There's once again some talk around the corporate governance blogosphere of proposals to prohibit a corporation's CEO from serving as the chairman of the corporation's board of directors. Jay Brown is all for it:
We are discussing Exchange Act Release No. 60280 (July 10, 2009), the SEC's recent set of rule proposals designed to improve disclosure in connection with the corporate governance process.
One of the most obvious areas of abuse concerns the resolute insistence by most public companies to have the CEO serve as chairman of the board. (Some stats are here). With the board responsible for supervising the CEO, the the combination of the two positions materially weakens the function. Moreover, the chairman has the authority to call meetings and exercise control over the issues placed on the agenda.
Nor is this the norm overseas. Most other countries, including the United Kingdom, call for a separation. Pressure is growing for this to occur in the United States. Shareholders are agitating for a separation; a provision of the Shareholder Bill of Rights would require it for exchange traded companies. This Blog called on the SEC to address the separation as part of its corporate governance agenda. The call seems to have been answered.
The SEC's corporate governance proposals call for increased disclosure about a company's "leadership structure" and an explanation as to why "the company believes it is the best structure for it at the time of the filing." In other words, those companies that combine the two positions will have to explain why this is in the best interests of shareholders. As the release noted:
- Under the proposed amendments, companies also would be required to disclose whether and why they have chosen to combine or separate the principal executive officer and board chair positions. In some companies, the role of principal executive officer and board chairman are combined, and a lead independent director is designated to chair meetings of the independent directors. Those companies would also be required to disclose whether and why the company has a lead independent director, as well as the specific role the lead independent director plays in the leadership of the company.
The Commission has disavowed any attempt to influence the choice of management structure. Yet in explaining why the disclosure was necessary, the release could only offer the thin justification that it would "increase the transparency for investors into how boards function." In fact, for companies that separate the two positions, the disclosure will largely be meaningless. For those that do not, however, they will find themselves having to justify the explanation, either to institutional investors, the Commission, or, perhaps, to a judge should they be sued for securities fraud under a theory that the justification was misstated.
The SEC's claim that it's proposal is not intended to have substantive effect is, of course, a material misrepresentation. The proposal is a classic example of so-called therapeutic disclosure.
Therapeutic disclosure requirements undoubtedly affect corporate behavior. Therapeutic disclosure, however, is troubling on at least two levels. First, seeking to effect substantive goals through disclosure requirements violates the Congressional intent behind the federal securities laws. When the New Deal era Congresses adopted the Securities Act and the Securities Exchange Act, there were three possible statutory approaches under consideration: (1) the fraud model, which would simply prohibit fraud in the sale of secu¬rities; (2) the disclosure model, which would allow issuers to sell very risky or even unsound securities, provided they gave buyers enough information to make an informed investment decision; and (3) the blue sky model, pursuant to which the SEC would engage in merit review of a security and its issuer. The federal securities laws adopted a mixture of the first two approaches, but explicitly rejected federal merit review. As such, the substantive behavior of corporate issuers is not within the SEC’s purview. Second, and even more disturbing, in this case the SEC’s rules overstep the boundaries between the federal and state regulatory spheres.
In other words, the SEC uses therapeutic disclosure to effect corporate governance changes it has no authority to regulate directly. It's an abuse of the constraints on the scope of the SEC's authority and a violation of basic federalism principles. (I'd direct the same complaint against a possible SEC proposal to mandate disclosure of board of director diversity, another item Brown supports.)
Anyway, back to the issue of non-executive chairmen.
John Coates also recently addressed it:
... the evidence on the proposal to mandate the separation of the chair and the CEO of public companies is more extensive and considerably more mixed [than evidence on say on pay]. At least 34 separate studies of the differences in the performance of companies with split vs. unified chair/CEO positions have been conducted over the last 20 years, including two “meta-studies.” Dalton et al. (1998) (reviewing 31 studies of board leadership structure and finding “little evidence of systematic governance structure/financial performance relationships”) and Rhoades et al. (2001) (meta-analysis of 22 independent samples across 5,271 companies indicates that independent leadership structure has a significant impact on performance, but this impact varies with context). The only clear lesson from these studies is that there has been no long-term trend or convergence on a split chair/CEO structure, and that variation in board leadership structure has persisted for decades, even in the UK, where a split chair/CEO structure is the norm.One study provides evidence consistent with one explanation of the overall lack of strong findings: optimal board structures may vary by firm size, with smaller firms benefiting from a unified chair/CEO position, with the clarity of leadership that structure provides, and larger firms benefiting from the extra monitoring that an independent chair may provide given the greater risk of “agency costs” at large companies. Palmon et al. (2002) (finding positive stock price reactions for small firms that switch from split to unified chair/CEO structure, and negative reactions for large firms). If valid, this explanation would suggest that it would be a good idea for any legislation on board leadership to (a) limit any mandate to the largest firms and (b) permit even those firms to “opt out” of the requirement through periodic shareholder votes (e.g., once every five years).
