Outside Directors and CEO Selection
Kenneth A. Borokhovich
Robert Parrino
Teresa Trapani
April 1996
Outside Directors and CEO Selection
Abstract
This paper documents a strong positive relation between the percentage of outside directors and the frequency of outside CEO succession. The likelihood that an executive from outside the firm is appointed CEO increases monotonically with the percentage of outside directors. This monotonic relation is observed for both voluntary and forced departures. Evidence from stock returns around succession announcements indicates that, on average, shareholders benefit from outside appointments, but are harmed when an insider replaces a fired CEO.
Outside Directors and CEO Selection
I. Introduction
The forced departures of the Chief Executive Officers (CEOs) at American Express, General Motors (GM), International Business Machines (IBM), Kodak, and Westinghouse in the early 1990s focused public attention on the issue of CEO selection. Following prolonged periods of poor performance, the boards at each of these firms fired the CEO. While the boards at American Express and GM appointed insiders as replacements, those at IBM, Kodak, and Westinghouse appointed executives from other firms. Several studies have examined the choice between promoting an insider to the CEO position and appointing an outsider. However, we still know little about the factors that affect this choice.
This paper examines how director incentives affect the likelihood that a new CEO is hired from outside the firm. An examination of how director incentives affect the CEO selection decision is a natural extension of Weisbach's (1988) study on director incentives and CEO turnover. Weisbach finds that the relation between firm performance and the likelihood of CEO turnover is stronger at firms with outsider-dominated boards than at firms with insider-dominated boards. He interprets his findings as evidence that the incentives of outside directors differ from those of inside directors. Weisbach argues that outside directors are more likely to favor replacing a poor CEO because, as suggested by Fama and Jensen (1983), the value of their human capital is affected by the signals that board decisions send concerning their abilities as experts in decision control. Inside directors, on the other hand, are less likely to challenge the incumbent CEOs to whom their careers are tied.
If director incentives affect the likelihood that a poor CEO is replaced, they are also likely to affect the choice of the new CEO. To the extent that the appointment of a strong CEO enhances the reputations of outside directors, they will tend to select the best candidate for the position, regardless of whether that candidate is an insider or an outsider. In contrast, inside directors are likely to prefer inside candidates for several reasons: Inside directors are generally the leading internal candidates for the CEO position (Hermalin and Weisbach (1988)); a CEO who is appointed from inside the firm is less likely than an outsider to substantially alter firm policies that the inside directors have helped develop and implement (Helmich (1974)); and inside appointments tend to be followed by less turnover among senior managers (Helmich and Brown (1972)).
This study reports evidence from a sample of 969 CEO successions at 588 large public firms between 1970 and 1988. This large sample provides the most detailed evidence to date on the relation between board composition and the likelihood that a new CEO is appointed from outside the firm. Other studies also examine this relation, but the evidence they report leaves the question of whether director incentives affect the CEO selection decision unresolved. Dalton and Kesner (1985) find no evidence of a significant relation between outside director representation on firm boards and the inclination of boards to appoint outsiders to the CEO position. In contrast, Park and Rozeff (1994) find a positive relation between the percentage of outside directors and the likelihood of an outside appointment.
Evidence from stock returns around the succession announcements examined in this study suggests that the market views the appointment of an outsider to the CEO position more favorably than the appointment of an insider, especially when the incumbent CEO is forced to resign. New CEOs from outside the firm appear to be perceived as more likely to alter firm policies in a way that benefits shareholders. On average, a significant positive abnormal return is observed when a CEO is replaced by an outsider following either voluntary or forced turnover. In contrast, while inside appointments following voluntary successions are associated with small positive abnormal returns, large negative abnormal returns are observed when insiders replace fired CEOs.
Evidence on the relation between board composition and the likelihood that a new CEO is appointed from outside the firm is consistent with the prediction that outside directors are more likely to support outside candidates. A positive monotonic relation is found between the proportion of outside directors and the likelihood that an outsider is appointed CEO. This relation holds after controlling for firm size, firm performance, CEO stock ownership, and regulatory effects.
