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Reducing CEO Power Can Undermine a Company's Legitimacy - Ideas for Leaders
Idea #610

Reducing CEO Power Can Undermine a Company’s Legitimacy

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KEY CONCEPT

A separation of power between CEO and a board of directors is often viewed as a sign of good governance. A new study reveals that reducing the power of a CEO may actually diminish rather than reinforce the legitimacy of a company in its foreign markets.


IDEA SUMMARY

The ‘legitimacy’ of a company is based on whether outsiders consider that a company takes appropriate actions — and has the governance structures in place to ensure that it continues to take appropriate actions.

One measure of legitimacy is the balance of power between the CEO and the board of directors. In general, investors and regulators view a company as more legitimate if its CEO does not have too much power. The thinking is that a strong board can limit the actions of a CEO and thus prevent potential abuses of power and position.

A new study reveals, however, that a weakened CEO can hurt rather than help the legitimacy of multinational companies. First, customers in a company’s foreign markets determine the legitimacy of the firm in that market — not the company’s home-based investors and regulators. Second, in many cultures, authority and power are viewed as positive signals of control and strength. These cultures expect a wide range of power between the bottom and the top of the organization, an attitude known as ‘power distance’. In high power distance cultures, customers will view a strong CEO as a signal of legitimacy — a sharp contrast to the common wisdom on CEO power. In low power distance cultures, a strong CEO is a warning flag.

Multinational companies, however, operate in a variety of countries with a variety of cultures. Which cultural preferences should take precedence?

The answer lies in the weight or influence that customer opinion carries within the company — a factor that, this study shows, depends on several factors.

The first is the geographic concentration of the company’s sales. Some companies have a few large institutional customers. Other companies may be much more global, serving customers in 15 or 30 markets. Intuitively, the cultural preferences of customers from one out of three or four markets will carry much more weight with a company than the cultural preferences of customers from one of 30 markets. This intuitive conclusion is confirmed by the data in the study.

Another factor that impacts the influence of customer opinion on a company’s decision is the bargaining power that companies have over their customers. This bargaining power depends on industry — that is, companies in some industries have little bargaining power over customers, while companies in other industries have much greater bargaining power.

This study focuses on two industries — the pharmaceutical and semi-conductor industries — that were deliberately chosen because of the wide differences in their bargaining power. It is relatively easy for customers to leave a semi-conductor company in favour of another. For pharmaceuticals, however, a certain medicine will be available from only one company; and even when patents run out, the number of competitors making a certain medicine is limited. Pharmaceutical companies thus have greater bargaining power over their customers than semi-conductor companies.

Analysis of the data in this study confirms that customer preferences on CEO power had less influence on the pharmaceutical firms than on semi-conductor firms. 


BUSINESS APPLICATION

This study has direct practical implications for companies competing in different world markets.

First, CEO power can boost a company’s standings. Companies operating in certain cultures can use CEO-dominated boards to gain legitimacy, which leads to a cautionary lesson: make sure your governance decisions are not inadvertently hurting your standing in key markets.

Cultural sensitivity should influence governance decisions. This study shows that whether CEO power legitimizes or de-legitimizes a company in the eyes of customers depends on the culture of their nation. It is important to note that this same cultural sensitivity factor should also be applied to other governance issues, such as gender or director nationality. Ask yourself: How will my choices on these types of issues impact my company’s standing in key markets?

Evaluate boards based on context, not structure. Investors and regulators often look at structure (e.g. board independence or CEO duality) to evaluate a board’s effectiveness. This study argues that structure-driven evaluations fail to consider the context in which the board operates. Variables such as geographic concentration of sales, cultural variance and industry must be factored in.

In sum, no one doubts the legitimizing role of boards of directors. Understanding which governance decisions help or hurt a company, however, is more subtle and complex than many assume.


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Idea conceived

July 16, 2015

Idea posted

May 2016
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