CEO) who is responsible for the company's governance. "Shareholders have paid a big price for collegiality at the board level," he says.

To see what can happen when a company lacks a strong board, consider Adelphia. Members of the founding Rigas family accounted for five of the nine board seats. Following a recent Securities and Exchange Commission probe, Adelphia revealed that it had guaranteed $2.3 billion in off-balance-sheet loans to partnerships controlled by the Rigas family. Six weeks later, CEO John Rigas resigned; Adelphia shares soon tumbled to less than $1.

Big investors like TIAA-CREF lately have focused on the three most important committees on any board: the audit committee, the compensation committee and the nominating committee, which selects director candidates. Each should be 100% independent, no exceptions. "If the insiders have the ability to nominate the independent directors, then the ones they nominate become beholden to them for their position on the board," notes Selbach. The NYSE agrees: Its proposals require that a majority of the board be independent and that each listed company have nominating and compensation committees that are entirely independent.

All but six of the 50 megacaps we reviewed had boards where more than 50% of directors were classified as independent. Laggards include Fannie Mae, United Parcel Service and Kraft. (See the graphic below at right.) But your analysis should not end there: 22 of the 50 don't have fully independent nominating committees, and nine don't have fully independent compensation committees. The latter include General Electric, Bank of America and DuPont.

Who is considered "independent"? Not current and former employees. Not relatives of executive officers. According to IRRC, directors are also considered "affiliated" if they or their employers provide professional services to the company (say, legal advice) or are a major customer. IRRC also looks for what's called an interlock--when two execs sit on the boards of each other's companies.

Investors can read the proxy's director biographies and its "related transactions" section to determine director independence. Keep in mind, though, that the proxy may not tell the whole story. The dry details of a director's resume probably don't reveal personal ties to management--what Patrick McGurn of Institutional Shareholder Services calls "soft ties." A director who's technically independent but has such soft ties as, say, a long friendship with the CEO "is unlikely, given their past relationship, to stop management in any forceful way," McGurn says.

To see how hard it can be to measure independence, consider the board of AOL Time Warner, the parent company of MONEY. Although IRRC describes the board as 60% independent, there are a variety of soft ties between management and independent directors. Director James Barksdale, for instance, was CEO of Netscape in 1999 when America Online bought the Internet browser in a $4.2 billion stock deal. Director Frank Caufield's venture-capital firm reportedly counts AOL Time Warner chairman Steve Case among its investors. Meanwhile, AOL Time Warner CEO Richard Parsons sat on the Philip Morris board while Michael Miles, now an AOL Time Warner director, was Philip Morris' CEO. Parsons also sat on Fannie Mae's board with its current chief, Franklin Raines, now also an AOL Time Warner director. IRRC considers all those directors--Barksdale, Caufield, Miles and Raines--independent, despite these historical relationships. "There are always situations where you look at individuals and wonder, 'Are they really independent?'" concedes McGurn. An AOL Time Warner spokeswoman says, "We drew the conclusion that none of these relationships are material to our company."

When evaluating boards, investors also should consider whether the company staggers its elections. Most major companies hold elections for all directors annually, yet some employ terms of several years, staggering their elections so that investors vote only on a minority of the board at any one time. Companies with staggered elections, like Morgan Stanley, say they provide stability and foster better long-term planning. But such boards also insulate companies from takeovers--and from angry blocs of investors who might want to toss out all the directors.

A final board yardstick: Does the company require directors to own stock? Governance experts believe that directors who own significant stakes in their companies are more apt to get involved in the business and challenge management. Stock options and stock given as part of the director's compensation aren't always sufficient. "Usually, $100,000 invested in the company is enough to make them pay attention," says Nell Minow, a veteran shareholder activist.

Surprisingly few companies (seven of the 50) require directors to sink money into the stock. DuPont, for example, instituted guidelines in January requiring directors to own stock worth at least five times their annual retainer. (Some companies may have such policies but not disclose them; call investor relations to ask.) For individual director ownership, check the proxy. Make sure to read the footnotes to see how many shares are simply options.

Beware of stock options

Stock options are a cheap way to pay employees because companies don't have to report them as an expense on their income statements. But options cost shareholders plenty: Every option that's exercised adds to total outstanding shares, thereby diluting the stake of existing shareholders. In effect, managers who dole out options too freely are gradually giving away the company. To avoid dilution, the company may have to use cash to buy back shares--cash that could otherwise be invested in the business or paid as a dividend.

In addition, some money managers have come to believe in the wake of the late-'90s bull market that options did not live up to their early-'90s billing. The idea was that options would align top executives' interests with those of the shareholders. But in many cases, options seemed to lead executives to use questionable techniques to give a short-term boost to the stock price so that they could cash out. "The trouble with options," gripes Davis, "is that they allow management to get rich even if shareholders do lousy."

