When is it time for an underperforming CEO to go and how should the board handle the termination? Tony Featherstone investigates.

    Only one board job is harder than hiring the right CEO: firing your most important executive. Persevering too long with the wrong CEO inevitably sees the board criticised for sanctioning poor performance and failing in its most important duties – choosing the right CEO and incentivising and monitoring him or her.

    Moving too early to axe an underachieving CEO, or doing so in the wrong way, can be an even bigger minefield for boards. Nothing damages an organisation more than when a CEO or his or her supporters are furious about a dismissal and wage a war against the board in the media.

    The shock dismissal last year of Methodist Ladies College principal Rosa Storelli was an example of the fallout when a CEO or supporters dispute a sacking and criticise the board. Storelli’s termination played out in the media for weeks and damaged the prestigious school’s reputation.

    The damage can be far worse for listed companies. Share prices tumble if there is a perception that the board has been negligent in monitoring CEO performance, and has backed itself into a corner where the only option is to sack the CEO immediately even though there is no successor. Right or wrong, it suggests the board is incapable of governing the organisation and safeguarding shareholder interests.

    Boards are showing less tolerance for sustained CEO underperformance or bad executive decisions.

    Most recently, news that Marius Kloppers would leave BHP Billiton followed a 58 per cent fall in first half profits, large write offs in assets and his $20 billion splurge into the exploding oil and gas shale business in the US.

    Rio Tinto’s decision in January to dump CEO Tom Albanese was in part because of a $3-billion write-down on Rio Tinto’s coal assets in Mozambique and write-downs in the aluminium business.

    Boral’s decision in May 2012 to oust CEO Mark Selway, who had been in the top job for just over two years, also surprised the market. Led by chairman Dr Bob Every FAICD, the Boral board’s bold decision appears to have paid off, with Boral shares rallying in the past year. Rio Tinto’s decision to appoint a new CEO, Sam Walsh, was also received favourably by the market.

    Market forces are also pressuring boards to take swifter action when CEOs make decisions that destroy shareholder value. Greater compliance, the risk of continuous disclosure breaches and shareholder class actions for listed companies, greater shareholder activism, heightened proxy adviser activity and intense media focus on executive remuneration are issues that have helped to narrow the window of tolerance for boards that don’t remove underperformers. Directors who persevere too long with underperforming CEOs risk their own re-election.

    Better board communications with stakeholders is another factor. As more chairmen meet institutional shareholders, retail shareholder representatives and proxy advisers, there is greater scope for investors to provide direct feedback on the CEO to the board. A remuneration committee might also receive market feedback on CEO performance from key investors.

    "There’s a lot more tension about CEO performance now compared to five years ago," says Robert Webster MAICD, a non-executive director and senior client adviser at executive search firm Korn/Ferry International. "CEO remuneration has become such a huge issue and there is an unrelenting focus on company performance from the market, stakeholders and the media. Every company is under pressure to improve. The days of boards tolerating underperforming CEOs are long gone."

    Webster’s view is supported by the latest CEO succession report by global consultant Booz & Co. Released in November 2012, the report found Australia had the highest rate of CEO turnover, with almost a quarter of CEOs of ASX-listed companies leaving their jobs in 2011. This compared with 13 per cent of Australian CEOs leaving in 2010, and a 14 per cent global average CEO turnover in 2011.

    Most departures resulted from mergers and acquisitions, especially in the mining industry. Booz & Co found only five per cent of CEO departures were for performance reasons, although it is not clear how many underperforming CEOs publicly "retire" to preserve their reputation after a push from the board.

    Performance-related CEO departures are usually clear-cut. "It all comes back to how well the company is doing," says Webster. "If it is doing well, the board is usually reluctant to remove the CEO even if it has concerns about executive performance. You rarely see boards remove CEOs when the share price is rising and the company appears to be performing well."

    Falling performance is another matter. Larger organisations typically build CEO remuneration packages around performance targets and have formal and informal performance reviews. If the CEO repeatedly misses those targets, and it is clear he or she is a big contributor to overall organisation underperformance, the decision to terminate the CEO is in some ways easier. One or two bad executive decisions, as in Rio Tinto’s case, can also help the board explain its decision to stakeholders and the market.

    Bigger challenges emerge when the board senses CEO performance is waning, but is yet to show in performance metrics or other formal reviews. Alison Gaines FAICD, global practice leader at board consultant and executive search firm Gerard Daniels, says she occasionally sees boards that have lost confidence in their CEO and this has manifested over a few years as the relationship breaks down.

    She says boards can look for signs of deteriorating executive performance. "The CEO might start to become overly defensive of the company’s performance or dismissive of the board. Or his or her direct reports might begin to lobby the board about the CEO’s performance. This inevitably leads to a breakdown in trust in the executive team and in the relationship between CEO and board if not handled correctly," says Gaines.

