VideoMore progress has been made improving the governance of US corporations during the past couple of years than in the several decades preceding them. New reporting requirements that stock exchanges have ordered in response to high-profile scandals, together with tougher auditing standards under the landmark Sarbanes-Oxley Act, have pushed boards and managers to become far more diligent in preparing and reporting accurate financial information. Boards have also grown acutely aware of their responsibility to shareholders and of the consequences of failing to live up to it, so many have become more independent from management.
But our latest research on board governance in the United States indicates that directors and investors alike feel that, so far, reform has led to only modest improvement. Much more must change, they think, before high-quality board governance can be achieved.
Although the reforms so far have created more work for finance departments, as well as higher accounting expenses, the direct impact on executives and directors hasn't been particularly troublesome. But the reforms now being demanded by investors and activist advisory groups will be much more of a burden. The investors and directors we surveyed want companies to move toward separating the roles of CEO and chairman, to make directors more independent and accountable, and to scale back and restructure executive compensation so that it is aligned more closely with the creation of long-term value.
It is perhaps understandable that these deeper reforms haven't yet been pursued. As high-profile corporate abuses have unfolded, one after the other, most boards have become preoccupied with reassessing their responsibilities and implementing the new accounting rules. Although directors themselves shoulder a good deal of blame for the lack of profound reform, they join with investors in pointing to CEO resistance as a primary impediment to it. Certainly, few CEOs see the need for change. The US model of capitalism—with a combined chairman and CEO and a board comprising both insiders and independent directors—has worked well for many companies. So it is hardly surprising that CEOs have little desire to share their power or to sacrifice any of their stature or compensation.
Nonetheless, maintaining the status quo is probably a high-risk option. Investors seem intent on pushing a reform agenda—including regulatory change—that will make boards more responsive to their interests. Given the pressure from shareholders and the resistance from management, it will be up to boards to craft solutions that balance the expectations of all parties. Any failure to respond will leave boards more exposed to the investors' ire and less prepared to handle a more challenging governance environment.
A Clear Split
In the summer of 2003 and the winter of 2004, McKinsey surveyed 150 US directors as well as 44 US institutional investors with more than $3 trillion in assets under management. (The surveys were undertaken in partnership with the Directorship Search Group and the Institutional Investors Institute.) Although the surveys were conducted 12 to 18 months after the passage of Sarbanes-Oxley, they revealed an even greater appetite for reform than did a comparable survey conducted in May 2002, just before the law's enactment. (See Robert F. Felton and Mark Watson, "Change Across the Board," The McKinsey Quarterly, 2002 Number 4, pp. 30—45.) For activist advisory groups, perhaps the most important item on the near-term agenda is splitting the roles of chairman and CEO.
Both directors and investors believe strongly that this separation must occur if boards are to provide the kind of independent oversight of management that investors demand. Investors are acutely aware that CEOs have tended to dominate boards over the past decade—sometimes with disastrous results—and wonder how a board with the CEO as chairman can oversee management. They also point out that the split structure works quite well in parts of Europe, in Canada and Australia, and in a small number of US companies.
CEOs, though, are resisting the change. Many argue that the combined model has served the US economy well and that splitting the roles might set up two power centers, which would impair decision making. CEOs also point out that finding the right chairman is difficult and that there are real negative consequences for choosing the wrong person. Clearly, they will strongly oppose giving up the power and influence they have worked so hard to accumulate.
Yet given the growing demand for change, CEOs, directors, and investors must form a plan that works for everyone. Since the topic of separating these roles can be highly charged and very personal, the board should discuss it solely as a business problem. Collectively, the board and the CEO need to come up with an approach that satisfies investors while retaining and motivating the CEO. At a minimum, a lead (or presiding) director should be appointed as an interim step. To bring more credibility to a role that many shareholders view as merely symbolic, however, the lead director must have clearly defined responsibilities and meaningful authority.
At the same time, the board should at least consider the idea of installing a nonexecutive chairman over time. The current CEO might support such a plan upon his or her retirement, which for many companies would be two or three years away. (The average CEO's tenure is now five to six years.) Any prospective new CEO would be recruited on the clear understanding that the plan will be implemented. Shareholders are likely to consider these arrangements preferable to losing or diminishing the motivation of a high-performing CEO. In fact, discussions with CEOs indicate that many of them think that the roles of chairman and CEO will eventually be divided; they just hope this doesn't happen on their watch.
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