Board members often conduct one interview six or eight different times, instead of conducting six or eight different interviews. As a result, the data and findings coming out of the interviewing cycle are of limited value. The same narrow lines of questioning, duplicative information gathering – by the fourth or fifth interview, the CEO candidate can feel a “Groundhog Day” experience setting in. And without assessing specific behavior patterns and experiences against the required competencies, the board can find it very difficult to accurately determine whether a CEO candidate might ultimately succeed or fail. Devastating consequences for the company can result.

Rather than make the CEO interview process a haphazard series of conversations, we recommend that chairmen, lead directors and/or committee chairs adopt a thoughtful and planned interview process that identifies a role for each of the board members. There are five best practices in particular that can maximize the effectiveness of the information-gathering and assessment. These will bring structure to the process, and will elicit the fullest picture of the candidates – and how well they are likely to handle the job.

Interviewing CEO Candidates

1) Assemble the right team
The make-up of the succession and selection committee is critical. Boards need to recruit people who are “qualified” to interview prospective CEOs – qualified by having been through a similar process in their own companies or by having extensive experience interviewing in a corporate capacity. The chairman of the committee, especially, will need some experience in CEO or other executive succession and selection; this experience can come from being a board member or a corporate officer.  Diversity of experiences on the search committee is also important. A board might include a current or former CEO, CFO, and EVP of Human Resources. These different experiences will improve the collective depth of the group, as each interviewer can take a tack that is based on his or her own knowledge and experience.

2) Ask the right questions
As many board members do not have a lot of practice assessing and/or selecting CEOs, the Chairman should prepare his fellow directors for the CEO selection process. Preparation comes in the form of thinking deeply about the requirements for the next CEO and developing questions that will get beyond superficial programmatic feedback from the candidates. Socratic questioning from the interviewing team can dig into the second and third layers to truly understand the executive’s experiences and capabilities against the needs of the company going forward. There are many examples where boards have recruited the most articulate candidate with the highest profile without focusing on the real core competencies that are required to be successful.

In interviewing the CEO candidate, board members should be looking for key examples of demonstrated behavior – not a high-level overview of their perception of their approach. The key to a great interview is digging in and asking for concrete example after concrete example. We do not really care what they think; we care about what they really did. Whenever an interviewee makes a point, ask them for an example that can illustrate their point. This simple strategy adds massive amounts of data and richness to the process, and you come out of the interview with behaviorally specific examples versus what the person thought the right answer should be. The final element of the interview is to take copious notes and capture the examples so your feedback is specific and not simply your “gut feel” on a candidate.

3) Don’t repeat the same interview
Many board members interview CEOs by simply asking about the candidate’s career history. This can lead to essentially the same interview being done over and over again, becoming redundant and not allowing the board to extract the optimal information.  It also creates a tiring and repetitive environment for the candidates.  It is important to have different directors focus on different core competencies and create a strategy for extracting the right information. For instance, a board member with CEO experience might work to assess operating and managerial ability; a board member with CFO experience might assess financial acumen; and a board member with HR experience might assess the type of workplace cultures the candidate has created.

4) Compare notes
A frequent misstep in interviewing CEO candidates is that, due to the hectic board and C-suite schedules, oftentimes the interviews are isolated. Information may not be shared among board members until after the process is finished.  If board members communicate in between interviews and provide feedback immediately after their meetings, they can give other board members important areas to probe. Areas of potential concern that surface in one interview can then be further explored in subsequent meetings — e.g., if the interviewer suspects that the candidate may not be able to make difficult people decisions or if the candidate appears to be a micromanager, or even perhaps that a candidate’s spouse may not want to relocate. Flagging these issues can alert other board members to spend additional time probing these areas in their drill-down.

5) Verify and fill in the missing pieces with references
The board should take the information obtained from the interviews to develop a referencing strategy. For instance, if a concern in the interviews arises about an ability to replace under-performing executives, this should be a key area probed during the referencing process. You can learn a lot about candidates by interviewing correctly; however, you are always going to get the best information from people who have worked with the candidate for years. The perspectives gained by board members during the interview process should always be verified with references. Also, references allow boards to fill in missing pieces related to prior career changes or times when the candidate was not successful.

The referencing process must be done no matter how well someone on the board knows a candidate. In one board recruiting situation, a number of the directors were familiar with the potential candidate, so little additional interviewing or referencing was completed. The incoming CEO ended up not being a fit with the company because of reasons that would have likely surfaced during detailed references. The referencing process should be standard in all recruiting instances. Trust but verify.

In summary, best practice in determining your company’s next CEO demands careful selection of members of the selection and succession committee, as well as careful attention to the end-to-end process. When done very well, where roles are assigned and communication is flowing, it can be a very rich process that truly examines candidates both inside and outside the company through a detailed lens. And all this planning and preparation will improve the chances of attaining the objective: selecting the best person to be the next CEO.

Stephen A. Miles is a vice chairman of Heidrick & Struggles where he runs Leadership Advisory Services within the Leadership Consulting Practice and co-author of a new book, Your Career Game: How Game Theory Can Help You Achieve Your Professional Goals. Jeffrey S. Sanders is the managing partner of the North American CEO practice for Heidrick & Struggles.

