A selection of recent international journal articles on board/CEO issues.

    Are ‘Home Alone’ CEOs a governance risk?

    What happens when you leave a CEO “home alone” on the board? That is, when a board is full of independent directors and the CEO is the only executive director. Could this board structure weaken governance and reduce the firm’s performance over time?

    United States academics have studied the effects of “lone-insider” boards on CEO pay, financial misconduct and firm performance. They found that having only one executive director on the board weighs on firm performance and corporate reputation. Put another way, the board is more effective with a few executive directors who serve with independents.

    The research is timely. More than half of all firms in the US S&P 500 index now have lone-insider boards, where the CEO is the only “inside” director. The push for board independence in the US may have swung too far.

    Like other countries, Australia has had intense governance debates about the merits of board independence. Corporate scandals in the previous decade heightened attention on the need for greater board independence. Agency theory advises that boards should be comprised of a majority of outside, independent directors.

    Professor Alex Frino, Deputy Vice-Chancellor (Global Strategy) at the University of Wollongong, has found that board independence in Australian improves firm performance – to a point.

    His paper, “The Relationship between Board Independence and Stock Price Performance”, found that the largest 200 ASX-listed companies with balanced boards (between independent and non-independent directors) outperformed all others in terms of market-adjusted stock-price returns. Companies with boards that had 40-60 per cent independent directors performed best.

    The finding suggested that too much independence weighs on firm performance in Australia, as does too little independence. The key for boards is finding the right balance.

    US academics Michelle Zorn, Christine Shropshire, John Martin, James Combs and David Ketchen, sampled companies in the US S&P 500 index from 2003 to 2014. They identified lone-insider boards and assessed firm performance, financial misconduct and CEO pay. Their research was published in the latest issue of Strategic Management Journal.

    The authors wrote: “Our results support pro-insider agency theory’s claim that one or more inside directors beyond the CEO adds value. In their absence, CEOs receive excessive pay and enjoy larger CEO pay gaps (with the executive team). firms engage in more financial misconduct and firm performance suffers.” The negative effects of lone-insider boards were reduced when the firm had a high level of stock analyst coverage and greater institutional ownership.

    The authors argue that lone-insider boards are an extreme form of governance that have negative unintended consequences.

    In the push to increase board independence, firms overlook the value of non-CEO executive directors. Such directors, such as the firm’s Chief Financial Officer, enhance the ability of independent directors to monitor CEO performance; provide better board access to critical information; and enhance CEO succession options by allowing the board to work with executive directors who might be candidates for the CEO role.

    Arguably, the best check on the CEO comes from his or her executive peers. The exit of talented executives can be a signal that they are unhappy with the CEO’s performance, judgement or ethics. Also, having a few executive directors serve with a majority of independent directors can be a counterbalance to CEO power on the board.

    • Zorn, M., Shropshire, C., Martin, J., Combs, G., Kretchen.,D, “Home Alone: The Effects of Lone Insider Boards on CEO Pay, Financial Misconduct and Firm Performance,”, Strategic Management Journal. Vol 38. Dec 2017.

    How large is the CEO talent pool?

    Debate has raged in Australia and overseas for years on the quantum of executive pay and its link with firm performance. A body of academic research examines whether CEO pay levels are set fairly and proxy advisory firms scrutinise executive pay in minute detail.

    Less considered is the scarcity of CEO talent. Proponents of high CEO pay argue that executive salaries reflect the reality of global markets. The pool of CEOs who are capable of leading multi-billion-dollar organisations and lifting their performance is small.

    This argument is largely anecdotal. Few studies have tried to quantify the size of a qualified labour pool for CEO roles across industry or how hard is it to attract such people to CEO roles. The scarcity of CEO talent pools is an important issue for CEO pay, performance evaluation, succession planning and talent development and retention.

    Researchers at the Stanford Graduate School of Business and the Rock Centre for Corporate Governance attempted to answer these questions. They surveyed directors on the boards of the largest 250 companies in the US (by revenue), to understand their perspective on the size and quality of the labour market for CEO talent. Just over 100 directors gave their view.

    The resulting paper, by Nicholas Donatiello, David Larcker and Brian Tayan of the Stanford Graduate School of Business, argues that the market for CEO talent is much tighter than many governance experts realise – a finding that has implications for the CEO pay debate.

    Directors, according to the survey, believe that fewer than four executives have the right skills to run their company (and perform at least as well as the current CEO) – a remarkable finding that reinforces the challenges that boards of large organisations face when choosing the CEO.

