STANFORD CLOSER LOOK SERIES Topics, Issues, and Controversies in Corporate Governance and Leadership Are Current CEOs the Best Board Members? By David F. Larcker and Brian Tayan August 17, 2011 Introduction By many measures, current CEOs should be the best candidates to serve on boards of directors. Active CEOs bring an important mix of managerial, industry, and functional knowledge that equip them to advise and monitor a corporation. They can contribute to multiple areas of governance that are important for a firm s long-term success, including development and vetting of the corporate strategy, risk management, internal talent development and CEO succession planning, performance measurement, and shareholder and stakeholder relations. They also bring important intangible attributes such as leadership skills, decision making, the ability to prioritize, the ability to lead in a crisis, and a strong work ethic. To this end, a survey by the NACD finds that CEO-level experience is the single most important functional background in recruiting a new director. Ninety-seven percent consider it critical or important, responses far higher than for any other background. 1 For these reasons, it is not surprising that some of the most visible CEOs in America serve on the boards of other large corporations. For example, James Mulva (CEO of ConocoPhillips) is on the board of General Electric, Patricia Woertz (CEO of Archer Daniels Midland) is on the board of Procter & Gamble, and David Cote (CEO of Honeywell) is on the board of JPMorgan Chase. Interviews with senior-level executives indicate that they gain considerable insights from board experience that benefit their own organizations as well. However, over the last ten years, the number of active CEOs serving as directors has declined in a precipitous fashion. According to Spencer Stuart, active CEOs represented over half (53 percent) of the pool of newly elected independent directors among S&P 500 companies in 2000. By 2010, that percentage fell to 26 percent. Active CEOs now sit on an average of 0.6 outside boards, down from 1.4 a decade ago. Corporate guidelines that limit outside directorships have no doubt contributed to this reduction. Almost two-thirds of companies limit the number of outside board seats that their CEOs may serve on, a policy not widely in effect a decade ago. 2 Increased time demands both from directorship and from being a CEO also likely encourage CEOs to voluntarily limit outside board service. Companies have responded to this trend by recruiting new directors who are executives below the CEO level or who are retired CEOs (see Exhibit 1). It is unclear whether the change in professional composition of corporate boards represents a reduction in board quality or an improvement. Currently, there is no widely accepted, rigorous study that demonstrates that current CEOs are better board members or that companies with CEO directors benefit in terms of improved advice or monitoring. In fact, recent survey evidence suggests that active CEOs might not always be the best board members. According to a study by Heidrick & Struggles and the Rock Center for Corporate Governance at Stanford University, 80 percent of corporate directors believe that active CEOs are no better than non-ceo board members (see Exhibit 2). Although respondents value the strategic and operating expertise of CEO directors, when asked about their unattractive attributes, a full 87 percent state that active CEOs are too busy with their own companies to be effective. 3 To be sure, survey respondents identified several stanford closer look series 1
positive aspects of having active CEOs serve on the board. Beyond their strategic and managerial expertise, respondents value active CEOs for their experiences in dealing with a crisis or failure and for their extensive personal and professional networks. In terms of intangible attributes, active-ceo directors were seen as being able to identify with the CEO on a range of pressing issues, build trust with the CEO, prioritize challenges, and demonstrate current knowledge of business issues. On the other hand, active CEOs are criticized for not being as engaged as the company needs them to be and for being unable to serve on timeconsuming committees or participate in meetings called on short notice. Respondents also find fault with active CEOs for being too bossy, poor collaborators, and for not being good listeners. The tenuous benefit of appointing active CEOs as directors is reflected in part in the research literature. Fahlenbrach, Low, and Stulz (2010) find no evidence that the appointment of an outside CEO contributes positively to future operating performance, decision making, or the monitoring of management by the board. 