Editor’s Note: This is the second in a series of conversations between top executives as they discuss business scenarios that impact the boardroom.

Timothy W. Burns: As you know, I spend a good deal of my time counseling boards of directors and officers on insurance issues. If their company is solvent, and their insurance is strong, directors have historically faced very little risk of personal liability. What keeps me up late at night these days, however, is 1937. Here’s what I mean: Eight years after the 1929 stock market crash, the economy went into a tailspin again. And, I’m concerned that perhaps we haven’t seen the end of 2008.

Lawrence Fine: I guess you’re saying that inevitably, big disasters will have their aftershocks.

Burns: Right. And if it happens again, good insurance becomes of critical importance in protecting the personal assets of directors.

Fine: Directors and officers have been exposed for decades, but earlier in the millennium when the WorldCom and Enron scandals made front pages, plaintiffs seemed to really step up their game in volume and severity. Those actions brought a new level of awareness to the potential exposure to directors and officers. Our litigious society is becoming a danger for everyone.

Burns: With the credit markets tightening in 2007, and then the economy melting down in 2008 and early 2009, it really forced directors and officers to consider how they may be targeted personally. The good news, though, is that except for certain market segments, the D&O market has—at least to date—remained somewhat reasonably priced.

Fine: But there are a number of plaintiffs’ lawyers pushing the envelope with legal theories and increasing settlement demands. That’s partly inspired and supported by a lot of anti-corporate sentiment right now. As a result, plaintiffs, who have always threatened that they would try these cases, have actually been doing that lately, with, unfortunately, mostly positive results from their perspective. It seems that juries are not looking favorably on corporate defendants. So, Tim, let’s take a moment to talk about these new developments and what directors need to be aware of and prepare for.

Burns: A big issue is that institutional investors definitely seem to be competing among themselves to see who gets the biggest settlement. They’re encouraging their lawyers to do the same thing and the bounties that some of these institutional investors are purportedly offering their counsel are designed to confiscate money directly from the personal assets of individual defendants.

Fine: Yes, that poses a difficult and interesting situation. We are now seeing instances in which a particularly competitive institutional plaintiff will seek the money directly from the individual and try to prevent the company or the insurer from reimbursing it. That poses a very difficult circumstance for a board director. This approach can be taken even in the face of a settlement involving the corporate defendant. We’ve had success in diffusing these situations, because a high percentage of the time, the plaintiff counsel is blustering for effect. The job here is to have them convinced by a practical insurer, through an experienced claims analyst, particularly one who is known to the plaintiff counsel, that they should just let it go and move on. From the plaintiff’s perspective, money is money, so how can they turn down the settlement the insurer is offering to pay?  Because we say that there just won’t be any settlement if plaintiff counsel insists on going down the other route, seeking the money from the individual, which, while dramatic from the plaintiff’s point of view, may well be complicated and uncertain to yield results.

Burns: I am concerned that in these changing times, plaintiffs’ lawyers are going to be under increasing pressure from the institutional investors to get more and more. Historically, the dynamics of these cases have favored settlement, but there is a lot of uncertainty out there in this post-crisis environment.

Fine: One reason the plaintiffs are taking more cases to trial is that they are competing for the institutional-investor business. Also, the plaintiff bar has been fragmented and unconsolidated after several of the old-guard plaintiff lawyers were the subject of government investigations, and several of them were sent to prison. The plaintiff lawyers that remain are aggressive litigators, and are much less committed to settling cases, and more interested in making a name for themselves through trying cases. It’s harder to get a reasonable dialogue going in a case.

Burns: Insurers, directors, officers and companies all face a wide array of enemies. It’s not just the plaintiff securities bar anymore. There are derivative lawsuits. There are government investigations galore. The environment is getting continuously more costly and more difficult.

Fine: The competitive nature of litigation means there’s more incentive than ever for institutions to opt out of class actions and seek higher percentage returns. That’s one of the things that the plaintiffs’ lawyers are pitching to them, and that’s just another major complication for any given company in resolving all of the issues they face on numerous battle fronts.

Burns: The government appears to be getting more aggressive as well, and I guess that’s to be expected after the recent financial turmoil. But this certainly has directors and officers that I talk to worried about their liability.

Fine: Yes. Sometimes dealing with the government can be a longer, more difficult process than dealing with civil plaintiffs, because it is not, at the end of the day, necessarily a predictable decision maker, in that its decisions may not be governed by practical, quantifiable measurements such as dollars. Mary Schapiro (chairman of the Securities and Exchange Commission) has made many public statements about increasing enforcement and cooperating with other government entities. Recently, the SEC has been utilizing Section 304 of Sarbanes-Oxley, the clawback section, to recover bonuses from individuals who they are not even alleging personally committed any fraud, which is pushing the envelope of what it would seem that SOX 304 was designed for. That’s after several years of the SEC not pursuing clawback claims, and receiving some criticism for that.

Burns: Congress is looking to legislatively expand liability exposures for directors and officers, isn’t it?

Fine: The tone in Congress is, in many ways, anti-big business, with several bills currently being pushed which could drastically increase exposures to directors and officers. One such bill would lower pleading standards for all civil litigation and turn back the clock a few decades, so that plaintiffs can get by a motion to dismiss in virtually every case, it would seem. The other bill would undo the Supreme Court decision in the Stoneridge case, and affirmatively  create a civil action for aiding and abetting of securities fraud. It’s always been the case that the government can pursue aiding and abetting claims, and the SEC is probably prepared to do that now.

