Monday, June 27, 2005

Governance and CEO Turnover: Do Something or Do the Right Thing? by Raymond Fisman, Rakesh Khurana, Matthew Rhodes-Kropf

SSRN-Governance and CEO Turnover: Do Something or Do the Right Thing? by Raymond Fisman, Rakesh Khurana, Matthew Rhodes-Kropf

Conventional wisdom suggests that replacing a manager if the stock price is falling is good. Along the same lines we often view (and teach) that managerial entrenchment is bad. However, maybe that is too simplistic of view. Entrenchment can play a positive role in reducing unwarranted managerial firings.

Fisman, Khrurana, and Rhodes-Kropf
suggest that in the absence of entrenchment, sometimes managers will be replaced too quickly. In their words, their paper "explores whether, in caving in to shareholder demands, boards act in the best interests of shareholders or simply respond to their whims: Do they do just do something, or do they do the right thing?"

In this light, entrenchment is not all bad as it can protect managers from whimsical boards.

A longer description of the basis of this paper:
"...the recent uproar over accountability to shareholders has raised the possibility that shareholders may agitate for CEO dismissal in response to short-run per-formance changes, even when these changes are beyond the CEO's control. For example, arecent report on CEO turnover by the consulting firm, Booz, Allen, and Hamilton states that "In the U.S., investors apparently want CEOs to share the pain of poor returns. Although this reaction is not surprising, it is irrational...This conclusion is one of several this year that raise uncomfortable questions about the relationship between boards and management, for it indicates that directors are highly responsive to shareholder pressure about share prices, even if management is not solely responsible for the performance.""
So is entrenchment good? Yes and No. That is, while completely entrenched managers may not look out for shareholders, some degree of entrenchment may be good to prevent needless (and costly) managerial firings.

To test for this the authors look for empirical differences (largely operating performances) between so-called entrenched and less entrenched manegrs. Again in their words:
"Interestingly, the two contrasting views on entrenchment generate a number of overlapping predictions, namely: (1) post-firing firm performance improvements are greater for entrenched CEOs (2) entrenched CEOs are fired less frequently (3) market reaction is more positive for the firing of entrenched CEOs. We find strong support in the data for each of these predictions. We also consider two situations where the views make contrasting predictions: (1) the relationship between governance and pre-firing returns of dismissed CEOs, and (2) the subsequent performance of retained CEOs where there had recently been poor corporate performance.The results of these further tests lean in favor of the `misguided shareholder' view."

Kisman, Raymond, Khurana, Rakesh and Rhodes-Kropf, Matthew, "Governance and CEO Turnover: Do Something or Do the Right Thing?" (January 2005).

As a sports analogy to this, let me offer the firing of a coach. If we fire a coach just for the sake of doing something, we may increase uncertainty which can lead to worse performance in the future (to say nothing of the direct cost of the firing and hiring). So some entrenchment may be good. On the other hand, a policy of never replacing an underperforming coach would worsen incentives (and likely team performance as well)
(Mmm, I wonder if Steinbrenner is reading).

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