Law & Governance

Law & Governance January 2005 : 0-0

Leadership: Staying the Course


Management succession is one of the board's primary responsibilities, but planning ahead to fill the chief executive's chair is not getting the attention it deserves.

In this issue of Law & Governance, we present to you the edited version of the Corporate Board Member Academic Council 2005 roundtable discussion on executive compensation, personal liability in the wake of Enron and WorldCom, and the need for long-term succession planning. The participants in this roundtable discussion were:

Duke K. Bristow, Executive Director, Corporate Governance Center, The Rady School of Management University of California, San Diego

Jay W. Lorsch, Louis E. Kirstein Professor of Human Relations, Harvard Business School, Harvard University

Stephen M. Wallenstein, Executive Director, Duke Global Capital Markets Center and Senior Lecturing Fellow, Duke School of Law and Fuqua School of Business, Duke University

Julie H. Daum, Practice Leader, North American Board Services, Spencer Stuart

T.K. Kerstetter, Corporate Board Member

For the last three years, Corporate Board Member magazine has conducted a directors survey in conjunction with PricewaterhouseCoopers LLP in which we ask boards what areas they are most and least effective in with regard to performing their duties. Without a doubt, each year the respondents say they are least effective in implementing a management succession program. Why is that the case?

Jay Lorsch: Any director will tell you that their most important responsibility is the selection, motivation, appraisal, and, if necessary, removal of a CEO. That is sort of the ultimate weapon they have to effect change.

But the board's responsibility should also be to develop internal candidates. Now what can directors do about that? Not much. They can urge the CEO to do it. They can request charts and data that show there is a replacement for everyone in top management. But it's hard to keep the pressure on the CEO for a couple of reasons. One is that it's always deferrable. In other words, management development is something you can always postpone to the next board meeting. And on most boards, there's always more to do than there is time to do it. So the management development process gets pushed to the next meeting and the next meeting and the next meeting. Too often the signal that is sent to the CEO is that he or she can defer doing anything about it and the management team can defer it, too.

The second problem is that for a board to take any action with regard to succession depends on the information and knowledge it has about that particular issue. Trying to understand and really know the management team and what kind of progress is being made on grooming internal candidates is difficult for boards. It's hard enough to understand the financials and the competitive position, where you can actually review hard numbers and so forth. But how do you know if you are doing a good job of developing managers? The CEO comes in and says, "We're doing a great job," and perhaps you have dinner with the management team once every six months. You can't put pressure on the system if you don't have any basis for assessing how well it's working. Because of the deferability of the issue and because of this problem of not knowing whether it's being done well, boards do not do a very good job.

Duke Bristow: All theory and experience leads one to conclude that management succession may be the board's most important responsibility, but the answer to your question differs between larger, older firms and smaller, younger firms. An experienced investment manager who was an active director on a number of boards once told me he viewed his role and the board's role in the monitoring of management succession as a three-position switch, with position one as being in 100% support for the CEO. Position two is bringing the CEO in to explain his or her position to the board in a particular situation. And position three is calling the executive search firm. So that means 100% support, clarification, or removal. While this view is clear and perhaps economically efficient, it underscores how boards may need to quickly shift from a long-term view of succession planning to a short term view. This uncertainty over the time associated with management succession may explain why boards believe it to be the least-effective job they do. The timeline for succession planning may be both unknown and unknowable. For that reason, contingency planning is often described as the ointment or even the panacea for solving this problem. But therein lies the difference between what is appropriate for firms, depending on whether they are larger, older firms or younger, smaller firms. For a mature firm, such as GE or GM or General Foods, to not have a management succession plan that considers multiple contingencies probably qualifies as director malpractice. But, I would say the complete opposite holds true for emerging growth or young firms. At a young firm that has recently gone public with a healthy entrepreneur at the helm, for the board to think they need complex written contingency plans for various replacement strategies for a CEO is probably a gross waste of time and attention. They need to be more focused on growing the firm. They should probably concern themselves with director succession because our research indicates that these firms are much more likely to have rapid and unexpected turnover of directors than rapid and unexpected turnover of the CEO.