    "In some situations, the CEO might try to politicise his or her relationship with the board and lobby certain directors for support, creating mischief and distrust among the board. He or she might become critical of the board and attribute more of the company’s poor performance to directors. Or the CEO’s behaviour might be seen to set a poor example for the rest of the company.

    "Sometimes directors just sense the CEO is losing energy and does not have the stamina for another round of innovation or reform. The board decides that a new CEO is needed to reinvigorate the company. These are very difficult decisions for the board to make."

    Gaines says the decision to remove an underperforming CEO sometimes leads to a choice between the board and CEO if the dispute goes public. "If the board does not deal with this issue properly, it risks severely damaging its standing in the market. Ultimately, the board will win if the feud with the CEO goes public, but nobody ever comes out of such disputes well. Boards need to carefully manage the fallout."

    One of Australia’s leading non-executive directors, Peter Hay FAICD, says strategy, succession planning and market signals are key opportunities for directors to assess CEO performance. As a veteran director, and current non-executive director of ANZ Banking Group, Myer Holdings and Alumina, Hay looks for signs of company and executive performance that rely as much on director intuition as fact.

    "As a director, you must decide in your own mind whether the CEO is addressing the right issues," he says. "A good discipline before receiving the monthly board papers is to step back and think about issues that should be addressed in those papers. CEOs are bright people and if they are performing well, you usually find an alignment between the issues they present in board papers and those you want addressed. If the CEO continually fails to anticipate key board questions, there might be performance issues."

    Hay says strategic sessions, held annually or biannually, between the board and executive team are a vital opportunity for directors to assess the CEO. "The key issue is one of trend: what is about to happen in the markets in which the company operates? Is the CEO positioning the company for the next part of the cycle? Has the CEO addressed the right questions in high-level strategic sessions? Is the CEO abreast of industry and technological change, and is there a clear understanding of the level of investment required to capitalise on opportunities?"

    Hay says market signals are another clue to CEO performance. "Listen to what people say about the company and reflect on your own experiences in dealing with it. For example, if you are on hold forever trying to phone a company, it might be a sign that customer service standards are slipping. Such problems might be small in the overall scheme of things, but often it is issues at the ground floor that indicate senior management is not driving the necessary cultural change hard enough or provide good clues about emerging problems within the company."

    How the board deals with the termination of an underperforming CEO – and how the CEO responds – speaks volumes about the organisation’s culture and governance. Ideally, the board should ensure the company has a clear succession plan for executive leadership, the chairman is aware of the CEO’s career and personal intentions, and there are performance targets that identify underperformance early.

    In this scenario, the CEO knows when it is time to leave and there are no surprises. The CEO’s relationship with the chairman is strong enough for the CEO to confide when he or she starts to lose motivation, feels he or she is underperforming, or the company needs a CEO with different skills. The CEO and board work together to groom an internal successor or find an external replacement.

    That is the theory. In reality, many companies struggle with internal succession planning, in turn making it harder for boards to sack underperforming CEOs, even though succession planning should be a key CEO performance target. And some CEOs will never admit they have underperformed or recognise it is time to retire gracefully. They force the board to sack them in full combat mode.

    Boards, too, can contribute to CEO underperformance. Poor composition could mean the board lacks sufficient industry and technical skills, or networks, to support the CEO. A chairman who joins the board from another industry may struggle to mentor the CEO or lack energy or personal skills that are vital in building the company’s most valuable relationship: between the chairman and CEO.

    Although CEO underperformance is presented as a "board issue", it is normally a matter led by the chairman. After all, the chairman spends more time with the CEO than all directors combined, usually has a more personal relationship because of regular meetings, leads formal and informal assessments of the CEO and has most contact with external stakeholders such as fund managers.

    Craig Perrett, principal of act3, a niche leadership and personal strategic planning consultant, says an ever-increasing focus on governance and organisational controls is challenging the traditional chairman/CEO relationship. "Historically, the relationship was often more of a mentor/trusted adviser role and in a perfect world they should be able to have uninhibited, constructive conversations. But how open can a CEO be in discussing his or her personal challenges, fears and aspirations with the chairman, given the changing nature of governance and the potential for this information to be misinterpreted?"

    Perrett has seen the issue from both sides. Boards have hired act3 to help develop the organisation’s leadership capabilities though executive development planning and Perrett has worked as an executive coach to CEOs of top 100 ASX-listed companies. "It’s not easy for boards and C-suite executives to have meaningful, insight-driven conversations about performance," he says. "Doing this well requires more than just completing performance assessments and scorecards. It requires a willingness from all parties to take the time to invest in the relationship, to have honest and timely conversations, and focus on more than just obvious leadership metrics."

