Governance and CEO Turnover: Do Something or Do the Right Thing?

by Ray Fisman, Rakesh Khurana & Matthew Rhodes-Kropf

Overview — CEOs who become "entrenched" by the board of directors can gain an extra buffer between themselves and angry shareholders. Entrenchment has potential costs (a poorly performing CEO hangs on to the job) but also benefits (the board can deflect shareholder cries for dismissal of a CEO who was merely unlucky). The authors hope to shift the emphasis of the debate on entrenchment to a consideration of these tradeoffs and to shift the focus of the entrenchment-performance discussion toward the decisions, such as CEO dismissal, that are directly tied to the actions of the board. Key concepts include:

By caving in to shareholder demands, boards may act against the long-time interests of the company and those same shareholders.
Governance is a very important mediating factor in the relationship between performance and firing.
At the time of founding a forward-looking investor may wish to put in place governance mechanisms that address these issues.

Author Abstract

Shareholder delegation of the power to fire the CEO to the board of directors is central to corporate governance. While the board ideally acts as desired by shareholders, board entrenchment may insulate a poorly performing manager from shareholders agitating for her removal. The conventional 'costly firing' model of managerial entrenchment views this protection from shareholders as purely negative. Yet recent anecdotal evidence on managerial turnover suggests an alternative view of entrenchment: If shareholders misattribute poor performance to the CEO rather than to circumstance, then insulating management from the whims of shareholders may lead to better firing decisions. We propose that entrenchment has an inherent trade-off. We present a model that directly incorporates both sides of this trade-off, and generates a set of empirical predictions that we explore using recently collected data on governance statutes and on the dismissals of CEOs of large U.S. corporations. Our results demonstrate that governance is a very important mediating factor in the relationship between performance and firing. Furthermore, we find support for the 'misguided shareholder' view of entrenchment. Fundamentally this paper explores whether, in caving in to shareholder demands, boards act in the best interest of shareholders or simply respond to their whims: Do they do just do something, or do the right thing?