Shareholder Wealth Effects of CEO Succession

doi:10.4236/ajibm.2013.36067

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American Journal of Industrial and Business Management, 2013, 3, 583-588

http://dx.doi.org/10.4236/ajibm.2013.36067 Published Online October 2013 (http://www.scirp.org/journal/ajibm)

583

Shareholder Wealth Effects of CEO Succession

Kevin Banning

Auburn University Montgomery, Montgomery, USA

Email: [email protected]

Received August 4th, 2013; revised September 4th, 2013; accepted September 13th, 2013

permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

ABSTRACT

Companies often dismiss their chief executive officers (CEOs) when financial performance falters. This study examines

why, despite the positive stock market effects, the replacement of the CEO often does little to change a company’s fi-

nancial performance. Thanks to the agency arrangements in some companies, new CEOs are able to negotiate favorable

contracts which benefit the CEO rather than the shareholders. In a sample of 140 publicly-traded firms, we found that

compensation systems for new CEOs differed as a function of institutional ownership, with total executive compensa-

tion higher and compensation risk lower in firms with lower levels of institutional ownership. Financial performance

was also weaker in firms with less institutional ownership.

Keywords: CEO Compensation; Institutional Ownership

1. Introduction

Previous research has identified several causes of CEO

turnover, such as mergers and acquisitions [1], but poor

firm financial performance is the most common reason

[2]. When a firm replaces its CEO because of poor finan-

cial results, there are positive consequences for financial

markets, and more so if the new CEO comes from out-

side the firm [3]. The consequence of CEO succession

for company financial performance, however, is more

ambiguous than the effect on financial markets. While

there is some evidence that replacing a CEO has positive

implications for firm performance [4], there is also evi-

dence that CEO turnover is associated with performance

declines [5]. Other studies suggest that instead of im-

proving financial performance, CEO succession has often

had no relationship to company performance [6]. The

presence of institutional owners, who might serve as ef-

fective monitors of new CEOs, could explain the mixed

empirical results concerning the consequences of execu-

tive succession.

Replacing the CEO when firm financial performance

is lacking creates some confusion for equity owners.

There is some evidence the board of directors will grant

significant decision autonomy to new CEOs, which can

lead to significant change, regardless of whether the in-

coming chief executive came from inside or outside the

company [7,8]. However it is also the case that because

the effects of succession on financial performance are

mixed, and the changes initiated by new CEOs may or

may not lead to improved company performance, the

objective of changes initiated by new CEOs may be to

protect their positions of power in the organization [9].

New CEOs who fail to deliver strong or improved fi-

nancial performance are vulnerable throughout their first

few years on the job [10], and it would be rational for

them to fortify their positions after appointment, regard-

less of the circumstances of the succession. Because ex-

ecutives who serve on the firm’s own board are known to

contest the new CEO [10], new chief executives have

strong incentives to solidify their positions if post-suc-

cession financial performance is unimproved. Conse-

quently a new CEO has both the incentive, because of

contests among board members, and the opportunity,

thanks to a brief “honeymoon period” associated with

succession, to arrange an attractive agency contract dur-

ing the transition.

The agency contract specifies the relationship between

a CEO and board of directors. An agency contract will

include how the CEO will be monitored and how the

CEO will earn his or her compensation [11]. Because

there are too many unknowable contingencies, perfect

and completely specified contracts are not feasible, re-

sulting in a “relational contract” [12]. Relational con-

tracts are necessarily ambiguous, and could result in

some problems relevant to how new CEOs could en-

trench themselves after succession. One possibility is

Shareholder Wealth Effects of CEO Succession

584

opportunistic behavior, arising from private information,

moral hazard, or adverse selection, throughout the con-

tract negotiations. A new CEO could negotiate terms

more favorable to him or her because of undisclosed

knowledge. Another possibility is post-contractual op-

portunism, where a new CEO takes advantage of any

ambiguities in the contract, because there are many un-

anticipated contingencies. Such opportunism seems es-

pecially likely when the board does not adequately moni-

tor the CEO.

