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.