    Perrett adds: "It’s pretty easy for boards to give feedback around more visible outcomes of leadership, such as the return on equity or share price. But the most fundamental dimensions of leadership are harder for boards to measure and provide feedback on. These include the CEO’s ability to think strategically, without losing sight of short-term goals, balance people and business needs, create trust, motivate, engage and inspire multiple stakeholders, balance risk and reward, persevere in the face of adversity and not be afraid to make tough decisions."

    Perrett says many CEOs contribute to a poor relationship with the chairman. "The catch-22 is that many CEOs don’t ask for direct feedback or know how to frame the conversation with the chairman. In some cases, they are reluctant to start the conversation, for fear of where it may lead. The last thing they want to convey is that they are struggling, even though high-performing organisations have a culture where people crave performance feedback and are constantly trying to improve."

    The chairman/CEO relationship around performance issues should evolve through the different stages of a CEO lifecycle. Prominent management academic Manfred Kets de Vries, of the INSEAD Global Leadership Centre, wrote in his classic paper The Retirement Syndrome: The Psychology of Letting Go that the CEO lifecycle has three distinct phases: entry, consolidation and decline. In the entry phase, the CEO is energised by fresh challenges. In the consolidation phase, he or she starts to produce results and gain a sense of control. In the decline phase, the CEO’s performance peaks, plateaus and inevitably falls if he or she cannot re-invent and re-energise him or herself. Good boards provide CEOs with a different type of mentorship and support through the three phases. The decline phase is hardest to identify and rectify, either by providing the CEO with extra support or deciding the only solution is replacement. No one likes to admit to being in decline, least of all high achievers such as CEOs, who may try to keep their jobs at all costs, for financial, reputational, ego, personal insecurity and anxiety reasons.

    For some boards, the decision to ask the CEO to retire is triggered by longevity; they have been in the job for several years and a fresh outlook is needed. For others, a changing business cycle provides the impetus; the board believes the CEO’s cost-cutting and restructuring skills suited the company well during and after the global financial crisis, but now a CEO with strong mergers and acquisitions skills is needed to capitalise on opportunities.

    The business cycle argument to replace CEOs holds less sway in large corporates. At that level, boards should hire CEOs who can adapt their leadership styles and develop new skills as needed. More likely is that the company sees a changing business cycle as an opportunity to refresh the executive leadership rather than an admission the CEO cannot operate as effectively in a new cycle.

    Having decided the CEO is underperforming in certain areas, the board must decide whether performance can improve through extra training, executive coaching or other management support. Boards might hedge their bets by using an external search firm to draw up a list of possible external candidates, should the CEO fail to improve, and even make contact with some.

    This strategy is fraught with danger if the board tests the market for a new CEO without the incumbent’s knowledge. "It is too big a secret to share," says Egon Zehnder International managing partner Neil Waters. "It’s one thing to draw up a list of possible candidates, but approaching candidates to be interviewed risks the secret being divulged and the CEO learning about it. It is a very risky strategy … and in my mind symptomatic of a company with deep cultural problems and a poor relationship between the chairman and CEO. This approach can easily backfire and damage the company."

    Waters says a better strategy is to inform the CEO that the board is using an external search firm to examine the market for potential successors. "This should be a normal part of the board’s risk-management processes to ensure the organisation has sufficient succession planning," he says. "It doesn’t mean the board is looking to replace the CEO, but that it wants to keep abreast of executive talent and remuneration practices in its industry."

    Another strategy is recruiting a potential CEO as a non-executive director to assess his or her performance and suitability for the top job. Waters says this is also risky. "Putting a potential CEO on the board to pressure the incumbent, without the CEO’s knowledge, is not in anybody’s interests. It may work if the board and CEO are working on succession, or if a potential replacement is in between jobs and a suitable board candidate. But I don’t see this as a technique more boards will use to replace underperforming CEOs."

    Waters says the best boards think about CEO performance constantly. "It all gets back to the relationship between the chairman and CEO. If it’s based on mutual trust and transparency, performance warning signs emerge much earlier and the decision to fire an underperforming CEO, or ask him or her to retire, becomes clear-cut. But it’s still the hardest decision any board will make."

    Mining board succession

    The conventional view that CEOs should be able to adapt their styles to different business cycles and organisational strategies does not always hold true in smaller companies. Sometimes a high-performing CEO leaves simply because he or she is the wrong person to lead the evolving company.

    Boards of emerging enterprises should pay great attention to the fit between the CEO and the stage of the organisation’s lifecycle. While founder CEOs can adapt their styles and develop new skills as the company grows, they are more likely to hand the baton to someone with a different skill set.

    This trend is most obvious in the resources sector. Professor Allan Trench, of the Graduate School of Business at Curtin University, says executive leadership of a minerals company should change as it grows. "Ideally, at the exploration stage, the managing director or executive chairman should be a geologist. At the mining stage, he or she should be an engineer. Finally, when the company grows to a sufficient scale, the leadership switches to someone with a finance or commerce background."

