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Insider directors bring a valuable dynamic to corporate boards, new study suggests

December 1, 2002

For more information, contact: Benjamin Haimowitz,

"A degree of rivalry...between top execs can be a good thing."

When the CEO of McDonald's resigned last week, its lagging stock price rose at the news then quickly lost much of the gain when it became clear that his successor was a board member who had long been a senior executive of the firm.

As the authors of a new study of CEO succession see it, the market's response was of a piece with current conventional thinking -- that, as a general matter, poorly performing companies should not only force out their CEO but go outside for a successor.

Yet, the study in the December/January Academy of Management Journal finds that most dismissed CEOs are succeeded by company insiders, even though lagging company share price is a powerful factor in dismissals.

And notwithstanding the current tendency to equate outside directors with good corporate governance, the study also finds that the proportion of outsiders on a board has no significant effect either on a company's likelihood to dismiss its CEO or on whether the successor of a dismissed chief comes from the firm's own ranks or from another company.

But they did find a strong relationship between the proportion of insiders on the board -- that is, senior executives besides the CEO -- and the likelihood of CEO dismissal followed by inside succession.

Insiders, in other words, tend to fight harder than outsiders to get their way, pursuing CEO dismissal as a path to power.

And the study's authors don't believe this is necessarily a bad thing.

"Amid the current prejudice in favor of outside directors, we shouldn't lose sight of the virtues of having executives other than the CEO on the board," comments Wei Shen, an assistant management professor at the University of Florida, who carried out the study with Albert A. Cannella Jr. of Texas A&M University.

"Nowadays the general assumption seems to be that senior executives are allies of the CEO and that having them on the board leads to managerial entrenchment. But directors who are senior executives can strengthen the firm's internal monitoring system and limit the CEO's power, particularly if they own a lot of stock. A degree of rivalry and competition between top executives can be a good thing."

Shen and Cannella studied a random sample of 387 publicly traded firms reporting at least $200 million in sales. Over the 10-year period from 1988 to 1997, there were a total of 334 CEO successions for which they could find news reports. Based on these, the authors judged 65 to be cases where the CEO was forced out. In 38 instances (58%), the CEO was succeeded by another company executive and in 27 (42%) the new chief came from elsewhere.

To determine what factors drove these different outcomes, the authors carried out an extensive analysis in which 16 variables were analyzed for each of the companies in the sample for each of the 10 years. This gave them data for something on the order of 3,000 firm-years. They then did three comparisons: firm-years in which CEO dismissals occurred (65) vs.all other firm-years; firm-years with CEO dismissal/insider succession (38) vs.all other firm-years; and firm-years with CEO dismissal/outsider succession (27) vs. all other firm-years.

Findings included the following:

-- The greater the proportion of insiders (non-CEO execs) on the board, the greater the likelihood of CEO dismissal followed by insider succession. But this proportion had no significant effect, either positive or negative, on CEO dismissals in general or on dismissals followed by outsider succession, meaning that the proportion of outsider directors had no effect on these either.

-- The amount of share ownership by board insiders -- that is, the proportion of total company shares owned by them -- had a significant effect on CEO dismissals followed by inside succession but not on CEO dismissals followed by outside succession or on CEO dismissals in general.

-- The amount of share ownership by board outsiders had a strong negative relationship to CEO dismissals followed by insider succession; in other words, the more shares outsiders own, the smaller the likelihood of this scenario. But this factor had no significant effect on CEO dismissals followed by outsider succession or on CEO dismissals in general.

-- CEO tenure of less than five years was a significant risk factor for dismissal, with either insider or outsider succession.

-- Outsider CEOs are significantly more likely than insiders to be dismissed, particularly followed by inside succession.

-- Company financial performance as measured by return on assets is inversely related to the likelihood of CEO dismissal with outside succession but is not significantly related to CEO dismissal with inside succession. This leads the authors to warn that "outside directors need to closely monitor the power dynamics within top management and make sure that the competition is under control and contributes to the firm's operations."

The finding that dismissed CEOs are in most instances succeeded by insiders is at variance with some other recent management research. In a study presented in August at the Academy of Management annual meeting, Prof. Margarethe Wiersema, of the University of California, Irvine, reviewed all succession events in Fortune-500 companies for 1997 and 1998 and found 62 percent of dismissals were followed by outsider succession. Shen and Cannella allow that there might be a trend in that direction: dismissals were more likely to be followed by outsider succession in the latter part of the decade they studied than in the earlier years, even though insider successions continued to be a majority.

Whether or not outsider successions to CEO dismissals are becoming more popular, the more important question, Shen and Cannella believe, is how to maintain a proper balance between insiders and outsiders on corporate boards, so that the unique contributions that insiders have to offer will not be lost.

After all, Shen points out, of the 17 directors on Enron's board, the only Enron executive besides CEO Jeffrey Skilling was the chairman, Kenneth Lay. It could not have hurt to have a few knowledgeable senior-exec directors willing to pursue CEO dismissal as a path to power.

The Academy of Management Journal, a peer-reviewed publication now in its 45th year, is published every other month by the academy, an organization with more than 12,000 members in 60 countries that seeks to foster the advancement of research, education, and practice in the management field.

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