[By Binit Agrawal]
This Blog is part of a series of posts as a collaboration titled “KAIZEN” between the Centre for Business and Commercial Laws (CBCL), NLIU Bhopal and Law School Policy Review (LSPR). To view this blog on LSPR, please click here.
Binit Agrawal is the Founder-Editor of LSPR and a 3rd Year B.A. LL.B. Student at NLSIU, Bangalore.
The Securities and Exchange Board of India has accepted most of the recommendations made by the Uday Kotak led committee on Corporate Governance Reforms. The Kotak Committee was set up as a response to the multiple boardroom struggles to shake up important corporate houses. These include the struggles within the Tata Group and Infosys. Both these companies saw their chairman being sacked, retired founders forcing their way through board decisions, independent directors being shown the door and allegations of shady dealings marring their reputations. Corporate governance measures were found wanting, leading to the setting up of the committee. One of the most important measures suggested by the committee has to do with the separation of the leader of the company management (CEO) from that of the board (Chairman). The final recommendation on this issue, which has now been accepted by SEBI, was that the posts of Chairperson and CEO/MD be separated for listed entities with more than 40% public shareholding. Further, it was recommended that from 2020 onwards all the listed entities be required to bifurcate the two posts. Quoting the Cadbury Committee on Corporate Governance in the United Kingdom, the Kotak committee wrote, “given the importance and the particular nature of the chairmen’s role, it should in principle be separate from that of the chief executive. If the two roles are combined in one person, it represents a considerable concentration of power”.
In this post, my aim will be to find out what the reasoning behind such a move is, what the counter arguments are, and what the practical reality is. I will leave the reader with a view that mandating of such separation amounts to regulatory overreach.
The Controversy over CEOs simultaneously serving as Chairmen
The debate on whether or not to separate the two key positions goes back to the very origins of the concept of corporate governance. Berle and Means, who are considered to be the earliest theorists on Corporate Governance, first depicted the phenomenon of large corporations having two different sets of interested parties, the shareholders and the executives. They found that the shareholders, who were the owners of the company, exercised near to no control over how it functioned. Rather it were the managers who exercised complete control over the workings of the company.[i] However, these managers had trivial ownership in the company, and majority of the shareholders, dispersed in large numbers, could not take part in the functioning of the company. Thus, the interests of the shareholders and the managers often diverged, giving rise to the problems of corporate governance. This is theoretically referred to as the problem of agency. The problem of agency arises when the agent (in this case, the CEO) has certain goals which are contrary to those of the principal (in this case, the Board, representative of the shareholders). For example, a CEO who has no financial interest in the company will always be seen to be having goals which are significantly different from that of the shareholders, or entrepreneur CEOs. He will, prima facie, spend more time trying to expand his power and purse, as against rewarding shareholders. This hypothesis has also been found to be the reality in multiple studies.[ii] Prime example is that of Nokia CEO, whose huge payout while the firm failed led to angry reactions in Finland.
This agency problem can be resolved if the position of CEO is separated from that of the Chairman. The CEO’s job will be to manage the company, while the Chairman and his board oversees the CEO and his team. Here one can clearly spot the benefits of having separate CEO and Chairman.
Given the fact that the board is to oversee the management, a fusion of the leader of the board and the leader of the management presents a typical case of conflict of interest. If the CEO is also the Chairman, he will overlook failures on the part of the management and will be slow to take decisions which go against the interests of the company executives. Thus, he clearly cannot perform the essential functions of hiring, firing, assessing, and regulating remuneration, without keeping aside his personal interests.[iii] Consequently, in theory, an independent chairman will give a fillip to the board’s ability to look after the management. By bifurcating the two posts, a corporation clearly delineates and distinguishes the responsibilities of the board and management. As a result, it gives one director the sole authority of speaking on the board’s behalf and to oversee its meetings. The other director is given the authority to speak on behalf of the management and be responsible for the operation and strategy of the company.[iv] As a consequence of such separation, discords in the areas of performance appraisal, executive remuneration, succession designs, and director recruitment are eliminated. Furthermore, the CEO is also better enabled to concentrate exclusively on strategizing, overlooking operations, and resolving organizational issues.[v]
Such separation is also important to avoid creation of all powerful CEOs, as has been seen in many tech companies.[vi] If the CEO and the Chairman are one, such a leader will have immense power over who gets appointed to the board, and will thus be able to manufacture board loyalty.[vii] Most of the inside directors in a board are company executives, who owe allegiance to the CEO. Outside directors too may feel a sense of gratitude to the CEO as he often plays an important role in their election, more so when he is also the Chair. Further, as the Chair, such CEO will have the ability to make committee assignments. This will lead to the creation of an all-powerful centre within the company, who may not act in the best interests of the company at large.