Burns: Some carriers have opined that this aiding and abetting liability, if it comes to pass, might not be covered under D&O insurance policies. I don’t really see the logic in that view. It appears to me that aiding and abetting would fall within the definition of wrongful acts in a D&O insurance policy.

Fine: We would agree, but it depends on the exact phrasing of allegations. Basically, Chartis’ policies are generally supposed to cover directors and officers for things that they’re alleged to have done in that capacity, and we’re not sure how or why a carrier would argue otherwise.

Burns: We also are seeing the potential that more and more companies may not be there to back up their directors and officers when things start to go wrong on all fronts.

Fine: When a company has bad news that leads to litigation, one of the worst-case scenarios is that the company may have to file for bankruptcy, whether it’s a re-organization or liquidation, as in the case of Lehman Brothers. Your concerns seem warranted, in that bankruptcy filings have been way up recently, and they’ve been leading to increased litigation against directors and officers.

Burns: The good news is that the trend over the past few years has been for companies to increasingly purchase Side A coverage that protects directors and officers in the event the company becomes insolvent. It appears to me that a lot more of these Side A policies are going to be triggered than in the past.

Fine: Side A policies generally are starting to see more action, from derivative suits as well as bankruptcies. For example, in the Broadcom case, $40 million of the settlement was paid by Side A carriers. Probably, some carriers who have been writing Side A coverage have enjoyed years of low activity, and felt it might be relatively low risk. But hopefully, those carriers are prepared to start paying more on Side A policies.

Burns: It certainly appears from those numbers that some of the Side A insurance policies are likely to come into play. What I’m interested in, and I’m sure others are as well, is your view of the recent statistics on securities class-action filings. Securities- fraud class actions were down last year. What do you make of this?

Fine: It’s really a moving target. The numbers for 2009 on the Stanford Securities Clearinghouse website keep increasing as additional suits are added to the list belatedly. The count is now up to 178, nine higher than the 169 suits which were discussed in Cornerstone’s 2009 year-end report and press release. Various other commentators such as Advisen and NERA post consistently higher numbers. So there’s definitely more to the story than just one headline.

Burns: Another recent trend that offers some concern is the rash of under-the-wire lawsuits. And, by that I mean lawsuits filed just before the statute of limitations expires. There are an increased number of cases in which the defendants are sued almost two years after the disclosures on which they are being sued were made. It used to be that your stock would decline, and you’d be sued within the first few days of the decline.

Fine: Directors and officers ought to know that when the stock goes down, they are likely to be sued. The statute of limitations was increased by Sarbanes-Oxley from one year to two years and it gives the plaintiffs freedom to plan when they’re going to get the cases filed, and how they’re going to manage their inventory.

Burns: There do appear to be a lot of game-changing developments out there. The one thing that provides me some comfort is that in the past, directors and officers who have had strong and adequate D&O insurance have not had to pay personal assets. Even with these recent developments, hopefully that trend will continue.

Fine: Good lawyers are expensive these days. Discovery can be a black hole if it’s not managed well and efficiently. The cases are just very expensive, and individual insureds should be concerned about who is spending the limits and how fast the money is going.

Burns: That does pose a concern. You could have a case in which a rogue former officer effectively monopolizes the spending on the D&O policies. And, you’re absolutely right that defense costs seem to be getting more expensive. Boards and directors need to pay attention to who is going to have access to these policies. Given the multiple individuals with access, and sometimes the company itself, it’s important to seriously evaluate how much insurance the board needs.

Fine: People often ask how much is enough insurance. What type of advice do you give?

Burns: Frankly, I’d say that you want to look at what’s been enough in the past, and increase it considerably. Defense costs are rising, potential liability that’s covered under these policies is rising, and at the same time, you’re looking at increasing D&O insurance limits. You should be careful in deciding from whom to purchase D&O insurance.

Fine: There are other more specialized policies for outside directors that probably bear looking at. But we think that directors are best off to make job one focusing on getting the best possible foundation for their insurance program with the best primary policy. Not every gap can be filled by the primary policy, however, because of potential bankruptcy issues and whether the debtor has rights in a traditional ABC D&O policy.

Burns: The economics of the purchase of D&O insurance makes Side A, B and C policies a fact for most companies. The company and the board want to protect the directors, officers and the company from liability from securities claims and other liabilities that are covered under these policies. Because of this fact, it is important to make sure that you’re purchasing the best ABC Side coverage that you can get.

Fine: Have you been seeing carriers in excess positions being asked to pay more money, and has that been going smoothly or not?

Burns: There are a lot of cases in which the settlements are in the multimillion-dollar range. Excess insurance policies are coming more and more into play. That is an unusual development for most excess D&O insurance companies. Many of them are not in the habit of paying claims day to day, in my experience, and you have to do a lot more work to collect from some excess D&O insurers. You may have to file litigation at times with respect to some excess D&O insurers who just were not expecting to have the number of claims and the size of settlements that we’re seeing now.

Fine: We’re seeing that when we go to mediations, which increasingly have a lot of different layers of carriers, one never knows at which level there’s going to be a hard stop or what the reasons given will be.

