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Insular decision-making in the board room: why boards retain and hire sub-standard ceos

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  • Meg Sato
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    Abstract

    It is widely believed that corporate boards are overly reluctant to fire their CEOs. The conventional explanation for retaining a CEO regardless of his/her talent is that a CEO chooses the board members and has the power to fire them. However, very few studies have investigated how a new CEO is chosen. This paper explores an unexamined cause of board reluctance in removing a CEO: the incentive to minimize the leakage from the decision-makers’ future surplus. I argue that this same logic provides the theoretical explanation for how a new CEO is chosen for both voluntary and forced CEO replacements. I show that this incentive of the incumbent board and CEO often departs from the shareholders’ interest. In short, if the net surplus of the incumbent board and CEO is expected to be larger under an incumbent sub-standard CEO, or under an internal candidate rather than an external candidate, then they retain the incumbent sub-standard CEO or promote an internal CEO candidate, even though the expected corporate profit generated by appointing an external candidate is likely to have been greater.

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    File URL: https://crawford.anu.edu.au/pdf/pep/apep-384.pdf
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    Bibliographic Info

    Paper provided by Australia-Japan Research Centre, Crawford School of Public Policy, The Australian National University in its series Asia Pacific Economic Papers with number 384.

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    Length: 32 pages
    Date of creation: 2009
    Date of revision:
    Handle: RePEc:csg:ajrcau:384

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    1. Fama, Eugene F & Jensen, Michael C, 1983. "Separation of Ownership and Control," Journal of Law and Economics, University of Chicago Press, vol. 26(2), pages 301-25, June.
    2. Agrawal, Anup & Knoeber, Charles R. & Tsoulouhas, Theofanis, 2006. "Are outsiders handicapped in CEO successions?," Journal of Corporate Finance, Elsevier, vol. 12(3), pages 619-644, June.
    3. Benjamin E. Hermalin, 2005. "Trends in Corporate Governance," Journal of Finance, American Finance Association, vol. 60(5), pages 2351-2384, October.
    4. Edward P. Lazear & Sherwin Rosen, 1979. "Rank-Order Tournaments as Optimum Labor Contracts," NBER Working Papers 0401, National Bureau of Economic Research, Inc.
    5. Sherwin Rosen, 1985. "Prizes and Incentives in Elimination Tournaments," NBER Working Papers 1668, National Bureau of Economic Research, Inc.
    6. Anup Agrawal & Charles R. Knoeber, . "Firm Performance and Mechanisms to Control Agency Problems between Managers and Shareholders (Revision of 29-94)," Rodney L. White Center for Financial Research Working Papers 8-96, Wharton School Rodney L. White Center for Financial Research.
    7. Borokhovich, Kenneth A. & Parrino, Robert & Trapani, Teresa, 1996. "Outside Directors and CEO Selection," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(03), pages 337-355, September.
    8. Adams, Renee & Hermalin, Benjamin E. & Weisbach, Michael S., 2009. "The Role of Boards of Directors in Corporate Governance: A Conceptual Framework and Survey," Working Paper Series 2008-21, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    9. Renée B. Adams & Daniel Ferreira, 2007. "A Theory of Friendly Boards," Journal of Finance, American Finance Association, vol. 62(1), pages 217-250, 02.
    10. Chan, William, 1996. "External Recruitment versus Internal Promotion," Journal of Labor Economics, University of Chicago Press, vol. 14(4), pages 555-70, October.
    11. Yermack, David, 1996. "Higher market valuation of companies with a small board of directors," Journal of Financial Economics, Elsevier, vol. 40(2), pages 185-211, February.
    12. Parrino, Robert, 1997. "CEO turnover and outside succession A cross-sectional analysis," Journal of Financial Economics, Elsevier, vol. 46(2), pages 165-197, November.
    13. Gillan, Stuart L., 2006. "Recent Developments in Corporate Governance: An Overview," Journal of Corporate Finance, Elsevier, vol. 12(3), pages 381-402, June.
    14. Warther, Vincent A., 1998. "Board effectiveness and board dissent: A model of the board's relationship to management and shareholders," Journal of Corporate Finance, Elsevier, vol. 4(1), pages 53-70, March.
    15. Agrawal, Anup & Knoeber, Charles R., 1996. "Firm Performance and Mechanisms to Control Agency Problems between Managers and Shareholders," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(03), pages 377-397, September.
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