    As a non-executive director of several ASX-listed exploration companies, and author of Strictly (Mining) Boardroom, Trench has given plenty of thought to leadership transitions in mining companies.

    "When the transition from exploration to mining is not accompanied by a switch from geologist to engineer at the helm, you can end up with exploration ‘lunatics’ running the mining asylum. That has worked for a few companies, but it carries greater risk than a succession plan [to have the company] run by an engineer as the explorer becomes a mining company."

    Trench says the success or failure of a junior miner can hinge on a few decisions. "When you look at case studies of why resource companies struggle and on occasion fail, it often comes down to two or three key decisions by the board that proved to be incorrect. Good directors in the mining sector have been around long enough to have made some incorrect calls themselves."

    His advice to mining boards? "Get the best people you can and insist they challenge the thinking of the founder and add value through their contributions. In small companies, it is absolutely right to expect more from independent directors than simply good governance."

    Ten tips on dealing with CEO underperformance

    1. Ensure the organisation has a transparent, performance-driven culture

    Organisational and executive performance should be something boards think about constantly, not just at annual strategy sessions or after formal management reviews. The best organisations have clear staff performance targets and excel at communicating whether those goals have been met. The result is organisations with fewer surprises and secrets, more high performers who always try to improve and a culture where underperformers know when it is time to leave and there is someone internally to replace them.

    2. Understand what drives value

    Directors need to be clear about the key drivers of commercial or social wealth creation for their organisations so they have a framework to assess CEO performance. There is always a risk that directors mark CEOs down on issues that, in the scheme of things, have little effect on wealth creation and overlook the big drivers, such as strategy execution, that create far more value.

    3. Know the formal cues for CEO performance

    The CEO’s remuneration package and structure of short- and long-term incentives will be based on defined performance objectives. When assessing performance, directors need to ensure the CEO understands the company’s expectations. Documents, such as self-assessments by the CEO and formal reviews by external parties, provide other performance insights.

    4. Understand informal cues

    The best directors have sharp antennae that pick up CEO underperformance before it starts to show in falling earnings, a weak share price or damage to the enterprise’s reputation. They use common sense to assess the company’s products and services, listen to stakeholders, assess how the CEO deals with the board or his or her direct reports and whether his or her personal energy is flagging. Chairmen are usually better placed to assess informal cues, given they spend much more time with the CEO.

    5. Pay special attention to strategy sessions

    There is no better indicator of CEO performance, current or future, than at annual or biannual strategy sessions. Does the strategy make sense? Has the CEO anticipated the main board questions and responded to them convincingly? Is the strategy strong enough to keep the organisation ahead of changing industry dynamics? Has the CEO communicated the strategy well? Or does it seem tired?

    6. Have a protocol for communicating executive performance assessments to directors

    It begins with the chairman providing feedback to the CEO, when required, in their regular weekly meeting. The chairman might ask the CEO for a written self-assessment of his or her performance each year, and seek assessments of the CEO from his or her direct reports, in a structured, transparent process. The chairman then shares that information with directors, perhaps annually, asks directors for their views on CEO performance and gives them an opportunity to express any concerns. As such, a structured, rather than ad hoc, process is created for directors to share their views about CEO performance.

    7. Always respect the sanctity of the boardroom

    Never express CEO performance concerns to other directors to gauge their views or solicit support and create board factions. Always go straight to the chairman. Be clear about your concern and ask the chairman for a "sanity check". The chairman should consider the concern and, if warranted, ask other directors whether they share similar concerns. At this stage, such communication is outside normal board meetings and board papers.

    8. Understand the sensitivities

    Nothing damages a company more than having the CEO and the board at war. Most self-respecting CEOs go on the warpath if they sense the board has not been transparent about communicating performance concerns, has lined up possible successors without their knowledge, or dealt directly with their direct reports and undermined their authority. No board issue is more delicate – or important – than communicating performance concerns to the CEO and taking steps if they cannot be resolved.

    9. Plan for the fallout

    If the board ensures the organisation rigorously follows point 1 – ensuring a transparent, performance-driven culture – the CEO should go quietly and help plan for the leadership transition. If that is not the case, boards should ensure the organisation has met its legal obligations when terminating the CEO and has a clear communication strategy to explain the changes to stakeholders. The organisation might need specialist public relations support if the CEO is likely to voice his or her concerns about the board through off-the-record media interviews.

    10. Reflect on the board itself

    Sometimes CEO underperformance might be a symptom of an underperforming board. Perhaps the board is not capable of giving the CEO the support he or she needs, or poor composition means the board lacks sufficient expertise, hampering the CEO. Perhaps the chairman is partly at fault; he or she may not have the skills, energy or desire to mentor the CEO and ensure life at the top is not always lonely.

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