Walking 'on Eggshells': Corporate Boards Juggle Many Intangibles When Judging Performance
When Mark Hurd was forced to resign as chief executive of Hewlett-Packard last month in the wake of fudged expense reports, the first person to come to his defense was Larry Ellison, the founder and CEO of Oracle, an HP partner and competitor. In an email to The New York Times, Ellison lambasted the HP board's judgment, calling the move "the worst personnel decision since the idiots on the Apple board fired Steve Jobs many years ago."
After all, Hurd -- who took over HP in 2005 after the tumultuous reign of Carleton S. Fiorina -- presided over a company that by most accounts was performing extraordinarily well. Revenue last year was $115 billion, up 44% from five years ago. On Hurd's watch, HP averaged annual 18% profit increases -- impressive given the firm's massive size. And during his tenure, the company's stock price more than doubled, from $19 to $45. (Shares today are trading at around $30.)
In the press release announcing Hurd's resignation, the company noted that while an HP consultant had made a claim of sexual harassment against Hurd, he had been exonerated of the charges. In a vague reference to inaccurate expense reports, the release said that Hurd had acted in "violation of HP's standards of business conduct."
Ellison, a personal friend of Hurd's, was not convinced. "The HP board admits that it fully investigated the sexual harassment claims against Mark and found them to be utterly false," he said. "In losing Mark Hurd, the HP board failed to act in the best interest of HP's employees, shareholders, customers and partners."
Did Ellison have a point, or was there more to the board's forced resignation than meets the eye?
An Uneasy Feeling
"Boards lose confidence in CEOs all the time; it's rarely black and white," notes Robert Mittelstaedt, dean of the W.P. Carey School of Business at Arizona State University and a former vice dean at Wharton. "There's more to it than just, 'Did you make your numbers this year?' They get a creeping, uneasy feeling about the CEO's ability to move the company forward, sometimes even when the company is doing well. It's a feeling that maybe this isn't the right person anymore."
True, a board's primary fiduciary responsibility is to ensure a CEO is generating profits for shareholders, but Hurd's abrupt departure underscores how boards of directors do not judge a CEO's performance on company prosperity alone. Rather, boards use a broad set of intangible criteria -- ranging from how well leaders are able to earn employees' trust to how well they deal with customers to how they conduct themselves off site -- as a way of evaluating success or failure. But while these intangible standards are relevant in both good and bad economic climates, experts say they can be extraordinarily difficult for boards to assess.
There are many reasons a board might force a resignation, according to Mittelstaedt. "It could be that the CEO is so arrogant that he doesn't have a good relationship with the board. It becomes a personality [issue]: The CEO is at odds with the board because he resents it. Or it might be that the board feels the CEO doesn't have a vision for the company -- he may be a good operator on a daily basis but he can't articulate where the business is headed in five to 10 years. Or there may be a revolving door in the management suite; people keep leaving after a year or two. Maybe the CEO is aloof and doesn't have respect for customers. Finally, it could be that trust is eroded because of unethical behavior. That changes the tone of the relationship and raises questions in people's minds."
In the case of Hurd, financial press reports indicate that he was roundly disliked by employees -- distrusted for his heavy-handed cost cutting of the company's research and development budget, and resented for his outsized compensation. Last year, he made $24.2 million; the year before, his compensation package totaled $34 million, even as he slashed thousands of jobs in the rank and file. From the board's perspective, the sexual harassment claim may have been the last straw -- or merely an excuse -- to force him out.
"When something like the Hurd situation happens, it's natural for a board to ask, 'Is this CEO going to be effective?'" notes Wayne R. Guay, a professor of accounting at Wharton. "If we keep him on, does it set a bad precedent? Does it tarnish the standing and reputation of the company? And will it be a distraction going forward? The board can't ignore unfavorable perceptions by employees or the general public, as these perceptions can often be important to the CEO's leadership qualities and effectiveness. The board might decide to remove the CEO from power even if the company is doing well."
Hurd, for his part, has landed quite nicely. HP's board awarded him a severance package reported to be worth between $40 million and $50 million. And last week, Ellison announced that Hurd would join Oracle as its new co-president.
The Hurd case, of course, is not the first time a board has fired a CEO, or forced a resignation, over personal transgressions. In 2005, for instance, Boeing asked its chief executive, Harry C. Stonecipher, to resign after an investigation uncovered that he had an affair with a female employee. Stonecipher had rejoined Boeing -- he had retired 15 months earlier -- to help restore the aerospace company's reputation after a string of military procurement scandals led to the resignation of his predecessor. At the time, Boeing was gaining momentum; in 2003-2005, its share price dramatically outperformed the S&P 500 index. But the board was intent on dismissing Stonecipher as a clear signal that it had no tolerance for ethical missteps.
In 2006, David Edmondson, then CEO of RadioShack, resigned after admitting that he misstated his academic record. His resignation came after the board announced it was hiring outside lawyers to investigate claims that he had reported two college degrees from Pacific Coast Baptist College for which his school had no records. When the revelations emerged, the company was suffering: It had just announced a 62% decrease in its fourth-quarter earnings as well as plans to close between 400 and 700 stores. But the inaccurate school record was the only reason given for Edmondson's departure.