The positive monotonic relation between board composition and the likelihood of an outside appointment is observed for both voluntary and forced turnover. This evidence indicates that outsider-dominated boards are not only more likely to appoint outside candidates when poor performance dictates a change in the policies of the firm, but that they are also more likely to hire an executive from another firm during a routine succession.
The rest of the paper is organized as follows. Section II discusses other research on director incentives and on the choice between inside and outside CEO candidates. The data and methodology are described in Section III. Section IV presents the empirical evidence and Section V the conclusions.
II. Director Incentives and CEO Choice
A. Director Incentives
The board of directors is charged with representing shareholder interests. Fama and Jensen (1983) characterize the board's principal responsibilities as the ratification of management decisions and the monitoring of management performance. The legal authority to hire and fire managers and to set their compensation provides the board with the means of fulfilling these responsibilities. However, the board does not always use its authority to advance shareholder interests. When the incentives of individual board members differ from those of the shareholders, a board may take actions that benefit directors at the expense of the shareholders.
A number of studies suggest that the degree of alignment between board and shareholder incentives varies with the composition of the board. Fama and Jensen (1983) argue that outside directors, who tend to be major decision-makers at other organizations, have incentives to signal to the labor market that they are experts in decision control by acting in shareholder interests. Outside directors increase the value of their human capital by strengthening their reputations as decision control experts. Inside directors, on the other hand, are more apt to be concerned about maintaining their current position in the firm. As Weisbach (1988) notes, inside directors are less likely than outside directors to challenge the CEO to whom their careers are tied. Inside directors, including the CEO, also have incentives to protect any above-market compensation or excess non-pecuniary benefits that they receive through their positions as managers.
Contrary to the argument that outside director incentives are better aligned with those of shareholders than inside director incentives, several board and outside director characteristics suggest that outside directors will not necessarily act in shareholder interests. First, Mace (1986) and Lorsch and MacIver (1989) find that CEOs often dominate the director nomination process. If CEO incentives are not aligned with those of the shareholders, they may nominate outside directors who are more inclined to support their decisions. Second, interlocking directorships may reduce the willingness of outside directors to challenge the CEO. Fearing reprisal, an outside director may decide not to challenge the CEO if the CEO is on the board of a firm at which the director is a senior executive. Finally, outside directors who are appointed because of their expertise in a narrow area may feel uncomfortable challenging the CEO on decisions outside their area of expertise.
Whether or not outside directors better represent shareholder interests than inside directors is ultimately an empirical question. The evidence in other studies suggests that they do. Gilson (1990) and Kaplan and Reishus (1990) report evidence consistent with a link between an outside director's reputation and the overall value of his or her human capital. Gilson finds that outside directors who resign from the boards of financially distressed firms subsequently hold fewer positions as outside directors at other firms. Kaplan and Reishus find that executives of firms that reduce dividends also subsequently serve on fewer outside boards.
Rosenstein and Wyatt (1990), Hermalin and Weisbach (1988), and Mayers, Shivdasani, and Smith (1994) suggest that outside directors are appointed in the interests of shareholders. Rosenstein and Wyatt report a positive and significant stock price reaction when an outsider is named to the board, an indication that the market expects shareholders to benefit from the appointment. Moreover, Hermalin and Weisbach find an increase in outside director appointments, relative to appointments of insiders, after a firm has performed poorly. This latter evidence implies that outside directors are perceived as more likely to enact changes that improve firm performance than are inside directors. Mayers, Shivdasani, and Smith find that life insurance firms that change from stock to mutual ownership increase the percentage of outside directors, while property/casualty firms that switch from mutual to stock ownership reduce that percentage. Mayers et al. also find that boards of insurance firms with mutual ownership tend to have a larger percentage of outside directors than firms with stock ownership and that, among the mutual firms, costs tend to be lower when there are more outside directors. They suggest that monitoring by outside directors compensates for the lack of a credible external monitoring mechanism at mutual firms.
