Tuesday, February 08, 2011
Why not fire your CEO?
Wharton Finance Professor Luke Taylor has published a thought provoking new study in the Journal of Finance. Taylor examines the issue of CEO dismissals. He built a complex model to examine the issue, and specifically, to quantify various elements of the decision process by a Board to fire a CEO. Taylor identifies two types of costs associated with the forced dismissal of a CEO. Direct costs constitute the first category. They include severance for the dismissed CEO, executive search firm fees for the new hire process, and other negative effects on profit due to the turmoil caused by a CEO firing. Entrenchment costs constitute the second category, and they involve the intangible costs borne by the Board, but not the shareholders, during the dismissal process. For instance, the Board members' personal relationships with the CEO may be irreparably harmed. Taylor finds that these entrenchment costs are quite substantial, and they cause far fewer CEOs to be fired than if Boards only considered the direct costs of dismissal. In fact, his empirical work shows that 2% of CEOs in his sample were fired each year. He estimates that over 10% of CEOs would be fired each year based on poor performance if entrenchment costs were not considered by Boards. While the study surely will provoke great reaction, and many will disagree with its conclusions, the notion of entrenchment costs resonates with me. Undoubtedly, these costs have a key role in the Board's decision process.