Burns: That’s a dangerous situation. These cases, in order to be resolved successfully, require that all the parties obligated to participate actually participate in resolving the case.

Fine: The purpose of insurance is to reduce uncertainty and provide reliable protection. You have to be an educated consumer and achieve as much certainty as you can, so saving some money on a premium, but being less sure that the claims will be paid, means that you’ve really got nothing. So in these times, despite occasional overly reassuring remarks from a pundit, anything can happen, and I think that it’s the job of directors and officers insurance to be a reassuring backstop against that world of uncertainty.

Do we, in your opinion, have a good rationale for when we bail out institutions?

The short answer is that we’ve bailed out too many institutions. If we had a good rationale, then we might decide that there are 10, 20 or even 30 financial institutions that are too big to fail. But we’ve recapitalized over 600 institutions. We need an articulated rationale for these bailouts.  In my view, there are two good reasons for rescuing a troubled bank. First, if it is critical to the functioning of the payment system—the processing of checks and wires—and, second, if the insolvency of this institution would probably cause widespread failures in the entire financial system. That probably was true in the cases of Freddie Mac and Fannie Mae.

We also need a more disciplined process. Right now, if you yell systemic risk in a crowded room, we bail you out. The Treasury Secretary needs to write down on a piece of paper the specific reason for bailing out this institution, and make that public. Then we should have an independent body like the GAO do a review of every bailout after the fact. Through that process, we could start to develop some sense of whether these bailouts achieved their objectives.

It also seems that when we do these bailouts, Treasury is taking preferred stock with warrants. Does that make sense, particularly from a taxpayer perspective? Is that something we all should be concerned about?

This is one of the main themes of my book. I call it one-way capitalism. If taxpayers are going to bail out these institutions, we own the downside. However, we really don’t own much of the upside…If we’re going to bail out institutions in the future, the Treasury should take back a lot of warrants, or perhaps in some cases common stock. When JP Morgan redeemed the Treasury’s preferred stock, the Treasury realized almost $1 billion of profit on its warrants.  But we as taxpayers should have received more than six times the amount of warrants and six times the amount of profits. We need those profits on the successful rescues to offset the losses that taxpayers are likely to incur on AIG and Bear Stearns.

How much blame do the boards have for what went wrong in the financial crisis?

I don’t think that the boards bear the most blame for the financial crisis. There are a lot of other groups and a lot of other factors that were more important. But on the specific question of the compensation system, a lot of boards dropped the ball.  They approved a lot of bonuses based on one-year performance, and that performance soon evaporated. They didn’t require deferral of cash bonuses in many cases, and they often went along with guaranteed contracts and golden parachutes regardless of performance.

So, let’s say we get it right, and boards are composed the right way. Can they alone hold management accountable, particularly in financial services?

When we think about holding management accountable, we need to think about both the bondholders and the shareholders, as well as boards. One of the most unfortunate things about this financial crisis is how we’ve taken bondholders out of play. Financial institutions have issued $340 billion of guaranteed debt, in which the government is guaranteeing 100 percent of their debt. We have bailed out the Bear Stearns’ bondholders, some of the most sophisticated investors in the world. We’ve also directed AIG to pay out 100 cents on a dollar to very sophisticated investors on the other side of its credit default swaps.

If large bondholders never take a loss, they are going to stop being careful in choosing bonds; they are not going to push management to avoid excessive risks. This is moral hazard in the worst sense. If we want to hold bank executives accountable, we need to bring large bondholders back into action. That can best be done by requiring all large banks to issue subordinated debt, which would not be protected by the federal government if such a bank became insolvent.

The most important change in the shareholder area is one that’s already happened—stricter rules on when brokers may vote the shares held in the accounts of their customers.  In most public companies, the “broker vote” involved 30 to 40 percent of the outstanding shares. Under prior rules, the brokers didn’t need instructions from their customers, and they tended to vote for management. Now, under the new rules, brokers can’t vote without their customers’ instructions, and therefore, they usually won’t vote. So that means a substantial shift of power from management to institutional investors, who normally vote their shares in every corporate election. Hopefully, institutional investors will use that new power intelligently.

What you’re suggesting relative to smaller boards and more focus on the business, is that applicable to boards across the board?

I would think that the new model should apply to very large and very complex companies. If you’re a     director of such a company, you really should spend a lot more time on the board, and you should try to get on top of what the company is doing.  In such a company, the board should be more professionalized.

There’s been a lot of discussion about the failure of the boards of mega-banks to adequately assess risk.  How serious a problem is this?

The directors of many megabanks do not seem to have fully understood the risks being taken by these banks. In part, this may have happened because of undue reliance on internal risk models like VAR (variance at risk). VAR measures a bank’s risk exposure over a very short period, like a day or a week.  Moreover, VAR covers risks only to a 98% degree of profitability. In other words, it does not deal with risks beyond the second standard deviation in a normal distribution curve.

However, the most important risks often materialize over much larger time periods, such as a year.  And some of the most catastrophic risks have a probability of less than 2%, but they can destroy a company.  So directors should not be lulled into complacency by risk models like VAR. Similarly, under Basel II, regulators currently allow large banks to set their own capital requirements based on their own internal assessment of the riskiness of their assets.  This approach has at least three flaws. First, Basel II has a built-in conflict of interest – banks have an incentive to set their capital requirements at relatively low levels.

