Academic journal article Journal of Economics and Finance

The Retention of CEOs That Make Poor Acquisitions

Academic journal article Journal of Economics and Finance

The Retention of CEOs That Make Poor Acquisitions

Article excerpt


Does the failure to replace CEOs following a bad takeover represent a cost-effective strategy or a failure of boards of directors and the market? We study 104 white knight contests to examine why poorly performing firms retain their CEOs. We find the majority are poor performers before they enter the control contest (q<1), in the control contest, and after the control contest. We compare the costs of replacing CEOs with the benefits of keeping them. Our results show the market works. The benefits of keeping CEOs under such circumstances are greater than the costs of replacement. Thus, keeping poorly performing CEOs does not represent a failure of a firm's board.

Keywords White knights * Tobin's q * CEOs

JEL Classification G34

1 Introduction

Stockholders charge Boards of directors with removing poorly performing CEOs, yet many choose to retain CEOs despite their faults. Some studies show a tendency to replace CEOs based on poor performance (Coughlan and Schmidt 1985; Gilson 1989; Kaplan and Reishus 1990). Others show that chief executives keep their jobs even if they continue to underperform (Burkart et al. 1997).

Gilson (1989) finds just over half (52%) of his sample of 381 financially distressed firms experience top management turnover. Kaplan and Reishus (1990) find that fewer than 30% of the CEOs of firms that cut dividends (a measure of poor performance) lose their jobs within three years after the cut. They also note that when they measure poor performance by stock returns, a little over 30% of underperforming executives lose their jobs compared to 10.9% of their more successful counterparts. Coughlan and Schmidt (1985) note many believe CEO turnover to be conditional on stock price performance, but the percentage of CEOs replaced is small although greater than a control sample. Burkart et al. (1997) find that forced management replacement is rare and more likely because of external events than board action. In general, the literature shows the chief executives of poorly performing firms keep their positions.

Carroll et al. (1998) study a group of white knights (defined as friendly bidders who enter a control contest after hostile bidders, often at the request of the target. firms). They also describe white knights as poorly performing firms who rarely replace their CEOs. Most white knight firms have inefficient CEOs (Tobin's q<\) who make visible, value-reducing bids for target firms. Therefore, we can view the CEOs of white knight firms as having settled patterns of making costly and visible value-decreasing investment decisions. Even though a white knight bid puts a spotlight on the poor performance of a firm's management, firms rarely replace the CEOs of white knights following a bad bid. Carroll et al. (1998) also note that in the three years following a white knight bid, white knights do not replace their CEOs any more often than the hostile bidders involved in the same contest do. Nor do they replace them any more often than the general population of all business firms. In other words, they keep their jobs when theoretically they should lose them.

These and similar scenarios raise two important questions that guide our research:

1. Does a board's failure to replace a poorly performing CEO represent an action taken in the shareholders' best interests?

2. Do firms retain CEOs because the costs of replacing them exceed the benefits?

1.1 Costs and benefits of replacing top management

Boards of directors may decide against removing incumbent CEOs if they see the costs of replacing them exceed the benefits. Replacement costs include (a) costs associated with making a search; (b) marginal differences in old and new compensation packages; (c) costs associated with having a lame duck administrator; (d) the potential for losses as new CEOs leam the details of managing the firm; and (e) the cost of a potential proxy fight. …

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