There is some utility in exploring how the incentive

structure differs after succession as a way to understand

how the new CEO could strengthen his or her position.

For example, when there are some equity holders, such

as institutional owners who control large enough blocks

of stock to influence management, it seems likely that the

agency contract will be more favorable to the board of

directors. The greater oversight by institutional owners

could result in lower levels of CEO control as might be

seen in more effective compensation contracting and

incentive alignment and potentially stronger firm per-

formance.

2. Agency Theory in Organizations

When viewed through an agency framework, sharehold-

ers of public companies contract with managers to act on

their behalf, and thus delegate to managers the ability to

utilize company resources. Because both the shareholders

and managers are thought to be rational, the owners must

devise ways to effectively supervise the actions of man-

agers. This supervision typically occurs through the con-

tract which specifies how managers will be monitored or

share risks with owners, and effectively aligning owners’

incentives for success with managers pay, with tools like

performance-contingent compensation. When well con-

structed and executed, monitoring and incentive align-

ment support strategic choices which benefit both share-

holders and managers.

One solution to the agency problem in organizations is

monitoring by individual owners. Individual owners of-

ten own too small a position or are otherwise unable or

unwilling to carefully monitor managers of companies in

which they have ownership [12]. Some researchers (e.g.,

[13]) have observed that institutional owners pay more

attention to managerial decisions in the firm because the

decisions and consequent company performance are

critical to their financial holdings. Consequently when

those institutional owners act in ways likely to be benefi-

cial to shareholders, markets react positively [14-16].

While it is clear that there are positive, stock-market

effects associated with activism by institutional investors,

this activism has produced less consistently positive re-

sults with respect to a firm’s financial performance, but

the finding that performance improvements are associ-

ated with investor activism is more common than not

[17]. With the generally positive performance effects

associated with institutional ownership, there may be

other consequences of these owners on outcomes favored

by shareholders, and one such outcome is CEO compen-

sation.

2.1. Creating Incentive Alignment

Agency theory suggests that a new CEO will attempt to

negotiate both more total pay and a smaller perform-

ance-contingent component of pay than the predecessor

CEO [18], and these conditions are more likely to be

granted in the absence of institutional owners. Previous

research suggests CEO pay for incumbent CEOs will be

lower overall and favor performance-contingent forms of

pay when the proportion of institutional investors is

higher [19]. Similarly previous research suggests that

new CEOs receive compensation packages favoring in-

centive pay instead of guaranteed forms of compensation

[8], but whether the presence of institutional ownership

affects the compensation structure has yet to be tested

with the compensation of new CEOs.

There are impediments to proper management control

in modern corporations, as well as reduced incentives for

monitoring by singular, individual owners, and conse-

quently a new CEO could negotiate a compensation con-

tract with more total pay and less risk. The greater levels

of total compensation and their smaller proportions of

performance-contingent pay are negotiated with the

board upon succession. This kind of contract, highly fa-

vorable to the incoming CEO, is possible because of the

relative weakness of managerial oversight in firms with

no strong institutional investors. Any weakness in mana-

gerial oversight might be exploited at the time of succes-

sion, and the new CEO may achieve an attractive com-

pensation package.

H1: The level of post-succession CEO compensation

will be greater in firms with lower institutional holdings.

H2: The level of post-succession CEO compensation

risk will be smaller in firms with lower institutional hold-

ings.

2.2. Performance and CEO Succession

Improved firm-financial performance constitutes the

most effective defense strategy for new CEOs, and better

financial results would reduce any vulnerability to other

managers who serve on the board of directors [10]. There

is likely to be some risk of dismissal for a new CEO

whose appointment follows poor financial performance.

