ECONOMIC POLICY UNCERTAINTY AND BOARD MONITORING: EVIDENCE FROM CEO TURNOVERS

• Author: Melissa B. Frye,Duong T. Pham
• Published date: 01 August 2020
• DOI: http://doi.org/10.1111/jfir.12222
• Date: 01 August 2020

The Journal of Financial Research Vol. XLIII, No. 3 Pages 675–703 Fall 2020

DOI: 10.1111/jfir.12222

ECONOMIC POLICY UNCERTAINTY AND BOARD MONITORING:

EVIDENCE FROM CEO TURNOVERS

Melissa B. Frye

University of Central Florida

Duong T. Pham

Georgia Southern University

Abstract

We examine whether economic policy uncertainty (EPU) affects a board’s chief

executive officer (CEO) replacement decision. We find that high EPU reduces the

likelihood of forced CEO turnover. Our results support the idea that performance

assessment may be more difficult when uncertainty is high. We provide evidence

that succession planning may be important to firms in reducing the effects of EPU, as

firms with an identifiable heir apparent are not influenced by high EPU. Likewise,

voluntary CEO turnovers are not affected by EPU. Overall, our results provide

evidence that boards make personnel decisions in response to external macro-

economic pressures.

JEL Classification: G30, G34

I. Introduction

Huson, Parrino, and Starks (2001) contend that the decision to replace a chief executive

officer (CEO) is one of the most important choices made by the board of directors.

They assert that replacing the CEO has long‐term consequences for the firm’s

investing, operating, and financing decisions. The most obvious reason that a board

decides to replace the CEO is poor performance. The literature showing a link between

poor performance and CEO turnover is extensive and consistent: poor performance

leads to CEO termination (see, e.g., Weisbach 1988; Parrino 1997; Huson, Parrino, and

Starks 2001; Jenter and Kanaan 2015). The finance literature shows that other factors

also affect the board’s replacement decision. For example, Karpoff, Lee, and Martin

(2008) show that about 90% of CEOs lose their job when they are the target of

enforcement actions from the U.S. Securities and Exchange Commission and U.S.

Department of Justice for financial misrepresentation. Cline, Walking, and Yore (2018)

find that indiscretions by a CEO significantly increase the likelihood that he is

replaced, and Gupta, Misra, and Shi (2018) find that backdating option scandals

increase CEO turnovers. Fredrickson, Hambrick, and Baumrin (1988) note that not

meeting the expectations of the board can lead to a CEO’s dismissal. Bushman, Dai,

We thank our discussant and seminar participants at the 2019 Eastern Finance Association annual meetings

for helpful comments. We also thank the anonymous referee for the detailed suggestions and valuable guidance.

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© 2020 The Southern Finance Association and the Southwestern Finance Association

and Wang (2010) show that the likelihood of CEO turnover is increasing in

idiosyncratic risk and decreasing in systematic risk.

1

Although the literature focuses on internal or firm‐specific reasons for CEO

turnover, we know relatively little about the role played by the external environment.

In this article, we consider whether economic policy uncertainty (EPU) affects the

board’s decision to replace a poorly performing CEO. EPU refers to the uncertainty

introduced by government policy makers regarding fiscal, regulatory, or monetary

policy (Brogaard and Detzel 2015). Baker, Bloom, and Davis (2016) highlight that

concerns about EPU have intensified recently. They contend that EPU captures

questions around who will make economic decisions, what policy actions will be

undertaken and when, and what the effects of policy actions or inactions are. Thus,

EPU is a more comprehensive measure of uncertainty, which is intended to capture

uncertainty about the firm’s operating environment rather than simply proxy for an

imminent recession or weak economy. Baker, Bloom, and Davis show that EPU spikes

around close presidential elections, wars, the September 11 attacks, and the collapse of

Lehman Brothers. They show that EPU is associated with stock market volatility and

reduced investment rates. Thus, their findings suggest negative economic effects from

shocks in uncertainty.

Although EPU certainly has macroeconomic effects, the ambiguity may also

affect firm decision making. However, the literature in this area is much more limited.

Julio and Yook (2012) and Gulen and Ion (2016) find that EPU leads firms to reduce

investment expenditures. Bonaime, Gulen, and Ion (2018) show that policy and

regulatory uncertainty reduce merger activity at the macro and firm levels. Ion and Yin

(2017) introduce the idea that EPU may affect CEO behavior. They show that CEOs

sell their own shares of the firm and exercise fewer stock options when uncertainty is

high. They also find that firms are more likely to hedge and undertake diversifying

mergers when there is economic ambiguity. Their findings support Waldman et al.

(2017), who suggest that environmental uncertainty alters the CEO’s influence on

performance.

We extend the idea that EPU may affect corporate behavior. Specifically, we

consider whether EPU influences the board’s decision to replace a poorly performing

CEO. Although Ion and Yin (2017) suggest that CEOs may alter their own behavior,

we know little about whether the board will take strategic actions. Brickley (2003)

contends that the level of uncertainty about the future prospects of the firm should

affect CEO replacement decisions. Waldman et al. (2001) suggest that CEO leadership

attributes and performance depend on perceived environmental uncertainty.

Overall, EPU may make a board more apprehensive about replacing a poorly

performing CEO. It is possible that uncertainty makes it more difficult to assess the

CEO’s true value. In other words, performance assessment may be challenging in an

uncertain environment. We hypothesize that monitoring becomes more difficult for

1

Bushman, Dai, and Wang (2010) define idiosyncratic risk as risk related to CEO talent and systematic risk

as risk unrelated to CEO talent but related to firm performance. Hence, they do not specifically examine factors

exogenous to firm performance.

676 The Journal of Financial Research