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The Ideas and Analysis Letter: The Sanchez “Take”

May 2013

Chairman or CEO or Both:

 A Corporate Governance Issue Lost in the Personality Cult


The business community eagerly watched with great interest the recent, tense, corporate governance story involving the J.P. Morgan Chase & Company (JPM) stockholders and its CEO & Chairman of the Board, James (Jamie) Dimon. The central issue was whether JPM should separate the roles of the chairman of the board and the chief executive officer.

 

The issue has been one of great importance, particularly since the 1980s, when corporate governance seemed to be at a low point in America and the disease know an “Enronitis” attacked the business community.

 

To split or not to split the two top roles came back into focus when early in 2012 JPM reported massive losses as a result of its seemingly out-of-control derivatives trading. The situation was so out of control that reporting the dollar amount of the losses was difficult and the losses finally reported were significantly different (three times more) than the amount initially reported. The “egg on the face” CEO & Chairman Dimon rekindled the fire that was blazing back when Enron, Tyco, Global Crossing and a host of others seemed to be dealing with little or no oversight from corporate directors and reported numbers that lacked credibility. CEO & Chairman Dimon’s knack for appearing overly confident and his “rein” over JPM with little supervision or oversight brought back into the spotlight the debate about the different roles of the different players charged with corporate governance.

 

Corporate Governance Overview – The Stakes are Extremely High

 

The vested interest of management in the financial reporting process quite naturally causes concern for investors, lenders and regulators.

 

Management’s desire to put its “best foot forward” and its financial stake in reporting favorable results clearly contributed to the “Enronitis” epidemic that hurt the credibility of financial markets.

 

Unless the public has confidence in the financial markets and the reports that are made by financial market players, the capital allocation process will become less efficient.

 

Everyone must be concerned with timely, fair reporting by management.  Market participants rely on and expect those charged with corporate governance to assure the accuracy and hence the credibility of management’s reports.  Failure to ensure confidence in financial reporting puts the entire public market mechanism at risk. 

 

The capitalist system we know can not survive without belief in fair, well-run capital markets with ethical participants.  The survival of the capital markets, in a sense, is in the hands of those charged with corporate governance.

 

What is Corporate Governance?

 

There is no single, comprehensive, universally accepted definition of corporate governance. Certain common elements are present in most definitions that describe it as the policies, processes, and structures used by organizations to:

 

·    direct and control its activities

·    achieve its objectives

·    protect the interests of its diverse stakeholder groups in a manner consistent with appropriate ethical standards.

 

A frequently-used definition of organizational governance comes from the Organization for Economic Cooperation and Development (OECD):

 

Corporate governance involves a set of relationships between a company's management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.

 

The Roles of the Corporate Governance “Players

 

The important parties in the corporate governance arrangement include the following:

 

·       The Board of Directors

·       Management

·       Internal Auditors

·       External Auditors

 

The role of the parties are separate, and the responsibilities of each role are different.  Effective corporate governance is diminished if the role boundaries are not respected. Good governance comes from effective synergy generated among the activities of these differing roles, while maintaining their separation.

 

Board of Directors

 

Undeniably, the board is the focal point for all governance activities. The board establishes the “tone at the top.” It implements best governance practices. 

 

Although the board oversees organizational activities, it does not have direct management of any of them. The board is ultimately accountable and responsible for the:

 

-      performance and affairs of the organization

-      effective risk management practices

-      establishing a risk appetite level

 

Management

 

Under the oversight of the board, senior management sets strategic direction and establishes an entity’s value system. 

 

Senior management does the following on a continuous basis:

 

-      provides assurance that risks are managed as part of a risk management process

-      monitors operations

-      measures results

-      implements corrective actions in a timely manner

 

Operating management deploys strategy, enforces internal control, and provides direct supervision for areas under its control.  It is accountable to senior management, and ultimately to the board, for implementing and monitoring the risk management process and establishing effective and appropriate internal control systems. 

 

Internal Auditors

 

The internal auditors perform objective assessments to provide assurance that governance structures and processes, including internal control, are designed properly and are operating effectively.  Internal auditors also provide advice on potential improvements to governance structures and processes.

 

External Auditors

 

The external auditors provide independent assurance on the financial statement preparation and reporting activities, in accordance with applicable regulations and generally accepted accounting principles.  External auditors carefully coordinate their work with the work of internal auditors and, where possible, rely on the work of the internal auditors.

 

A brief summary of the roles follows:

 

Role

Responsibilities

Board

·    The focal point for all governance activities.

·    Ultimately accountable and responsible for the performance and affairs of the organization, effective risk management practices, and establishing a risk appetite level.