Julie H. Daum: Most directors know management succession is their most important job, and it's the one job they are not doing. That's a given. But the problem is boards have traditionally let it be the CEO's job. And so they rely too heavily on the CEO to evaluate internal candidates. Boards must take responsibility for this. In the past that was very difficult because it's an act that indicates you are not 100% in favor of your CEO. But there have been enough cases recently, and McDonald's is the obvious case, where there were two unforeseen tragedies in such rapid succession, to illustrate that even if you are 100% behind your CEO, you are not doing your job if you don't have a contingency plan. It's not enough to have one internal backup for the CEO, because that person may get recruited to be a CEO somewhere else. A board cannot just say it supports its CEO and that's enough, as he or she is young with many good years left at the helm. It must always consider the contingencies and the fact that it can't have just one person waiting in the wings. That's not responsible either. Boards must start taking responsibility for management succession. Jack Welch and GE put management succession at all levels as a key part of the business. And that's something boards must do. It can't be done once a year. It must be much more ingrained in the board's culture so that it's an ongoing process and a regular discussion point and not something the CEO or board can defer.

Stephen M. Wallenstein: It's difficult for a board to get an accurate and objective view of management's strengths and weaknesses. Ideally, that's where you want your next leader to come from. However, the CEO is not always an objective source of information about other members of management. And even if you have an accurate assessment, how do you address the weaknesses of senior management and groom them for leadership positions? That's not something boards have experience with or can easily address. Defining and measuring performance metrics for senior management is very important. It's also critical for the board to set clear expectations and to meet regularly with potential internal candidates, both individually and as part of board meetings. It's very difficult for the board to be thinking about replacing the CEO, especially when the CEO isn't cooperating with that process or when you have a strong CEO, such as AIG's Hank Greenberg, or a company founder who is also CEO.

What are some best practices in management succession that boards should examine to ensure they are following through on this important responsibility?

Lorsch: At the heart of it is making sure you are bringing good people into the organization. Are you recruiting the kind of talent in middle and lower-middle management that you want around for the long term? Second, are you moving those people around in a responsible manner? Obviously you don't just move people around to educate them; you've got to run the business. But there must be a balance between retaining people who are doing a good job and finding internal opportunities to help them grow. Coca-Cola is an example where almost everyone in the company has worked in a number of locations around the world. I'm not saying it's a paragon of virtue, but it has set an example of the kinds of things companies must be thinking about while making sure there is a sound process in place for performance appraisal and feedback. Obviously, the compensation scheme must motivate people. And the board can check the process to make sure these things are being done. How do directors know how well it is working? That goes back to the information problem. They have to take the word of the senior vice president of human resources and the CEO and maybe one or two other senior executives.

The other point I would make concerning the process of management succession is a lot of companies simply can't do this well. General Electric and McDonald's have done an extraordinary job, but there are few companies that are doing this well, and the ones that are doing everything I'm talking about are very large, complex companies with a lot of opportunities. For example, there are probably 15 or 20 opportunities within GE to run a business that is probably as large as many public companies. That is a great way to assess someone's capabilities. But even at a good-size $2 billion to $4 billion company, there may only be one or two jobs like that. Then you have the problem of someone who is doing a great job, but he or she is closer to retirement than the CEO, so how do you develop the talent? Those are real problems. So even if a board is trying to do the job well, it is constrained by people's age as well as the limited number of positions where you can move people. So it is not a simple problem for most companies, and we ought to recognize that from the beginning.

