In its 2013 proxy, Johnson & Johnson claims the guiding principle behind its executive compensation program is "attracting, developing, and retaining global business leaders who can drive financial and strategic growth objectives and build long-term shareholder value."

However, allowing Alex Gorsky to serve as both CEO and chairman of the board risks achieving the opposite.

Let's look at why J&J's decision to combine the CEO and chairman roles, and shareholders' decision to side with management against a shareholder proposal pushing for an independent chair, may reduce your long-term returns.


Procedural concerns
While it's common for large companies to have the same person occupy the CEO and board chair roles, clear conflicts of interest arise within this structure. Remember that the board is responsible for evaluating the CEO, creating executive compensation packages, and choosing new board members. When the CEO leads the board, he or she can prevent this group from properly performing these duties by putting pressure on them to make decisions he or she likes even when they aren't in the best interests of shareholders.

But you don't just have to rely on the theoretical argument against this structure. Data gathered by corporate-governance expert Nell Minow's organization, GMI Ratings, supports my view that companies with the same person serving as CEO and chairman can lower the long-term growth potential of your investments.

Higher pay
In its shareholder proposal pushing J&J to require its board chairman to be an independent board member, the American Federation of State, County, and Municipal Employees -- also known as AFSCME -- pointed out that the company's executive compensation plan has been a point of contention. Just last year, only 57% of shares supported the company's executive compensation plan. That's a very close result, especially when you consider how normally lopsided shareholder votes are.

In other words, AFSCME suggests that the dual chairman/CEO structure may undermine the creation of reasonable compensation plans.

And it may have a point.

According to a recent GMI Ratings study of 180 North American megacaps, CEOs who do not also serve as chairmen earn only about 66% of their peers who occupy both roles. Even more striking, the study shows that the median cost of employing a separate CEO and non-independent chairman is about 10% less than the cost of paying one person to serve in both roles.

And the savings grow even more when a company employs an independent, non-executive chair. In this case, the total cost of these positions is only about 57% of the cost of the combined roles.

J&J isn't the only health-care business with a dual chair/CEO in which shareholders are concerned about oversized pay packages. Pfizer also combines the roles of CEO and chair, and its 2013 proxy contained a shareholder proposal pushing for longer stock retention requirements among executives. In the supporting statement, Pfizer's shareholder proposal points out that Chairman and CEO Ian Read got $25 million in 2012, and that GMI criticizes Pfizer for not tying pay to performance.

Lower long-term performance
If the higher costs associated with combining the CEO and chairman roles were necessary to bring in the most qualified leaders, then shareholders may have had reason to side with J&J's board against AFSCME's shareholder proposal.

But it's not clear that's the case. The GMI Ratings study shows that the median five-year shareholder returns at companies with a separate CEO and chair were nearly 28% higher than the returns at companies with the same person serving in both roles. 

In other words, shareholders of companies that combine the CEO and chairman roles often pay more for lower long-term performance.

Risks at Johnson & Johnson
In addition to the compelling general argument for separating the CEO and chairman roles, there are compelling reasons to separate these roles at J&J in particular.

As was pointed out by a separate shareholder proposal pushing for longer stock retention requirements among J&J executives, GMI Ratings has given J&J a "D" rating every year since 2008 and marked the company as a "Very High Concern" for executive pay. The shareholder sponsoring this proposal was particularly unhappy that former CEO/Chairman William Weldon got compensation packages worth $27 million in 2011, along with a $143 million sendoff associated with retirement and deferred pay.

And shareholders should note that Weldon managed to gain these sweet compensation deals even though he led J&J during a troubled period marked by significant product recalls and public and regulatory scrutiny. For example, the company brought on the FDA's scorn for continuing to sell defective insulin pumps produced by its Animus unit, and for failing to report cases in which the pumps may have contributed to deaths or injuries. Also, J&J has had to recall a number of prescription and non-prescription drugs over the past few years, including Tylenol and Motrin, and prescription drugs for HIV and seizures.

The Foolish bottom line
For a board to play a meaningful role in creating long-term value growth and appropriate executive compensation packages, I believe the CEO and chairman roles should be divided. Without such a division, I fear that the board may not be empowered to make appropriate compensation decisions or carry out an honest assessment of the CEO's performance. For these reasons, I suggest that investors note the possibility that J&J's dual CEO/chairmanship structure may undermine long-term share growth before purchasing shares of the company.

Looking beyond pharma
While you can certainly make huge gains in biotech and pharmaceuticals, the best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "
3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

The article 1 Way This Company Limits Long-Term Value originally appeared on Fool.com.

Motley Fool contributor M. Joy Hayes, Ph.D. is the Principal at ethics consulting firm Courageous Ethics . She owns shares of Johnson & Johnson. Follow @JoyofEthics on Twitter.  The Motley Fool recommends and owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


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