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«Three essays on corporate boards R. Øystein Strøm A dissertation submitted to BI Norwegian School of Management for the degree of Dr.Oecon SERIES ...»

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4.7.3 Board turbulence and firm performance In the case of CEO control, the CEO gets to select the board after showing good firm performance. Till now, I have treated all turnover equally with regard to effects upon board turbulence. But actually, I should differentiate between turnovers leading to better firm performance and those leading to worse. Then the Hermalin and Weisbach (1998) hypothesis should imply that board turbulence increases after the CEO turnover in firms with improved performance. In case of bad performance, the CEO should be changed. Thus, the implication is that board turbulence is unchanged with weak performance after a new CEO enters office.

To perform a test, I categorise firm performance as “improved” or “reduced” in the following way. First, stock returns are year and industry adjusted. I calculate the adjusted stock return Rijt = rijt − r jt /|r jt |, where rijt is the stock return of firm i in industry j in year t, and r jt is the average stock return in industry j in year t. Second, a firm is classified as

4.7. ECONOMETRIC EVIDENCE 129 “improved” if the two-year average adjusted stock return following the CEO turnover year is higher than the two-year average stock return before turnover, that is, if 1/2 Rij1 + Rij2 1/2 Rij−1 + Rij−2. Correspondingly, the firm falls in the “reduced” category if the adjusted stock return is lower than before turnover, calculated in the same manner as the improved. Thus, the measure excludes year 0 when a new CEO is recorded.

This is done in order to avoid observations that the new CEO may for example initiate a “big bath”, whereby the firm’s financial position is made to look unfavourable, or contrarily, whereby he or she tries to increase shareholder expectations to the firm leading to higher stock return. Murphy and Zimmermann (1993) document evidence of such behaviour.

Figure 4.4 shows board turbulence around the year of CEO turnover for improved and reduced firm performance companies.

Figure 4.4

It turns out that in firms with improved stock return, the board turbulence increases before the turnover year, and falls thereafter. Except for high values in the tails, the board turbulence is highest in the turnover year. The same general pattern is repeated in firms with reduced stock return. Again excepting the high values in the tails, the turnover year has the highest turbulence in this category as well. Also, the level of board turbulence is about the same in the two types of firm, although they may differ in particular years. No pattern emerges from the difference in average board turbulence between the two types. Thus, a striking similarity is evident for both types of firms.

This is very much against the CEO control hypothesis. Instead CEO and directors tend to leave together. They appear to be a team, that is, the case of joint control is confirmed.

I make a rigorous test by creating dummy variables for firms that experience an improved performance after the CEO turnover and firms that have weaker performance. Given the information in figure 4.4, I should expect the effects to be negligible for both variables. Table 4.7 shows results.

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Again overall statistics of the regressions are satisfactory. As expected from figure 4.4, the dummy variables are not important. They are not significant in any regression. The exclusion restriction test further confirms


this conclusion. The test says that no confirmation of non-zero coefficients can be given. I cannot confirm the CEO control hypothesis that good performance leads to higher board turbulence following CEO turnover.

A comparison of the coefficient values in table 4.7 to the corresponding values in table 4.6 shows a very close similarity. The same variables as before are the significant ones. The only noticeable difference is that the employee directors variable has become significant to a greater extent.

Thus, having employee directors on the board reduces board turbulence among shareholder elected directors.

4.8 Conclusions

The CEO appointments and dismissals are part of the board’s primary functions (Monks and Minow, 2001). When the board is unable to fulfil this task for some reason, the potential for agency cost increases. Berle Jr. and Means (1932) described how the CEO in effect chooses his own board, which comes about when ownership and control are separate. The monitored CEO elects his own monitors. The board becomes “endogenously determined” (Hermalin and Weisbach, 1998). Therefore the CEO and director turnover constitute a natural setting for studying manifestations of agency problems. This has been exploited in the empirical literature for CEO-chairman duality (Goyal and Park, 2002) and a staggered board (Falaye, 2007), and both imply a lower CEO turnover. The fact that company law bans both CEO-chairman duality and staggered boards in Norway (Aarbakke et al., 1999) makes the institutional setting favourable for the study of the relative timing of CEO turnover and board changes, and may reveal whether CEO control needs some form of regulatory protection to be realised.

In this paper, I use the timing of CEO turnover relative to director substitutions and board enlargements to characterize the distribution of control between the CEO and the board. I differentiate between three forms of control. CEO control happens when the CEO chooses his own board. Then the CEO stays and directors are substituted, or new are added. Shareholder control is the case when the board fulfils its primary functions of hiring and firing the CEO. When this is so, CEO turnover tends to be unrelated to director turnover. The third case is joint control, when the CEO and the board together constitute a team and are jointly responsible for firm performance. Then CEO turnover tends to be simultaneous with director turnover. Thus, the timing of CEO and director turnover should


reveal the board control type, and thereby the seriousness of agency costs.

The shareholders have no part to play in the choice of directors under CEO control. Therefore shareholders’ influence over the election of directors varies from none in the case of CEO control to high in the cases of shareholder and joint control. At the same time, if the election and hiring processes are functioning correctly, owners should have no influence over the choice of CEO. Thus, the influence of ownership on the election of directors and the hiring of a CEO can further differentiate between types of board control.

CEO turnover is the dependent variable in one type of regressions, with former and simultaneous board turbulence as explanatory variables together with other variables. In the other type of regressions, the roles are reversed, with board turbulence as the dependent. Now the simultaneous and former CEO turnovers are explanatory variables. The regressions show that simultaneity is important and significant in both types of regressions. However, the most important in the board turbulence regressions is the former CEO turnover, indicating that board changes take place after the CEO has taken office. These results hold across different specifications of CEO turnover, from the all CEO turnover to forced, and across definition of firm performance, that is, stock return and return on assets.

Thus, the CEO turnover and the board turbulence regressions do not give a clear-cut answer regarding the location of board control.

However, the results for outside ownership concentration point towards joint or shareholder control. Higher outside ownership concentration implies that board turbulence increases, while no significant relation to CEO turnover can be detected. Thus, the shareholders wield their inuence through the board. A more independent board is less likely to fire a CEO and is itself less likely to be changed. Consistent with Fich and Shivdasani (2006) busy directors are less likely to fire the CEO. The joint control result is further confirmed from the entrenchment variables, as these turn out to be either non-significant, or the reverse of expectations for the imported CEO in the CEO turnover regressions. Both the results for the individual variables, and the fact that they all point in the same direction indicate that the board control is of the joint control type.

My main conclusion is that the control type between CEO and directors is one of joint control, that is, the CEO and directors together constitute a team. This supports the friendly board hypothesis of Adams and Ferreira (2007).

Thus, the data do not support the Hermalin and Weisbach (1998) hyCHAPTER 4. BOARD CONTROL pothesis that board composition is endogenously determined. It seems that CEO control can only be realised if some protection is given, for instance in the form of CEO-chairman duality or a staggered board, shown in Goyal and Park (2002) and Falaye (2007). The results in this paper show that when such protection is not in place, shareholders are important in choosing directors. By implication, for the CEO to gain control over the board, regulations must favour CEO protection.

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