Second, the internal risk models of many banks turned out to be wrong – for example, some assumed U.S. housing prices would fall only once in 50 years. Third, these risk models are so complex that they cannot be understood by most bank directors, unless he or she happens to have a PhD in math from MIT.

Directors should insist on a clear delineation of all the assumptions underlying these risk models, and then push back hard on the validity of these assumptions.  In the final analysis, quantitative models are not substitutes for common sense.

Let’s begin with Washington: what are you telling your boards to be on the lookout for?

Mostly there is trepidation around what is unknown. Washington is focused on health care right now, but boardrooms, obviously, need to be aware of what’s happening. At Nasdaq OMX and on behalf of our issues, we want companies to be public companies. It’s good for our capital market. It’s good for job creation and it’s good for innovation. There is certainly an awareness that Washington is going to play a key role as we come out of the recession on issues such as tax, cap and trade, immigration and jobs.

And there any non-corporate governance challenges that concern you?

There’s a common belief that health care is going to be expensive and we will need resources to pay for it. Where are those resources going to come from? It’s still an unknown and is making a lot of people very uneasy.

Is the recession over? What are some of the important challenges that remain in your opinion?

There are positive signs. We’ve had resurgence in the IPO market. The second half was strong with some private equity and a few venture capital deals…There is general awareness that we need to create more jobs and more opportunity.

What should we to come out of the great compensation debate?

We just completed a corporate governance survey going into 2010. Proxy access, compensation and board elections are all up in the air. We do believe that there will be changes driven by the SEC and the exchange will follow suit. The U.K. financial services sector has been interesting in particular but I don’t think here you will see changes that lead to other industries. Instead, I do think there’s a greater move toward more disclosure around executive pay and I would expect that to continue.

What’s new on the activist shareholder front and what is NASDAQ OMX doing to help directors navigate this landscape?

Activism has been increasing from even before the economic downturn. We have tools to help you understand your shareholder better, to identify when shareholders are in acquiring positions, and to get messages out to your shareholders. Activists were here before the downturn and it’s likely we will see an increase as more investors turn to stock. We may see an increase–see more investors for stocks

As you look ahead to the New Year, what are the main governance themes you see for 2010?

This will be the first year that brokers will not be allowed to vote shares, which will create new costs, as you make sure you’re getting your shareholder vote. Given that this is the first year, companies will have to spend a lot more time making sure that every vote is counted. The other question that every board member is going to want to know is what is the risk element and it could be as minor as is our cash protected to what’s the dollar doing. I think the government will put into place greater transparency around securities and risk. Nobody liked the stock price but at least you knew what the stock price was. I think you will see over-the-counter derivatives traded on more exchange-type platforms as well to give investors a better sense of their value.

Green initiatives took a back seat during the recent global climate, but do you see things changing coming out of the Copenhagen  summit? ?

Carbon trading is going to be looked at in 2010, 2011, 2012–it’s a matter of priorities. We just saw that coming out of Copenhagen. I do believe that companies must be prepared and understand that we will have carbon trading. To that point, Nasdaq acquired Nord, an energy and carbon-trading platform in Norway where there is more trading. Directors need to keep a close watch. Europe has a lot of trading.

What’s are your professional priorities for the New Year?

To continue to execute on our strategy. As part of our deal with OMX, we now operate 70 exchanges around the globe. Nasdaq itself was always known and now with the Philadelphia options market we are much more diversified for equity. In the last year, 24 companies have switched to Nasdaq including large cap brands such as Mattel, DreamWorks, and most recently, Micron.

Can you share with us the lessons that at least you personally took away from the crisis?

We’ve learned a lot of lessons:  do not delegate risk management to rating agencies. That while remotely improbable events will happen rarely, there are improbable things that are guaranteed to happen every day. So you have to prepare yourself for things that have never happened before in the history of the world, like housing prices dropping around the United States. What one has to do is make sure you’re well capitalized. Have all your exposures on your balance sheet. And mark your positions to market so you get the early warning signs. When things start to deteriorate, prices deteriorate, and if you can’t otherwise explain them, you’d better start searching.

Tell us about the first rumblings that led your firm to believe there was more risk in the atmosphere that others missed.

We started to see more volatility and we started to see that the prices of some assets weren’t holding up. To that moment, if you’d asked me, for example, “Would real estate assets at the end of ’06 or the beginning of ’07 go down?” I would have had no idea. I have no idea today where things are going. What I do have an idea about is what risks are we running, and the idea that we should get closer to home. Through this period, I was sure that we were selling things that we would regret selling. Who the heck thought that these things would go down by so much? But the anticipation of that is not what drove us. We were in the world of risk management, not in the world of guessing where things were going.

In what ways has your world changed from being a private to a public company?

We are very mindful of our responsibilities to public shareholders. We embarked on this, because frankly, we were the last partnership probably for longer than was reasonable to do. And so when we became public, it was really by necessity. And to the extent that we possibly could, we carried our partnership culture into the public company. So we have an ownership culture…We mostly pay in shares and we hold essentially the bulk of their shares for their whole career. And when I address my senior employees, I’m really addressing partners, they’re also owners.