Another argument in support of such bifurcation has to do with the flow of information. If the board has better and more information, it will have improved decision-making capacity. If the Chairman and CEO are the same person, the lead source of information to the board will be limited to a single person. But if they are separated, the board will have access to an additional source of information.[viii] Such independent source of information is vital to the board’s decision making and oversight functions. An illustration of this can be the Satyam Computer imbroglio. Ramalinga Raju served both as the Chairman and CEO of the company, and hence, was better positioned to mislead the shareholders. Whereas if an independent chair had been in place, the possibility of such embezzlement would have considerably reduced.
Lastly, the importance of a separated CEO-Chair position is seen during times when shareholder value is in issue. These include situations like those of takeover bids. An independent chair has been found to be more open to takeover bid, which is often beneficial to the shareholders. As against this, a board led by a common CEO-Chair is seen to resist takeover bids by taking poison pills, at the cost of shareholder value.[ix]
While, in theory, multiple benefits have been shown in support of separating the two leadership roles in a company, arguments have been adduced against doing so. One line of argument theorizes that separation of such powers can often be artificial, especially, in large corporations where the role of CEO is but to oversee.[x] In such a scenario, bifurcation will lead to duplication of leadership and of efforts. This will cause confusion as to authority and responsibility. It will also cause feuds and disputes during times when quick decision making is needed.
It is also contended that a combined CEO-Chair helps enhance the board’s performance. The board is supposed to be making the key decisions about the company. As such, a common CEO-Chair allows the board to have more timely, first hand and complete information about the workings of the company.[xi] An independent chair will fail to have the kind of knowledge about the strengths and weaknesses of the company that a CEO will possess.
Lastly, it is contended that Corporations, after all, are private business bodies and not public institutions. Thus, imposing principles of conflict of interest, which are central to public institutions, will prevent corporates from undertaking risky propositions. It is argued that if the Chair-CEO is one, the company can engage in dynamic planning and invest in risky ventures supported by the vision of the clear leader of the business.[xii] Whereas a division of roles at the top will mean greater possibilities of discord and safe playing on the part of the company. It is also cited that most firms in jurisdictions where it is not mandatory to separate CEOs and Chairs tend to have common CEO-Chair.[xiii] This, they argue, represents the efficiency of the model.
The important question, after looking at contentions for and against separating the positions of CEO and Chairman, is whether it is prudent to make it a compulsory requirement for all publicly listed companies? This would require us to weigh arguments from both the sides and see if we have a clear winner.
The first test is to find out whether the Board of Directors and their Chairman really are the true stewards of shareholder interests. In a conclusive study, it was found that they may not necessarily be so.[xiv] The study, which surveyed over a thousand directors, concluded, “while the directors’ duties are clear, at least in legal theory . . . in an era of institutional ownership, leveraged buyouts, and unfriendly takeovers, understanding who the shareholders are and where their real interests lie . . . is difficult”. One director interviewed in the above study reasoned, “I think the most pressing issue that now confronts corporate directors is the question of who are the constituencies that they represent . . . Some companies have 60 to 70 per cent institutional investors . . . now we have a shareholder who’s with you on a Tuesday and on a Wednesday he’s gone and then he’s back again on a Friday. How do you attend to his interests?”. Therefore, if the Board is not sure of where the interests of the shareholders actually lie, how is it possible for them to be the highest body within the company, giving shape to the interests of their constituents. This problem is resolved when the company has one true leader providing the company a clear direction.
Furthermore, many would maintain that the choice of whether to have a dual or single CEO-Chair should be left to the company, instead of being statutorily defined.[xv] They add that one-size fits all strategy may not work in case of corporations. It is contended that the selection of CEO, Chairman and other top-level executives is not an easy task. It requires the availability of suitable talent and involves huge salaries and perks. As such, every company may not be in a position to invest in two top-level leaders or may lack suitable candidates. Thus, it must be left for a company to analyse if it needs, and can suitably fill these two posts by two different people. Additionally, each company faces a different business environment. In a highly competitive market, a company may prefer to have a single person leading the company, whereas in a more certain market duality may be preferred. This being a strategic business choice should be for the company to decide.
