Sarbanes-Oxley’s Unfinished Business:                                                              Abolish the Imperial CEO!                                                                      by Scott Green Although Congress passed what is arguably the most comprehensive public company legislation since the 1930’s, the Sarbanes-Oxley Act nevertheless left undone one of the most contentious governance issues of our day: the deconstruction of the “Imperial CEO.”   The Imperial CEO is a single individual who holds both the role of public company chairman of the board as well as its CEO.  The chairman of the board is responsible for running the board of directors that, in addition to general corporate oversight, has a fiduciary responsibility for selecting new directors, setting executive compensation, evaluating executive performance and, through the audit committee, evaluating the company’s financial reporting and disclosures on behalf of shareholders.  This role conflicts with that of CEO because the CEO often is, or should be, the subject of  board discussions and will be directly affected by decisions on matters such as who joins the board, management team performance, and compensation. An Imperial CEO who has unfettered control of the board can discourage discourse and implement a range of policies that serve only management as opposed to the shared needs of management and shareholders. Not all Imperial CEOs will take full advantage of their position to advance their own personal agenda.  I suspect that most CEO’s want what is best for their company.  But the temptation is great and this clear conflict of interest can have disastrous results if not eventually checked. This unfinished business was not due to a lack of visibility or knowledge of this structural weakness.  Academics, corporate governance experts and shareholder activists have ensured that both Congress and Corporate America are well aware of the conflict and its detrimental impact on our companies.  Rather, it appears that Imperial CEOs are so pervasive in our public companies that many believe to it would be too disruptive to summarily demand separation.  Yet shareholder activists are not waiting for corporate boards or Congress to begin reform.  They are taking the fight to the boardrooms of some of our largest corporations.  Smart executives who are both CEO and chairman of the board will take the initiative to make certain that change will occur on their terms.  Others will spend significant time and energy fighting activists and holding on to power rather than leading their companies. Today, nearly 80% of U.S. public companies run under the Imperial CEO model.  While not a uniquely American problem, only France combines the roles of chairman and CEO more frequently than the U.S. and other major western economies. The United Kingdom, along with the United States, is often cited as having some of the strongest corporate governance practices in the world.  Over 95% of the FTSE 350 companies split the duties of Chairman and CEO.   Germany and the Netherlands maintain a split board structure.  In those countries, a non-executive supervisory board exerts general oversight and governance rights and a management board consisting of company executives provides operational supervision.  This structure, by definition, precludes the creation of the Imperial CEO. But does splitting the role of Chairman and CEO really make a difference in corporate performance?  A recently published work by Yale economist Paul W. MacAvoy and internationally recognized corporate governance expert Ira M. Millstein makes a compelling argument that good corporate governance leads to better returns for shareholders.   Their study found a causal link between corporate governance practices and Economic Value AddedTM    at the largest public companies.  The authors’ most important recommendation culminating from their work is to separate the roles of chairman and CEO and to designate an independent director as chairman.     So, other countries are doing it, and it seems to be a profitable practice, so why haven’t the boards of our public companies embraced this governance initiative?  The most obvious reason is that Imperial CEO’s are loath to give up the power they have achieved, and boards are unwilling to upset a CEO they view as important to the company.  Most CEOs have worked hard for their companies, and the august title of chairman is the highest recognition of that contribution.  Additionally, some also argue that separating these roles will not ensure good operating performance.   Furthermore, some believe that, even if you find a qualified chairman, any benefits to a company are short lived as a director’s independence of mind degrades the longer they are in the role.  This is because  they begin to identify themselves with some of the decisions previously made.   Regardless of the counter-arguments, shareholder activists are not waiting for debate to settle the question.  As Michael Eisner found out at the last Walt Disney Company board meeting, institutional shareholders are banding together to force change.   The California Public Employees’ Retirement System (CalPERS), the nations largest and, arguably,  most influential public pension fund refused to support Eisner’s re-election; and many other public pension funds followed suit.   A remarkable 43% voted no confidence in Eisner and would have likely been higher had concessions not been made by the board.  Under shareholder pressure, he was forced to resign his role as chairman in order to continue as the company’s CEO.  But Disney is not the only company facing challenges from shareholder activists.  TIAA-CREF, another pension fund behemoth, has targeted 50 companies that they have identified as having independence issues.  This is both good and bad news if you are an Imperial CEO.  The bad news is that, whether you like it or not, this issue will require significant time and effort to resolve….if not now – then soon.   The good news is that the activists may be picking too many battles and waging war against the wrong targets.  For instance, CalPERS recently opposed the election of Warren Buffett to the board of Coca-Cola.  Most view this action as absurd.  Buffett has created substantial wealth for his shareholders, not just for a five or ten-year period, but over decades.  Any rational shareholder would want his presence on and counsel to the board of their company.   For those companies with strong share price appreciation, this lack of focus will help keep activists at bay, but any turn in fortune will leave a CEO vulnerable.  Poor operational results, even over a short period, regardless of the reason will refocus institutional shareholder initiatives into a more effective threat.  There is also the risk of the next financial scandal (which will happen, only the timing and character of the scandal is in question) energizing a regulatory response.   Requiring a split of the chairman and CEO functions would seems a populist response and natural next step in regulatory tightening and oversight.  A smart management team will take steps to address this issue now on their own terms rather than waiting for the inevitable market downturn or financial scandal.  They will not wait for their largest shareholders to raise the issue, rather they will work with their board to adopt a roadmap or plan that takes concrete steps to aid board independence and create a succession plan that will eventually lead to the creation of an independent chairman.      The first action is to appoint an independent lead director to develop and run executive session meetings where management is not present.  The CEO may still be chairman of the board, but the lead director will guide discussion of management performance, compensation and other sensitive issues with the other independent directors.  This intermediate step demonstrates the board’s commitment to independence while buying some time to prepare a succession plan in a deliberate fashion.  Furthermore, by working with the board now, the management team will help determine who can best assume these duties and how the role should be structured.  Many companies appear to be adopting this approach.  The American Society of Corporate Secretaries report that the number of companies with an independent chairman, independent lead director, or presiding outside director increased from 26 percent before passage of the Sarbanes-Oxley Act to 62 percent a year later.   However, this is only an intermediary step. The second necessary action to take is the preparation of succession plan for both the CEO and chairman positions to be implemented upon the retirement or unavailability of the current CEO.  The most difficult aspect of a succession plan is not preparing the plan itself, but identifying successor candidates.  The successor to the CEO should ideally be developed from the management ranks.  The importance of this concept was recently underscored by the untimely death of McDonald’s Corporation’s CEO.  Due to the foresight of the CEO, a succession plan was in place at the company that resulted in the transfer of power in a manner that assured the least possible impact on the company’s strategy and operations.  The choice for the chairman role, however, should not originate from within the company, rather it should be an independent director that the board begins to prepare immediately for the duties of the job.   Finally, the board should designate the conditions under which the succession plan will be implemented.  Retirement, incapacitation, untimely death, or a successful vote of no confidence from shareholders would all seem to qualify.   Most Imperial CEOs are good people and great managers. They got to where they are by creating value for shareholders.  Accepting the chairman role along side their every-day CEO duties was likely conferred as recognition for a job well done.  Smart executives will see that the governance model in the U.S. is changing and will take steps to be out in front of it.  It is always better to be a change agent rather than be the subject of change. By addressing these valid concerns now, CEOs’ can manage this coming revolution while meeting the interests of both shareholders and the management team. Copyright 2004 Wiley Periodicals.