I’ll tell you another consequence to the firm. No one at Goldman Sachs gets paid out of his or her own P&L. It matters how your business is doing, it matters how your performance is, but it matters more how the firm as a whole is doing. It makes everybody an agent for everybody else, looks over shoulders, you see something that doesn’t make sense to you. With the self-righteousness born of ownership, people will come up and say, “That doesn’t make sense to me.” In a lot of places, you want to have a good career, you run as fast and as far as you can from the locus of the problem. At Goldman Sachs, you won’t get anywhere if you do that; you have to run to the problem.

What can you tell us about CEO succession that we can share with boards?

Succession, is the hardest thing we have to do at Goldman, I think we have very, very good people, and I think our people tend to be very attractive to others. And it’s not hard to keep the number-one quarterback in the league on your team, but what if the back-up quarter back would be the number-two quarterback in the league. How do you keep that person in your organization and not lose them to another organization where that person would be a number one? And that’s something that we have to do and I spend a lot of time thinking about that, and giving people exposure, and making sure people have a chance to grow in the firm and see succession.

Several of your predecessors went onto prominent government service. Is this part of the culture?

When I first became a partner at Goldman Sachs, a senior partner had a chat with me and said two things, “You’re expected to keep all your shares in the firm.” and then said, “You should organize your career so that, if and when there’s an obituary written for you, and it’s nine paragraphs long, no more than two should be about your career at Goldman Sachs.” And if you look at my predecessors, you’d have to say that not more than two of them, of their nine paragraphs, would be about Goldman Sachs.

What exactly is the future of programs like the TARP and additional regulation?

There is a lot of behavior and practices that has to be fixed and sorted through. There’s no doubt about it and everybody succumbed to it to one extent or another, some more or less, we include ourselves as well. I know I’ve learned a lot from this and we should put those lessons into practice.

You can make anything absolutely safe. But guess what: you’re going to really curtail (growth) and have a very big consequence on growth. We’re going to have to find that right place to be in and understand the tradeoffs. But clearly, we don’t want to be at the extreme level that we were at before.

Fed Chairman Bernanke asked a question whether or not there was a fundamental divide between client business and proprietary trading?

If you separate principal activity, risk-taking, from the advice business, I think the world will be kind of a poorer place. Think of the things, the economic activities, the role that banks, and particularly investment banking plays – it’s to help capital accumulate, to help identify needs, to help allocate that capital. And so you have to step in and intermediate it, often by extending your balance sheet in the interim. If you can’t do that activity, no doubt, business will get done, but it will be a far less nimble system.

How do you keep tabs on the information flow?

We have a pretty flat organization. And I would say I don’t have to invite people into coming in. I think people feel it is their right to come in. They behave that way and they don’t even have to assert that right. They just live that right. I hope they use some judgment, but I never want them to hesitate to tell me, that would have been the stitch in time that would have saved nine. I get a lot of communication.

You’re said to make a 100 calls a day. Is that how you stay in tune with all that’s going on?

I grew up in the middle of a trading room, and it’s just all noise and you can’t break anything out. But if somebody 30 or 40 yards away from you, in just the din of the white noise said something that was wrong or the opposite, the whole room comes to a dead stop and everyone stops to stare.

It’s been reported the day that you were brought down to Washington to accept the TARP funding that you called a special board meeting at the Treasury Department.

Well, that particular day…being down there and being told this is the package and we’d like you to do this; in fact, you have to do it and you’ll be happy to know I raised my hand and I said, “Gee, $10 billion dollars of preferred, put aside the shock of it and the surprise, and this is several weeks after our Buffett deal and our capital raise At the time I said, “This is a $10 billion dollar capital raise. I actually can’t do this by myself. I have to get in touch with my board. And they said, “I understand completely. That’s no problem. You have Conference Room 12C. Take your time and when you’re done, you can leave, whatever time it is. We never close.” So that’s what happened. We went into the conference room and got our board together and at that point, our board was used to impromptu meetings. During this period of time, communication was very important in our firm and our culture. It was a pretty good outcome, all things considered. You didn’t know how difficult things were. But the one thing that was important to us, and frankly, a comfort to me, was being able to share what was going on with my very, very, very involved board who made themselves available for calls everyday. And frankly, at the end of some days, I had nothing special to report, and everyone wanted to hear that I had nothing special to report. And I can tell you, far from being a burden, it was a big help and I felt I was sharing a burden at the time.

What are the skills and expertise you look for in board members?

We look for wise people who are very successful who lived through stressful moments and came out the other side in their own industry. Specific things; we try to make sure that we try to get diversity to reflect the diversity of our businesses and our people. And, frankly, more recently, we try to reflect the areas in the world in which our business is growing. (in terms of the Compensation Committee)– every member of our board is a member of the compensation committee – now, why would that be? We don’t’ have inventory or costs of goods sold. All our firm has is people. The largest expense by far in our firm is people. Everything we produce for our shareholders is their override on the talents of our people.

Are you worried about your image and what are you doing to fix it?

The answer, of course, is we’re very concerned. We’re a confidence business. Our reputation is very important to us, and in some cases, there are things that we had no involvement in and we couldn’t even affect if we wanted to. On the other hand, there are also people who feel that we and the industry participated in things that were clearly wrong and we have reasons to regret and apologize – and, some of this is real and some of this is extrapolated. And so, we’re very concerned, but at the end of the day, we’re an institutional firm. We care what people know about us.