The evidence from studies of stock price reactions to board decisions indicates that the market tends to view decisions by outsider-dominated boards more favorably than similar decisions by insider-dominated boards. The market appears skeptical that insider-controlled boards are acting in shareholder interests. Byrd and Hickman (1992) find that abnormal bidder returns on the date of takeover bid announcements are significantly higher when the board's decision is likely to have been made by outside directors than when it is likely to have been made by inside directors. Similar results have been reported for management buy-outs (Lee, Rosenstein, Rangan and Davidson (1992)) and the adoption of poison pills (Brickley, Coles and Terry (1994)). Lee et al. and Brickley et al. find that abnormal returns in these situations are significantly higher when outside directors have voting control of the board.
The evidence on CEO turnover reported by Weisbach (1988) also suggests that outside directors represent shareholder interests better than inside directors. After controlling for ownership, size, market, and industry effects, he finds that CEOs are more likely to be removed following poor performance if outside directors have voting control. Furthermore, Weisbach reports weak evidence that firm value tends to increase around CEO resignations at firms with outsider-dominated boards, but that no such increase is apparent for firms with insider-dominated boards.
B. CEO Choice
The decision to fire a poor CEO does not benefit shareholders unless the board also appoints a more capable successor. Vancil (1987) and Lorsch and MacIver (1989) maintain that the board has its greatest impact on the direction of a firm when it selects a new CEO. A typical CEO holds that position for over eight years (Parrino (1992)). During this period the CEO plays a major role in defining and implementing the policies of the firm. He or she serves as a conduit through which information flows to board members and generally sets the agenda for board meetings.
Several studies suggest that CEOs who are appointed from outside the firm are more likely to change firm policies than are insiders. For instance, Helmich (1974) finds that while the rate of firm growth generally tends to increase after CEO succession, the increase is greater when an outsider is appointed CEO. Helmich and Brown (1972) report that the rate of organizational change, as proxied by departures and personnel shifts at the level immediately below that of the CEO, is also greater following an outside succession.
Evidence from studies of stock price reactions to top management turnover indicates that, on average, shareholders benefit from the changes instituted by new senior executives that are hired from outside the firm. Reinganum (1985) and Warner, Watts, and Wruck (1988) report significant positive abnormal returns around such announcements while Furtado and Rozeff (1987) report positive, but statistically insignificant abnormal returns. In a study that separates CEO appointments from those involving other top management positions, Bonnier and Bruner (1989) show that abnormal returns are significantly larger when an outsider is appointed CEO.
Even if shareholders are likely to benefit from outside appointments, there are several reasons to believe that inside directors will tend to oppose them. As Hermalin and Weisbach (1988) suggest, inside directors tend to be the leading internal candidates for the CEO position. Inside directors are likely to promote their own candidacies rather than those of outsiders. Furthermore, inside directors who helped develop and implement their firms' policies may oppose the appointment of outsiders who are likely to alter those policies. Finally, the evidence reported by Helmich and Brown (1972) suggests that inside directors may resist outside appointments in order to protect their jobs.
If the incentives of outside directors are better aligned with those of the shareholders than inside director incentives, then outside directors are more likely to conduct a broad search for the best possible CEO candidate. This suggests that the likelihood of an outside appointment will increase with the percentage of outside directors. The inconsistent evidence reported by Dalton and Kesner (1985) and Park and Rozeff (1994) suggests that additional evidence would be valuable in helping us understand how director incentives affect the CEO selection decision. The rest of the paper presents new detailed evidence on the relation between board composition and the likelihood that an outsider is appointed CEO.
III. Data and Methodology
A. Data Selection
The sample consists of 969 CEO successions at 588 large public firms between 1970 and 1988. These successions, a subset of those studied by Parrino (1996), include all successions between 1970 and 1988 that satisfy the following criteria: 1) the incumbent and successor are both profiled in the Forbes annual compensation surveys; 2) the Wall Street Journal reported the succession announcement; 3) accounting data is available on the COMPUSTAT tapes beginning in the year after the incumbent becomes CEO; and 4) the succession is not directly related to a takeover.
