When most people think of a company's organization chart, they put the chief executive officer at the top of the pyramid. But those with an interest in corporate governance know that's not correct.
After all, the CEO reports to the board of directors, which focuses on such critical issues as CEO performance and succession, corporate strategy, and executive compensation. In a recent interview at Harvard Business School, governance expert Jay Lorsch, the School's Louis Kirstein Professor of Human Relations, offered his insights.
Jim Aisner: According to an article in yesterday's New York Times, "the top 200 chief executives at public companies with at least $1 billion in revenue got a big pay raise over last year," with a median 2012 compensation package of $15.1 million, up 16 percent from 2011. What's going on here?
Jay Lorsch: My colleague Professor Rakesh Khurana and I wrote at length about the The Pay Problem posed by executive compensation in a May/June 2010 article in Harvard Magazine. There we argued that evidence of the link between executive compensation and company performance is not clear. We noted, for example, that one comprehensive survey found that "changes in firm performance account for only 4 percent of the variance in CEO pay." That said, to what extent can you really argue that a CEO can affect the stock price of a company? There may be some connection, but the state of the economy and numerous other factors have a more significant impact. Nonetheless, boards have been focusing strictly on monetary rewards as an incentive for CEOs to achieve desired results, tying the returns that go to stockholders to the size of the chief executive's paycheck.
At the same time, consultants have been hiking up the cost of CEOs by producing tables that establish the going rate for talent according to company size, industry, and geography. Salaries in these tables are reported in quartiles, from highest to lowest amounts, and no corporate compensation committee wants to say that it went bargain hunting for low-hanging fruit. So the trend has been ever upward.
There was some hope that the concept of "say-on-pay," where shareholders vote on the CEO's compensation, might have some impact by making compensation committees more cautious, but we clearly still have a long way to go. I stand by what Rakesh and I wrote in our article three years ago: "Rethinking the nature of executive pay within the context of our larger economic and social system and the challenges we face may enable us to create a new model of compensation rooted in a more realistic recognition of the social context within which firms operate [one that includes both stockholders and stakeholders]. It should, and can, rest on valid assumptions and fundamental values that allow us to build a more inclusive and sustainable economic future—one in which we don't have to bribe executives to do the duties we have entrusted to them."
“Too often the separate chairman can begin to be more active and try to control the CEO.”
Q: On another front, when it comes to corporate governance, the pros and cons of separating the roles of chairman and CEO continue to receive attention, most recently in regard to Jamie Dimon's role at JPMorgan Chase. What do you think about that issue?
A: There is a set of beliefs emanating largely from Europe and the United Kingdom that having a separate chairman and CEO is a good idea, better than the American model of combining the two. The notion is that if the chairman and CEO are the same person, you're letting the fox into the chicken coop, so to speak, since the CEO/chairman sits at the head of the table, leads the discussions, and in effect controls the flow of information, since he knows more than anybody else. The notion of a strong leader has been an American value for a long, long time. Over the last couple of decades, however, there's been growing pressure to separate the two jobs in the interest of more effective checks and balances. This comes mostly from the big state employee pension funds like CalPERS, some of the big union pension funds such as the AFL-CIO, and others who have become interested in it. It's easy to see why some people think it's a good idea, because you have another powerful and influential person involved. But there's also a downside. Too often the separate chairman can begin to be more active and try to control the CEO. Beyond that, some directors don't like it because they believe that the chairman is trying to control the whole show, and so they feel left out.
Going back 20 or 25 years, some of us came up with an alternative idea, the creation of a lead or presiding director. With that model, the independent directors on the board elect one of their own to lead them in those instances where they need to meet alone, especially when they see problems that the combined chairman and CEO isn't addressing. This gives the board more power and the ability to act independently of management if they think it's necessary. Nearly all companies have lead directors now because both the New York Stock Exchange and Nasdaq, as part of their listing requirements, stipulate that boards must have a separate chairman or a lead director. In addition, Dodd-Frank stipulates that boards must have a separate chairman, and if they don't, they have to explain why. For a lot of companies, the explanation is that they have a lead director. All the evidence I've seen suggests that this concept of a lead director works well. Does it work as well as a separate chairman? Fact of the matter is, it's hard to say that one is better than the other.
Q: When companies run into problems—be it a Hewlett-Packard or more recently Procter & Gamble and JC Penney—is the only alternative firing the CEO and starting over?
A: You don't have to fire the CEO. A lot depends on establishing the right kind of working relationship between the board, the CEO, and other top managers. The board's job is to approve strategy, and management's job is to propose strategy for the long-term direction of the company in terms of its products, pricing, customers, service, etc.,—all major decisions for scoping out a firm's direction. If you look at really well run companies, the board and management are usually on the same page. If things aren't going well, the board has to step in and tell the CEO it's just not working. That's where it gets sticky, because presumably the board has approved the direction, and now it's not working. Does the board take any responsibility for it or do they just get rid of that CEO and go find another one? I think that depends upon the judgment of the directors and their understanding of why a particular strategy is not successful. But the board certainly has a responsibility to be in the middle of that.
When it comes to making a change, boards unfortunately tend to do a very bad job of managing the succession process. Even if they have an inside candidate, which most do, they select that person mostly on past performance. But what they don't think about is the company's future strategic direction, the candidate's ideas about that, and his or her ability to do what's necessary to move the company from one place to the other. As a result, you're likely to end up with the problem HBS professor Clay Christensen has identified as discontinuity. That's no way to put a company back on the road to success.
Q: What about the paucity of women and other minorities on corporate boards?
A: It's no revelation that US companies are not doing very well in this regard. Even if a company has a woman and an African American on its board, what about an Hispanic or an Asian or a Native American? America is a land of great diversity, but Corporate America still doesn't adequately represent that. Norway has instituted a rule that 40 percent of corporate directors in that country must be women, but I don't think that kind of edict coming from the federal government would fly here, partly because the regulation of our boards is done by the states. If we're going to do something about this, I think the noise and accompanying pressure have to come from the various interest groups themselves.