Why Do CEOs Survive Corporate Storms?

In our paper Why Do CEOs Survive Corporate Storms? Collusive Directors, Costly Replacement, and Legal Jeopardy, which was recently made publicly available on SSRN, we consider new explanations for the puzzling result that a majority of misreporting CEOs retain their jobs.  We extend the literature by investigating the role of directors’ both personal and reputational incentives in the CEO retention decision.  Overall, our analysis improves our understanding of the CEO retention decision by 30 to 40% relative to a benchmark model based on the severity of the misreporting, the firm’s performance and risk characteristics, and traditional measures of the strength of corporate governance.

We show that two types of personal benefits make conventionally independent directors less likely to remove CEOs: loss avoidance on equity-contingent wealth and increased compensation. First, we find that in firms where independent directors emulate CEOs’ trading behavior and also engage in abnormal insider selling over the misreporting period, CEOs are 13.6% more likely to be retained.  We view independent directors’ trading as suggestive of collusion because, like CEOs and other executive directors, they personally benefit by selling their equity at inflated prices during the period over which earnings are misreported.  To the extent that the misreporting sustains the firm’s overvaluation, the fact that directors engage in abnormal selling suggests they have access to negative information about the firm that they do not reveal to shareholders.  We posit that independent directors prefer not to attract attention to their own abnormal selling.  Thus, even though dismissing the CEO could enhance shareholder value by restoring credibility, directors whose trading actions align with those of CEOs have weaker incentives to replace the CEO.

Second, we show that directors are 14.8 % more likely to retain CEOs when they have ratified a merger that resulted in a loss of shareholder wealth.  Given that both executive and director compensation increase following acquisitions (Grinstein and Hribar 2004; Harford and Li 2007; Certo, Dalton, Dalton, and Lester 2007), we propose that independent directors prefer not to draw attention to the ratification of economically deficient investments and thus have weaker incentives to replace the CEO.

We also show that independent directors act in shareholders’ interests (and indirectly in their own) as they strive to reduce the expected cost of the misreporting on firm value.  Thus, we find that directors are less likely to remove a CEO when it is costly to find a replacement, and more likely to remove a CEO when the misreporting is more severe and expected costs of litigation are higher.

We find, consistent with economic intuition, that CEOs with a good track record and higher managerial ability are more likely to be retained, whereas when a succession plan provides a readily available replacement, CEOs are less likely to be retained.  In line with prior work (e.g., Parrino 1997; Leone and Liu 2010), we also find that founder CEOs are more likely to be retained than non-founder CEOs (60.4 vs. 50.4 percent).  However, we identify instances when the founder gives up the CEO hat but remains as board chair: under this extended definition of leadership, we find that founder CEOs are more likely to remain as the head of the firm (69.8 percent) than previously thought.

In terms of costs of retaining the CEO, we find that directors are less likely to retain CEOs when the firm is subject to 10b-5 litigation.  Indeed, we find that litigation precedes CEO dismissal by 35 days for the median firm.  We estimate the effect of the initiation of litigation proceedings to decrease the probability of retention by 19.9%.  We find no evidence that abnormal equity issuance influences the likelihood of retention but show that abnormal borrowing decreases the probability of retention by 5.9%. This suggests that firms borrowing abnormal amounts of public debt fire CEOs as a way to assuage bondholders.

We use independent directors’ insider trading and the market assessment of a board-ratified merger to infer collusion between a firm’s executives and its non-executive directors.  Because these actions are observable, our findings suggest that financial economists consider collusive trading and merger ratification as additional means of assessing the independence and the monitoring effectiveness of non-executive directors.

The full paper is available for download here.