CEO Job Security: An Explanation of Board Behavior

Leslie Gaines-Ross of Weber-Shandwick is one of the world's leading experts on corporate reputation and on the relationship between the reputation of those corporations and those of their CEOs. In this artilce from her blog, ReputationXchange, she highlights research done by Luke Taylor of the Wharton School, who provides a compelling take on why corporate boards behave the way they do in hiring and firing CEOs, behavior which frequently appears to contravene logical understanding of institutional health.

CEO reputation is always of interest to me and of course this week has been a cataclysmic and newsy one with the medical leave of Steve Jobs at Apple and Google Eric Schmidt’s relinquishing of the CEO title to Larry Page.

WIth CEOs on my mind, I stumbled across a research study by Wharton finance professor Luke Taylor who built a model to understand what happens when boards fire a CEO and what holds them back, if anything. Taylor found that there are two costs to firing a CEO — the severance payment (direct costs including headhunters and other exec departures) and second, what he calls “entrenchment” costs. Entrenchment costs are the personal ties that get severed when board members decide to let a CEO go.”Taylor’s model found that the entrenchment cost per firing was, on average, $1 billion — far more than the $300 million in direct costs.”

One of the downsides to firing CEOs in his model is that more aspiring executives might not choose the CEO track. In past research I have done, I learned that the CEO role was already diminishing in stature due to public scrutiny and stress. The economic problems of recent years have probably dampened that corner suite goal even further. See below.

His model does, however, predict that if the entrenchment cost went to zero — meaning that sacking a CEO came with only financial costs and no intangible consequences — the annual rate of CEO firings for the S&P 500 would go from 2% to 13%. That would result in a one-time bump in value for the S&P 500 of 3%. Taylor notes that this higher level of firings could potentially cause talented individuals to choose career paths other than those that might lead to a CEO position.
The whole idea of entrenchment costs is fascinating, especially because it is over three times more costly than just severance costs according to Taylor’s research model. The Wharton Leadership article said:

According to Taylor, this remaining $1 billion probably stems from two factors. First, there is a personal cost to board members who terminate the company leader — in the form of the time and stress of making a management change — as well as the loss that directors face in the departure of a business ally or golfing friend. Another contributor may be the fact that the board simply does not care all that much about maximizing shareholder value — at least not as much as keeping a CEO with whom they feel comfortable.
Of course this became more interesting when I read that entrenchment costs depend on company size. For the larger S&P 500 companies, Taylor found that the entrenchment costs were nearly zero. Whew. That was a relief to learn since this research was alarming me – board members hesitating to fire poor-performing CEOs because of their feelings (?) and losing golf partners (??). I agree with Taylor that the larger the company, the more board members have to lose in their own reputational equity. No one wants to be on those board of shame lists.

Reputation works in funny ways but maybe it works well when it comes to decision-making on large company boards. Sounds like a good thing