User:Soc25ty/The Growing Importance of the CFO, CEO and Firm Positions to Boost Shareholder Value

CEO Compensation and the Agency Problem
For publicly traded companies, there exists a tangible and often problematic difference between ownership and management. While shareholders represent the company’s ownership group, top corporate executives and directors conduct all the firm’s decisions and day-to-day management. The fact that CEOs in the past had “almost complete discretion in management” yet did not hold significant stake in the company created a conflict of interest, in that they would be expected to conduct business for the owners’ benefit but often acted based on their own natural self-interests.[1] Stock market problems throughout the 1970s led Michael Jensen and William Meckling to publish their “agency theory,” which argued company and shareholder value suffered greatly from this issue.[2] As a result, most companies have adopted new CEO payment structures that better align their management’s interests with those of the shareholders.[3] The goal in restructuring CEO compensation was to put the executive in a position where they had the same stake in the company as shareholders and thus their self-interests were parallel. While CEOs previously were paid large guaranteed sums, the majority of their compensation package now derives from stock options and incentive bonuses.[4] Stock options allow the CEO to purchase company stock at a certain target price no matter where market value sits. As a result, if shareholder value exceeds this option price, the executive can make a large amount of money, and vice versa if the shareholder value drops. While stock prices may not increase by a huge amount, CEOs held more than 1.5 percent of company equity on average, giving stock options a large effect on earnings.[5] Incentives similarly drive CEOs to perform well for the company, as they are rewarded with a bonus for every fulfilled goal. These payment options give CEOs the opportunity to make incredible amounts of money if they increase shareholder value; in 2006 the guaranteed portion of the median CEO’s contract was about $700,000, but he earned almost $3.3 million due to stock options and bonuses.[6] These adjustments to CEO payment structure both better align management and shareholder interests, capitalizing on the fact that both improve their financial standings if the company stock rises. Another factor that has kept CEO actions in line with shareholder ambitions is increased transparency between management and the public. Over the last 30 years, the accuracy of analyst forecasts for company earnings has improved considerably, as shown by the fact that a greater percent of forecasts are met, and the median standard deviation from these forecasts is lower.[7] The fact that the public now has greater insight on a company’s projections implies that less management activity is remaining private within inner company circles. This increase in transparency increases the CEO’s responsibility to perform well and make value-added decisions, as the public and shareholders specifically have greater access to the company’s activity. While incorporating stock options and incentives into CEO contracts theoretically helps motivate executives to maximize shareholder value, this does not assure that they will act on behalf of the company’s best interest in the long run. CEOs who do not plan to hold a lengthy tenure at their company may focus on activity that boosts short-term shareholder value rather than long-term growth, capitalizing on stock options and bonuses prior to departing. A study by Graham, Harvey, and Rajgopal in 2005 reported that most executives would pass up a project with a positive net present value and future growth potential if it meant they would not meet their current quarterly forecast.[8] In this way, choosing a CEO with the right character and intentions matters just as much as having a mutually beneficial compensation package.

New Executive Positions
For many companies during the middle part of the 20th century, the official creation of the CEO title came as a trend to keep separate the roles of the President and the Board of Directors while the company grew in size. “These sources do not remember it being a significant decision at the time, but agree that a simple desire to differentiate between the President and Chairman may have been the motive to designate a CEO.”[1] In correlation with this growth it became increasingly popular for companies to assign strategic decisions to one individual, hence the creation of the CEO. It has since become the duty of the CEO to delegate the tactical responsibilities of day-to-day operations to other executives within each area of the business by hiring Presidents, Vice Presidents and other managers. With the day-to-day operations and logistics being handled by other executives, the CEO is left “focusing instead on strategic issues, such as which markets to enter, how to take on the competition, and which companies to form partnerships with.”[2] As a result, the CEO has become the biggest decision maker at any particular company, while all other executives answer to him or her.

A unique relationship has evolved over time between the Board of Directors and CEO and it varies significantly from company to company. The Chairman of a company is the highest-ranking official on the Board, and the Board of Directors is “elected by shareholders and responsible for protecting investors' interests, such as the company's profitability and stability.” The Chairman is the chief representative of the investors of company and usually has significant power in pushing his or her agenda. Because Directors are looking to protect investors’ interests, they are motivated to select highly qualified executives who are capable of generating both short and long term growth and success for the company. The CEO requires approval by the Board in order to make major moves for the company, and because the chairman has the most power on the board, “the chairman of the board is technically his or her superior”[3] In most companies, the chairman is not heavily involved, leaving the CEO with plenty of flexibility to run the company. In other words, the CEO is essentially hired to run the company by the owners, or chairman and shareholders.

