How To Govern The Governors

The financial crisis of 2008 unleashed intense public fury at the corporate world, much of it aimed at chief executive officers and their boards of directors. Corporate governance in the United States has become a topic for front-page news articles and television talk shows. Concentrated public scrutiny is placing corporate boards under increasing pressure as they grapple with a broad range of challenges, including the allocation of resources and accounting transparency. A push for sweeping new federal regulations may accelerate changes that were already under way.

The prospect that there will be significantly different rules in the United States governing the way companies are run frightens some observers. “With the exception of Sarbanes-Oxley, which was very specific, for the first time there are people at the federal level who want to legislate corporate governance,” said Jay W. Lorsch, a professor at Harvard Business School and author of books on the subject. “That’s never happened before and it could be dangerous.” (The Sarbanes-Oxley Act of 2002 is a federal law aimed at increasing auditing transparency at United States corporations.)

Apart from possible new federal regulations, public pressure is already forcing boards to reassess what are perceived as “best practices.” It’s important for directors to maintain a firm sense of purpose. In the midst of the tumult, a consensus is beginning to form on how boards can maintain and improve performance. Here are a few hard and fast rules boards can live by:

When regulations become more stringent, there’s a tendency to focus on dotting i’s and crossing t’s. But it’s a mistake to lose sight of the forest for the trees. Professor Charles Elson, who is chairman of the John L. Weinberg Center for Corporate Governance at the Lerner College of Business & Economics at the University of Delaware, warns of the dangers of a checklist mentality. “Sarbanes-Oxley, although it was well-intentioned, ended up causing more problems, because a lot of boards thought that as long as they were complying with that, their job was done,” he said.

New rules could worsen the problem. Robert Hallagan, a corporate governance expert at Korn/Ferry International, recommends that directors stay grounded by examining items on the board meeting agenda. They should start by asking themselves how much time is dedicated to long-term strategic issues. “If that’s not most of the meeting, then there may be an issue,” Hallagan said.

Regardless of what happens legislatively, certain constants remain. One is the definition of a board of directors’ central role: finding a good CEO, or getting rid of a bad one. “Without an appropriate and effective CEO in place, no amount of hard work will protect shareholders from disappointment,” said William F. Pounds, the former dean of the Sloan School of Management at M.I.T. “And only the board has the power to hire and fire CEOs.”

So how do you get a great CEO? Despite widespread criticism and even outrage over CEO pay in the United States in the aftermath of the financial crisis, a fatter salary remains a powerful way to attract talent. A 2007 report by the consultancy Watson Wyatt (admittedly, it was conducted before the 2008 stock market collapse) concluded that the link between CEO compensation and corporate performance is strong. For many executives, it seems, money still talks. And, because hiring competition for high-level operating talent has also been coming from deep-pocketed private equity, venture and hedge funds, CEO pay has been rising.

Yet, others see this reasoning as flawed. Not all CEOs appear to be motivated by pay alone. Eric Schmidt of Google, Larry Ellison of Oracle and Vikram Pandit of Citigroup are just a few of the American CEOs who this year accepted an annual salary of $1. Skeptics argue that $1 salaries are great public relations moves for companies in which these CEOs hold a lot of stock. Still, the low salaries challenge the notion that managers’ commitment depends solely on compensation.

In fact, it may not be absolute pay, but pay relative to other CEOs in the same industry that matters most. Sarbanes-Oxley requires corporate boards to justify CEO salaries, and most do so in part by benchmarking those salaries against others in the industry. The rule has had some unintended consequences. The financial economists Jun Yang and Michael W. Faulkender noted in a study this year that benchmarking tends to encourage CEO salaries to rise in “leapfrog” fashion, as no company wants to be seen as paying their top gun less than its competitors.

Enter the Lead Director

More than half of the companies in the Fortune 500 combine the roles of chief executive officer and chairman, and so a Securities and Exchange Commission proposal to prohibit the practice could have far-reaching consequences for corporate governance in the United States.

The proposed move risks oversimplifying a key issue of corporate governance in the United States. “There’s no proof that splitting the two is a better practice,” said Robert Hallagan, a corporate governance expert with Korn/Ferry International. “General Motors was one of the first big companies to officially separate the two, and that hasn’t turned out so well.” Citibank and Bank of America, at the center of last year’s financial crisis, follow a similar model.