Today, given the flood and the flow, sometimes we’re met with cynicism. But instead of responding in kind, we going to fulfill our commitment and our obligation to the world to be good allocators of capital, to make sure we’re doing the right things, make sure we’re helping the country pull out of recession, grow businesses that help generate jobs, and make the kind of constructive suggestions that people would think Goldman Sachs should be able to come up. Is that enough? I don’t know. I get a lot of opinions. Some people come in and say, “You’re doing too much. Don’t say another word.” And other people say, “We should go on talk shows.” One thing I know for sure: Three years from now, I’ll know exactly what I should have done.

How were you able to avoid the siren call of the mid-2000s that was the subprime mortgage market?
In the early 2000s, Fannie Mae and Freddie Mac were very, very competitive and basically were reducing the profitability of the basic mortgage business, so that you couldn’t generate a good return. At that point the industry was starting to move toward subprime. We looked at how subprime worked over a long period of time. The assumption we made is that even if you assumed you got your money back from the house, the operating expenses during foreclosure and foreclosure-management in a downturn eliminated any profitability. In other words, our analysis was that it would end in tears. As a result, we elected to sell our mortgage business and stay away from subprime. That was a key decision we made in 2001 and 2002.

Walk us through the decision to become involved in the TARP program.
The regulators encouraged us, as you know, to participate in the Troubled Asset Relief Program, (TARP) and take TARP money. If you recall—and everybody forgets this—the TARP investment was originally designed to only go to the strong banks. It wasn’t to go to the weak banks. In that promotion, if you didn’t take TARP money, then you could be perceived as a weak bank. For example, National City didn’t receive TARP money and they got a lot of notoriety about being a weak bank.

Do you think there will be a permanent change on how executives are compensated or how compensation is communicated?
When I look at our proxy statement, it’s extraordinarily transparent on how the CEO and others are paid. And we’ve essentially eliminated all of the perks. There is no country club or airplane usage. Any airplane usage has to be fully reimbursed at 100 percent basis. So that’s very important. That’s a good trend. I think the government will continue to stay involved, but the philosophical statements that they’ve made will get down at some point to the specific ratios. But we expect to repay TARP, so I don’t think we will be significantly impacted by it. I think the way people are paid will change, and I think transparency will continue to be very bright. The way we pay our people around here, much of it is long term and much of it—two thirds of it—is incentive based. So you win when the shareholder wins, and we think that’s the way it should work.

What about the rules being considered to provide greater transparency on some of the more complex financial products?
I think the derivative world is a world that clearly needs more transparency, as do the players that are in it. The hedge funds are now a major part of our financial system. To the extent you want to understand systemic risk, you need to understand the positioning of the hedge funds as well as the insurance companies because they are so large.

We’re dealing with this new, much lower yield environment. What will be the unintended consequences of people trying to chase ways to get more yield?
People will always look for yield, but I think people will look more on a risk-adjusted basis than they did before. People chased yield throughout the early 2000s and, to some extent, lost their company. It’s interesting; people say the market didn’t work, so we need stronger regulation. I do think we need stronger regulation, especially in the area of systemic risk. I don’t think there’s any question that we—as a country or an industry—didn’t understand or manage the systemic risk as well as we should have by far. There’s no question about that. But the idea that people went out on the risk curve in the credit space the way they did with subprime, for example, they’re not going to go back out there. We were talking to a newspaper and the reporter said, “The market didn’t work.”

The market didn’t work? You want to go ask Lehman Brothers whether the market didn’t work? You want to ask Bear Stearns or Merrill Lynch? People took too much risk, and nobody could have foretold that the housing market would have fallen the way it has. But I think if you step back, you can tell there was too much risk and if you leverage yourself 38 to 1, you have too much risk. And people won’t go back to that. This market taught a lot of people a lot of lessons.

Do you think Lehman Brothers and Bear Stearns  and some of the other large banks that had problems were handled fairly by the Treasury and the Fed?
I think the Fed and the Treasury did an extraordinary job. I think there was more systemic risk in play than anyone knew. When Bear Stearns was sitting on top of a massive swap book I don’t think anyone wanted to know or could fathom how the failure of that book worked its way around the world. I think by putting Bear Stearns in safe hands it clearly saved us from a tremendous amount of damage. And I will tell you, if AIG had failed I think all of Wall Street would have failed the next day.

How should a board like yours be looking at risk?
You’ve got a significant portion of the talent on the board on the risk committee, and that has worked very well for us. We have a number of risk committee meetings—more than any other committee—and we give them a tremendous amount of information. There’s a lot of discussion at the risk committee, and they probe management regularly, but they’re not trying to tell us what to do. We have answers to the general questions that they have and that’s important.

