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Insular Decision Making in the Board Room: Why Boards Retain and Hire Substandard CEOs

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  • Meg Adachi-Sato

    (Royal Melbourne Institute of Technology University)

Abstract

This paper explores one reason why a corporate board often fails to replace a substandard CEO. I consider the situation in which the incumbent CEO and direscotrs make decisions in the absence of the new CEO. I show that in this situation, which is common in practice, the board and the CEO end up maximizing the expected utilities of the negotiating parties that do not include the expected utility of the potential CEO. This sometimes results in the retention of an inefficient CEO. Moreover, I argue that this same logic provides a theoretical explanation for how a new CEO is chosen in relation to both the voluntary and enforced replacement of an existing CEO. Specifically, the equilibrium succession policy may depart from the optimum succession policy; that is, the optimum from the shareholders' perspective.

Suggested Citation

  • Meg Adachi-Sato, 2010. "Insular Decision Making in the Board Room: Why Boards Retain and Hire Substandard CEOs," CIRJE F-Series CIRJE-F-710, CIRJE, Faculty of Economics, University of Tokyo.
  • Handle: RePEc:tky:fseres:2010cf710
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    References listed on IDEAS

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    1. Milton Harris & Artur Raviv, 2010. "Control of Corporate Decisions: Shareholders vs. Management," Review of Financial Studies, Society for Financial Studies, vol. 23(11), pages 4115-4147, November.
    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. Roman Inderst & Holger M. Mueller, 2010. "CEO Replacement Under Private Information," Review of Financial Studies, Society for Financial Studies, vol. 23(8), pages 2935-2969, August.
    4. Andres Almazan & Javier Suarez, 2003. "Entrenchment and Severance Pay in Optimal Governance Structures," Journal of Finance, American Finance Association, vol. 58(2), pages 519-548, April.
    5. Renée B. Adams & Daniel Ferreira, 2007. "A Theory of Friendly Boards," Journal of Finance, American Finance Association, vol. 62(1), pages 217-250, February.
    6. Chung, Kee H. & Elder, John & Kim, Jang-Chul, 2010. "Corporate Governance and Liquidity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(02), pages 265-291, April.
    7. Raheja, Charu G., 2005. "Determinants of Board Size and Composition: A Theory of Corporate Boards," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 40(02), pages 283-306, June.
    8. Oliver E. Williamson, 2008. "Corporate Boards of Directors: In Principle and in Practice," Journal of Law, Economics, and Organization, Oxford University Press, vol. 24(2), pages 247-272, October.
    9. Aghion, Philippe & Bolton, Patrick, 1987. "Contracts as a Barrier to Entry," American Economic Review, American Economic Association, vol. 77(3), pages 388-401, June.
    10. Rosenstein, Stuart & Wyatt, Jeffrey G., 1990. "Outside directors, board independence, and shareholder wealth," Journal of Financial Economics, Elsevier, vol. 26(2), pages 175-191, August.
    11. David Clutterbuck, 1998. "Handing over the reins: should the CEO's successor be an insider or an outsider?," Corporate Governance: An International Review, Wiley Blackwell, vol. 6(2), pages 78-85, April.
    12. Benjamin E. Hermalin, 2005. "Trends in Corporate Governance," Journal of Finance, American Finance Association, vol. 60(5), pages 2351-2384, October.
    13. Laux, Volker, 2012. "Stock option vesting conditions, CEO turnover, and myopic investment," Journal of Financial Economics, Elsevier, vol. 106(3), pages 513-526.
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Why boards keep bad CEOs
      by Economic Logician in Economic Logic on 2010-02-25 21:48:00

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