Managerial turnover and entrenchment

• Published date: 01 October 2018
• Author: Xi Weng,Zenan Wu
• DOI: http://doi.org/10.1111/jems.12248
• Date: 01 October 2018

742 © 2018 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jems J Econ Manage Strat. 2018;27:742–771.

Received: 12 July 2016 Revised: 8 March 2018 Accepted: 22 March 2018

DOI: 10.1111/jems.12248

ORIGINAL ARTICLE

Managerial turnover and entrenchment

Zenan Wu1Xi Weng2

1School of Economics, Peking University,

Beijing,China (Email: zenan@pku.edu.cn)

2Guanghua School of Management,

Peking University,Beijing, China

(Email: wengxi125@gsm.pku.edu.cn)

Fundinginformation

SeedFund (School of Economics, Peking

University);Key Laboratory of Mathematical

Economicsand Quantit ativeFinance (Peking

University),Ministry of Education

Abstract

We consider a two-period model in which the success of the firm depends on the

effort of a first-period manager (the incumbent) as well as the effort and ability of

a second-period manager. At the end of the first period, the board receives a noisy

signal of the incumbent manager's ability and decides whether to retain or replace

the incumbent manager. We show that severance pay can be utilized in the optimal

contract to provide a credible commitment to a lenient second-period equilibrium

replacement policy, mitigating the first-period moral hazard problem. Unlike existing

models that aim to rationalize managerial entrenchment, we identify conditions on the

information structure under which both entrenchment and anti-entrenchment emerge

in the optimal contract. Specifically, our model predicts that it is optimal fort heboard

to design a contract to induce entrenchment (respectively, anti-entrenchment) if the

signal regarding the incumbent manager's ability becomes sufficiently uninformative

(respectively, informative).

1INTRODUCTION

Designing compensation schemes in managerial contracts and deciding whether to replace a manager, such as a CEO, are

important firm organization activities. These decisions are linked through the severance agreement, a key component of the

contracts between boards and managers. The severance agreement specifies payments tot he managerupon his forced departure.

Approximately,50% of the CEO compensation contracts implemented between 1994 and 1999 involved some form of severance

agreement (Rusticus, 2006). The percentage of S&P 500 firms that included a severance agreement in their CEO compensation

contracts increased from 20% in 1993 to more than 55% in 2007 (Huang, 2011). In general, a contract with a severance agreement

adds an explicit cost to the board's retention decision and makes replacement more difficult relative to a compensation contract

without such an agreement.

A widely held belief is that CEOs are replaced too infrequently, that is, they become entrenched.1Entrenchment may arise

for many reasons. For example, it may be due to governance failure in the form of a captive board of directors (Hermalin &

Weisbach, 1998; Inderst & Mueller, 2010; Shleifer & Vishny, 1989) or a way to mitigate a moral hazard problem (Almazan

& Suarez, 2003; Casamatta & Guembel, 2010; Manso, 2011). Taylor (2010) makes the first attempt to measure the cost of

entrenchment using a structural model of CEO turnover and finds suggestive evidence of the opposite. In particular, he finds

that boards in large firms fire CEOs with higher frequency than is optimal. We refer to this phenomenon as anti-entrenchment.

We thank a coeditor and two anonymousreferees for very detailed comments that have helped us to significantly improve the paper. Weare deeply indebted to

Hanming Fang and Aislinn Bohren for their guidance and continuous support. We thank DavidDillenberger, Zehao Hu, Navin Kartik, SangMok Lee, Qingmin

Liu, George Mailath, Steven Matthews, Andrew Postlewaite, Xianwen Shi, Wing Suen, Lucian Taylor, and seminar participants at the Chinese Universityof

Hong Kong, Peking University,Renmin University, Shandong University, Shanghai Universityof Finance and Economics, and University of Pennsylvania for

helpful comments and suggestions. Wu acknowledges research support from the Seed Fund (School of Economics, Peking University). Weng acknowledges

support from Key Laboratory of Mathematical Economics and Quantitative Finance (Peking University), Ministry of Education. All remaining errors are our

own.

WU AND WENG 3

743

This finding cannot be rationalized by the existing models on CEO turnover and thus calls for a newmodel to better understand

the determinants of managerial turnover.