Having two different people at the helm of a corporation often makes sense. In the interest of succession planning, for instance, a long-term CEO may assume the chairmanship role for a limited time while the new CEO learns the ropes. It can also be a way for a highly successful executive to maintain a hand in a company’s operations. Bill Gates, for instance, ceded the CEO position at Microsoft to Steve Ballmer in 2000, but kept the title of chairman.

Sometimes, the chairman and CEO perform very separate and well-defined roles. In 2004, for instance, the software company Computer Associates appointed Lewis Ranieri to serve as its chairman. His main job was to deal with a federal investigation of the company, leaving the day-to-day operations to other managers.

Yet having two top executives can lead to confusion about who makes the final decisions. “Sometimes you’ve got a chairman who wants to be the CEO, and you create a rivalry that is not healthy for the corporation,” Hallagan said.

The real challenge for American companies may be to separate not the chairman and CEO, but the executive and nonexecutive leadership roles. The appointment of a lead director of the board is an increasingly popular model at many corporations. “It creates a nonoperational, nonmanagement office that still has the weight of the independent directors behind it,” said Chris Andersen, who himself acts as the lead director for Terex, the construction equipment company.

A lead director performs a role very similar to that of a nonexecutive chairman — a chairman who doesn’t hold an operational management position. But a chairman can do two things a lead director can’t do: call board meetings and set the agenda of those meetings.

Still, lead directors have real power. “The main thing is that when I talk to management as a lead director, they know I represent the views not just of one board member, but of all the board members,” Andersen said. “I have the right — and I’ve used it, on occasion — to add something to the agenda of a meeting or insist that we schedule plant visits, for instance, if the board feels it wants more information on a specific issue.”

Britain and Canada follow a model of nonexecutive chairmanship. Often they have staffed offices within a corporation and so have a useful familiarity with day-to-day operations. “The main advantage there is that you’ve got someone who knows what’s going on but can lift his or her head above the throng to provide a somewhat objective viewpoint,” Andersen said. The primary disadvantage of nonexecutive chairmen is that they usually make more money than lead directors. Unless the conditions of their office are explicitly spelled out, they can also be difficult to get rid of.

Because corporations have different needs, corporate governance experts say, it may be wise to allow them to choose a solution for themselves. “One size doesn’t fit all,” said Jay W. Lorsch, a professor at Harvard Business School. “One company may thrive with a CEO who’s also a chairman; for another, it could be a big mistake.”

One excellent, and often disregarded, way to limit CEO compensation is through effective succession planning, an issue that is not part of the current corporate governance overhaul discussion. Building a strong bench internally keeps CEO pay under control for two reasons. First, corporations have a tendency to offer more when they recruit their top guns from the outside. Second, if another manager is poised to take over, the board is likely to be less beholden to the CEO. So if the top person makes unreasonable demands or fails to perform, directors can transition smoothly to their second in line. Most boards in the United States fail miserably in this area, Professor Lorsch says. “Corporate directors will talk a good game when it comes to succession, but in reality it’s too easy to put it off to the next meeting,” he said. Succession planning is impossible to regulate and difficult to assess. It entails important but “soft” human resource skills, like accurately evaluating secondand third-tier managers, and ensuring that promising executives get the right assignments to develop their skills. Hewlett-Packard has been much maligned for its succession planning, which many said left the company wed to Carly Fiorina for too many years. When the board dismissed her in 2005, it had to scramble for a replacement. McDonald’s, on the other hand, benefited from its strong bench when its CEO, Jim Cantalupo, died unexpectedly in 2004. A few weeks later, the man chosen to replace him, Charlie Bell, learned he had cancer, and the board was able to make another orderly replacement (See “How McDonald’s Plans Ahead,” by Deborah Jacobs, also in this issue).

Compensation is not just about salary. In the 1990s, corporate boards thought they had stumbled upon an almost foolproof method for aligning the CEO’s interests with those of the corporation: stock options. It makes sense, the theory goes, to make the CEO a substantial owner. If the company performed well, its value would rise, thereby benefiting top management. Corporate America passionately embraced this new philosophy.