Has your relationship with your board changed at all as a result of the financial crisis?
I don’t think so. I think the chief executive has an obligation with the board to be totally transparent. A fellow who was on our board years ago told me, “All surprises are bad.” That’s true for the most part in life and it is clearly true with the board of directors. Whether we’re going through good times or troubled times, we’re jointly trying to manage the company, and so if there’s a difference between where the CEO and the board want to go, then you have a significant problem. If you are not keeping the board fully informed about what’s happening in the company, then you have an opportunity to have a gap and then surprises, and those are bad. Communicating with the board is something that’s been important to me since I got the job. Some times are better than others, but communicating and being totally open with the board allows you to build your reputation or your relationship with the board on an integrity basis. To the extent that a board doesn’t trust the CEO or it doesn’t trust the management, then it’s time to make a change.

You recently announced an increase to your dividend. How are you able to do that when many companies are making cuts?
We have a very strong balance sheet and we have a very large capital program. What we try to do is maintain our dividend and have small, incremental growth in it, which is less than the growth in our earnings. And we’ve been able to do that. While earnings have been somewhat flat—like everyone else, we have been affected by the economy—we continue to batten down the hatches and work our way through this downturn in the economy.

What’s the board’s involvement in the planning process as you plot your way through an environment like this?
I just came off our board retreat. We did something different this year. It takes us 10 years to build a nuclear plant, it costs $10 billion, and the plant will operate for 60 to 80 years. So that’s the kind of timeline we have to have in our minds. So what I did with the board that was different than the past is, I said let’s not worry about the next five years. Instead, I suggested that we focus for five to fifteen years out, and try to imagine what the business will look like. We brought in some people that had views that are different from ours, to help challenge us, so that we don’t find ourselves drinking our own Kool-Aid.

You have earned a reputation as an environmentalist energy company CEO. Wouldn’t it be a lot easier to not address the environmental side? Because in some ways, it makes you a target for both sides of the debate.
It really does, and in some interesting ways. But you know, I actually believe, in my role—we’re the third-largest generator of electricity in the country, the third-largest generator of coal, the third largest generator of nuclear power— and part of my mission is to educate the public on these issues. There’s an amazing lack of understanding of how we generate energy in this country. And so one of the things I strive to do is to get out and tell a story. Now the environmentalist part of it is that I actually believe our mission has changed. In the 20th century, our mission was to provide easy access to electricity in the United States. In the 21st century, our mission is going to be to help our communities become the most energy efficient. We’ll have to change our regulatory business model to do that. We are going to retire and replace every power plant we own between now and 2050. But the country—and the scientists believe this is a problem that needs to be addressed—wants us to have a low-carbon generation fleet. There couldn’t be a better time in history for me to make that transformation, because I’m going to have to replace them with something, so let’s replace it with something that’s low-carbon.

Does your board support your stance on these issues?
We have a rich debate on them. Some of the directors approach the global warming issue slightly different than I do. But I welcome such a different view, because it crystallizes the conversation. You have different points of view that lead to robust conversation, but it also leads to a policy that really reflects a lot of optionality and recognition of:  “Well, wouldn’t you do this anyway, without global climate?” or, “Shouldn’t you pursue this option versus that one?” I’m also a big believer in bringing outside speakers in with various points of view. I have a long history of doing that. And I’m a big believer in having diverse points of view on the board and engaging these diverse points of view.

You have a new CFO. What does it require of you and the board when you have a high-level change like that?
I think one of the important things, is that any time you change the CEO, CFO, or COO, it’s really important to have clear communication about why there’s a transition and it’s important to introduce your new person to the primary constituents that they’ll be addressing. So that is one of the things that we did. It was a seamless transition. We had the perfect replacement in Lynn [Good], who was a controller of Cinergy and CFO of Cinergy immediately before the merger with Duke.

How has the role of CEO, generally, changed over time? Do you think there’s a new paradigm for the CEO’s job?
I do. And the advantage for me is that I’ve been a CEO for so long, I have a good sense of the operation, but probably more importantly, I have incredibly strong people in operating roles that really complement my capabilities, but also complement the demands that I have—on me. I’ve started to think that I have two roles: One is the traditional running the business—in military terms, it’s “the general.” I also think that another aspect of my role is external. And this role is about building relationships and collaborating. Business people are used to talking to other business people, but I think the real alliances of the future is when businesspeople are reaching out with NGOs, with environmental groups, with consumer groups, with people outside and with differing points of view. I think that collaborative, working-together role is a key part of what I do. I think the other part, and what I really enjoy now in this very transformative period, is looking at new technologies. I believe I’m a “scout,” so part of my mission is to look at new value propositions and make sure we understand these disruptive technologies and are incorporating them in our business model.

There’s a lot of effort underway to give shareholders more say in what’s going on. Is there a danger that the pendulum swings too far?
The pendulum is swinging, and there is a risk that it swings too far. And a lot of this is a reaction to the economy, and returns are down, and stock prices are down, and it’s a reaction to some excesses that occurred primarily in the banking industry, and bank boards didn’t perform particularly well; in fact, they didn’t understand the products they were selling and investing in. So I think this is a natural thing, and I think we need to be careful to keep it centered.

What are your thoughts on CEO pay and the debate over compensation?
I think it’s changing and I think you will see a push to tie pay more closely with performance. I just signed a contract for five years; I get no cash salary, no cash bonus, and most of the stock I get paid is at the end of the five-year period. And, the way that it works is that part of my stock compensation doesn’t occur until two years after that. So I’m incented to make sure I have a really strong team performing well after I leave.

Directorship interview conducted by Joseph McCafferty.