The Forbes surveys provide initial information on CEO tenure, years with the firm, and age. The exact date of and reason for each succession is obtained from the Wall Street Journal announcement. The Wall Street Journal announcements, various Marquis Who's Who publications, and Dun and Bradstreet's Reference Book of Corporate Managements are used to confirm the ages of the CEOs and the length of their employment at the firm. CEOs who vacate the position prior to age 60 and do not leave for other employment or for health reasons and CEOs reported by the Wall Street Journal to have been forced from their position are classified as having been forced out.
The Million Dollar Directory, the Moody's industrial, banking and financial, transportation, and utilities manuals, and proxy statements are used to determine the composition of the board of directors in each of the 969 succession years. Directors who are officers of the firm are classified as insiders. All other directors are classified as outsiders. This classification scheme differs from that used in several other studies, such as those by Weisbach (1988) or Byrd and Hickman (1992), in which directors who have a close business relationship with the firm (such as lawyers, investment bankers, commercial bankers and other advisory personnel) are classified as "greys" or "affiliated outside directors."
Our choice of a simple insider/outsider director classification scheme is dictated by the difficulty of obtaining corporate proxy statements for years prior to 1978 when commercial firms, such as Disclosure, Inc., began making them widely available. Information on the affiliation of outside directors is not available in either the Million Dollar Directory or the Moody's manuals. We expect that, to the extent that our classification procedure results in a noisy measure of the percentage of independent outside directors, any bias caused by this procedure will be against our finding evidence in support of a positive relation between board composition and the likelihood of outside succession.
The sensitivity of the empirical results to the director classification scheme was checked using the 535 observations for which detailed director information is available in proxy statements. The evidence is qualitatively similar to that reported below when the analysis is replicated using a definition of outside directors similar to those used by Weisbach (1988) and Byrd and Hickman (1992).
B. Data Description
An outside CEO appointment is defined as one in which the new CEO assumes the CEO title within three years of the date that he or she joins the firm. We classify CEOs who join the firm as long as three years prior to their appointment as outsiders because new CEOs who have been employed at the firm for only two or three years are likely to have been hired with the expectation that they would eventually be appointed to the CEO position. Hiring an executive before the succession allows the board to obtain more information concerning the executive's suitability for the position before making a final decision. It also provides the candidate with an opportunity to obtain additional specific human capital necessary for the position. The above definition of outside CEOs is consistent with the wide range of definitions used in other studies. For instance, Reinganum (1985) classifies only executives who join the firm at the time of the succession as outsiders, while Vancil (1987) includes all executives who have been employed at the firm for five years or less. In our sample, 187 (19%) of the 969 CEOs are classified as outsiders. Among the 187 outsiders, 145 (78%) have been employed at the firm for one year or less, with most of these joining the firm at the time of the succession.
Table 1 lists the total number of successions, the number of outside successions and the mean board composition by year. Except for 1970, the successions are evenly distributed over the sample time period, with an average of 51 successions per year. Outside successions average 10 per year and, like the full sample, are not obviously clustered in any sub-period.
The mean board composition values are for the firms at which successions take place during the indicated year. Outside directors, on average, hold a voting majority in all years. The mean percentage of outside directors from 1970 through 1988 is 70.7%. This mean is higher than the corresponding value of 56.3% in the Hermalin and Weisbach (1988) sample. However, some of the difference can be explained by different sample selection procedures and study periods. Hermalin and Weisbach exclude public utilities, airlines, railroads and financial institutions to control for possible differences in board composition caused by regulation. Excluding observations for the same industries from our sample lowers the mean percentage of outside directors to a more comparable 65.8%.