4 At the same time, the research suggests that the appointment of active CEOs as directors might lead to increased CEO compensation. O Reilly, Main, and Crystal (1988) find a strong association between CEO compensation levels and the compensation level of the outside directors who serve on the board, particularly the compensation committee. They argue that, consistent with social comparison theory, committee members refer in part to their own compensation levels when approving CEO pay packages. If committee members are current CEOs with high compensation levels, this can lead to a distorted view of fair market value and a propensity to approve large compensation packages. 5 The Heidrick & Struggles and Stanford Rock Center survey cited above also found criticism of current CEOs for being too generous with compensation. For these reasons, it might be that the trend of recruiting fewer active CEOs and more retired CEOs as directors is beneficial to governance quality. After all, retired CEOs have the same strategic, operating, and leadership experience as current CEOs but without the time demands that distract them from their director duties. There is also common consensus that their leadership experience provides value well beyond their retirement date. Evidence to this effect, however, is not overwhelming. According to the survey by Heidrick & Struggles and Stanford Rock Center, only 55 percent of respondents believe that retired CEOs are better directors than active CEOs. Only 46 percent believe that retired CEOs are above average. Why This Matters 1. Many people believe that current CEOs are the best board members. Is there convincing evidence that this is the case? If not, maybe it is time for companies (and the nominating and governance committees) to reassess the importance of this criterion when looking for new board members. 2. How much does the requirement for CEO-level experience limit the pool of available directors? Does this restrict the availability of diversity candidates who might be less likely to have that experience? 3. If the availability of current or even retired CEOs is low, should professional directors (directors whose primary job is to serve on boards) be used to fill this gap? 4. In the Heidrick & Struggles and Stanford Rock Center only 26 percent of respondents believe that CEO-level experience becomes outdated within five years. A full 38 percent believe that it never becomes outdated. Is there a shelf life to CEO experience? Do the positive qualities of retired CEOs deteriorate, or do they never become outdated? 1 National Association of Corporate Directors (NACD) and The Center for Board Leadership, 2009 NACD Public Company Governance Survey (2009). 2 Spencer Stuart, Spencer Stuart U.S. Board Index, (2010). 3 Heidrick & Struggles and the Rock Center for Corporate Governance at Stanford University, 2011 Corporate Board of Directors Survey, (2011). 4 Rüdiger Fahlenbrach, Angie Low, and René M. Stulz, Why Do Firms Appoint CEOs as Outside Directors? Journal of Financial Economics (2010). 5 Charles A. O Reilly III, Brian G. Main, Graef S. Crystal, CEO Compensation as Tournament and Social Comparison: A Tale of Two Theories, Administrative Science Quarterly (1988). stanford closer look series 2
David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanford s Center for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit: http://www.gsb.stanford.edu/cldr. Copyright 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. stanford closer look series 3
Exhibit 1 S&P 500: The Backgrounds of Newly Elected Independent Directors 2000 2005 2010 CEO / COO / Chair / President / Vice Chair 62% 45% 43% Active 53% 32% 26% Retired 9% 13% 17% Other Corporate Executives 10% 16% 18% Division / Subsidiary President 4% 5% 8% EVP / SVP 6% 11% 10% Financial Backgrounds 17% 20% 21% CFO / Treasurer 8% 8% 8% Bankers 3% 4% 2% Investment Management / Investors 2% 6% 9% Accountants 4% 2% 2% Other 11% 19% 18% Academics / Nonprofit 2% 10% 8% Consultants 4% 3% 5% Lawyers 3% 4% 1% Other 2% 2% 4% Source: Spencer Stuart Board Index, 2010. stanford closer look series 4
Exhibit 2 2011 Corporate Board of Directors Survey: Selected Data All Respondents Active CEO/Chair Only Retired CEO/Chair Only Are directors who are active CEOs better than non-ceo board members? Yes 20.5% 33.3% 25.0% No 79.5% 66.7% 75.0% Are directors who are retired CEOs better board members than active CEOs? Yes 54.9% 50.0% 66.7% No 45.1% 50.0% 33.3% Are directors who are retired CEOs better than average board members? Yes 46.5% 57.1% 60.9% No 53.5% 42.9% 39.1% How many years before the experiences of a retired CEO become outdated? 5 years or less 26.0% 35.7% 20.8% 5 to 10 years 19.9% 19.0% 25.0% More than 10 years 16.4% 9.5% 8.3% Never 37.7% 35.7% 45.8% Are professional directors better than traditional board members? Yes 19.1% 22.5% 36.4% No 80.9% 77.5% 63.6% Source: Heidrick and Struggles and the Rock Center for Corporate Governance at Stanford University, 2011 Corporate Board of Directors Survey. stanford closer look series 5