Management Retention Following Poor Performance: Board Failure or Management Entrenchment

Abstract

Acting in shareholders' best interests, the board of directors should remove top management when a firm performs poorly. However, empirical evidence indicates that sometimes boards replace top management and sometimes they do not. When top management is not replaced following poor performance, does this represent a failure of boards of directors and the market or is management so entrenched that it is not cost effective to remove management? That is, if the benefits of replacing management exceed the costs and yet the board does not replace top management then the board has failed in its fiduciary responsibility to act in shareholders' best interests. On the other hand, if the cost of replacing management exceeds the benefits, then boards are behaving in shareholders' best interests by not replacing management. Management is so entrenched that it is not cost effective to remove them. In this study, we examine a group of firms that performs poorly but boards do not replace management. Our measure of poor performance is white knights who lost money when acquiring a target firm and have q-ratios less than one. For these firms, proxies for the costs of replacing management are compared to proxies for the benefits of retaining management. We find that the market works, that the retention of a poorly performing CEO does not represent a failure of the boards, but rather the costs of replacing a poorly performing manager are greater than the benefits. Poorly performing management is so entrenched that it is not cost effective to replace them. We also find that if the share price falls too drastically, the probability of replacing management increases. A proxy battle indicating serious opposition to management also increase the probability of replacement even if the proxy battle is unsuccessful. Boards also tend to replace managers with no prior bidding experience who lose big when acquiring a target company. It is also less costly to replace managers who are close to retirement age. And the more control a CEO has over the company as evidenced by holding two job titles, the less likely the board is to replace him/her.