The Durants’ The Lessons of History makes a compelling argument that accumulating power and influence is a positive human trait. If that is true, it makes sense that CEOs would strive to consolidate power, that shareholders would value their doing so, and that boards would put into power CEOs who can persevere in competitive situations. Such enormous, consolidated power, however, further underscores the need for an effective system of checks and balances.
Complex structures give executives greater flexibility in manipulating and reporting financial results and the ability to walk a fine line in terms of GAAP compliance.
The Power of Winning the Game
CEOs certainly have exerted their power in playing the Share Price Game. As discussed in The Share Price Game, the Share Price Game is fairly easy to win for relatively short periods of time, and sometimes for five years or more. Shareholders (subscribers to the Greater Fool Theory, especially) want CEOs to win. Directors who served under CEOs who won during the market boom of the 1980s and 1990s became big financial winners as well. Once directors tacitly accepted earnings management and manufacture as legitimate management activities, they endorsed the strategies and tactics required to win the Game. By that time, it would have been inconceivable and inconsistent, if not impossible, for directors to try to curb the power of a CEO who had delivered such seemingly impressive results.
The Star Power of the CEO
CEOs who attain star status have little difficulty in exerting enormous power over their boards. When a CEO is singled out as the primary reason for a company’s success, the board’s ability to exert discipline is greatly curtailed.
From 1980 to 2000, the positive results that companies showed were directly attributed to the CEOs. This is somewhat ironic because common sense says that a company’s success is the product of the cumulative efforts of many people—albeit under the leadership of the CEO. Nonetheless, CEO power and board weakness were propelled respectively to new heights and depths each time a headline lauded the achievements of star CEOs—such as Kozlowski, Welch, Messier, Ebbers, Bossidy, Gerstner, Lay, or Dolan. People should have been objectively reporting on the real performance of their companies—Tyco, GE, Vivendi, WorldCom, Allied Signal, Enron, or Bristol-Myers Squibb—instead.
With so many corporate leaders now stuck in the unflattering glare of the public spotlight, many reputable sources have proclaimed that the era of the star CEO is over. To paraphrase Mark Twain, the reports of the demise of the star CEO have been greatly exaggerated. As long ago as January 1993, an article in Fortune magazine declared, “The King is Dead,” and the “imperial CEO has had his day.”Fortune was just one among many respected publications that sounded the death knell over the next few years. In the November 3, 2002, issue of Fortune (again), Jerry Useem cited the publication’s 1993 obituary and candidly surmised, “As we know now, the imperial CEO was not only alive and well but very much on the upslope of his career … The more things change, the more creative CEOs get at turning circumstances to their advantage. In other words, they’ve got the power.”
So what’s a board to do with a star CEO? It all depends. CEOs should shine, but for the right reason: not as managers of stock price, but as managers who build enduring value in their companies. Leadership and charisma are both star-making characteristics. Leadership is essential to continuously improving performance across the entire organization. Strong leaders provide the focus and direction a company needs to attain its goals, and they motivate others to perform well. Strong leaders set high standards of behavior and exemplify them by their own actions. Strong leadership also reduces uncertainty about the company’s future and creates an environment where reasonable risks can be taken to deliver superior results.
Leadership combined with personal charisma instills confidence in the company’s prospects. Such confidence is not only critical to a company’s ongoing success, but also sets expectations of future results. Leadership and charisma in conjunction with full and honest disclosure is the most that shareholders could ask for in a chief executive.
Boards of directors should beware when a CEO achieves star status because their ability to discipline or replace that CEO is greatly compromised. If an excessive premium is built into the stock price primarily because of a star CEO, the cost to replace him can be high. Even if the board has legitimate reasons for wanting to make a change in CEO, they may feel hamstrung by the probability of a stock price decline in the near term. In such a case, the easy decision is no decision, and disclosing the dilemma to shareholders is not even a consideration.
Boards of directors should beware when a CEO achieves star status because their ability to discipline or replace that CEO is greatly compromised.
Although Alan Ehrenhalt, editor of Governing magazine, was referring to politicians, his comment in the New York Times of September 30, 2002, rings equally true when applied to star CEOs: “The leaders we have trouble dealing with are those of obvious talent and genuine achievement who turn out to have displayed appalling ethical insensitivity—or worse.” John Randolph, a Virginia aristocrat and member of Congress in the 1820s, coined a phrase to describe people like Henry Clay who, he complained, was so brilliant, so capable and yet so corrupt that, “like a mackerel in the moonlight, he both shines and stinks.”
When it comes to their confidence in and the legitimacy of corporate leaders, investors are dealing with the mackerel in the moonlight issue. Unlike the case with politicians, bad behavior on the part of corporate executives can have immediate, direct, and quantifiable effects on their constituents—especially their investors and employees.
The Power of Compensation
The enormity of executive compensation clearly demonstrates the power that CEOs command. According to the Institute for Policy Studies’ Seventh Annual CEO Compensation Survey, “Executive pay jumped 535% in the 1990s (before adjusting for inflation), far outstripping growth in the stock market (the S&P 500 rose 297%).” At the same time, the report goes on to say, workers’ pay grew by only 32 percent, which barely outpaced inflation.