Daum: I agree with everything Jay said. There's been a huge amount of attention paid to this area. It started a few years ago when consulting firm McKinsey & Co. coined the phrase "war for talent." Every company decided to establish a rigorous process for evaluating internal candidates, not only for CEO, but for every level of management. And there were a lot of programs put in place, but they were only as good as the support the CEO gave them. Often it was just a human-resources-driven process where they had lots of books on the subject and could tell you where people stacked up, but these were not live exercises. People weren't moved around the corporation, and there weren't development plans. It was really just an evaluation tool. As soon as the Internet bubble burst, companies weren't so worried about losing their people, and a lot of those processes were thrown out the window. So it has been a real inconsistent process at most companies as to how they evaluate their people. Part of the problem, going back to the GE example, is day in and day out they live and breathe this stuff, so most companies said, "Well, what does the form look like; we're going to put this form in place at our company, too." But that is very different from actually assessing people. If you are sitting on the board, it is very hard to know if this is really effective or not. And it is difficult for companies that are not complex to give people experiences that will aid their development, particularly with regard to CEO succession. What do you do if you have two heir apparents to give them the kind of expertise they need? Do you move them both into a CFO-type role, or do you move them into other staff positions? So this is not a one-sizefits- all process. It must become ingrained so that it is not a process, but instead it is something the CEO considers very important. That message needs to come from the top of the organization, rather than from the head of HR.

Wallenstein: Well, it is simple in theory: Begin early, look inside your company for exceptional talent, and then find ways to cultivate that talent and help those people grow. The problem is that it sounds simple, but it's hard to put into practice, and often the qualities a company needs for a leader now are not the same kind of talents the company will need five years from now. So it is very important for a board to establish strategic goals and identify the skills, leadership capacities, and metrics of the person that will take the company to the next level. That's all part of the strategic planning process, which very few boards have time to engage in. The other issue, which has already been pointed out, is there is too much reliance on the CEO to identify his or her successor. Often CEOs will pick someone just like them. That gets back to the question of whether the company needs the same type of person as the current CEO to take the business forward. The CEO may not be extremely objective about his or her favorites.

So even though developing a succession plan sounds simple in theory, it is something boards have a lot of difficulty with. One best practice is to discuss, at least once a year, what would happen if the CEO was no longer around. What is the succession plan? Who are the potential candidates? Boards should have a working list and then develop those internal people with the proper skills.

Are there any trends with regard to developing inside candidates?

Daum: In many recent cases, such as the Merck decision, selecting an internal candidate has been by default. Companies are starting to think about this issue of developing internal CEO candidates versus going outside the company more carefully, because if you look at the statistics about the success of an external CEO versus someone who has been with the company, the external CEO usually does better at the very beginning of his or her tenure, but the internal CEO candidate does better in the long run. However, another troubling statistic is the incredible turnover in CEOs that we're seeing and the decreasing length of time they are serving. So there is a huge churn of CEOs, but there is also recognition that an internal candidate is a better option, in most cases, than an external candidate. Boards are starting to take responsibility for this, and whether it falls to the compensation committee or the nominating committee-and we're seeing a little of both-they are starting to say, "We need an ongoing process of looking at CEO succession, and we are going to benchmark our internal candidates against external candidates on an annual basis." Another problem is a lot of the information is controlled by the CEO. We are working with boards now where there is no CEO, and we are helping them look at their management team, compare them to outside people with the same job, and ask, "Are they as good or better?" So they are evaluating their internal team while also developing a sense of what their options are if something happens and they have to go outside. Who would be available? Would they actually get less than what they have internally? This gives them a very good sense of the universe and what their choices are so that if a company does lose its CEO, hopefully it will understand its internal candidate pool much better. It will also help it understand some of its weaknesses and develop plans on how to augment some of the things it doesn't have. For example, in a smaller company, if it is hard to rotate positions internally, maybe it's getting andidates to serve on an outside board, thereby giving them a different kind of exposure. So we are starting to see people being creative about developing candidates from within. For example, we've seen a few companies assign members of management to the board, so directors can become familiar with the internal candidates at board meetings. This is not a trend yet, but creative boards are heading toward not relying on the CEO, but relying on themselves and developing ways of making sure they know their internal pool and are doing everything they can to develop that internal pool.

