Corporate Social Responsibility (CSR)

The Many Roles of Boards of Directors

"You're fired!" is a phrase most closely associated with Donald Trump as he dismissed candidates on his reality show, The Apprentice. But who has the power to utter these words to today's CEOs, whose paychecks rival those of top celebrities and athletes? This honor belongs to the board of directors—a group of individuals that oversees the activities of an organization or corporation.

Potentially firing or hiring a CEO is one of many roles the board of directors plays in its charge to provide effective corporate governance for the firm. An effective board fills many roles—approving financial objectives, advising on strategic issues, making the firm aware of relevant laws, and representing stakeholders who have an interest in the firm's long-term performance (see Table 11.4, "Board Roles"). Effective boards can also bring prestige and important resources to the organization. General Electric's board, for example, has often included the CEOs of other firms as well as former senators and prestigious academics. Blake Mycoskie of TOMS Shoes was touted as an ideal candidate for an "all-star" board of directors because of his ability to fulfill his company's mission "to show how together we can create a better tomorrow by taking compassionate action today."

One of the key stakeholders of a corporation is generally agreed to be the shareholders of the company's stock. Most large, publicly traded firms in the United States have thousands of shareholders. While 5% ownership in many ventures may seem modest, this amount is considerable in publicly traded companies—where such ownership is generally limited to other companies—and could result in representation on the board of directors.

The possibility of conflicts of interest is considerable in public corporations. A conflict of interest exists when a person could receive personal benefit from decisions they make in their official capacity. For example, if a firm's purchasing agent's husband owns an office supply company that could sell products to the firm, the purchasing agent has a conflict of interest. CEOs favor large salaries and job stability, and these desires are often accompanied by a tendency to make decisions that benefit the firm (and their salaries) in the short term, at the expense of decisions viewed over a longer time horizon. Shareholders, in contrast, prefer decisions that grow the value of their stock in the long term. This separation of interests creates an agency problem, in which the interests of the individuals who manage the company (agents such as the CEO) may not align with the interests of the owners (such as stockholders).

The composition of the board is critical, because board dynamics play an important part in resolving the agency problem. However, exactly who should be on the board is an issue subject to fierce debate. CEOs often favor board insiders, who tend to have intimate knowledge of the firm's business affairs. In contrast, many institutional investors—such as mutual funds and pension funds that hold large blocks of stock—prefer significant representation by board outsiders, who can provide a fresh, unbiased perspective on a firm's actions.

One particularly controversial issue regarding board composition is the potential for CEO duality, a situation in which the CEO is also the chairman of the board of directors. This has been known to create a bitter divide within a corporation.

During the 1990s, for example, The Walt Disney Company was often listed in BusinessWeek's rankings as having one of the worst boards of directors. In 2005, Disney's board forced the separation of then-CEO (and board chairman) Michael Eisner's dual roles. Eisner retained the role of CEO but later stepped down from Disney entirely. Disney's story reflects a changing reality: boards now act with considerably more influence than in previous decades, when they were viewed largely as rubber stamps that generally folded to the whims of the CEO.

William Shakespeare once wrote, "All the world's a stage, and the men and women merely players." This analogy applies well to boards of directors. When board members' performance is impressive, the company can put on a dynamic show; but if a board member phones in their role, failure may soon follow. The different roles board members may play are discussed below.

Managing CEO Compensation

One of the most visible roles of boards of directors is setting CEO pay. The value of the human capital tied to the rare talent some CEOs possess can be illustrated by a story about an encounter one tourist had with the legendary artist Pablo Picasso. As the story goes, Picasso was once spotted sketching by a woman who, overwhelmed with excitement at the serendipitous meeting, offered him fair market value for a quick sketch of her image. After completing the commission, she was shocked when he asked for five thousand francs, responding, "But it only took you a few minutes." Undeterred, Picasso retorted, "No, it took me all my life."

This story illustrates the complexity of managing CEO compensation. On the one hand, large corporations must pay competitive wages for the scarce talent needed to manage billion-dollar enterprises. Like the pay of celebrities and sports stars, CEO pay is much more than a function of a day's work for a day's pay—it is a market-driven function of the competitive wages other corporations would offer for a potential CEO's services.

On the other hand, boards face considerable scrutiny from investors if CEO pay is out of line with industry norms. From 1980 to 2000, the gap between CEO pay and worker pay grew from 42-to-1 to 475-to-1. Although efforts to close this gap have been made, as recently as 2019 reports indicated the ratio remained as high as 278-to-1—much higher than in other countries (Germany's ratio, for example, is half the U.S. figure). Meanwhile, shareholders should be aware that research has found CEO pay to be positively correlated with firm size: the bigger the firm, the higher the CEO's compensation. Consequently, when a CEO tries to grow a company—say, by acquiring a rival—shareholders should question whether such growth is truly in the company's best interest or simply an effort by the CEO to earn a pay raise.

