Liberating the Board of Directors

Giving non-executives ultimate authority . . . and then holding them accountable

In five years – maybe sooner — Boards of Directors in the US are going to govern their companies much more freely than they do now.    

Today, more than half the companies in the S&P 500 combine the roles of Chairman and CEO.  When those two positions are held by the same person, the CEO listens only to himself.  He also basically gets to handpick all the other members of the board and senior management.   That generally provides a captive audience for the CEO.

…through their recent campaign successes, hedge fund activists have shown that the Boards of some of the largest and best-known companies in the country lack the objectivity to identify and exploit strategic maneuvers that would benefit their shareholders.

Whether the two roles should be combined is a debate that has been brewing for years.  No one really knows if one governance model outperforms the other.   For a couple of very good reasons, however, the momentum has shifted decidedly in favor of splitting the roles.  First, thanks to the recent spate of banking scandals and product recalls, institutional investors have begun to clamor for separate roles as a way of rehabilitating organizational culture and tightening operational controls.  Secondly, through their recent campaign successes, hedge fund activists have shown that the Boards of some of the largest and best-known companies in the country lack the objectivity to identify and exploit strategic maneuvers that would benefit their shareholders (and not just in the form of quick pops in their stock prices). 

Stocksy_txp22897f9f4nD000_Small_205628Because they can’t help but be wedded to their own courses of action, company managements are inherently resistant to the bold moves typically promoted by activists.  Activists, meanwhile, are attracting increasing support for their campaigns from the largest institutional investors in the country.  Sovereign wealth funds, such as Norway’s gargantuan Government Pension Fund (almost $900 billion in assets), are now also playing a more activist role with their investee companies.

What is evolving is a profound change in US corporate governance.  Many of the largest companies have demonstrated their strategic weaknesses by conceding – sometimes sooner, sometimes later – that the activists on their case have good ideas or that the scams uncovered within their ranks expose serious cultural and operational infirmities.  The public cannot help but think that lots of US companies are just too big or too complex to govern.   

Short of breaking up those companies, we can take a crack at improving their performance by separating their Chairmen from their CEOs, which is what seems to be happening in the US.  In 2002, for example, three out of every four Chairmen of S&P 500 companies were also their CEOs.  Today, that figure is down to 57%.  In the UK, by contrast, splitting the roles is considered best practice and only one of the 150 largest companies in the country (Carnival plc) still unifies the Chairman and CEO. 

When the Chair is separated from the CEO, the former has the last word on any major corporate resolution.  Now map that concept onto twin-hatted US moguls like Jamie Dimon (JPMorgan) and Lloyd Blankfein (Goldman Sachs) and guess how they would choose between those roles (if they had the choice).  That would put someone else in charge of day-to-day operations who would report to them – not in their capacity as CEOs, but as the legal guardians of their companies’ shareholders.

To free the non-executive directors entirely from the clutches of the CEO, the next step would be to require all of them to be nominated by a committee of outside directors.

Once a non-executive Chairman has been installed, US regulators may then require the majority of directors to be independent1.  To free the non-executive directors entirely from the clutches of the CEO, the next step would be to require all of them to be nominated by a committee of outside directors.  The CEO’s job would then be to present to an independently-controlled Board what the management team wants to accomplish for the company – short-term and long-term – and then abide by their resolutions.

Under this arrangement, the outside directors would not be dependent on the CEO for their seats on the Board or for the remuneration, reputational benefits and other perquisites they receive for their Board service.   Their fiduciary duty to shareholders would then take priority over preserving the organizational status quo, and that would make the Board more likely to give serious consideration to business plans or policies different from those advocated by management, even if they are put forward by activists.

To make sure that independent directors fulfill their duty to shareholders once they have been liberated from the shackles of CEO investiture, their newfound authority should be matched with commensurate accountability to their shareholders.  One way to accomplish that may be to track the EU’s new rule holding bank executives personally liable for “reckless staff behavior.”  Extending that potential liability to the independent directors of a split public company Board would almost certainly reduce the likelihood of a rogue corporate culture or deficient corporate controls.

1 US mutual funds, for example, have already taken a step in this direction and currently require that at least 40% of their boards are independent directors. In Europe, independent directors constitute an average of 43% of corporate boards and, in some countries such as the Netherlands (75%), Finland (69%), Switzerland (65%), the UK (61%) and Norway (50%), they already constitute the majority according to the OECD.