The noticeable upward trend in the percentage of outside directors over time (Table 1) is consistent with that reported by Hermalin and Weisbach. The increase is particularly pronounced after 1979. A test of the difference in the mean percentage of outside directors in the 1970s versus the 1980s rejects the hypothesis that these means are equal at the 1% level (z-statistic of 8.15). Eliminating successions that occurred outside of the 1971 to 1983 period studied by Hermalin and Weisbach further reduces the mean percentage of outside directors in our sample to 63.3%.
The 70.7% mean proportion of outside directors does not fully indicate the extent to which these directors hold majority representation on the boards of the sample firms. The distribution is skewed. Table 2 shows how the 969 successions are distributed by board composition. The median proportion of outsiders is 73.3%, with only 89 (9%) of the 969 succession decisions being made by boards that have insider majorities. Within our sample, only the Alexander and Alexander board (in 1978) has no outsiders, and only the Public Service Enterprise Group board (in 1986) has no insiders.
Parrino (1996) reports evidence of systematic differences across industries in the likelihood that an outsider is appointed CEO. If there are also systematic differences across industries in board composition, evidence of a positive relation between the proportion of outside directors and the likelihood of outside succession may be spurious. Such a relation may be due to industry characteristics that are unrelated to director incentives. The data was examined to determine whether there is systematic variation in board composition across industries. This examination revealed that firms in the communication (SIC 48), gas and electric utility (SIC 49), and financial (SIC 60-69) industries tend to have a greater proportion of outside directors than firms in other industries. In Table 3 it can be seen that outside directors comprise at least 80% of the board in more than half of these regulated firms. In contrast, the median outside director representation at unregulated firms is less than 70%. The effect of these differences on the empirical evidence is examined in Section IV.
C. Methodology
This study uses probit models to examine the effect of board composition on the likelihood that the departing CEO is replaced by an outsider. The dependent variable in these models equals 1 if an outsider is appointed CEO and 0 otherwise. A selectivity problem arises in the estimation of the outside succession relations since a board's preference for an inside or outside executive is observed only when turnover occurs. To the extent that the decision to replace a CEO is contingent on the availability of a qualified successor, the turnover and successor choice decisions are not independent. Consequently, a binomial probit outside succession model that is estimated using only observations for turnover years yields inconsistent coefficient estimates. This selectivity problem is analogous to that considered by Heckman (1979) for continuous dependent variables.
Consistent estimates are obtained for the outside succession relations by using a bivariate probit model, described by Van De Ven and Van Praag (1981), that jointly estimates b1 and b2 for relations of the form
zi1 = b1'xi1 + ei1
zi2 = b2'xi2 + ei2.
In this model, zi1 and zi2 are unobservable probabilities, xi1 and xi2 are vectors that contain observations on the explanatory variables, and ei1 and ei2 are residuals that are assumed to be bivariate normally distributed with correlation coefficient r. The model is estimated using observed values of yi1 (turnover) and yi2 (CEO choice) as dependent variables where it is assumed that yij = 1 if zij > 0 and 0 otherwise. The Van De Ven and Van Praag procedure accounts for the selectivity problem by using a full information maximum likelihood method to estimate simultaneously the coefficients for the two relations.
IV. Empirical Evidence
This section first presents evidence that shareholders tend to benefit more when an outsider is appointed CEO than when an insider is promoted to that position. This difference in shareholder benefits resulting from inside and outside appointments is central to the thesis that outside directors are more likely to favor appointing an outsider to the CEO position because their incentives are better aligned with those of the shareholders than are the incentives of inside directors. Evidence on the relation between board composition and the likelihood of outside CEO succession is discussed next. This relation is examined for the entire sample and for forced and voluntary successions.
A. Shareholder Gains from Inside and Outside Appointments
Abnormal returns around succession announcements are estimated to determine how shareholder gains differ for inside and outside CEO appointments in the current sample. Table 4 summarizes this evidence for the 618 successions for which there are no confounding announcements in the Wall Street Journal between days -2 and 2, relative to the initial succession announcement in the Wall Street Journal, and for which stock return data are available on the CRSP tapes. The abnormal returns reported in Table 4 are for the two-day period from -1 to 0.