    When asked how many executives could step into the CEO role of their biggest competitor (and perform at least as well), directors estimated six candidates.

    Directors agreed that CEOs in their industry have “specific skills that are extremely hard to replicate”, that successful CEOs had “general management expertise and industry expertise”, and that it is “impossible to be a top company in our industry without having a top CEO”.

    The findings have five main implications for corporate governance, argue the researchers:

    • The labour market for CEO talent is inefficient. The scarcity of outstanding CEO talent can distort the balance of power between CEO and the board.
    • Pay. The extraordinarily tight labour market for top CEO talent helps explain increasingly high compensation levels. The best CEOs are hard to secure and the risk of losing them to a competitor can be high.
    • Performance evaluation. The scarcity of CEO talent can influence the board’s assessment of their performance. The challenge of finding a replacement CEO in such a small pool might encourage boards to tolerate less acceptable firm performance and CEO behaviour than they would if there was much larger pool of candidates from which to choose.
    • Succession planning. The small CEO talent pool increases pressure on boards to ensure a strong succession planning process to ensure there are sufficient internal candidates.
    • Talent development and retention: The authors argue it is more economic for companies to invest in – and retain – their best internal talent, given the scarcity of external candidates with the right skills to lead the company.

    Donatiello. N., Larcker, D., Tayan, B., “CEO Talent: Dime a Dozen or Worth its Weight in Gold”, Stanford Closer Look Series, Rock Centre for Corporate Governance, September 2017.

    Corporate Social Responsibility and CEO dismissals

    Most CEOs are fired because of poor firm performance: bad strategic choices, weak implementation or ill-timed acquisitions, for example. But how long until more CEOs are dismissed because of corporate social responsibility (CSR) issues?

    Markets believe the CEO’s main task is to generate economic returns for shareholders; that firm performance is the main metric to evaluate their performance; and that CEO dismissals are most influenced by firm performance. CSR issues, offering important context to firm performance, are mostly considered a secondary issue for CEO focus.

    That could change if corporate scandals have a greater negative impact on firm valuation; institutional investors place greater weight on CSR in investment decisions; and as social media amplifies reputational damage from CSR problems.

    Consider banking. Australia’s banking sector, rocked by corporate scandals this decade, is working hard to lift its reputation with the public. Although the sector has delivered a strong financial performance this decade, there has been executive change after CSR problems and boards have taken stronger action to link executive pay with corporate reputation.

    The Commonwealth Bank of Australia in August required CEO Ian Narev and other group executives to forfeit short-term incentives for FY17 after the Australian Transaction Reports and Analysis Centre (AUSTRAC) initiated civil penalty proceedings. Narev will retire by the end of this financial year.

    QBE Insurance Board and Seven West Media are others that reduced CEO pay after corporate-reputation damage that stemmed from the CEO. How long until boards go a step further and dismiss CEOs for significant CSR failings, even when firm performance is strong?

    US academics, Timothy Hubbard, Dane Christensen and Scott Graffin, studied almost 100 CEO dismissals in the US, where CEOs were reported to have been fired or forced out, resigned immediately or unexpectedly, or retired early amid firm-performance issues. Their research was published in Strategic Management Journal.

    The researchers found that the firm’s earlier CSR decisions may affect the current CEO’s career. They wrote: “Our results suggest that past CSR decisions amplify the negative effect between (the firm’s) financial performance and CEO dismissal.”

    Greater prior investments in CSR expose CEOs of firms with poor financial performance to greater risk of dismissal, and shield CEOs of well-performing firms from dismissal.

    The authors argue that a high level of past investment in CSR amplifies the positive framing of good financial performance; it appears that the CEO can deliver strong economic returns in a socially responsible manner, thus limiting the risk of their dismissal if a CSR problem emerges.

    Equally, high past investment in CSR can amplify the negative effects of poor firm performance. Some shareholders might argue that the CEO is too concerned about the firm’s CSR agenda and not enough about delivering economic returns for shareholders, thus increasing the risk of their dismissal.

    The research has two key learnings. First, that CSR will play a greater role in CEO dismissals in coming years amid the global move towards responsible investing (which incorporates Environmental, Social and Governance factors in investment decisions).

    And second, boards and CEOs must consider the firm’s past CSR investments as they affect how the market interprets current firm performance and whether the CEOs should keep their job.

    • Hubbard, T., Christensen, D., Graffin, S., “Higher High and Lower Lows: The Role of Corporate Social Responsibility in CEO dismissal,” Strategic Management Journal, Vol 38, Nov 2017.

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