CEO Turnover and Relative Performance Evaluation

• Date: 01 October 2015
• DOI: http://doi.org/10.1111/jofi.12282
• Published date: 01 October 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 5 •OCTOBER 2015

CEO Turnover and Relative Performance

Evaluation

DIRK JENTER and FADI KANAAN∗

ABSTRACT

This paper shows that CEOs are fired after bad firm performance caused by factors

beyond their control. Standard economic theory predicts that corporate boards filter

out exogenous industry and market shocks from firm performance before deciding

on CEO retention. Using a hand-collected sample of 3,365 CEO turnovers from 1993

to 2009, we document that CEOs are significantly more likely to be dismissed from

their jobs after bad industry and, to a lesser extent, after bad market performance.

A decline in industry performance from the 90th to the 10th percentile doubles the

probability of a forced CEO turnover.

WHETHER TO RETAIN OR FIRE A CEO after bad stock price or accounting per-

formance is one of the most important decisions made by corporate boards.

Standard economic theory suggests that, when assessing the quality of its

CEO, the board of directors should ignore components of firm performance

that are caused by factors beyond the CEO’s control. Previous studies of the

relation between (arguably exogenous) market or industry performance and

CEO turnover find evidence that is largely consistent with this hypothesis.

However, using a larger data set that covers a more recent time period and a

better methodology, we find that CEOs are significantly more likely to be fired

after negative performance shocks to their peer group.

Specifically, using a new data set of 2,490 voluntary and 875 forced CEO

turnovers in 3,042 firms from 1993 to 2009, we document that low industry

stock returns and (to a lesser extent) low market returns increase the frequency

∗Dirk Jenter is at Stanford University and the National Bureau of Economic Research. Fadi

Kanaan is at Liberty Mutual Insurance. We thank an anonymous referee,Nittai Bergman, Andrew

Bernard, Franc¸ois Degeorge, Xavier Gabaix, Diego Garcia, Robert Gibbons, Jeffrey Gordon, Yaniv

Grinstein, Jarrad Harford, Li Jin, Rafael LaPorta, Jonathan Lewellen, Katharina Lewellen, Kalina

Manova, David McAdams, Todd Milbourn, Holger Mueller, Thomas Philippon, Joshua Pollet, An-

toinette Schoar, Jeremy Stein, Karin Thorburn, Joel Vanden, Eric Van den Steen, Ivo Welch,Kent

Womack, and seminar participants at MIT Sloan, the University of Illinois at Urbana–Champaign,

Dartmouth Tuck, Stanford GSB, Berkeley Haas, the University of Frankfurt, the 2006 Washing-

ton University Corporate Finance Conference, the 2006 Western Finance Association Meeting, the

2006 Caesarea Center Finance Conference, and the 2006 NBER Corporate Governance Summer

Institute for their comments and suggestions. All remaining errors are our own.

DOI: 10.1111/jofi.12282

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2156 The Journal of Finance R

of forced CEO turnovers. A decrease in the industry component of firm per-

formance from its 90th to its 10th percentile doubles the probability of a forced

CEO turnover. There is some evidence that boards partially filter industry and

especially market performance from their assessments of CEO quality, but the

filtering is too weak to remove all of the peer performance effect. We conclude

that boards allow exogenous shocks to firm performance to affect their CEO

retention decisions.

Standard agency theory shows that there are benefits to evaluating agents

on the basis of their relative performance when agents are affected by common

shocks (Holmstr¨

om (1979,1982), Diamond and Verrecchia (1982)). In most

of the theoretical literature on CEO dismissals, a corporate board learns the

quality of its CEO from firm performance and other signals. If the board’s as-

sessment of CEO quality falls below some threshold, often the expected quality

of a replacement, then the board dismisses the CEO.1Since CEO and CEO-firm

match quality are not functions of the business cycle in these models, it fol-

lows that efficient boards do not force out more CEOs in bad times than in good

times. More generally,these models hold that boards should filter all observable

exogenous shocks from firm performance before updating their assessments of

CEO quality. This prediction is strongly rejected by our empirical results, and

we conclude that the simple framework used in much of the literature does not

fully explain real-world CEO dismissals.

There are several possible explanations for why more CEOs are fired when

their peer group is not doing well, almost all of which fall into one of three

categories: First, CEOs may optimally be rewarded or punished for peer group

performance if CEOs’ actions affect peer performance, as would be the case

in an oligopolistic industry. Second, peer group performance may affect the

optimal frequency of CEO dismissals if boards receive more (or more important)

information about their CEOs in times of bad peer performance. This may be

the case because, for example, downturns change the skills required of CEOs

or downturns test skills that are otherwise unobservable.2Finally, peer group

performance may affect CEO turnover because boards do not behave optimally

and misattribute exogenous performance components to the CEO.

To shed light on why CEOs are fired less frequently when their peer group

is doing well, we examine the relationship between CEO dismissals and peer

performance in more detail. The main result of these analyses is that peer

performance has only small effects on outperforming CEOs, but large effects on

underperforming CEOs. Better peer group performance substantially reduces

the probability that an underperformer is dismissed, which implies that many

fewer underperformers are fired in good times than in bad times. This may be

optimal if underperformance in good times is less revealing about deficiencies

1See, for example, Hirshleifer and Thakor (1994,1998), Hermalin and Weisbach (1998,2003),

Wart her (1998), Adams and Ferreira (2007), and Taylor (2010).

2See Eisfeldt and Kuhnen (2013) for a model in which industry downturns are associated with

changing CEO skill requirements.