Wallenstein: Boards are somewhat overwhelmed. Getting to know internal candidates, especially in a large company, is difficult because there are so many different people to choose from. How do you identify those people, and how do you allocate the time to give them the necessary skills and the necessary signals that they are in line? It is very difficult. It is better to promote from within. It shows good planning; it shows depth; it shows human resource capability; it's less expensive; and it's less time consuming. The new person doesn't have to spend a lot of time learning to understand the company, the people, and the culture.

Bristow: I'd like to offer one additional thought on the topic of best practices in succession planning. In Thomas J. Dougherty's new book on directors' duties, "The Directors' Handbook," he identifies an emerging trend where the regulatory climate has changed such that boards should consider the possibility of their CEO, CFO, or COO needing to be replaced under a regulatory cloud, and barely a day goes by that we don't see this in the newspaper. This is a new challenge for boards to consider, where the CEO is neither guilty nor innocent, but simply under investigation. And if that's the case, has he or she been made ineffective by the investigation? So boards need to have that as part of their best practice plan. As far as external versus internal candidates, unquestionably, as has been said, there is a longterm trend in our culture and in the managerial labor market toward external candidates that has shifted from 30 or 40 years ago when internal candidate promotion was by far the norm. Now we see Mr. Gilmartin being replaced by Mr. Clark at Merck, and this action taking securities analysts by surprise. Perhaps we've reached the limit in terms of the cost and effectiveness of always going outside for the superstar CEO replacement candidate and maybe we do need, as Professor Lorsch suggested, to focus on the very difficult job of explaining why it is so hard to develop candidates internally, because we've forgotten what a good source of candidates that can be.

Lorsch: First of all, one can make a rational argument, I suppose, for going outside versus looking inside, if you've got a situation where the company is in deep trouble. That's why the analysts were a bit disappointed about the Merck appointment. There is no question an outsider comes in with the opportunity to bring about change, but in the long run, he or she could have the sorts of problems Steve just mentioned and quite often does not do as well as anticipated. The insider, obviously, sometimes has trouble seeing new opportunities because he or she is part of the old culture. So you could make the argument back and forth. While Duke used the term "superstar," one of my colleagues talked about charisma in his book a few years ago. We have gotten ourselves into the notion that you want to pick this glamorous CEO-as if somehow this person could create a miracle. That's nuts. You've got to think about the qualities needed to lead the organization well and if you don't have them inside, then you may have to look outside. But the important thing with an outsider is to be clear about what it is you are looking for and what kind of skills you need to run the company, and not just pick a well-known name. The other point is the data is very clear that if you promote an insider, it will be much less expensive. Part of what we are dealing with is a big compensation explosion with the superstar CEOs being like sport stars with their agents and their big negotiations. If you promote someone from the inside, usually that person's psyche says, "I've been working for this job for 15 years, and I'll take whatever you are going to pay me," and they aren't out to bust the company. Whereas when you try to attract someone from the outside, his or her first idea is "How much money can I hold these guys up for? They really want me." It's a very different mentality, and it is a very different negotiation process. It's really a negotiation that you are engaged in, and the price of what a Shaquille O'Neal can get or what any CEO can get depends on his or her bargaining power.

How do you all feel about the retiring CEO hanging around on the board, serving as an adviser or, worse yet, serving on the board?

Wallenstein: Or, worse yet, serving as the chairman. It's certainly a challenge to have the old CEO around. That's an understatement. There is the second-guessing that goes on, the inability of the existing CEO, especially if he or she was promoted from within, to take over the reins, and the potential conflict between an outside candidate and the inside candidate. What we've seen as best practice is outgoing CEOs lining up four or five other boards on which they can play an important role, possibly serving on the audit committee since they've supervised the preparation of GAAP financial statements. Riding off into the sunset is a much better model.

Bristow: The exception to that, of course, is the entrepreneurial firm where, unfortunately, the founder/CEO is still a major shareholder. Asking this person to not have any continuing role when perhaps all of the family's wealth and all of the wealth he or she has amassed is tied up in the firm, is almost an impossible request. But with that exception, I think Jay has taught us that it's an enormous burden on the incoming CEO to have the outgoing CEO remain as an active chairman.