The abnormal returns and test statistics are calculated using the procedure described by Dodd and Warner (1983) with the market model parameters estimated over the 200-day period ending 60 days before the succession announcement. The test statistics are calculated as follows. The prediction error for each day for each turnover observation is first standardized by dividing it by the estimated residual standard deviation from the market model regression for that observation. The two-day cumulative standardized prediction error for each observation is then computed as the sum of the day -1 and day 0 standardized prediction errors divided by the square root of two (the number of days in the cumulation period). Each of these cumulative standardized prediction errors are assumed to be distributed unit normal when there is no abnormal performance. Finally, the test statistic is computed by multiplying the mean of the individual cumulative standardized prediction errors by the square root of the number of observations.
Column (1) in Table 4 presents abnormal returns for sub-samples based on whether the succession is classified as voluntary or forced and, within these groups, whether the new CEO is an insider or from another firm. The sub-samples in column (1) are further divided, in columns (2) and (3), according to whether the percentage of outside directors is above or below the total sample median. The sample is partitioned based on whether the incumbent CEO departed voluntarily or was forced from the position because the potential impact of the CEO choice decision on shareholder value is expected to be greater following forced departures. If CEOs from outside the firm are more likely than insiders to break with the policies of their predecessors, then shareholder gains are likely to be greater when a poor CEO is replaced by an outsider. Parrino (1996) shows that the forced departures in this sample largely occur among firms whose financial performance is very poor relative to the rest of the sample.
The average abnormal return is positive and significant for both inside and outside appointments when the incumbent departs voluntarily. However, the return associated with the appointment of outsiders (0.67%) is over three times as great as that for inside appointments (0.21%). While this difference is not significant (z-statistic of 1.50), it does suggest that, on average, a greater shareholder benefit may be associated with outside appointments. The evidence for voluntary successions in columns (2) and (3) indicates that the significant abnormal returns in column (1) are largely attributable to the returns at firms that have a low proportion of outside directors. However, the signs of the average returns and their relative magnitudes are similar for both the high- and low-outside director groups.
The abnormal returns for forced successions are quite different from those for voluntary successions. On average, there is a 0.85% decline in shareholder value when a fired CEO is replaced by an insider. In contrast, the appointment of an outsider is associated with an average increase in shareholder value of 1.64%. Both of these abnormal returns are highly significant and significantly different from each other. The signs of the abnormal returns in columns (2) and (3) are consistent with those for the total forced departure sample. However, the average returns for the low-outside director group (in column (2)) are not significantly different from zero. For the high-outside director group, the mean abnormal returns for inside (-1.63%) and outside (2.06%) succession are both significant.
The markedly different stock price reactions to inside and outside appointments associated with forced departures are consistent with the prediction that insiders are more likely to maintain the status quo, while outsiders are more likely to break with the policies of the previous CEO. The different stock price reactions to inside and outside appointments in distressed firms has not been previously reported. Furtado and Rozeff (1987) and Denis and Denis (1995) report significant positive abnormal returns around forced turnover, but neither examines how those returns differ between inside and outside appointments.
The evidence in Table 4 suggests that outside directors are more likely to prefer an outside candidate when the incumbent is forced from the CEO position. The high-outside director group replaced 65% (32 of 49) of the fired CEOs with outsiders. In contrast, the low-outside director group appointed outsiders to replace fired CEOs only 41% (14 of 34) of the time. The difference in these proportions is significant at the 5% level (the z-statistic for the normal approximation to the binomial test of differences in proportions is 2.17).
B. Board Composition and CEO Selection
Table 5 presents evidence of a positive relation between the percentage of outside directors and the likelihood that an outsider is appointed CEO. In this table, the total sample of 969 successions has been split into seven groups based on board composition. The positive monotonic relation between the proportion of outside directors and the frequency of outside appointments in column (3) is statistically significant. The c2 test on the full sample rejects, at the 10% level, the null hypothesis that the percentages in column (3) are equal. Furthermore, a c2 test also rejects, at the 2% level, the hypothesis that the proportion of outside successions is the same among firms with the lowest percentage of outside directors (£ 40%) as it is among firms with the highest percentage of outside directors (³ 90%).