It’s obvious that CEOs are getting a more than proportional share of companies’ higher reported returns. Don’t interpret this to mean that executives do not deserve excellent compensation. Those who build real value in the companies they lead should be paid handsomely for their performance. When compensation is not aligned with the right kind of performance, though, problems can arise. Those problems surely land most squarely at the feet of boards of directors who can control how executives are compensated. The Federal government has not made their job any easier. By limiting the deductibility of cash compensation to top executives, Congress during the Clinton administration encouraged the use of options as compensation, a primary driver of the Share Price Game.
The Alignment of Interests and How Options Work went into considerable detail about the issues that can surface when options become a major part of executive compensation. How major is major? The authors of In the Company of Owners: The Truth about Stock Options, Joseph Blasi, Douglas Kruse, and Aaron Bernstein, say that according to their calculations, “just the top five executives at the 1500 largest U.S. companies reaped a total of $18 billion in option profits in 2001.” For the entire decade of the 1990s, this group made a “collective total of about $58 billion.” They add that as late as the end of 2000, after the stock market had declined so dramatically, “the top five officers in the largest U.S. companies would have pocketed a total of some $80 billion in profits if they could have exercised all those options at once.” With so much at stake in terms of personal gain, one can easily understand why some greedy, unethical executives have taken as much as they could.
The Power of Information
To support and sustain their power over the corporation and the board of directors, many CEOs have circumvented governance mechanisms by supplying the board with information that is incomplete, inaccurate, or incomprehensible. They have prevented or discouraged directors from collecting independent outside information, meeting separately with internal and external auditors, and holding executive sessions of committees and the board. In a great show of reform, many companies are adopting guidelines to encourage such independent oversight from the board but have not empowered directors who continue to be deprived of time and resources.
A Power Base of Outside Experts
CEOs have found valuable allies for consolidating their power in the form of outside advisers and experts. While some experts have vigorously resisted the decline of good governance or have contributed meaningful solutions to the shareholders’ dilemma, others have simply been part of the problem. Much has been written and said about the problems and potential conflicts of interest that can arise when a company’s independent audit firm also provides outside consultation and advice to the company’s management. In recognition of this potential for conflict, regulatory and legal impediments, including provisions within the Sarbanes-Oxley Act of 2002, prevent auditors from providing general consulting advice to their audit clients, and the major audit firms have complied.
Until the passage of Sarbanes-Oxley, many audit firms generally reported to management. The clear requirement in the legislation is that auditors report to the audit committee of the board. This means that auditors are far more likely to alert the board to potential irregularities than they previously were. This may, in fact, turn out to be a significant factor in improving governance because it recognizes that boards need to have auditors working and reporting to them instead of to management.
Less well reported is the role of compensation and succession-planning consultants. Frequently CEOs engage their own compensation consultants to “advise” the board on what the CEO should be paid (of course, the company, not the CEO, pays for this advice), and the typical result is a rapid escalation in pay. How does this come about? The most important consideration seems to be what CEOs of comparable companies make, and the definition of “comparable” can easily be gamed to point to a higher “comparable” salary.
CEOs have also found power-building and power-sustaining allies in many, but not all, corporate governance experts. Over the past decade or so, some attorneys and university professors have promoted themselves as governance experts, and some have come to fairly high levels of prominence in corporate governance circles. As consultants, they are paid by companies and report to CEOs. Another category of expertise can be found in professional organizations that are directly controlled by or composed of CEOs. The Business Roundtable, for example, presents itself as an organization dedicated to good governance and routinely offers advice on the subject. Not surprisingly, this body of CEOs has consistently taken the side of executive management. In the past it has supported options as the primary component of compensation and opposed putting all stock option plans to shareholder votes or expensing options. It has opposed the separation of the CEO and board chairman positions, and only recently endorsed the concept that a majority of a board should be independent directors. Faced with continuing corporate scandals, the Business Roundtable has, to its credit, reversed many of those earlier positions.
Other governance experts, including members of various Blue Ribbon Commissions on corporate governance, have endorsed concepts of a single person serving as CEO and Chairman, the absolute and overriding necessity of friendly relationships between the board and CEO, and the predominant use of options to compensate both executives and directors.
As corporate governance has become an increasingly hot public relations topic, many companies have hired in-house governance experts and proclaimed with great fanfare their commitment to better governance. These staff experts report to the CEO. Undoubtedly many of them are very intelligent and well-meaning, but one can reasonably wonder whether a governance expert who reports to the CEO can operate effectively or independently in the interests of shareholders.
Corporate governance experts reporting to management can serve a very useful purpose: to collect and analyze information, benchmark performance, and provide a third-party perspective on the interrelated and complicated topics that directors face. Having such expertise available helps both directors and management to stay better informed, to share and agree on relevant information, to identify value drivers of the business, and to help identify and organize key issues.
To give shareholders the assurance that expert advice is being used in their best interests, it makes sense for experts to be hired by directors and report to them, whether for financial expertise, audit committee support, compensation advice, succession planning, or other corporate governance issues. Such experts can coordinate with those reporting to management to ensure that issues are vetted from all perspectives. This process can often resolve tensions and improve governance through information, analysis, and discussion.