... while mandating a split between the chair and the CEO is not clearly a good idea for all public companies, it may well be a good idea for larger companies. Because shareholders of those same companies may find it difficult to initiate such a change, given the difficulties of collective action, a legislative change requiring a split leadership structure but permitting shareholder-approved opt outs may improve governance for many companies while imposing relatively minor costs on companies generally. Requiring that companies give shareholders a vote on such a choice episodically (e.g., every five years) would also be a way to help solve shareholders’ inevitable collective action problems without forcing a one-size-fits-all solution on companies generally.
I am not a fan of these proposals. I addressed them in a blog post back in May. In a more recent op-ed, I again argued against mandating a non-executive chairman:
A substantial number of corporate governance reforms advocates want to separate the positions of Chairman of the Board and Chief Executive Officer. When one person holds both posts, they argue, that person wields too much power to be supervised effectively by the board of directors. The result, they claim, is CEO entrenchment, excess CEO compensation, and other corporate ills.
The empirical evidence from studies of firm performance is, at best, mixed. There simply is no unambiguous evidence that splitting the CEO and Chairman positions between two persons has a statistically significant positive impact on firm performance. Although the absence of conclusive evidence--one way or the other—may seem surprising, on close examination it makes sense. Proponents of a mandatory non-executive Chairman of the Board have overstated the benefits of splitting the positions, while understating or even ignoring the costs of doing so. The reality of such costs is confirmed, at least anecdotally, when one recalls that both Enron and WorldCom--the poster children of bad corporate governance in the last decade--had separated the CEO and Chairman positions. The board of directors has three basic functions; selecting, monitoring, and compensating the top management team; advising top management; providing access to external resources (such as where a company's banker sits on the board). Only as to the former does it seem likely that there will be benefits to appointing a non-executive Chairman.
Famed economist Michael Jensen identified the potential benefits in his 1993 Presidential Address to the American Finance Association, arguing that: "The function of the chairman is to run the board meetings and oversee the process of hiring, firing, evaluation, and compensating the CEO. … Therefore, for the board to be effective, it is important to separate the CEO and Chairman positions."
In fact, however, "oversee[ing] the process of hiring, firing, evaluation, and compensating the CEO," is the job of the board of directors as a whole, not just the Chairman of the Board. Indeed, oversight of that process increasingly is designated to a Compensation Committee composed of independent directors.
To be sure, in many corporations, the Chairman of the Board is given unique powers to call special meetings of the board, set the board agenda, and the like. In such companies, a dual CEO-Chairman does wield powers that may impede board oversight of his or her performance. Yet, in such companies, the problem is not that one person holds both posts; the problem is that the independent members of the board of directors have delegated to much power to the Chairman. The solution, obviously, is to adopt bylaws that allow the independent board members to call special meetings, require them to meet periodically outside the presence of managers, and the like.
Turning from the benefit side to the cost side of the equation, let's consider the impact of separation on the board's monitoring role. Even if splitting the posts makes it easier for the board to monitor the CEO, the board now has the new problem of monitoring a powerful non-executive Chairman. The board now must expend effort to ensure that such a Chairman doesn't use the position to extract rents from the company and, moreover, that the Chairman expends the effort necessary to carry out the post's duties effectively. The board also must ensure that a dysfunctional rivalry does not arise between the Chairman and the CEO, both of whom presumably will be ambitious and highly capable individuals. In other words, if the problem is "who watches the watchers?," splitting the two posts simply creates a second watcher who also must be watched. A non-executive Chairman inevitably will be less well informed than a CEO. Such a Chairman therefore will be less able to lead the board in performing its advisory and networking roles. Likewise, such a Chairman will be less effective in leading the board's in monitoring top managers below the CEO, because the Chairman will not know those managers as intimately as the CEO.
In sum, corporate governance is not an arena in which one size fits all. Different firms have different governance needs. Boards of directors should be free to select the governance structures optimal for their unique firm without having corporate governance activists putting them in a straight jacket.