Chi-square test statistics are also calculated excluding observations from the communications (SIC 48), gas and electric (SIC 49), and financial (SIC 60-69) industries to determine whether the above evidence is due to the large number of regulated firms in the sample groups with high outside director representation. The results of these tests, which are reported at the bottom of Table 5, are consistent with those for the entire sample. Both null hypotheses are rejected with an even higher degree of confidence for the sub-sample of unregulated firms than for the full sample.
Table 6 shows the number of inside and outside appointments associated with both forced and voluntary successions for three sub-samples of roughly equal size based on the percentage of outside directors. The sample is split into three groups in this table, rather than the two in Table 4, because the larger number of observations (969 in Table 6 versus 618 in Table 4) facilitates more meaningful comparisons across three groups. Splitting the sample in Table 4 into three groups would leave a very small number of observations in some sub-samples.
In the last column of Table 6 it can be seen that 55.6% (70 of 126) of the CEOs who are forced from their positions are replaced by outsiders. In contrast, only 13.9% (117 of 843) of the CEOs who depart voluntarily are replaced by executives from other firms. The percentage of outside appointments following forced departures is four times as great as that following voluntary departures. The difference is highly significant (z-statistic of 11.06) and is consistent across all sub-samples in the table. In general, outside successions are more likely to occur following forced departures, regardless of board composition.
The percentage of outsiders on the board is, however, positively related to the likelihood of an outside appointment for both forced and voluntary successions. Tests of differences in the percentage of outside successions between the sub-samples with the lowest (£ 66.67%) and highest (³ 80%) percentage of outside directors indicate that these differences are significant for both voluntary (z-statistic of 1.79) and forced (z-statistic of 2.16) successions. Outside directors are more likely to appoint outside CEOs, regardless of whether the succession is forced or voluntary.
Table 7 presents evidence that the positive relation between the percentage of outside directors and the likelihood of outside succession persists after controlling for firm size, performance, CEO stock ownership, and regulatory effects. It reports coefficient estimates for outside succession regressions from bivariate probit models. Coefficient estimates for the CEO turnover regression in each bivariate model are not reported, since the relations in these regressions are consistent with those that have been reported elsewhere (see Warner, Watts, and Wruck (1988) and Weisbach (1988), for instance). The dependent variable in the outside succession regressions equals 1 if the new CEO has been employed at the firm for one year or less when he or she assumes the CEO title, and 0 otherwise. This narrow definition of outside succession limits the bias that might be introduced by using a performance measure that includes a period in which the new CEO is already employed at the firm.
The natural log of employment is used in the probit models to control for firm size because other studies suggest that outside successions may occur more frequently at small firms (see Dalton and Kesner (1983), Reinganum (1985), and Cannella, Lubatkin, and Kapouch (1991)). These studies suggest that if small firms have less managerial depth than large firms, they are less likely to have an insider who is qualified for the CEO position. Furthermore, CEOs appointed from outside the firm are likely to be more effective in small organizations.
Accounting and market measures of firm performance are included in the regression models because there is a growing body of evidence that the likelihood of outside succession is negatively related to firm performance (see Cannella, Lubatkin, and Kapouch (1991) and Parrino (1996)). The accounting-based performance measure, ROA, is the ratio of the annual earnings before interest and taxes (EBIT) to the book value of total assets, less the mean of that ratio for the 2-digit SIC industry in which the firm has its primary business. The market-based measure of firm performance, RET, is the total stock return during the 12-month period preceding the succession, less the average of that return for the 2-digit SIC industry.