The global financial crisis of 2008 showed, however, that this method does not always work. As the United States Treasury Secretary, Timothy F. Geithner, remarked earlier this year, too often “the incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage.” In other words, stock options may encourage executives to manipulate short-term stock prices by taking unnecessary and ill-advised long-term risks.

Over the next few years, greater attention is likely to be paid to the type of compensation being handed out. In the United States, in certain regulated industries, like banking and financial services, compensation that encourages excessive risk taking will be curbed. In addition, boards will be under pressure to make sure that a CEO’s interests align with those of the corporation, not just in the short term but in the long term as well. One option is to build greater flexibility into compensation packages, creating bonuses that would be at risk. If earnings flag, for instance, bonuses would be reduced.

Gene Sperling, a counselor to Mr. Geithner, recommends linking pay to relative performance in a given sector. By this measure, CEOs would be compared with competitors in the same industry, thereby avoiding giving an executive too much credit when a bull market was helping almost all stocks.

There’s no doubt that some corporate boards have neglected their main task, which is to ensure that CEOs behave responsibly. At times, this may be the result of an overly cozy relationship with top management.

At Enron, the energy company whose apparent success was built on accounting fraud, some of the directors, investigators discovered, were deeply beholden to the corporation’s executives for lucrative consulting contracts and big donations to their favorite charities.

How to Pay your CEO

The biggest trends in CEO pay guidelines, according to the Center on Executive Compensation Corporate boards are increasingly likely to include the following stipulations in their compensation contracts with top managers:

    * A requirement that CEOs own shares in the company equivalent to at least six times their salary.
    * Claw-back clauses that make it possible to recover a portion of compensation if performance is poor.
    * Stock awards linked to performance measures like cash flow, earnings per share and return to shareholders, generally over a period of three years (though many believe a longer time frame would be even better).
    * Retention clauses that require CEOs to stay on the job for five years or more in order to qualify for stock awards.
    * Limits on golden parachute payouts to three times or even two times the CEO’s annual salary.

The federal judge Richard Posner probably reflected the views of many when he wrote in an opinion last year that CEO pay is “excessive because of the feeble incentives of boards of directors to police compensation. Directors are often CEOs of other companies and naturally think that CEOs should be well paid.” There is a general fear that corporate boards are overly cozy with top managers and part of a culture of “I’ll scratch your back if you scratch mine.” It’s essential that the independent board of directors is just that — completely independent.

One new proposal for the United States by the Securities and Exchange Commission would be nothing less than an earthquake for corporate management: the mandatory separation of the roles of CEO and chairman of the board. Although common in other countries, like Britain and Canada, both of which are highly rated with regard to their corporate governance practices, separating the CEO and chairman roles is not mainstream in the United States. According to the Millstein Center for Corporate Governance and Performance at the Yale School of Management, 60 percent of Fortune 500 companies have CEOs who also serve as chairmen of the board.

The Millstein Center calls the shared role of CEO and chairman a mistake in most cases. “Too many boards are still led by the CEO — the person who is obviously conflicted in fulfilling the essential duty of providing oversight and monitoring the CEO and senior management team,” said Gary Wilson, a former chairman of Northwest Airlines and a current director at Yahoo.

A growing number of American corporations are trying to address any possible conflict of interest by appointing a “lead director” to preside at executive sessions and evaluate management. The lead director role is a uniquely American approach to corporate governance especially when the roles of CEO and chairman are combined. Where the CEO serves in a dual role as chairman, 84 percent have taken this step, according to Korn/Ferry International.

“Twenty years ago, board members would meet for an hour, then go play a round of golf,” Hallagan said. “Those days are over. They’re more professional. They go to training sessions and are constantly trying to improve performance.”

Board members are working longer hours. Directors in North America, for instance, reported spending 16 hours per month on the work of each board they serve on, according to a Korn/Ferry International study; 20 years ago, the figure was 9.5 hours. Because of the longer hours and a perceived increase in legal liability — highlighted by the Enron scandal and ensuing shareholder lawsuits against board members — some are becoming more reluctant to serve. “I’ve heard people say serving on a board is just not worth the time and the liability any more,” said Ralph Walkling, head of the Center for Corporate Governance at LeBow College of Business at Drexel University.