The creation of executive positions within companies has evolved over time. Some other executive positions created beneath the role of the CEO include the Chief Financial Officer (CFO), Chief Operations Officer (COO) and numerous other positions that vary with each company. Some reasons for the development of these positions include the need of the board of directors and CEO to redistribute responsibility for different areas, allowing top officials to focus on their strengths. Another theory is that the creation of these additional executives hired by the CEO provides the top executive with more power on the board, as many of these executives are provided a seat at the table.

The actual title CEO came about in the middle part of the twentieth century. Though the term ‘chief executive’ was being used even earlier, it was never really distinguishable between the president and chairman of a company. “In 1955 only one of the 200 largest industrial corporations in the United States used the title CEO to denote its chief executive. By 1975 all but one of these firms had a CEO.”[4] In 1980, roughly 15% of the largest companies had a CFO compared to over 92% today.[5]

How Boards Choose CEOs
A board of directors is, “A group of individuals that are elected as…representatives of the stockholders…to make decisions on major company issues.” [1] Therefore, boards are tasked with deciding on the next CEO of a company. The idea of legitimacy is central in business, and boards of directors must consider the company’s legitimacy when making decisions on new executives. “Legitimacy broadly tracks such social phenomena as trust and confidence…”[2] This idea of legitimacy is very important to a company’s reputation amongst its customers, peers, and the public. “The bigger challenge for legitimacy is to realign business missions to be consistent with those of other stakeholders.” [2] Legitimacy is essential to a company’s ability to increase shareholder value, and is therefore a central consideration of the board during the selection process.

One key to legitimacy is an independent board. “There is a widespread belief that boards controlled by independent outside directors do a better job of monitoring the CEO than boards controlled by inside directors.” [3] An independent board minimizes the biases, and in theory should indicate that the board members are focused solely on what decisions and strategies will best create shareholder value. Companies lacking independent boards have a harder time gaining legitimacy due to outside perceptions of bias.

When the board sets out to select a new CEO there are numerous criteria that should universally agreed upon within the board. These criteria vary necessarily based on the company. “Most boards doom their efforts at the start by committing the blunder of considering CEO candidates without knowing what they're looking for.” [4] The IBM case from 1993 illustrates the need for specific criteria. “The consensus of headhunters, pundits, security analysts, and media was that IBM's new boss needed infotech experience.” [4] Instead the search committee focused on several specific criteria, which they believed mattered more than experience in the industry. [4] The board selected Lou Gerstner – an outsider from Nabisco and American Express – who led the company for eight very successful years. [4] Having these specific criteria for selecting a new CEO is essential to maintain legitimacy. If a board meets its established goals with its selection of a new executive, then the competitors, customers, and the public may have increased confidence in the company.

Another key component that boards must consider in light of maintaining legitimacy is, “ensuring transparent handling of external candidates.” [5] It is important to the legitimacy of a company that a decision not be made rashly in appointing a new executive. “There are real advantages to extending the appointment process and giving the board the breathing space to assess the relative strengths of candidates over time.” [5] This more detailed and longer process gives outsiders confidence that the company is handling the decision correctly.

Finally the board must deal with internal candidates in an appropriate way (an independent board is a necessity to avoid bias here). It is often suggested that internal candidates have their management skills reviewed throughout their time at the company, so that when the CEO position becomes open there is already a base of knowledge on the candidate’s relevant skills and leadership abilities. [5]

In a broader sense, boards have tended to implement a specific succession plan in recent years. [6] “…How a board handles succession planning is increasingly viewed as a proxy for the competency and level of care it brings to its governance responsibilities.” [6] It is relatively clear now that a board’s process for determining a new CEO is largely based on maintaining (and increasing) the legitimacy of the company – often due to the perception of its contemporaries, customers, investors, and the public.

The Superstar CEO
The shift in focus towards appeasing shareholders since the late 1980s has radically transformed the role of the CEO. As the metric for performance shifts to meeting analyst expectations, the CEO must become a public beacon of trust and excellence that encourages and empowers shareholders’s faith in the company. Perception is held paramount to reality, and the Board of Directors embody this distinction in the CEO -- Steve Jobs, founder and longtime CEO of Apple, was known for charismatically enveloping his audience in a reality-distortion field that left them believing Apple’s products were magical.

CEOs’ newfound relations to stockholders adds a new strategic dimension for the boards of their respective corporations. If a company is performing poorly, the board can mobilize a task-force to bring in a new CEO with a stellar track-record and ostensibly fantastic leadership qualities to galvanize public opinion and shore up (or even dramatically improve) stock price. A consequence of a change in executives is often major press coverage, and a power player brought in to CEO is a much more compelling cover story than promotion from within; journalists under deadlines are able to maximize reader satisfaction with generalist human interest stories, rather than deep expertise-based forays into a company’s financials and relative industry position. The general population is vulnerable to the psychological effect of “fundamental attribution error,” where humans prefer to associate a single individual or hero as a reduction of complex interactions. In an infrastructure that exists to appease the shareholders, the end result is a preference on high-visibility, charismatic leaders as opposed to tried-and-true internal promotions.