Lorsch: It's just an absolute no-no. Steve makes a very good point about where we now seem to be moving. The UK has moved toward separate chairmen, and we seem to be moving in the same direction. Having the old CEO serve as chairman is an invitation to disaster. When the guy leaves, you should say, "It's been fun, my office will be across town, if you need me give me a call," and walk out the door. They do that at GE, and that's another thing they got absolutely right.

In the aftermath of the personal settlements at WorldCom and Enron, do you think the payouts will affect the recruitment of board directors, specifically at smaller companies that are not well known?

Bristow: The short answer is no. It's not likely to have a material effect. It is completely irrational for directors to live in constant fear that they will have to write a personal check for a settlement from shareholder lawsuits or any other service, assuming they are not outright felonious in their activities. Most evidence indicates directors have not lost protection and, therefore, should find comfort that they will not be personally liable for these things. That said, while they may not be writing the checks for cash, I do think there is a slightly higher perceived risk in smaller firms of writing checks out of your human capital account, where your reputation might get tarnished if you are involved with a company that's under some investigation. But in terms of the concern that we hear expressed over our director education effort, one study found 7% of directors imagined they were likely to write checks in a shareholder lawsuit situation, and that is just not going to be the case. One one-thousandth of a percent would be a better estimate.

Lorsch: Some law firms like to scare the hell out of directors. Some directors are panicked, but there isn't any reason to be. There is a reputational concern some people have. There are probably some directors who are not having much fun being on boards who are saying, "I don't want to do this," but by and large, there are plenty of people who want to serve on boards of all sizes and types, and it's just a question of getting Julie and her firm to find them.

Wallenstein: That's interesting. I'm not quite as sanguine. There may be no rational reason and the percentage may be quite low, but we've seen many directors being much more selective about which boards they want to join, which might bode well for some of those smaller companies that otherwise have even more trouble attracting directors. We've seen an increase in concern at recent directors' institutes over this personal liability issue. Directors are a lot more aware of it and that, perhaps, will encourage them to take the proper steps of duty of care, duty of loyalty, and duty of good faith. And if they are not prepared to do that, then they don't need to serve on boards. But it will make recruiting more difficult.

Julie, can you give us a perspective on both large and small companies?

Daum: I think most directors look at the Enron and WorldCom settlements as egregious situations that don't represent what's going on in their boardroom. So taken separately, it shouldn't change anything. It hasn't changed case law, so dispassionately, it shouldn't affect recruiting. But there are lawyers telling people to be nervous, and I can't tell you how many people say to me, "Well, my own lawyer tells me I'd be crazy to join a board." The environment has changed-not the legal environment, but the emotional environment. People are nervous. I'm not sure they should be, but they are. People are worried that the plaintiffs' bar is going to go after individual directors, and there is angst. However, there are still, as Jay said, a lot of people who are very interested in serving on boards. So it hasn't scared off everybody. It's just made them a little uncomfortable. They want to know what the D&O insurance looks like and they are much more careful and they are doing more due diligence. Believe it or not, I think it's actually easier to recruit to smaller companies right now than it is to big companies, because although you say anybody in the world would want to join Microsoft or GE, there are only a few companies like that, and the pool of candidates they are drawing from has disappeared. And it's not so much due to this personal liability issue. It's about the amount of time directorships are taking. Some of it can be blamed on the personal risk of your reputation. But it's much more because of the time it takes to be a director. Smaller companies tend to be fairly realistic about what kind of directors they want and what kind of directors they can expect to get. In fact, they have a healthy pool of candidates who are interested. The environment could change overnight, but right now most directors are pretty realistic that the WorldCom settlement happened for a lot of reasons that don't apply to their own company, particularly because it was a company in bankruptcy and there was no insurance. There were a lot of mitigating circumstances.


Reprinted with permission.

This discussion first appeared in the Corporate Board Member's 2005 Academic Council Supplement, Emerging Trends in Corporate Governance.


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