·    Oversees all organizational activities (risk management, strategic direction setting, compliance with laws, good business, and ethical practices etc.) but does not have direct management of any of them.

·    Establishes the "tone at the top" and implements best governance practices for organizational performance.

Senior

Management

·         Under the oversight of the board.

·         Sets strategic direction and establishes an entity's value system.

·         Provides assurance that risks are managed as part of a risk management process, operations are monitored, results are measured, and corrective actions are implemented in a timely fashion.

Operating

Management

·         Deploys strategy, enforces internal control, and provides direct supervision for areas under its control.

·         Accountable to senior management, and ultimately the board, for implementing and monitoring the risk management process and establishing effective and appropriate internal control systems.

Internal

Auditing

·         Performs assessments to provide assurance that governance structures and processes, including internal control, are properly designed and operating effectively.

·         Provides advice on potential improvements to governance structures and processes.

External

Auditing

·         Provides independent assurance on the financial statement preparation and reporting activities, in accordance with applicable regulations and accounting principles.

 

Separate or Don’t Separate?

 

Given the above it seems that there ought to be a clear distinction between the players – especially the board chairman and the head of the management, the CEO. This view is predominant in academia. This view believes the separation of the chair and CEO roles leads to better monitoring and oversight. Clearly there would be a conflict if the same person is the chair and the CEO since the chair leads the board in overseeing the CEO’s duties of hiring, compensating, assuming tolerable risks etc.

 

On the other hand, others believe that a clear, unambiguous authority figure is essential to corporate effectiveness. They hold that strong, stable, unconfused leadership is critical to organizational success. It must be clear who is ultimately accountable.

 

This writer’s take favors separation but recognizes that the personalities and the interrelationships must shape the dynamics between board and CEO. The duties must be clear to all parties and the accountabilities must be accepted. The overriding benefit of separation of the roles is the extra set of eyes that provide overview and constructive criticism to the CEO. It is not likely, for human nature reasons, to believe a strong-willed CEO would be critical of himself. The human frailty, itself, calls for more supervision, direction, objective overview. Unless the personalities are so incompatible the extra overview can only be a plus.

 

Revisiting the Issue at JPM

 

The latest JPM derivative scandal (I guess the “London Whale” story can safely be called a scandal - see the May 2012 Sanchez “Take” – What Again? Will We Ever Learn? – A Preliminary Reaction to the JPM Trading Debacle) once again has brought forth the issue of strengthening corporate governance via splitting the chair and CEO roles. The difference this time is the strong-willed personality of CEO Dimon. He seemingly made the issue go away, first by the suggestion that the losses were not material and JPM as it has done in the past keeps making money and creating value for its stockholders. His view seems to suggest a separate chair would not have made much of a difference. Such a view doesn’t say very much about the perceived value of the chair or the board. Does it? No doubt he is and has been the best risk manager in the financial services industry. He also is a shrewd, intelligent, suave political person when dealing with shareholders, investors, regulators and more recently elected congressional officials. His track record is admirable. He is one of the best CEOs.

 

Unfortunately Mr. Dimon’s personality became the overriding concern when discussing splitting the chair and the CEO roles at JPM. That is a shame. The issue deserves a debate without references to personalities of the players.

 

This time the tremendous lobbying (itself a costly distraction from the job of managing JPM) effort by proponents of the status quo at JPM overwhelmingly thwarted a shareholder motion to split the roles. Two-thirds of the shareholders rejected the motion to split. The mainly institutional holders of JPM shares had to listen to reasons why splitting would be detrimental. They even had to endure the rumored threat that Mr. Dimon may leave JPM if the roles were split.

 

I fear the merits for or against splitting the roles were not properly aired out. Instead, the personality of Mr. Dimon dominated the process. Yes, it is good the JPM has settled the issue and put in behind them (until the next risk “bust”). The issue however remains and its merits still need a debate.

 

Because the derivative fiasco did not deal a fatal blow, it will be put into the history books. Nevertheless, we will always wonder if things would have been different if a separate chair was available to  questioned activities before massive losses were incurred. The extra eyes may have helped.

 

The losses were sustained to the tune of $6,000,000,000 or approximately 28% of JPMs 2012 bottom line (net income) of $21,284,000,000. To me that is a material amount that cries out for a second pair of eyes.

 

I guess at this time that is not big enough. No doubt we will revisit the chair/CEO separation issue at a later time when once again we will hear “What Again? Will We Ever Learn?”

 

 

 

Paul J. Sanchez CPA, CBA, CFSA

President

Professional Service Associates

www.Sanchez-PSA.com

SanchezPSA1@Yahoo.com

May 31, 2013