It is reasonable to expect new CEOs in firms lacking

effective institutional owners to negotiate contracts with

strong defensive mechanisms, and that such arrange-

ments could harm firm performance. Several studies

Shareholder Wealth Effects of CEO Succession 585

show that compensation strategies favoring the CEO tend

to be more common in firms lacking effective owner-

oversight. Similarly, compensation contracts which are

structured to de-couple CEO pay from firm performance

are associated with decreased financial performance

[8,20]. Thus, new CEOs in firms with less oversight by

institutional owners might have fewer decision con-

straints than CEOs in firms with effective institutional

oversight, and financial performance could suffer.

H3: Lower post-succession financial performance is

associated with lower institutional holdings.

3. Method

The COMPUSTAT database provided the financial data

and succession events were identified in the Wall Street

Journal. Initially there were 157 publicly-traded firms

experiencing a single succession event during the event

period from 2004 to 2008. At five years, the succes-

sion-event window was short enough to attribute effects

to the new CEO and not to exogenous events, yet long

enough to capture enough succession events for statisti-

cal purposes. No firms experiencing multiple succession

events during the five years, or firms with a CEO succes-

sion in the four years immediately preceding the window,

or in the year following the window were included. In-

cluding companies with multiple successions, with the

associated negations of the compensation contracts,

would have unnecessarily muddled the analysis and hy-

pothesis tests. Ultimately there were 140 firms across the

five years with fully usable data. Using a fixed-effects

specification, where a dummy variable represents the

year of the succession event to test the hypotheses, per-

mitted robust testing but was simple to operationalize.

3.1. Dependent Variables

The first dependant variable, total CEO compensation,

was determined from proxy statements for the year fol-

lowing appointment. Total CEO compensation was com-

prised of all forms of pay reported in the proxy statement,

including the Securities and Exchange Commission (SEC)

estimate of the present value of stock options received

[19]. Despite the difficulty in estimating the present

value of stock options, the nearly ubiquitous use of stock

options as a large part of the total CEO compensation

package justifies their inclusion. The second dependent

variable is a measure of compensation risk that is com-

puted as the proportion of total pay that is performance

contingent [21]. The performance measure uses return on

investment, and is measured in both the year before and

year after the succession event. The value from the year

before the succession event is used as a control in the

regressions, while the post-succession performance serves

as the third dependent variable.

All three dependent variables are adjusted for mean

values of their corresponding four-digit SIC industry for

the first full year following the succession event. The

resulting dependent variable for each observation is the

observed value minus the industry mean. In a conceptual

sense, correcting the observed-value of each firm’s total

compensation and compensation risk with the mean of

the relevant industry creates a value of each dependent

variable that controls for any industry-effect. Thus in the

case of Total CEO Compensation, positive differences

indicate that the CEO for that firm received more than

the industry average total pay, and negative differences

indicate that the firm’s CEO received total pay less than

the relevant industry average. The computation for com-

pensation risk and for firm performance works in the

same way. This method permits controlling for industry

effects in the regression without the corresponding loss

of degrees of freedom [22].

3.2. Independent and Control Variables

This research addresses the question of whether a suffi-

ciently powerful institutional owner affects the negoti-

ated agency contract for a new CEO and if there is a fi-

nancial performance effect. The agency contract, includ-

ing the compensation component, would be expected to

differ in firms where the CEO exercised more control

relative to the board of directors, which represents own-

ers. Researchers seem to agree that effective oversight of

managers is associated with several important conse-

quences [9,23], but there is less consensus as to how to

operationalize the influence of institutional owners. This

paper uses an institutional ownership measure, after Ha-

dani [17], which takes the percentage of outstanding

shares held by the single largest institutional owner. The

measure has gained currency based on earlier findings

suggesting that only the largest institutional owner would

likely possess any information advantage [24].

The influence exercised by institutional owners is only

possible reason that compensation contracts for CEOs

might differ among firms. There are other firm-specific

variables that might affect the contract, such as the size

of the company, whether the new CEO came from within

the firm, and the conditions under which the previous

CEO exited the position. These influences are treated as

control variables.

Size. Firm size is operationalized as the natural log of

annual revenues reported for the first full year of the

successor CEO’s tenure.