This paper investigates how optimal design of the severance agreement influences managerial entrenchment. A manager is

said to be entrenched (or anti-entrenched) if the board retains (fires) him when his expected ability is lower (higher) than that

of a replacement manager. We proposea two-period pr incipal–agentmodel of managerial turnover and identify conditions that

predict the emergence of entrenchment and anti-entrenchment. Formally, weconsider a setup in which the first-period manager

is incentivized by a contract that contains performance-related pay and severance pay. The firm's success depends on the initial

manager's effort, the second-period manager's effort and his ability. Thus, the board faces an ability selection problem and a

period-1 moral hazard problem. After the initial manager exerts effort, the board observes a noncontractible signal regarding

his ability. The board can fire the initial manager by paying the severance pay specified in the contract and hire a replacement

manager.

Severance pay can be utilized in the optimal contract to provide a credible commitment to a lenient period-2 equilibrium

replacement policy, which mitigates the period-1 moral hazard problem and influences the period-2 manager's expected ability.

To see how the use of severance pay can be desirable for the board, it is useful to consider a contract with zero severance pay,

under which the board is able to dismiss the incumbent at will. Because the wage is only paid at the end of the second period,

the board will always preferto fire t he first-period manager if he is of the same ability as the replacement manager,so as to avoid

paying the higher promised wage. Such a zero-severance-pay contract, however, may not be in line with the interest of the board.

With a contract of zero severance pay in hand, the incumbent manager would expect an aggressive replacement policy and thus

would not exert much first-period effort. In such a case, the board can commit to a positive severance payment, ensuring a low

expected profit for itself after replacement. This would in turn lead to a less aggressive replacement policy, provide more job

security to the incumbent manager, and thus mitigate the period-1 moral hazard problem at the cost of the expenditure from

the severance agreement. Meanwhile, the introduction of a positive severance pay in the contract affects the expected ability

of the second-period manager: the higher the severance pay, the lower the expected ability of the manager who is retained to

save the cost. Therefore, the optimal contract must strike a balance between incentive provision, manager ability selection, and

commitment cost.

Our main result characterizes the optimal replacement policy and shows how it depends on the precision of the signal of the

manager's ability.When t he monitoring technology is noisy,entrenchment is optimal. In such a scenario, the board places higher

priority on motivating the incumbent manager to exert period-1 effort than on maximizing the manager's ability. Designing a

contract to induce an aggressive replacement policy will too often result in the firing of the incumbent of high ability and will

disincentivize the incumbent to exert effort, while saving little on severance pay. As a result, a contract that induces entrenchment

is optimal for the board.

Anti-Entrenchment is optimal when the board's monitoring technology is sufficiently informative. On the one hand, because

the board's monitoring technology is informative, the incumbent manager expects that the turnover rate relies mainly on his

ability rather than the replacement policy. Therefore, a less aggressive replacement policy does not have a significant impact

on motivating period-1 effort. On the other hand, through an aggressive replacement policy the board can (i) avoid the cost of

severance pay when replacement occurs; and (ii) avoid paying the wage to the incumbent manager and undercut the wage in

period 2 to further increase the firm's profit after the incumbent manager exerts his period-1 effort. Thus, anti-entrenchment is

optimal for the board. To the best of our knowledge, we are the first to study the interaction between the board's monitoring

technology and managerial turnover, and to show that anti-entrenchment can be part of the optimal contract.

1.1 Related literature

This paper belongs to the literature on the principal–agent model with replacement.2One strand of research views entrenchment

as a potential source of inefficiency that the board aims to mitigate. Consequently,anti-entrenchment cannot be observed. Inderst

and Mueller (2010) solve the optimal contract for the incumbent manager who holds private information on the firm's future

performance and can avoid replacement by concealing bad information.Consequently, the optimal contract is designed to induce

the incumbent to voluntarily step down when evidence suggests low expectedprofit under his management. Similarly, entrench-

ment occurs if the incumbent can make manager-specific investments that create replacement costs for the board (Shleifer &

Vishny, 1989) or if there exist close ties between the board and manager (Hermalin & Weisbach, 1998).

Another strand of research views entrenchment as a feature of the optimal contract (board structure) that helps overcome the

moral hazard problem. Manso (2011) shows that tolerance for early failure (entrenchment) can be part of the optimal incentive

scheme when motivating a manager to pursue more innovative business strategies is important to the board. Casamatta and

Guembel (2010) study the optimal contract for the incumbent manager who is concerned about his reputation. In their model,