Experts say boards must have a set of standards and values they adhere to and enforce, or else they risk undermining the fabric of the organization. But it's not always easy for a board to evaluate a CEO's performance based on intangibles, according to Lawrence Hrebiniak, a management professor at Wharton. "You have to take intangibles into account, but it's awfully hard to judge these things," he notes. "The drive toward political correctness is part of this. People are on eggshells. If any behavior or remark is on the border, on the edge, with even a hint of suspicion, there is a tendency for the board to want to cover itself. The question becomes: When do those intangibles create a situation where the CEO loses his ability to be an effective leader? In Hurd's case, he lost the trust of the board."
Prescriptive approaches are not advisable, experts suggest, because boards need maximum flexibility to determine the right course for the company. Hrebiniak warns that it is dangerous -- not to mention foolhardy -- to believe a board could write a rulebook that delineates every possible infraction, or create guidelines on specific actions or behaviors that would lead to a firing.
"It's impossible to come up with the criteria to judge when a CEO needs to go because you don't know what [circumstances are going to arise]," he points out. "You could say that anything a CEO does that affects the trust of shareholders, investors and employees could be a fireable offense. But that is a cloudy, murky area, no question about it."
Judging these less concrete qualities may be tricky, and some of the criteria -- such as whether or not the chief is well regarded by employees -- may, at first blush, seem arbitrary, but the fact is that "these intangible factors are important because everything is interconnected," states Charles M.Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware.
"Bill Clinton used to say that he could separate his personal life from his professional one, but no public figure can really do that today," he notes. "A CEO may be returning great metrics, but if they show poor judgment, this will affect their job. The board is there to evaluate the job of the CEO -- how they manage subordinates, how they treat customers and how they deal with suppliers. If someone is failing in one way or another, there will be consequences."
It would be unwise, for instance, for the board to disregard employee opinion of the CEO, according to Elson. "You don't have to like the person you're working for, but you do have to respect him. A leader has to have people to lead, people who will follow. After all, a CEO isn't the one who does the work of a company; it is done by the employees. They're the ones who make the money."
Still, boards are often slow to take action, experts note. By and large, corporate boards are conservative, risk-averse institutions, and there are serious costs to both the board and the company to forcing out a CEO. "No board gets rid of a CEO willy-nilly," says Elson. "For one, it leaves the company in a period of uncertainty. Two, the board needs to step in and effectively run the company for a while. And three, board members have to hope they can find someone as good or better than the last CEO."
Thinking about Litigation
Despite these obstacles, there appears to have been a rise in the number of ousted CEOs dominating the business headlines in the past few years. Financial services companies have had the most turnover: Ken Thompson, CEO of Wachovia, Martin Sullivan CEO of AIG, and John Thain, head of Merrill Lynch, are just a few of the casualties. But banking chiefs have not been the only ones to get the axe. Jerry Yang of Yahoo! resigned in 2008 in the face of stinging criticism for rebuffing a takeover offer from Microsoft that many shareholders favored; last year Rick Wagoner was forced out as the head of GM after the Obama administration threatened to withhold bailout funds from the automaker. In July, Tony Hayward of BP left the company, bowing to pressure over his botched handling of the Deepwater Horizon oil rig explosion in the Gulf of Mexico.
Does this mean that boards have become more vigilant and therefore more activist? Not necessarily, suggests Wharton's Hrebiniak. Over the last two decades, there has been a growing trend toward board independence and improved transparency, but the global financial crisis and subsequent economic downturn have most likely had a bigger impact on board behavior.
"During a recession, during bad economic times, yes, boards are going to take a closer look. Frankly, they are also thinking about litigation or being criticized for poor due diligence," Hrebiniak says. "In the past decade, more boards have been sued or embarrassed by things that happened on their watch. Take the BP oil rig explosion, for instance. The board is being blamed for not [giving closer scrutiny to] Tony Hayward. Could the board's vigilance have prevented it? Probably not."
HP directors have already been hit with a lawsuit over the departure of Hurd. The shareholder derivative suit, which alleges directors violated their fiduciary duties in connection with the events surrounding Hurd's resignation, seeks to reclaim the severance paid to Hurd as well as corporate-governance changes at the company.
But Wharton's Guay cautions against drawing a direct correlation between the economy and board activism. "Any time you have a lot of companies that are suffering substantial hardships in terms of profitability, [including] during a recession, one expects to see boards making a variety of changes," he says. "In the current economic climate, many companies have struggled with performance. In such cases, it is reasonable for boards to ask: Do we have the right person running the show? Is this person an effective leader? Is he taking on the right projects?"
In the last few years, there have been a number of high-profile management shake-ups, but the two most recent have also been characterized by very unusual economic times, he notes. Without careful empirical analysis, "it is difficult to draw a clear inference on whether boards are more active in making changes than they have been in the past. An alternative possibility is that boards are no more or less active than they have been and that any recent surge in management changes is simply the result of a particularly unusual economic environment."
Guay says the general public has a misperception that company boards ought to be more vigilant in a challenging economy than in a good one. In fact, he says, boards need to monitor management closely in both cases, but the types of problems they look for are different. "When a company is doing well, it's tempting to think the board doesn't need to be as vigilant. But when cash is flowing in, the potential for corporate waste is high," he points out. "That's when risk is greatest [because] CEOs take on pet projects, or buy companies they don't need to buy, or make investments they shouldn't. That is precisely a time when boards need to monitor their leaders closely."
On the other hand, when things are going badly for a firm -- in terms of weak profitability and poor share price performance -- this is a signal to the board that the CEO may not have the right skills to successfully manage the organization. "The board needs to stay on top of the situation and make a determination about whether the CEO or the management team needs to be replaced."