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This blog post is part of the HBR Online Forum The CEO’s Role in Fixing the System.The story is a familiar one: A company’s quarterly earnings fall significantly short of the investment community’s expectations, and the CEO announces a restructuring, including a cut in R&D, to lower costs, regardless of the negative impact on the firm’s long-term prospects. Another example of a CEO focusing on the short-term earnings rather than the creation of long-term value, right?
I believe that it is underappreciated how often CEOs are forced by their boards, either directly or indirectly, to take short-term actions that they deem not to be in the long-term interests of the company and all those it serves.
Because directors are elected by the shareholders, many define their role solely as representatives of shareholder interests. As such, their performance, along with the CEO’s, is evaluated by the performance of the stock price. One- and three-year performance measures are the time frames currently in use. If the stock price underperforms the median of a comparator group over those time frames, a shareholder advisory firm may recommend that shareholders vote against their election. An activist investor may seek to join the board to force ways to “unlock value for shareholders” that the activist claims the board has been neglecting. In this environment, it would not be surprising to find many boards focused on maximizing shareholder value and near-term performance.
But there is a solution: CEOs and boards should step back and come to grips with the fundamental beliefs that each brings to their leadership and oversight. The ensuing discussion and debate should lead to agreement in the form of a written pact on the set of beliefs about how the firm will be managed.
The contributors to the forum have set the agenda and provide content for this discussion and debate. They have put forth a number of important ideas that raise a number of questions CEOs and boards need to answer, such as the following:
- Where should we place our primary focus — shareholders, stakeholders, society at large?
- What is long-term shareholder value really about and how is it created?
- Can we influence who our shareholders are?
- What is our responsibility to the survival of the firm as an institution?
- What changes should we make in our pay practices to encourage long-term value creation?
- What should we be doing to build the intrinsic motivation of our people, recognising the possibility that our pay practices may be a detriment to motivation?
- Do we need to rethink the role of corporate social responsibility in our firm?
- What should we be doing now to ensure an internal successor is ready when the CEO retires?
The answers to these questions would form the basis of a pact between the CEO and the board that would make explicit the guiding philosophy of the firm and the framework within which decisions will be made. In addition, the pact should be detailed enough to provide guidance for critical decisions in areas that are fundamental to the long-term success of the firm.
For example, the pact for a science-based business, such as a pharmaceutical firm, could stipulate that research would have the highest priority of all expenditures and that research would not be cut to cover a shortfall from expectations for earnings growth. Instead, the expectations would be lowered. This stipulation would not only assure adequate funding essential to the success of the research programs but would also assure continuity and predictability of funding that is essential to attracting and retaining top scientists. In addition, the agreement upfront to protect research would remove the potential for debate and dissension among board members and between the board and the CEO in the circumstance that a trade-off had to be made.
The pact should be communicated to shareholders, the investment community at large, employees, and other stakeholders — much in the same way that corporations communicate their corporate governance policies and guidelines. All stakeholders would benefit from having access to the guiding philosophy and decision-making framework of the firm.
For example, investors would be able to better predict management actions under various circumstances, and investors who didn’t agree with priorities and how trade-offs would be made obviously wouldn’t invest in the company. Employees would have greater certainty of what to expect in the way of commitment from their management. Potential board members would self-select or be asked to join based on their alignment with the pact. Management could move decisively and with clarity when faced with an unexpected event that requires a rapid response.
Finally and importantly, the pact would serve as a way to reconcile any differences in beliefs among directors and the CEO. Given today’s high-pressure environment in which boards find themselves, the company’s long-term survival and the CEO’s job may depend on how well these differences are reconciled.
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