As a result, directors are being paid significantly more than they were just a few years ago. According to Korn/Ferry International, the average cash payment to directors rose 45 percent from 2002 to 2007, to about $62,000.

Demand is also shifting in favor of directors who can provide specialized experience. This has coincided with a shift in power from the general board to board committees, in particular the audit and compensation committees.

Financial experts are increasingly desirable as board members in the United States. The demand for accountants as directors, in particular, rose sharply in the wake of the Sarbanes-Oxley legislation of 2002, which required that audit committees have at least one member who is an expert in finance. That rule led to what Professor Pounds calls a “bonanza for retired CPAs.”

Continuing education for board members is gaining momentum, too, leading to a surge in supportive board services. Consultants say demand for their business has increased sharply. The greater use of consultants gives boards access to important expertise, but it also puts the onus on boards to make sure those consultants are truly independent and do not have conflicts of interest.

Many observers see the rise in pay, commitment and responsibility of board members as a big positive for corporate governance. “Before, boards weren’t paid as much, but then they didn’t do very much of value,” Robert H. Frank, an economist at Cornell University, explained. “In the future, they’ll be expected to do more, but in turn, they’ll be handsomely compensated. It’s the new model.”

Boards are paying increasing attention to shareholder demands. According to the consulting and research firm RiskMetrics Group, for example, almost two-thirds of the Standard & Poor’s 500 companies have adopted “majority voting” rules, which require a director to obtain at least 50 percent of the shareholder votes in an election.

In addition, “say on pay” resolutions, which allow investors to vote on executive compensation packages, have been filed at more than 100 United States corporations this year. Apple, Edison International, Honeywell, KB Home, Lexmark International, Pfizer and Marathon Oil are just a few of the companies whose investors have called for a say on pay.

Nevertheless, public anger in the United States over corporate governance is likely to fade quickly. The average individual shareholder is rationally apathetic about corporate management. “It’s simply not worth most people’s time to read several hundred pages of proxy statements if they hold just a few corporate shares,” says Charles G. Tharp, head of the Center on Executive Compensation, a Washington-based research group.

Institutional investors, on the other hand, will probably continue to flex their muscles. Companies with large proportions of such investors are generally governed more aggressively. A high concentration of institutional ownership, for instance, means lower pay and greater performance demands, according to a recent study by the McCombs School of Business at the University of Texas at Austin.

Pension funds and unions, in particular, are becoming increasingly bold and specific in their demands. Earlier this year CalSTRS, the California State Teachers’ Retirement System, said it would urge corporations in which it has a stake to put more women on their boards, citing a study that found the presence of female directors as a positive influence on financial performance.

International investors, too, are expected to push for a bigger voice. In August, Singapore’s state-owned investment fund Temasek Holdings, which has stakes in Merrill Lynch and Barclays and once owned a large piece of Bank of America, updated its investment charter to pledge “sustainable returns by engaging with the boards and management of our portfolio companies.” Other groups are likely to follow suit.

An excess of caution can undermine the effectiveness of corporate governance. Boards must remember that successful organizations are built on taking sensible risks. “What one fears with increasing regulation is that boards just go through the motions — be forced into what’s called the checklist mentality,” Mr. Walkling said. “We also don’t want them to avoid sensible risk, which is after all what builds corporate success.”

Over the next few years, the pace of corporate governance reform is likely to accelerate. So far, big multinationals have been at the forefront of shifting standards. Their practices will begin to be absorbed by smaller groups. “Over the next couple years, we’ll see a cascading down of these practices to smaller companies,” Mr. Tharp predicted.

For the most part, the overhaul will probably be a positive thing. But concern is growing that the pendulum may swing too far in favour of rules and regulations. According to Korn/Ferry International, directors say they have less time to strategize as they are forced to comply with new regulations and shareholder expectations. This could be a worrisome trend.

What makes for the success of corporate boards is positive human interaction. Directors must be able to work together well, make sensible demands of management and think strategically. These qualities are worth striving for, since they could make the difference between corporate failure and corporate success.

A long-time correspondent for The Financial Times, Victoria Griffith covers business from Boston.