There are numerous examples of savior CEOs being brought in to a company in peril. When George Fisher was announced as Kodak’s new CEO, share prices jumped up 7%. Jamie Dimon was hired to head First Chicago over veteran and presumptive candidate Verne Istock not because of experience or reliability (Istock had more of both), but for his superstar factor and to capitalize on the press surrounding his public departure from Citi. More recently, Yahoo’s 2012 hire of former Google exec Marissa Mayer was seen by shareholders as a coup from one of the company’s top competitors, and share prices jumped accordingly.

There are many potential pitfalls to electing superstar CEOs. First is the matter of oversimplification: even if the CEO in question is a brilliant leader who can inspire both the shareholders and the employees to pull the company out of a rut, there are many other factors influencing ultimate success besides the efforts of a single individual. Areas like research and development and marketing, are important components of a company’s overall success as well -- and these areas may not perform better or fundamentally change under a superstar CEO. In addition, charismatic leaders may be overly confident, leading to destabilization of some of the most effective components of the company, areas that didn’t need fixing in the first place. Similarly, a choice made by the Board of Directors for leadership qualities in a technical or industry-focused company may not realize that a potential CEO’s strengths are misaligned with their company until it is too late.

Executive Scapegoating
Corporate scapegoating—firing an executive to signal a change after poor company performance—is a mechanism utilized to protect shareholder value and the company’s reputation. Significant data indicate a structuralist reality for corporate performance[1] [2] [3]—one that attributes outcomes to environmental forces more than executive leadership—but some boards of directors utilize an executive scapegoating mechanism, mostly to signal progress for the future of the company. This corporate behavior indicates that scapegoating can be as much of a publicity maneuver as a substantive change, but its success depends on other factors, including whether the company’s issues are internal or industry-wide and if the corporate governance practices that led to a decline in shareholder value are changed or not. Scapegoating was exacerbated by the shareholder revolution, which shifted corporate executives from principals to agents.[4] [5] Pre-shareholder revolution scholars describe, “ritual scapegoating”[6] [7] as a motive for dismissal; however, scholarly work in recent years portrays scapegoating as an embedded phenomenon, and discourse now analyzes what factors might be driving scapegoating rather than executive dismissal in general.[8] Further, larger corporations—which are significantly more likely to be publicly held—are more likely to use scapegoating due to increased stakeholder pressure, as scapegoating signals a positive change in the company.[9] Data indicate that scapegoating is a positive change that protects shareholder value—sometimes. Some scholars argue that despite significant executive turnover in years leading to a company’s bankruptcy, no substantive changes in governance are realized.[10] However, a board of directors with more company “outsiders” is more likely to scapegoat an executive,[11] but also more likely to successfully protect shareholder interests.[12] Thus, there is a correlation—and potentially causation—between protection of stakeholder interests and scapegoating. Thus, scapegoating can be an effective practice if the issue is an internal problem and the dismissal is paired with changes in governance (e.g. culture, mitigating risk, etc.), but scapegoating will only be a temporary solution to an industry-wide issue. The most successful scapegoating involved firing executives who are actually negatively affecting performance. Instances of scapegoating a CEO but maintaining failing strategies include Nokia[13] and SAP in 2010;[14] scapegoating during industry-wide failures include most major investment banks, but most recently Citigroup[15] and JP Morgan; successful scapegoating underperforming executives includes Yahoo.[16] A classic instance of executive scapegoating is JP Morgan, who recently announced a change in its CFO position after “a misstep…undercut the bank’s reputation”[17] early in 2012. Jamie Dimon, the CEO faced tremendous pressure from “shareholders who have seen the company's stock decline by more than 14% over the previous five trading sessions,”[18] which prompted the “spate of executive changes that have come in the wake of the trading loss”[19] to regain legitimacy from the shareholders’ perspective. The change in the CFO position rather than the CEO is most likely due to Dimon’s clout in the industry.[20] The NY Times writes: “Other executives have stepped down following the trading losses. The most notable has been Ina R. Drew, who ran the chief investment office and was long a trusted lieutenant of Mr. Dimon.”[21] Dimon and Drew’s relationship indicates that Dimon was involved in the behaviors that led to the trading losses, so he should shoulder some blame as well. However, clearing out the other executive-level positions signal to investors and other stakeholders that the company is recovering from the enormous trading loss. Thus, the fired employees are scapegoats, blamed for a deeper internal—maybe industry—issue.

--