Aggressive Boards and CEO Turnover

• Published date: 01 May 2021
• Author: CYRUS AGHAMOLLA,TADASHI HASHIMOTO
• Date: 01 May 2021
• DOI: http://doi.org/10.1111/1475-679X.12350

DOI: 10.1111/1475-679X.12350

Journal of Accounting Research

Vol. 59 No. 2 May 2021

Printed in U.S.A.

Aggressive Boards and CEO

Turnover

CYRUS AGHAMOLLA∗AND TADASHI HASHIMOTO†

Received 22 October 2019; accepted 31 December 2020

ABSTRACT

This study investigates a communication game between a CEO and a board

of directors where the CEO’s career concerns can potentially impede value-

increasing informative communication. By adopting a policy of aggressive

boards (excessive replacement), shareholders can facilitate communication

between the CEO and the board. The results are in contrast to the multi-

tude of models which generally find that management-friendly boards im-

prove communication, and help to explain empirical results concerning CEO

turnover. The results also provide the following novel predictions concern-

ing variation in CEO turnover: (1) there is greater CEO turnover in firms

or industries where CEO performance is relatively more difficult to assess;

(2) the board is more aggressive in their replacement of the CEO in indus-

tries or firms where the board’s advisory role is more salient; and (3) there is

∗University of Minnesota; †Yeshiva University

Accepted by Haresh Sapra. We thank an anonymous reviewer for insightful suggestions.

We have benefited from helpful discussions with Tim Baldenius, Vivian Fang, Fabrizio Ferri,

Frank Gigler, Jon Glover, Chandra Kanodia, Tjomme Rusticus, Tracy Yue Wang, and Amir

Ziv. We thank seminar and conference participants at the 2020 Journal of Accounting Re-

search Conference, the 29th Stony Brook International Conference on Game Theory, Hitot-

subashi University, UCLA, and the University of Minnesota for helpful comments. An online

appendix to this paper can be downloaded at http://research.chicagobooth.edu/arc/journal-

of-accounting-research/online- supplements.

437

© University of Chicago on behalf of the Chookaszian Accounting Research Center,2021

438 c. aghamolla and t. hashimoto

comparatively less CEO turnover in firms or industries where the variance of

CEO talent is high.

JEL codes: C72, D82, D83, G34, M41, M51

Keywords: corporate governance; advising; CEO replacement; communi-

cation; CEO turnover; board independence

1. Introduction

A natural tension arises between the CEO of a firm and its board of direc-

tors, insofar as the board must sometimes take disciplinary measures on the

top executives while simultaneously helping through guidance. One of the

board’s primary responsibilities is to decide whether to replace or retain

the CEO (Lorsch and MacIver [1989], Laux [2014]). The board also serves

to provide the CEO with guidance and advice concerning the firm’s di-

rection, thus benefiting the CEO and shareholders. As Mace [1971] notes,

“directors serve as a source of advice and counsel, serve as some sort of disci-

pline, and act in crisis situations” (p. 178). Survey evidence also documents

that board members overwhelmingly believe that they help shape the firm’s

strategic direction (Demb and Neubauer [1992]). However, the CEO and

top executives control the nonpublic information that the board receives.1

Consequently, the CEO wishes, and is often able, to conceal negative infor-

mation from the board. The allure to manipulate information places the

CEO in an unfortunate predicament: The CEO stands to benefit from the

board’s guidance and expertise, but in doing so, she must communicate

potentially unfavorable information about the firm’s current operations,

which consequently lowers the board’s assessment of her ability. Indeed, it

has been a significant concern among U.S. public firms that CEOs often fail

to effectively communicate with boards by concealing negative information

from board members, as exemplified by the infamous cases of Enron and

Worldcom.2

To further illustrate the dilemma an incumbent manager faces, consider

a CEO who observes preliminary information regarding a project that she

has been tackling (such as the development of a new product). The pre-

liminary information is negative and hence the CEO is confronted with a

1This has also been noted by Song and Thakor [2006] and Adams and Ferreira [2007],

and has been referenced in the news: “[directors] depend largely on the chief executive and

the company’s management for information” (The Economist, March 31, 2001). Moreover, as

Jensen [1993] notes: “The CEO most always determines the agenda and the information given

to the board” (p. 864).

2Other examples include the CEO of Kmart misleading the board of directors regarding

supplier payments in 2001; see “Former CEO misled board, Kmart says,” Bloomberg News,Febru-

ary 25, 2003. Moreover, the CEO of Braidy Industries, an aluminum mill company,reportedly

overstated the company’s financial prospects; see “Former Aluminum Mill CEO Misled In-

vestors, Board,” Associated Press, April 27, 2020. Larcker and Tayan[2016] discuss cases of CEOs

lying to board members about personal information. For empirical evidence on CEO turnover

and accounting misreporting, see Hennes, Leone, and Miller [2007].

aggressive boards and ceo turnover 439

problem regarding the best path forward for the project. The CEO can

honestly reveal the problem to the board, and in turn she receives the

board’s expert advice concerning the most viable solution. This allows the

CEO to take the best action going forward. However, if the CEO commu-

nicates honestly, the board infers that she is of a low ability, considering

that her project was not successful, and this may affect the board’s decision

to replace the CEO. Alternatively, the CEO can overstate the performance

of her project thus far (such as conveying a milder problem), but then

the solution offered by the board will not be helpful for her. Conversely,

the manager would have no such inhibitions in truthfully communicating

good news, and receiving advice on the best action to take following a more

successful project (e.g., increasing investment). Overall, the board’s guid-

ance is effective as long as the CEO honestly communicates with the board

regarding the current status of the firm, however the CEO’s reputational

concerns may compel her to conceal or misrepresent negative information.

In this paper, we investigate the interdependency between the advisory

and disciplinary roles of the board in a communication game with a CEO.

The CEO aims to increase the value of the firm, while also receiving per-

sonal benefits from staying in power. The CEO observes private informa-

tion θregarding her ability or productivity at the firm and then sends the

board a report ˆ

θconcerning her private information. This report captures,

for example, the status of projects the CEO has been undertaking during

her tenure. After observing the report ˆ

θfrom the CEO, the board provides

advice that can be value-increasing for the firm. In particular, the board’s

advice is only helpful insofar as the CEO was honest with the board (i.e.,

ˆ

θ=θ). However, when unfit for the firm, the CEO is tempted to distort the

report ˆ

θupward in an attempt to preserve her position. The board then

observes the firm’s output y(i.e., a performance measure such as earnings)

and decides whether to replace or retain the CEO. Prior to the beginning

of the game described above, shareholders, who aim to maximize the firm

value, determine the optimal board policy on the replacement of the CEO.

Shareholders can set a friendly board, for example, by making CEO re-

moval difficult or through appointing lenient directors. Conversely, share-

holders can design a strict or aggressive board by allowing the board to

swiftly replace the CEO. By examining the interplay between advising and

replacement, we determine the shareholders’ optimal board policy.

As the main result of this paper, we find that shareholders often pre-

fer the board to be aggressive because an aggressive board enhances truthful

communication. This result is in contrast to the multitude of models that

find a benefit to management-friendly boards, such as Almazan and Suarez

[2003], Adams and Ferreira [2007], Harris and Raviv [2008], Laux [2008],

Casamatta and Guembel [2010], Inderst and Mueller [2010], Dow [2013],

and Chakraborty and Yılmaz [2017].3As we explain below, our results

3Hermalin and Weisbach[1998] andWarther [1998] find passive boards as the equilibrium

outcome arising from CEO influence over the board.