Involved investors are also becoming the norm. Imperial CEOs survived because investors weren’t actively involved in the governance of publicly traded corporations, limiting themselves to selling off stock when they lost confidence in a company’s CEO. Today’s involved investors include not only members of family-controlled businesses, but also private equity buyout firms, raiders, and hedge funds that take a stronger hand in the actual running of the companies they’ve invested in. Notice that “involved” investors are different from the traditional category of “active” investors. Active investors pick stocks that they expect to outperform the market, whereas passive investors go for index funds and exchange-traded funds that track the market. Involved investors are active investors who try to outperform the market by driving companies to change their behavior, whether by stimulating the removal of the CEO, suggesting a change in strategy, or triggering the sale of the company.
This new age of corporate governance is still taking shape. Sometimes, old battles from the transition period will be re-fought, like the current debate about softening or repealing some of the provisions of the Sarbanes-Oxley Act. Other battles haven’t yet been waged. How responsive, for example, should boards be to the demands of one large shareholder, especially if that shareholder’s suggestions hurt smaller shareholders? Should the board be more responsive to long-term investors than to hedge funds focused on making a quick buck? Now that investors are better able to enforce their preferences, should boards assume a greater role in securing the interests of other stakeholders? Many of the rules of the new era aren’t clear; some probably have yet to be written.
What is clear is that all the constituencies interested in the health and welfare of the corporation — CEOs, boards of directors, investors, consultants, regulators, legislators, and the business press — should say goodbye to the era of the imperial CEO and prepare for change. We shouldn’t expect a continuation of the patterns of CEO turnover and tenure that held sway in the transitional period. Instead, we should hope that a clearer answer emerges in future years to the fundamental questions of corporate governance: What is the best governance structure to stimulate the creative destruction that’s the hallmark of capitalist economies, and how can it produce the greatest benefits for all stakeholders?
Reprint No. 07205
Announcement Effects: Does Changing the CEO Move the Market?
This year, we investigated whether the announcement that a CEO will be replaced has a significant immediate effect on stock price, analogous to the jump that almost always occurs when a merger is announced. Because succession news can leak in the days before the announcement — as is often the case with mergers — we estimated the announcement effect as the returns to investors relative to a broad stock market average over a 30-day period extending through the day of the announcement.
The announcement effect of merger-related succession is clear. In the 30 days before a change in CEO is announced, annualized returns to investors for merger-related successions are 117 percent greater than average.
But the announcement effects of non-merger-related changes are less dramatic: Returns are 0.8 percent below average for planned successions, and 12.6 percent below average for forced successions. Furthermore, the change in stock price during the announcement period is entirely unrelated to how well the newly appointed CEO performs during his or her full tenure. Apparently, the stock market is no better at anticipating the ultimate performance of a CEO than is the board of directors. It’s how well the CEO does in improving a company’s performance, not the CEO’s characteristics coming into the job, that drives returns to investors.
In North America, announcing the replacement of the CEO produces a positive effect (3.8 percentage points better than the average return) when a company has been performing poorly for two years and a negative effect (10.2 percentage points worse than average) when the company has been doing well — exactly the pattern one would expect if investors believe that the new CEO will deliver average results. In Europe and Japan, the announcement produces the opposite effect. Perhaps the difficulty of bringing about significant immediate change in Europe and Japan is the cause: In North America, the normally negative returns during the announcement month at a poorly performing company are more than offset by the expectation that a new CEO will make changes that produce a big upside, whereas in Europe and Japan the normally negative returns balance the expected upside from change.
The one consistent announcement effect is that selection of an outsider produces a big downtick in stock price; selection of an insider triggers an uptick. This probably reflects investors’ assumptions that the outsider is taking over a poorly performing company, or that an insider will generally produce better returns for investors — assumptions that have been consistent throughout our study.
The pattern for outsiders brought in from other industries — typically the CEOs most expected to shake up a company — is consistent with our hypothesis. Industry outsiders enjoy a positive announcement effect (outsiders from within the industry have an extremely negative effect) and a positive effect during the 30 days following the announcement, as expectations continue to rise that they will bring beneficial change. However, because of the difficulty outsiders face in driving growth and changing the culture, industry outsiders produce very negative returns in the month before they are replaced (whereas outsiders from within the industry enjoy positive returns).
— C.L., S.W., and R.H.