CEO fractional share ownership is included in two of the probit models. CEO stock ownership was obtained from the 535 proxy statements that were used to collect the detailed board composition data. We include this regressor because Weisbach (1988) reports a significant negative relation between the shareholdings of top managers and the percentage of outside directors. Weisbach's evidence suggests that the positive relation between the percentage of outside directors and the likelihood of outside succession may be spurious. Outside appointments may simply be less likely at firms where the top managers own a larger percentage of their firm's shares.
The regulation dummy variable, FGEDUM, and an interaction term with the board composition variable are included in regression (2) to check for differences between firms in regulated and unregulated industries. This dummy variable equals 1 if the firm is in a regulated industry and 0 otherwise.
Regressions (1) and (2) in Table 7 are estimated for all successions between 1970 and 1988 for which all relevant data are available. In these regressions, the proportion of outside directors, OUTDIR, is defined as the percentage of directors who are not officers of the firm. The significant positive coefficient estimates for OUTDIR indicate that the likelihood of outside succession increases with the proportion of outside directors, even when controls for firm size and performance are included. Furthermore, the insignificant coefficient estimate for the interaction term between FGEDUM and OUTDIR indicates that the relation between board composition and the likelihood of an outside appointment is similar for regulated and unregulated firms.
Regressions (3), (4), and (5) are estimated using only observations for which the proxy statement immediately preceding the succession announcement is available. The significant coefficient estimate for OUTDIR in regression (3) suggests that the positive relation between board composition and the likelihood of outside succession in regressions (1) and (2) is not attributable to a spurious relation with CEO stock ownership.
The positive coefficient estimates for the board composition variable, OUTDIR1, in regressions (4) and (5) indicate that the evidence for the full sample does not reflect a bias resulting from the definition of outside directors. There is a significant positive relation between the percentage of outside directors and the likelihood of outside succession when outside directors are defined to include only non-employee directors who have no business or personal relationship with the firm or its officers.
The evidence in Table 7 of a positive relation between the percentage of outside directors and the likelihood of an outside appointment is robust to the definition of outside succession. The coefficient estimates for the board composition variables are qualitatively similar to those in Table 7 when an outsider is defined as a new CEO who joined the firm within three years of the succession and the average ROA during the three years preceding the succession is used as the performance variable.
The results from the regressions in Table 7 are also qualitatively similar to those reported when a forced departure dummy is included as an independent variable. This dummy variable is excluded from the reported regressions because it is significantly correlated with ROA, RET1, and RET2 (Pearson correlation coefficients of -0.26, -0.23, -0.20 respectively for the 713 observations in regression (1)). As in the sample used by Warner, Watts, and Wruck (1988), most of the forced departures in our sample are associated with very poor performance.
Finally, a comparison of the coefficient estimates from the independent probit regressions (not reported here) with those from the bivariate regressions indicates that the bias in the independent estimates is not generally substantial for the regressions described in this study. The two estimation procedures yield coefficient estimates that have similar economic meaning and statistical significance. The independent probit regressions, however, overstate the magnitude of some coefficient estimates by as much as a factor of two.
V. Conclusions
The evidence of a positive relation between the percentage of outside directors and the likelihood that an outsider is appointed CEO is consistent with the prediction that outside directors tend to consider a broader range of CEO candidates than inside directors. The positive stock returns for both inside and outside appointments following voluntary successions indicate that new CEO appointments in these cases are generally viewed as benefiting shareholder interests. In contrast, the substantially different stock price reactions to inside and outside appointments when the incumbent CEO is forced out suggest that outside appointments are viewed as more beneficial to shareholders when changes in firm policies are particularly important.
The increase in the proportion of outside directors on corporate boards from the 1970s to the 1980s suggests that outside directors assumed a more important role in corporate governance in the latter period. If this is true, then there is increased importance to understanding the role that outside directors play and their incentives to represent shareholder interests. This study adds to our knowledge concerning the effect of director incentives on CEO replacement decisions. Weisbach (1988) reports evidence that outsider-dominated boards are more likely to replace a poor CEO. Our evidence suggests that outsider-dominated boards are also more likely to replace fired CEOs with executives from outside the firm.
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