How Non-CEO Inside Directors Add Value After an Unplanned CEO Exit

The CEO-firm match theory posits that the CEO labor market is efficient and competitive and that the matching between CEOs and firms is optimal. However, both anecdotal and empirical evidence show that CEO departures, particularly unplanned CEO departures, can be disruptive, create friction (i.e., costs associated with appointing a non-optimal CEO replacement), and significantly and negatively affect shareholder value. In a new paper, we demonstrate that the presence of non-CEO inside directors (NCIDs) can help firms reduce friction costs and improve performance during unplanned CEO transitions. Using a comprehensive, manually collected data set of unplanned CEO departures from 1993 to 2012, we find evidence that firms with non-CEO inside directors incur lower costs and have stronger operating and stock performance after an unplanned CEO departure. The impact of NCIDs is particularly important when the firm hires an outsider as the new CEO.

Arguably, NCIDs possess superior firm-specific knowledge relative to other board members. As such, they can be a source of insightful guidance in both the selection of the new CEO and the operation of the firm following the leadership transition. Inside directors can also be high-quality internal candidates for the CEO position. If the NCID is not a candidate for the permanent CEO position, he could provide continuity and stability while the firm performs a comprehensive search for a new permanent CEO.

Following the selection of the new CEO, NCID guidance and firm-specific knowledge should be most helpful if the board decides to hire an outsider as the new CEO. Outsiders presumably have experience with CEO-level responsibilities, but they may take a while to assimilate and transition to the corporate culture. NCIDs could serve as a guide. The literature has predominantly focused on the downside of inside directors, finding that having too many can lead to ineffective boards and entrenchment. We focus, however, on a potential benefit of having inside directors.

Unplanned CEO departures can arise due to death and illness, unexpected forced departures due to lawsuits and criminal investigations, and poor performance or disagreements with the board. It is under these circumstances that immediate CEO succession becomes a primary board responsibility and the departing CEO is not available for consultation. We examine whether the presence of non-CEO inside directors on the board improves a firm’s ability to weather the loss in executive leadership.

We find that the likelihood of firms identifying an internal CEO replacement is significantly greater when firms have at least one NCID on the board. We demonstrate that inside directors often become the new CEO after the sudden loss of the CEO. However, even when an NCID does not assume the role of either permanent or interim CEO, we show that NCIDs are still beneficial when there is CEO turnover. We demonstrate that newly appointed CEOs last longer when there is an NCID on the board. We also show that the longer the NCID stays on the board following the transition, the longer the tenure of the new CEO. This is consistent with the NCID providing continued assistance and guidance to help assure the success of the new CEO following the transition.

Literature has focused on the valuation effect of outside CEO replacements in isolation and ignored the potential role inside directors can play in smoothing the leadership transition. We fill this gap by examining the valuation and performance implications of inside versus outside CEO replacements while also considering board composition. In isolation, firms that replace CEOs with outsiders have worse operating performance following a leadership change. We also find that the presence of an NCID makes no difference in the operating performance of firms following an unplanned CEO transition. However, when firms hire CEOs from outside the firm and they have at least one NCID on the board, they perform significantly better. Industry-and-performance adjusted operating performance from one year before to three years after the CEO departure is 8 percent higher for NCID firms that hire outside CEOs. Finally, we show that the stock performance of firms with an NCID and that hire a new CEO from outside the firm is significantly better than for comparable firms with no NCID for up to three years following the appointment of the new CEO.

Our paper sheds light on the important role directors, particularly non-CEO inside directors, play in mitigating the costs of unexpectedly losing a CEO. Given the importance of NCIDs, the findings in our paper help inform the debate on uniform mandates for boards. Despite the importance of CEO succession planning, empirical evidence on its necessity and the planning process has been scarce, possibly because firms are hesitant to disclose detailed succession planning information. For instance, when Ford Motor Co. announced that Mark Field would succeed Allan Mulally as CEO, Ford’s spokeswoman mentioned that the “company takes succession planning very seriously and has succession plans in place for each of the key leadership positions. However, for competitive reasons, Ford does not discuss succession plans externally.” We overcome the lack of publicly available detail in succession planning by using a comprehensive and hand-collected dataset with unplanned CEO departures and offer a glimpse of the role board members can play in facilitating successful succession.

This post comes to us from professors Laurie Krigman at Babson College and Mia Li Rivolta at Xavier University. It is based on their recent paper, “Can Non-CEO Inside Directors Add Value? Evidence from Unplanned CEO Turnovers,” available here.

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