Do Delaware CEOs Get Fired?

Adam C. Pritchard is the Frances and George Skestos Professor of Law at University of Michigan Law School; Murali Jagannathan is a Professor in the School of Management at Binghamton University (SUNY). This post is based on a forthcoming article by Professor Pritchard and Professor Jagannathan. Related research from the Program on Corporate Governance includes Firms’ Decisions Where to Incorporate by Lucian Bebchuk and Alma Cohen.

Our article, Do Delaware CEOs Get Fired?, to be published in January 2017 in the Journal of Banking & Finance, explores the relation between state corporate law and corporate governance. We focus on corporate governance in Delaware, the overwhelming winner in the competition for corporate charters. Delaware draws a clear majority of the nation’s largest public companies to incorporate under its corporate code, despite its relatively small population and share of the national economy. In 2014, nearly 89% of companies doing initial public offerings (IPOs) in the United States were incorporated in Delaware. This competition for corporate charters is not just about state pride: Winning the competition for incorporations yields tangible benefits: Charter fees made up more than a quarter of Delaware’s tax revenues in 2014.

Critics of issuer choice argue that Delaware competes for corporate charters by pandering to management. Delaware has won this competition, they claim, by leaving shareholders vulnerable to overreaching by corporate managers, who dominate the incorporation decision. Most famously, William Cary, a former SEC chairman, charged that states were caught in a “race to the bottom,” providing rules that undermine management accountability to shareholders. The race-to-the-bottom hypothesis suggests that Delaware encourages lax monitoring by protecting directors against liability.

To test this hypothesis, we first develop a model of incorporation choice. We argue—and document both cross-sectionally and through examination of reincorporations—that Delaware lures firms intent on growth, which has important implications for governance. Growth firms face a greater risk of securities fraud class actions and are also more likely be involved in mergers, which may also attract lawsuits. Consequently, directors of growing firms may prefer Delaware’s predictable courts and surer protection against personal liability. The downside of liability protections, however, is that they may reduce the incentive of directors to monitor management. Cary notes in particular Delaware’s director-friendly standard regarding the duty of care and indemnification. Since Cary wrote his famous article, Delaware’s duty of care standard has only been further diluted.

We document that the corporate governance of Delaware firms, including pay and service on multiple boards, differ from that of non-Delaware firms. Consistent with Delaware directors being in higher demand, we find that they are paid more and hold more directorships. They also have a shorter tenure than directors of non-Delaware firms. Delaware firms also have higher institutional and block ownership than other firms, which does not suggest weaker monitoring in these firms. We find that the governance of Delaware firms continue to be significantly different from that of propensity score matched non-Delaware firms; there is no clear pattern suggesting that it is weaker.

Having shown that Delaware firms differ in their financial and governance characteristics, we examine the relation between Delaware incorporation and the likelihood of forced CEO turnover. Cary and other race-to-the-bottom adherents argue that Delaware encourages lax monitoring, which suggest that Delaware boards will be less likely to fire CEOs. Our results do not support the race-to-the-bottom hypothesis. Overall, we find that Delaware incorporation is associated with higher rates of forced turnover. This relation holds when Delaware firms are compared to propensity score matched control firms.

We also find, however, that those decisions are less sensitive to firm performance than in other states. We conjecture that the reduced sensitivity of termination decisions to performance may reflect the relative opaqueness of firms incorporated in Delaware. Delaware firms have characteristics associated with growth firms: lower book to market ratio, greater expenditures on R&D, and greater stock price volatility. Those characteristics may make the decision to terminate a CEO more complicated than simply focusing on stock returns. Alternatively, our results are also consistent with Delaware directors turning over CEOs even prior to the onset of poor performance. When performance is classified into quintiles, we find that forced turnover is higher across all quintiles in Delaware, suggesting that turnover performance sensitivity may not be the only measure of strong monitoring. We do not examine how turnover affects subsequent firm performance however, so we draw no conclusions about whether Delaware boards are making efficient termination decisions. Overall, our results do not support the argument that Delaware CEOs are more entrenched than other CEOs.

What do these results tell us about the competition among states for corporate charters? Strong inferences in this area are impossible given the endogeneity of incorporation choice. Financial characteristics and governance are necessarily endogenous in a regime that allows for issuer choice of incorporation. Moreover, measures of governance quality are inherently noisy because they cannot fully control for differences in firm characteristics and operating environment. We believe, nonetheless, that showing an association of Delaware incorporation to governance choices and outcomes sheds light on the debate over state incorporation. Our mixed results—Delaware CEOs are more likely to be fired, but the decision is less sensitive stock price performance—may say as much about the limitations of those proxies for the quality of monitoring as they do about the relation of state corporate law to governance. All we can say based on these results is that Delaware boards are not reluctant to terminate CEOs. Overall, the relationship between incorporation choice, financial characteristics, and the decision to terminate the CEO appears to be more nuanced than the race-to-the-bottom hypothesis would suggest.

The complete article is available for download here.

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