CEO Power and Board Dynamics

Corporate boards are expected to oversee and monitor managers on behalf of shareholders. However, too much monitoring by the board can hinder the ability of management teams to make nimble, optimal decisions. In equilibrium, theory suggests that talented CEOs, whose skills match well to the firms they manage, should be optimally monitored less intensely by the board. Theory also suggests that inside directors (who have other ties or past work experience with the firm) are likely to monitor the CEO less intensely. Thus, an equilibrium outcome may result in talented CEOs working at firms with less independent boards of directors and the independence of the board falling over the tenure of a given CEO.

The theoretical framework of Hermalin and Weisbach (1998) models how this all works. In their model, the structure of the board (e.g., how “independent” the board is), as well as compensation and other features of the board-CEO relationship, are determined in a dynamic bargaining process. In this framework, CEOs prefer less monitoring and are able to affect the intensity of monitoring through their influence on the composition of the board of directors. The bargaining process between the CEO and board thus affects board structure, CEO tenure and compensation jointly, with many related effects. For example, in a given firm, good performance increases the CEO’s bargaining power by improving her perceived ability relative to potential replacements; and successful, powerful CEOs are more likely to be retained and are better able to bargain for a less independent board that monitors less. A number of testable implications emerge from this dynamic bargaining process.

Using a new database of officers and directors of more than 90,000 firm-year observations and more than 11,000 CEO turnover events from 1918 to 2011, we find empirical support for many predictions that emanate from this dynamic bargaining framework. First, our results indicate that as CEOs become more powerful at their firms, the board becomes less independent, they earn higher compensation, and they are more likely to become the chair of the board. We explore many dimensions of these central findings, most for the first time in the literature. Our tenure results can be summarized as follows:

1. We find that an additional year of CEO tenure is associated with a 0.15 percentage-point decline in the ratio of independent directors to total directors on the board. The negative relation between CEO tenure and board independence is a within-firm prediction, though almost all previous tests have been cross-sectional. Our long panel of data allows us to test this time-series prediction within-firm, with more power, and out-of-sample relative to previous research.
2. The magnitude of the reduction in board independence associated with CEO tenure varies across CEOs, firms, and time in the manner that theory says it should:
   • The CEO tenure-board independence relation increases with performance (and thus perceived CEO ability), such as among firms for which the CEO was initially successful (high ROA, high stock return), consistent with early-success-CEO’s gaining bargaining power. The results are even stronger when we instrument CEO tenure with firm performance (ROA).
   • The CEO tenure-board independence relation is also stronger when there is less uncertainty about the CEO’s ability, such as for the first CEO at the firm (e.g., the founder), and as the CEO’s career progresses. Conversely, the tenure result is weaker when there is more uncertainty about the CEO’s ability, such as upon CEO turnover, especially when turnover results from death of the incumbent CEO.
   • The CEO tenure-board independence relation is weaker when there are external shocks to CEO power. The relation disappears after hedge fund activists target a firm, and it becomes weaker during recessions when theory predicts board monitoring is tougher.
   • Regulation can constrain the influence of CEO tenure but any benefits may be muted. We find that the influence of CEO tenure on board independence disappears after implementation of the 2002 Sarbanes-Oxley and 2003 stock exchange regulations. However, the propensity of long-tenure CEOs to be promoted to board chair increases post-2002, consistent with dual chairmanship substituting for the CEO’s loss of her influence on board independence.
   • By contrast, when the advising role of the board is important, it may offset the CEO tenure effect. We find that when the newly appointed CEO is external to the firm (i.e., not previously an employee), board independence initially falls and is largely unaffected by CEO tenure, consistent with theory that external CEOs are likely to need more board advising relative to monitoring.
3. Powerful (long-tenure) CEOs also are more likely to also become chair of the board, as well as earn more compensation. An additional year of CEO tenure is associated with a 2.2% increase in the probability that the CEO is also board chairman and a 2.4% increase in annual compensation.

A second broad dynamic bargaining prediction is that more powerful CEOs are less likely to be replaced conditional on poor firm performance. Our long panel allows us to test this prediction within-firm, with more power, and mostly out-of-sample relative to previous research. We document that poorly performing CEOs (low ROA, stock returns, or both) are more likely to be replaced. More importantly, we confirm the prediction that CEO power attenuates the performance-turnover relation using four measures of power: CEOs with longer tenure, dual chairman title, superior past performance, and less independent boards.

A third prediction is that board structure should be persistent due to hysteresis: a strong CEO will bargain to achieve a weaker board, which will be inherited by the next CEO. Hence the next CEO will be relatively strong and the weaker board structure is likely to continue. Our long panel is particularly useful in testing this prediction. We find that firms that initially have an independent (or dependent) board on average will still have a more independent (dependent) board 30 years later. In regressions, we find that initial board independence is economically and statistically strong in explaining current board independence.

Our evidence discussed so far suggests that powerful CEOs are able to achieve many advantages, including higher pay, longer tenure, and greater job security. We next explore market reactions to the departure of powerful CEOs. On the one hand, if a CEO’s power were to emanate from perceived superior ability (or match quality) and expected performance relative to a replacement, her departure could lead to a negative market reaction. On the other hand, powerful CEOs may become entrenched (in that they may be shielded from being fired even if performance deteriorates) and thus their departures may increase shareholder value. Because of endogeneity concerns with a broad sample of departures, we focus on CEO turnover due to the CEO’s death or serious health issues. Consistent with powerful CEOs becoming entrenched, announcement returns to exogenous CEO departures are increasing in measures of CEO power (relatively long job tenure, board chairman, or founder of the firm). In particular, the announcement of a powerful CEO’s departure is associated with 2.0% to 3.1% higher abnormal cumulative return over a [-2, 2] day window, relative to departures of a less powerful CEO.

Finally, we document several stylized facts about long-term governance trends over the last century related to board independence, the dual CEO-board chair role, and CEO turnover.

The complete paper is available for download here.