Successor origin. The new CEO’s origin is deter-

mined by the last employer prior to becoming the CEO at

the focal firm [25,26]. If that position was held anywhere

other than the focal firm or its subsidiaries, successor

origin was one. If the successor CEO was promoted from

within the firm or any of its subsidiaries, successor origin

Shareholder Wealth Effects of CEO Succession

586

was zero.

Predecessor disposition. There is also the question of

the circumstances of the succession. In assessing the

predecessor’s disposition in text sources, such as the

company proxy statement and the Wall Street Journal, if

these were clear the predecessor had voluntarily retired,

died, or had voluntarily taken another position, or if it

was unclear despite multiple sources, this variable was

coded as zero. Only if it was clear that the predecessor

was forced to resign or retire, this variable was coded as

one.

Lagged performance. Pre-succession firm perform-

ance is measured as described above as the firm minus

the industry average of the company’s return on invest-

ment in the last full year preceding the succession event.

Pooled panel year. The data cover a five-year span so

the specification used a control variable to capture any

unique variance for a particular year in the regression

specification.

3.3. Analysis

The hypotheses were tested in three pooled regression

analyses. The first specification regressed total CEO

compensation on the independent and control variables,

while the second specification regressed compensation

risk, which is the ratio of performance-contingent pay to

total pay earned in the first full year after succession, on

the same set of independent and control variables. The

third specification regressed post-succession firm per-

formance on the independent and control variables.

3.4. Results

Descriptive statistics and intercorrelations for the study

variables appear in Table 1. Only standardized regres-

sion coefficients are reported in the tables for the sake of

comparability.

Compensation effects. The regression results for total

CEO compensation appear in Table 2. Hypothesis 1,

which predicted that the level of total CEO pay would be

higher in firms with lower levels of institutional owner-

ship, was supported. Higher levels of CEO compensation

were also associated with pre-succession firm perform-

ance.

The regression results for compensation risk also ap-

pear in Table 2. Hypothesis 2, which predicted that the

level of CEO compensation risk would be lower in firms

with lower levels of institutional ownership, was sup-

ported. When the predecessor CEO was forced out, pay

risk was also higher.

Firm performance effects. Regression results for

post-succession firm performance appear in Table 2.

Hypothesis 3, which predicted that firms with lower lev-

els of institutional ownership would experience lower

levels of post-succession financial performance, was

supported. Financial performance was also lower if the

successor CEO originated from a position outside the

firm.

4. Discussion

This research suggests that the influence of institutional

owners matters to the nature and consequences of the

agency contract that is negotiated with new CEOs. It

appears that new CEOs who face relatively weaker insti-

tutional-investor oversight are able to negotiate more

favorable compensation contracts, in terms of both size

and risk. Though there are potentially many circum-

stances which would permit a new CEO to strike a more

favorable compensation contract, a lack of institutional

ownership appears to matter a great deal. It is important

for new CEOs to negotiate an attractive compensation

package, because in their early years as chief executive

they are subject to competition from their internal col-

leagues on the board of directors [10].

Other than the influence of an institutional owner and

the predecessor’s involuntary dismissal, compensation

contracts did not seem to vary based on the circum-

stances surrounding the succession events. In terms of

company financial performance, only influence of an

Table 1. Descriptive statistics and intercorrelations.

{PRIVATE} Variable Mean S.D. 1 2 3 4 5 6 7

1. Firm size 3.03 1.51

2. Lagged performance 4.11 5.10 0.06

3. Origin 0.80 0.12 −0.03 −0.04

4. Disposition 0.42 0.46 0.03 −0.16 0.19*

5. Total compensation 12.4 1.36 0.38** 0.02 0.14 0.03

6. Compensation risk 0.69 0.25 0.12 0.17 −0.05 0.09 0.73**

7. Post performance 4.41 4.93 0.10 0.65** −0.02 −0.21* 0.14 0.15

8. Institutional owner 0.10 0.04 −0.18*0.03 0.08 0.11 −0.27* 0.19* 0.26*

Note: *p  0.05 **p  0.01.