Two yardsticks can help you determine who's been overly generous. The first, called option overhang, measures option grants as a percentage of the total shares outstanding. That number can provide a rough indicator of the potential for options to dilute earnings. Calculate overhang by adding up all the shares that have been made available to employees through option grants--the number of options given to employees but not yet exercised, plus the number of shares set aside for future options grants (available in the footnotes of the annual 10-K filing)--and dividing that sum by the total number of shares outstanding.

Institutional investors like Fidelity want to see option overhang of no more than 10% for most companies. (Some managers accept a 20% overhang for high-tech and biotech companies.) Yet according to IRRC, average overhang for the S&P 500 is 14.3%. And 13 of the 50 largest companies had overhang higher than the average. Financial stocks Wachovia and J.P. Morgan Chase, for instance, sport overhangs of around 20%. Microsoft and Intel are above 25%. Morgan Stanley is tied with Dell Computer for highest at 36%. (Again, check the graphic on page 31 for the full spectrum.)

The second yardstick, called an option run rate, offers a more current indicator of dilution. Add up the option grants for the past three years (also in the 10-K footnotes), divide by three, then divide by the number of shares outstanding. Davis argues that handing out an average of more than 1% of outstanding shares a year in options is giving away too much of shareholders' money--and 3% is a bright red flag. "At that point," he says, "we feel like increasingly any incremental growth in the business is being transferred from the owners, the shareholders, to the people they've hired to run the business."

Why? Take Cisco Systems, whose option run rate of 3.9% is highest in our survey. Let's assume that its earnings grow 7% a year and the stock rises a corresponding 7% annually--a decent, although unexciting, performance. According to our calculations, if Cisco continues to grant options at its current rate every year, after 10 years, employees would have gained $32 billion. Meanwhile, the actual earnings added by those employees over that same decade amount to just $14.8 billion. Think of it this way: For each additional earnings dollar accumulated for shareholders, employees earn nearly $2.

It's no surprise that tech companies ladle out options, but it turns out that financial firms can be quite generous too; for example, Bank of America and American Express have option run rates of 3.6% and 3%, respectively. (The graphic on page 31 also indicates option run rates for the 50 largest companies.)

Other things to look for are whether a company reprices its options after a stock plunge renders them worthless (it must report a repricing in financial statements) and whether the CEO gets an excessive share of total option grants. Anything over 5% is considered piggish, yet several of the best-known and most respected companies follow this practice: Freddie Mac, AIG, Fannie Mae and Wells Fargo top the list of megacaps, with their chiefs commanding 10.9%, 10.6%, 7.4% and 5.6% of the companies' latest annual options grants, respectively.

Accounts deceivable

The corporate blowups of the past year have highlighted how companies can bend accounting rules to make earnings look good. Xerox, for example, recently settled an SEC complaint charging that numbers tricks inflated pretax earnings from 1997 to 2000 by about $1.5 billion.

Without an accounting degree, it can be difficult, if not impossible, for investors to decipher the numbers and figure out if a company's accounting is appropriate. Although publicly traded companies must have their books audited, Enron and Arthur Andersen showed us all how little that safeguard can be worth. That's why reformers are calling for stronger board audit committees, changes to accounting rules that close loopholes and uniform standards for reporting earnings and balance sheets so that investors can better understand what's really going on.

Still, there are clues that can tip off investors to aggressive accounting. One involves the company's pension plans. Companies that offer pension plans deduct the costs of the pension benefits that they pay out annually and book income that they earn from the plan's assets (usually invested in stocks and bonds). Here's the trick: Accounting rules allow companies to estimate their expected annual return on those investments and record that amount as income--whether or not the investments earn that amount.

Bogle's criticism is that companies have been overestimating their expected long-term return on assets to increase the amount of pension income that shows up on earnings. How else, he asks, can companies justify estimating long-term returns of 10% when the stock market's historical return is around 8% and most pension plans aren't even invested completely in stocks? Plus, he says, the average pension plan earns roughly 80% of the market return because of plan costs and turnover. "It might be reasonable to expect returns in the range of 7% to 8%," he argues. "But 9.5% or 10% can't be justified." Investors can find expected pension returns in the 10-K footnotes. Of the 50 companies we examined, 24 estimated pension returns above 9% in 2001, including Eli Lilly, PepsiCo and Pfizer.

Ultimately, deciding whether a company is doing right by shareholders involves balancing all the above factors (honest accounting, reasonable pay practices and a strong, independent board) with the unique characteristics of each company. The criteria presented here are merely a starting point.

Let's look at one midwestern financial stock in particular. This company shuns stock options, and its 2001 pension plan expectation was a conservative 6.5%. So far, so good. The board, however, scores terribly, ranking least independent of the 50 biggest stocks. It's stacked with insiders and cronies, including the CEO's wife and son, and the corporate lawyer. The company? Warren Buffett's Berkshire Hathaway.