The central focus of research in corporate governance has historically been on the problems of controlling managers’ actions. Without minimizing the real-world importance of such control problems, in our paper, Understanding Corporate Governance Through Learning Models of Managerial Competence, which was recently made publicly available on SSRN, we argue that such a focus is incomplete and ignores important factors affecting corporate governance. In particular, it overlooks the crucial element of career concerns: managers care about the inferences that current and future employers draw over time about their abilities from observing their performance.
Posts Tagged ‘Executive turnover’
In our forthcoming Journal of Finance paper, The Executive Turnover Risk Premium, we make the simple point that forced turnover risk explains an important part of the cross-sectional variation of compensation for the CEOs of public U.S. corporations. The empirical magnitude of the turnover risk premium—about 7% greater subjective compensation for a one percentage point increase in turnover risk—is in line with calibrated theoretical predictions.
To identify the turnover risk premium, we use sources of job risk that are arguably outside the CEO’s control such as changing industry conditions. This strategy relies on the idea that, in practice, firing occurs not only when the CEO reveals low general ability. Rather, a board may fire a CEO when industry conditions change in such a way that his skill set no longer matches the new industry requirements. It is this kind of exogenous risk exposure that should plausibly be compensated in CEO pay.
The World Affairs Council of Atlanta’s 2013 Global Strategic Leadership Forum focused on a critical issue facing boards of directors: CEO succession. As arguably its most crucial responsibility, the board’s process for hiring and developing CEOs must be an extraordinarily thorough one that addresses the complexities of the modern global company. While there is no exact template that fits all circumstances, the board must ensure that its processes and oversight accurately reflects the organization’s future needs, identifies the skills and experience required in today’s complex global economy, and builds and closely monitors a truly robust succession plan.
CEO Succession Practices, which The Conference Board updates annually, documents CEO turnover events at S&P 500 companies. The 2014 edition contains a historical comparison of 2013 CEO successions with data dating back to 2000. In addition to analyzing the correlation between CEO succession and company performance, the report discusses age, tenure, and the professional qualifications of incoming and departing CEOs. It also describes succession planning practices (including the adoption rate of mandatory CEO retirement policies and the frequency of performance evaluations), based on findings from a survey of general counsel and corporate secretaries at more than 150 U.S. public companies.
Excessive risk-taking by financial institutions and overly generous executive pay are widely regarded as key factors in the 2007-09 crisis. In particular, it has become commonplace to blame banks and securities companies for compensation packages that reward managers (and more generally, other risk-takers such as traders and salesmen) generously for making investments with high returns in the short run but large risks that emerge only in the long run. As governments have been forced to rescue failing financial institutions, politicians and the media have stressed the need to cut executive pay packages and rein in incentives based on options and bonuses, making them more dependent on long-term performance and in extreme cases eliminating them outright. It is natural to ask whether this is the right policy response to the problem. It is crucial to ask what is the root of the problem—that is, precisely which market failure produced excessive risk-taking.
In our paper, CEO Job Security and Risk-Taking, which was recently made publicly available on SSRN, we use the length of employment contracts to estimate CEO turnover probability and its effects on risk-taking. Protection against dismissal should encourage CEOs to pursue riskier projects. Indeed, we show that firms with lower CEO turnover probability exhibit higher return volatility, especially idiosyncratic risk. An increase in turnover probability of one standard deviation is associated with a volatility decline of 17 basis points. This reduction in risk is driven largely by a decrease in investment and is not associated with changes in compensation incentives or leverage.
In Klaassen v. Allegro Development Corporation, 2013 WL 5739680 (Del. Ch. Oct. 11, 2013), Eldon Klaassen, the former CEO of Allegro Development Corporation (“Allegro”), brought an action under Section 225 of the Delaware General Corporation Law, requesting that the Court of Chancery declare that he: (1) was still the CEO of Allegro, (2) had validly removed two of Allegro’s directors and appointed their replacements, and (3) had validly filled a preexisting director vacancy. Klaassen claimed that his removal as CEO of Allegro by the board of directors (the “Board”) was void. If he was indeed still CEO, he had the power to remove directors and appoint new ones under Allegro’s governing documents. In a post-trial opinion, the Court of Chancery found that Klaassen was barred from challenging his removal as CEO by the equitable doctrines of laches and acquiescence. Regarding his changes to the Board, the Court of Chancery determined that Klaassen did succeed in removing one director and filling the preexisting vacancy on the Allegro Board, but that he did not remove the second director and new CEO, nor validly appoint a replacement for the removed director.
Considerable debate remains among academics and practitioners regarding the economic forces that drive CEO compensation practices in the United States. Some view the market for CEO talent as the main economic force that drives the level and form of CEO compensation (e.g., Rosen, 1992; Gabaix and Landier, 2008). Others argue that these forces have little effect on CEO compensation because of frictions such as managerial entrenchment, asymmetric information, and transaction costs of replacing managers, believing instead that compensation practices are by and large driven by the bargaining power that the CEO has vis-à-vis the board (e.g., Bebchuk and Fried, 2003).
The debate has intensified in recent years due to several controversial compensation practices, a first example of which is the tendency of firms to benchmark CEO compensation to that of other CEOs. While some find benchmarking consistent with competitive compensation (Holmstrom and Kaplan, 2003; Bizjak et al., 2008), others argue it is a way for CEOs to increase their compensation by benchmarking themselves to highly paid CEOs (e.g., Faulkender and Yang, 2010).
In our paper, Executive Pay Disparity and the Cost of Equity Capital, forthcoming in the Journal of Financial and Quantitative Analysis, we investigate the association between executive pay disparity and the cost of equity capital. Understanding the association is important because the cost of capital is one of the key considerations for managers in their capital budgeting and corporate financing decisions. In fact, the cost of capital is a more direct yardstick of corporate investment and financing decisions than firm valuation. A higher cost of capital means fewer positive net present value (NPV) projects, leading to fewer growth opportunities. In addition, the cost of capital summarizes an investor’s risk-return tradeoff in his resource allocation decision (Pástor, Sinha, and Swaminathan (2008)).
In general, there are two perspectives on executive pay disparity. The tournament perspective views the large pay gap between the CEO and other executives as the prize for a tournament in which players compete for the CEO position (Lazear and Rosen (1981); Kale, Reis, and Venkateswaran (2009)). A large pay disparity motivates non-CEO senior executives to work hard and to invest in firm-specific human capital. This, in turn, helps build a large pool of skilled internal candidates for the CEO position. The availability of skilled internal candidates not only reduces the entrenchment of the incumbent CEO by increasing the bargaining power of the board, but also reduces CEO succession risk. Therefore, this perspective predicts a negative association between executive pay disparity and the cost of capital.
A review of the CEO succession announcements made by S&P 500 companies in 2012 showed that they typically included details on when the succession would take effect, why the departing CEO is leaving, and whether the incoming CEO will be named board chairman; a statement by the departing CEO on his/her belief that the board has selected a qualified replacement; a statement by the lead independent director that the incoming CEO is the right choice for the company, given its current position, and thanking the departing CEO for his/her service; a statement from the incoming CEO that the existing management team is strong, the company is well positioned for the future, and expressing appreciation that the board has selected him/her as chief executive; and a description of the incoming CEO’s professional qualifications, and, if necessary, details on other director or senior management changes that will take place.