Abstract
We study how corporate governance affects firm value through the decision of whether to fire or retain the chief executive officer (CEO). We present a model in which weak governance—which prevents shareholders from controlling the board—protects inferior CEOs from dismissal, while at the same time insulates the board from pressures by biased or uninformed shareholders. Whether stronger governance improves retain/replace decisions depends on which of these effects dominates. We use our theoretical framework to assess the effect of governance on the quality of firing and hiring decisions using data on the CEO dismissals of large U.S. corporations during 1994–2007. Our findings are most consistent with a beneficent effect of weak governance on CEO dismissal decisions, suggesting that insulation from shareholder pressure may allow for better long-term decision making. This paper was accepted by Brad Barber, finance.
Highlights
From Adam Smith (1776) and Berle and Means (1932) to Hermalin and Weisbach (1998), economists have expressed concern about entrenched CEOs’ ability to pursue personal gain at the expense of shareholders
We analyze the role of entrenchment on performance surrounding CEO dismissal
We emphasize that entrenchment has potential costs and benefits, and the choice of entrenchment involves a trade-off. We illustrate this through a model that enumerates the trade-off between a traditional ‘costly firing’ view of entrenchment and an ‘ignoring misguided shareholders’ view based on the premise of performance misattribution
Summary
From Adam Smith (1776) and Berle and Means (1932) to Hermalin and Weisbach (1998), economists have expressed concern about entrenched CEOs’ ability to pursue personal gain at the expense of shareholders. The prevailing belief is that firms risk value destruction by self-serving CEOs, if they are left unchecked by weak boards or weak shareholders. Many companies have actively chosen to weaken shareholders’ powers with the explicit aim of ensuring that long-term profits are maximized. Facebook, LinkedIn, and Groupon completed initial public offerings (IPOs) with dual class share structures—with. In Google’s case, the company introduced a new class of nonvoting shares, saying, “outside pressures [from stockholders] too often tempt companies to sacrifice long term opportunities to meet quarterly market expectations.” Google’s concern about too much shareholders influence seems at odds with the traditional notion that entrenchment—the insulation of CEOs from shareholders—is bad for firms’ performance
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