Within American firms, the average CEO is paid over 200 times what the typical worker makes—one of the highest ratios in the world. Many CEOs also receive perks that the average employee could only dream of. Such perks are troubling to the extent that they reflect a board's lack of vigilance in monitoring CEO spending. A few examples are illustrated below.

In most publicly traded firms, CEO compensation generally includes a guaranteed salary, a cash bonus, and stock options. But perks provide another valuable source of CEO compensation (see Table 11.5, "CEO Perks"). In addition to the controversy over CEO pay, the perks of the position have come under considerable scrutiny. The term "perks," derived from "perquisite," refers to special privileges or rights that come with one's position. CEO perks have ranged from the sweet benefit of ice cream for life given to former Ben & Jerry's CEO Robert Holland to far more extreme benefits that raise investors' eyebrows while outraging employees. One such perk went to John Thain who, as former head of NYSE Euronext, received more than $1 million to renovate his office. While such perks may provide powerful incentives to stay with a company, they can generate considerable negative press and motivate vigilant investors—wary of the value of such spending—to shop elsewhere.

As noted earlier in this chapter, CEOs sometimes get involved in corporate scandals, pursuing their own self-interest instead of the best interests of the company. But this problem can be far more subtle than a scandal, and it is not limited to CEOs. An agency problem exists whenever an "agent" of the company—typically senior management—acts in their own self-interest at the expense of the firm. For example, a CEO may push for the acquisition of another company to enhance their salary and legacy when that acquisition is unwise. They might decide to expand into Spain instead of the United Kingdom because they prefer traveling to sunny Spain with its great food rather than the rainy U.K., even though the U.K. is the better choice. Selfish or self-centered motives can influence decision making in ways that are difficult to detect; at times, the decision maker may feel justified and not even recognize their impure motives. The board of directors—and the decision makers themselves—need to recognize that the agency problem exists and guard against it. The agency problem also exists in politics, where politicians are sometimes accused of making decisions that benefit themselves over their constituents.

The Market for Corporate Governance

The terms associated with mergers, acquisitions, and the actions executives use to block these moves often sound like material from the latest war movie. The important terms are explained below.

An old investment cliché encourages individuals to buy low and sell high. When a publicly traded firm loses value—often due to a lack of vigilance on the part of the CEO and/or board—it may become a takeover target, in which another firm or set of individuals purchases the company. The new top management team is generally charged with revitalizing the firm and maximizing its assets.

In some cases, the takeover takes the form of a leveraged buyout (LBO), in which a publicly traded company is purchased with sizable debt and then taken off the stock market. One of the most famous LBOs was of RJR Nabisco, which inspired the book (and later film) Barbarians at the Gate. LBOs are historically associated with workforce reductions to streamline processes and decrease costs. The managers who instigate buyouts generally bring a more entrepreneurial mindset to the firm, hoping to engineer a turnaround from the same poor performance that made the company an attractive takeover target.

Many takeover attempts increase shareholder value. However, because most takeovers are associated with the dismissal of previous management, the terminology of changing ownership has a decidedly negative slant against the acquiring firm's management team. Individuals or firms hoping to conduct a takeover are often called corporate raiders; an unsolicited takeover attempt is often dubbed a hostile takeover, with shark repellent as one potential defense. Although a targeted firm's poor management is often the reason it becomes a takeover target, when another, friendlier firm enters the picture as an alternative buyer, a white knight is said to have arrived (see Table 11.6, "Takeover Terms").

The negative tone of takeover terminology also extends to the target firm. CEOs and board members are likely to lose their positions after a successful takeover, and boards have used a number of anti-takeover tactics to deter a corporate raid. Many firms pay greenmail, repurchasing large blocks of stock at a premium to avoid a potential takeover. Firms may threaten to take a poison pill, selling additional stock to existing shareholders and increasing the number of shares needed for a viable takeover. And even if a takeover succeeds and the previous CEO is dismissed, a golden parachute that includes a lucrative financial settlement is likely to provide a soft landing for the ousted executive.

Section Video

Role of the Board in Creating an Ethical Corporate Culture [06:48]

This video describes the role of the board in creating an ethical corporate culture.

Key Takeaway

• Firms can benefit from superior corporate governance mechanisms, such as an active board that monitors CEO actions, provides strategic advice, and helps network to other useful resources. When such mechanisms are absent, CEO excess may go unchecked, resulting in negative publicity, poor firm performance, and the potential for a takeover by other firms. An agency problem exists when the CEO acts in their own best interest instead of the best interest of the firm.