Shareholder Wealth Effects of CEO Succession 587

Table 2. Regression results.

Total compensation Compensation risk Post performance

{PRIVATE} β β β

Firm size 0.389** 0.351 −0.131 0.047 0.092 0.378

Lagged performance 0.162* 0.278 0.058 0.202 0.301** 0.216

Origin −0.006 0.054 0.029 0.001 −0.174* 0.037

Disposition −0.050 0.125 0.156* 0.023 −0.108 0.094

Institutional owner −0.194* 0.069 0.207* 0.182 0.286* 0.255

institutional owner and successor CEOs from outside the

firm were significant influences. Stronger financial per-

formance was associated with greater institutional invest-

tor influence, while outside successor CEOs were associ-

ated with worse financial performance post-succession.

4.1. The Effects of Institutional Ownership

The ways in which new CEOs protect their positions

appears to differ in firms based on institutional owner-

ship. CEOs in firms with lower levels of institutional-

owner influence were able to achieve less compensation

risk than new CEOs in firms with higher levels of influ-

ence exercised by institutional owners. These differences

in compensation and risk-sharing may account in part for

the finding that firms lacking significant institutional

ownership do not perform as well as those featuring more

institutional ownership, a result consistent with other

work that shows that greater institutional ownership is

associated with better financial performance [17].

The compensation contract, and in particular the ar-

rangements with respect to how contingent pay is earned,

is the primary means shareholders have to align manag-

ers’ interests with their own. CEOs in firms with less sig-

nificant institutional ownership appear to receive higher

pay and less compensation risk in their negotiated con-

tracts, while successor CEOs in firms with significant

institutional ownership experience higher compensation

risk. These results suggest managers in firms with low

levels of institutional have more influence over the

structure and magnitude of their pay, and thus the results

are consistent with previous research [20].

Though no direct effects were tested, it may be that the

negotiated agency contract impacts the firm’s financial

performance. In firms with less institutional ownership,

where the new CEO may have more influence relative to

the board of directors, financial performance is lower

than in firms with significant institutional ownership.

The overall results suggest that the relatively greater in-

fluence of the new CEO under low levels of institutional

ownership, as reflected in the terms of the compensation

contract negotiated at succession, is one possible reason

for the positive association of institutional ownership and

financial performance.

4.2. Negotiated Compensation Terms and

Performance

Though institutional owners appear to influence the

compensation terms of the agency-contract negotiated

with the board of and the incoming CEO, such that when

institutional ownership is small the successor CEO cap-

tures a more favorable compensation contract, at least

one other factor during succession seems to impact per-

formance as well. The disposition of the previous CEO

seems to have some effect on the compensation ar-

rangements. New CEOs who followed one who was dis-

missed received proportionally more pay which was per-

formance contingent, shifting more of the firm's future

performance risk to the new CEO. Compensation terms

shifting pay risk to the new CEO represent a reasonable

response by firms that have dismissed their previous

chief executive, because increased pay-risk signals the

board’s demand for better future performance.

Though not significant to compensation, whether the

new chief executive came from within the firm seems to

matter to financial performance. These results contradict

previous evidence suggesting that the successor CEO’s

origin, whether from inside or outside the company, has

no effect on post-succession firm performance [26]. Fu-

ture research that takes into account the social networks

of the departing CEO, such as proposed by Cao et al.

[27], might further elaborate these results.

Ultimately, the compensation contract terms seem to

depend on the interplay between an incoming CEO, in-

stitutional owners, and the board of directors. The direc-

tors appear to create terms more favorable to sharehold-

ers when institutional owners have more influence on the

firm. When managers exercise more control, however,

the evidence suggests that shareholder interests may be

traded for managerial compensation. Firm performance

following succession may thus depend more on who

controls the contracting process than on other character-

istics of the new CEO.

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