Ceo Turnover and Relative Performance

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NBER WORKING PAPER SERIES

CEO TURNOVER AND RELATIVE PERFORMANCE EVALUATION Dirk Jenter Fadi Kanaan Working Paper 12068 http://www.nber.org/papers/w12068 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 February 2006

We thank Nittai Bergman, Robert Gibbons, David McAdams, Andrew Bernard, François Degeorge, Diego Garcia, Rafael LaPorta, Jonathan Lewellen, Katharina Lewellen, Kalina Manova, Antoinette Schoar, Karin Thorburn, Joel Vanden, Eric Van den Steen, Kent Womack, and seminar participants at MIT Sloan, the University of Illinois at Urbana-Champaign, and the Tuck School of Business at Dartmouth for their comments and suggestions. All remaining errors are our own. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. ©2006 by Dirk Jenter and Fadi Kanaan. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

CEO Turnover and Relative Performance Evaluation Dirk Jenter and Fadi Kanaan NBER Working Paper No. 12068 February 2006 JEL No. G30, G34, D20, D23, M51 ABSTRACT This paper examines whether CEOs are fired after bad firm performance caused by factors beyond their control. Standard economic theory predicts that corporate boards filter out exogenous industry and market shocks to firm performance when deciding on CEO retention. Using a new handcollected sample of 1,590 CEO turnovers from 1993 to 2001, we document that CEOs are significantly more likely to be dismissed from their jobs after bad industry and bad market performance. A decline in the industry component of firm performance from its 75th to its 25th percentile increases the probability of a forced CEO turnover by approximately 50 percent. This finding is robust to controls for firm-specific performance. The result is at odds with the prior empirical literature which showed that corporate boards filter exogenous shocks from CEO dismissal decisions in samples from the 1970s and 1980s. Our findings suggest that the standard CEO turnover model is too simple to capture the empirical relation between performance and forced CEO turnovers, and we evaluate several extensions to the standard model. Dirk Jenter MIT Sloan School of Management E52-446 50 Memorial Drive Cambridge, MA 02142 and NBER djenter@mit.edu Fadi Kanaan MIT Sloan School of Management E52-442 50 Memorial Drive Cambridge, MA 02142 fadi@mit.edu

The decision whether to retain or fire an incumbent CEO after bad stock price or accounting performance is one of the most important decisions made by corporate boards. Standard economic theory suggests that in assessing the quality of its CEO the board of directors should ignore components of firm performance which are caused by factors beyond the CEO’s control. Previous studies that have examined the relation between (arguably exogenous) market or industry shocks and CEO turnover have found evidence largely consistent with this hypothesis. Using a larger data set of CEO dismissals over a more recent time period and an improved methodology, we find to the contrary that CEOs are significantly more likely to be fired after negative performance shocks to their peer group.

In a newly assembled data set of 1,206 voluntary and 384 forced CEO turnovers in 2,548 firms from 1993 to 2001, we document that low industry stock returns and low market returns significantly increase the likelihood of forced CEO turnovers. A decline in the industry component of firm performance from its 75th to its 25th percentile increases the probability of a forced CEO turnover by approximately 50 percent. There is some evidence that boards partially filter industry and market performance from their assessment of CEO quality, but the extent of this filtering is too limited to remove most of the peer performance effect. We conclude...
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