Abstract
The decision to replace a CEO may be the most important decision that a board of directors makes. We study the interaction between the CEO replacement decision and the informativeness of stock prices. We show that there is a fundamental tension between informed trading in a firm's stock and the use of that information for CEO replacement decisions. In reaction to the stock price change, the board may replace the CEO, improving the firm's future cash flows, but reducing expected profit that informed traders can derive from their private information. To the extent that the information in the stock price is used for disciplining the CEO by the board of directors, the informed trader has a reduced incentive to produce the information in the first place. Producing and trading on private information is most profitable in the stock of firms with poor corporate governance - precisely because it will not be acted upon - while less profitable at firms with better corporate governance. We test our model of this tension using the probability of informed trading (PIN) and the probability of forced CEO turnover in a simultaneous-equation system. The empirical results support the model predictions.
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