11 April 2017 by Elisabeth Dedman
Relay model promotes smooth transitions
Preparing for orderly top management succession is an important and challenging board role, somewhat complicated in the UK by the Corporate Governance Code which, since 2003, has contained the provision that the chairman should be independent upon appointment and that only in exceptional circumstances should a CEO become chairman of the same board (Code Provision A.3.1).
In support of this standard there is academic work that suggests it is not always in the best interests of the company to allow the CEO to remain as chairman. There is a psychological argument that CEOs’ sense of self is so tied up with their perceived corporate legacy that they may sabotage, deliberately or subconsciously, attempts by their successors to implement changes at the company.
Another commentator likens CEOs to folk heroes who perceive retirement as a kind of death and therefore resist departing from the firm, even when they are no longer the best person to run it. A US study finds evidence that such ‘lingering predecessors’ prevent successors from implementing strategic change, a situation which is only remedied when the previous CEO retires as chairman and leaves the firm entirely.
“The outgoing CEO grooms the successor and then remains as chairman of the board following the handover of executive power”
There are therefore valid reasons for shareholders to be concerned about allowing retiring CEOs to remain as chairman. The fact that many firms have complied with the 2003 recommendation suggests that investors have expressed the view that they agree with it. There is, however, an alternative perspective to consider.
One consequence of compliance with Code Provision A.3.1 is the preclusion of the use of the ‘relay’ process of succession. Commonly used in the US, this involves the identification of an ‘heir apparent’ to a CEO approaching retirement. The outgoing CEO grooms the successor and then remains as chairman of the board following the handover of executive power – he or she runs alongside the CEO after passing the baton.
Often, the outgoing CEO holds the joint CEO-chair position prior to handing over executive responsibilities to the incoming CEO. This process enables the chairman to support the new CEO and allows a gradual handover of a complex role, but also, importantly, provides the company with a ‘safety net’ interim leader in case the new CEO drops the baton and must be replaced.
Academic studies have found this orderly succession process to be valued by investors, with US researchers observing a positive share price response to the news of a completed relay style succession event.
In the UK, I was co-author of a study which found on average no significant share price response to the news that a CEO is moving to the chairman role. The evidence available indicates that markets view the progression of the CEO to chairman either positively or neutrally, but not negatively.
A further benefit of the relay style of succession is that the outgoing CEO remains motivated until and beyond the end of his or her executive role. As managers approach the end of their careers, ‘horizon problems’ may become an issue. They are no longer motivated by concerns about their future career and may therefore take actions which benefit themselves in the short term, but are detrimental to shareholder value in the longer term.
“Horizon problems can be mitigated by providing the CEO with post-retirement opportunities, such as remaining as chairman”
Horizon effects may manifest in observable ways, such as cuts to long-term investment (for example, R&D or capital expenditure), which increase short-term profits (and the departing CEO’s compensation), but adversely affect longer-term performance. There are also likely to be other, less direct, costs to a reduction in a CEO’s interest in his or her firm’s future as a result of becoming ‘demob-happy’.
These problems can be mitigated, however, by providing the CEO with post-retirement opportunities, such as remaining as chairman of the board. US research has revealed two phenomena. First, chief executives often go on to serve as chairman in their own or another firm post-retirement, and second, that firms are more likely to retain the CEO as chairman if pre-retirement firm performance was higher.
The authors of this study conclude that post-retirement career opportunities mitigate horizon problems, as well as allowing firms to retain access to a source of expertise in the firm and its environment.
Following the Higgs Report in 2003, which introduced the recommendation that the chairman of the board should be independent upon appointment, I conducted a study of CEO succession in UK firms to investigate whether the relay process of succession had any effect on firm performance. If the incoming CEO is prevented from taking strategic actions in the best interest of the firm then this should manifest itself in poor firm performance following the handover of power.
To test this, I identified a sample of 225 CEO retirements from UK listed firms between 1996 and 2007; in 110 cases the CEO had left the board upon retirement and in 115 cases had remained as chairman. I then looked at measures of firm performance for two years approaching the retirement year, and two years following it.
If new CEOs were hampered by the old CEO (as chairman) and unable to run the firm in the best interests of shareholders, then we may expect to see profits and/or stock returns in CEO-remain firms suffer relative to CEO-depart firms in the first few years of the new CEO’s tenure. However, there was no evidence that performance was affected by the succession process adopted by firms.
This is consistent with economic theory which argues companies will choose the succession processes most appropriate to their circumstances and, as such, regulation is not required.
Of course, in the UK, our Corporate Governance Code is issued on a ‘comply or explain’ basis. Given firms appear to be selecting appropriate succession policies we may expect to witness little change in practice following the 2003 change. This is not the case, however. In sample cases prior to 2003, 61% of CEOs remained as chairman of the board; post-2003 only 37% of CEOs stayed on.
“Think carefully before taking actions to prevent companies from adopting this style of CEO succession – in many cases it is the best option for the firm”
The evidence from pre-2003 suggests the higher proportion of CEOs remaining was due to a relay-style succession process, with remaining CEOs being further from retirement age and more likely to have spent time in the joint CEO-chair role prior to handing over to an internal replacement. Firm performance remained stable during and after the transition.
The Higgs recommendations do appear to have had an effect on top management succession in UK firms, driving out an orderly handover process which generally caused no harm. My advice to investors would be to think carefully before taking actions to prevent companies from adopting this style of CEO succession – in many cases it is the best option for the firm. Plus, it prevents competitor companies from being able to pick up your talented retiring CEOs and make them chairman of their company.
|Read the investor viewpoint on the debate by Frank Curtiss|
|Elisabeth’s reflections are based upon her academic article, published in the British Accounting Review in 2016, entitled: ‘CEO Succession in the UK: An analysis of the effect of censuring the CEO-to-chair move in the Combined Code on Corporate Governance 2003’.|