This argument is strongly supported by ground realities. In a study of Fortune 1000 companies (in the United States), over a period of 20 years, it was found that 66 per cent of companies (almost 2/3rd) kept changing their governance structure, at times combining and at times separating the two positions. Such change was seen to be repeating once every 12 years for these companies on an average.[xvi] Another study also found that a change in corporate structure by separating the two positions did not seem to be conferring any provable stock return benefits to the shareholders.[xvii]
While in theory, the idea of a separating the positions of CEO and Chairman looks sensible. This is especially because of the perfect similarity between corporate structures to those of public institutions. However, it is important to realize that corporations are not public institutions, and they may have different motivations. Such motivations are best decided by the shareholders given their industry, business environment, talent availability, faith in certain individuals, etc. This means that it is the prerogative of the company to decide if the position of CEOs and Chairman should be separated or remain together. Imposing a mandatory position on this important corporate structuring issue, especially when there is no proof to indicate that such a change necessarily results in shareholder benefit, may be a regulatory overreach.
[i] Adolf A. Berle Jr. & Gardiner C. Means, The Modern Corporation and Private Property, 3-6 (1932).
[ii] C. W. Hill, and P. Phan, CEO Tenure As A Determinant Of CEO Pay, 34 Academy of Management Journal 707, 717 (1991); J. P. Walsh, and J. K. Seward, On The Efficiency Of Internal And External Corporate Control Mechanisms, 15 Academy of Management Review 421, 458 (1990).
[iii] K. J. Murphy, Performance Pay and Top-Management Incentives, 98 Journal of Political Economy 220, 225 (1990).
[iv] V. Brudney, Corporate Governance, Agency Costs, and the Rhetoric of Contract, 85 Columbia Law Review 1403 (1985).
[v] K. S. Chittur, Resolving Close Corporation Conflicts: A Fresh Approach, 10 Harvard Journal of Law and Public Policy 129, 154 (1987).
[vi] Ira M. Millstein & Paul W. MacAvoy, The Active Board of Directors and Performance of the Large Publicly Traded Corporation, 98 Columbia Law Review 1283, 1287 (1998).
[vii] Brian R. Cheffins, Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown? The Case of the S&P 500, 65 Journal Of Business Law 1, 5-9 (2009).
[viii] Judith H. Dobrzynski, Chairman and CEO: One Hat Too Many, 53 Journal Of Business Law 124, 125 (1991).
[ix] John C. Coates IV, Explaining Variation in Takeover Defenses: Blame the Lawyers, 89 California Law Review 1301 (2001).
[x] Roberta S. Karmel, Splitting the CEO and Chairman, 231 New York Law Journal 3 (2004).
[xi] Steven A. Ramirez, The Special Interest Race to CEO Primacy and the End of Corporate Governance Law, 32 Delaware Journal Of Corporate Law 345 (2007).
[xii] Larry E. Ribstein, Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002, 28 Journal of Corporate Law 1, 35-45 (2002).
[xiii] Lex Donaldson & James H. Davis, Stewardship Theory or Agency Theory: CEO Governance and Shareholder Returns, 16 Australian Journal of Management 49, 61 (1991).
[xiv] J. Lorsch, Pawns or Potentates: The Reality of America’s Boards (1989, Harvard Business School Press, Boston).
[xv] Mark S. Mizruchi, Who Controls Whom? An Examination of the Relation Between Management and Boards of Directors in Large American Corporations, 8 Academy of Management Review 426, 430 (1983).
[xvi] Larcker, David F. and Tayan, Brian, Chairman and CEO: The Controversy Over Board Leadership Structure (June 24, 2016). Rock Center for Corporate Governance at Stanford University Closer Look Series: Topics, Issues and Controversies in Corporate Governance No. CGRP-58; Stanford University Graduate School of Business Research Paper No. 16-32.
[xvii] Brian Boyd, CEO Duality and Firm Performance: A Contingency Model, 16(4) Strategic Management Journal 301, 302 (1995).