Determinants of CEO selection.
A number of empirical studies have looked at factors that are associated with the selection of insider versus outsider CEOs. For example, evidence suggests that boards are more likely to recruit CEOs from the outside when changes in the direction of the firm are desirable (Parrino 1997; Farrell and Whidbee 2003), when the industry is more homogenous (Parrino 1997; Zhang and Rajagopalan 2003), when the proportion of outside directors sitting on the board is greater (Borokhovich et al. 1996), and when the firm is smaller (Dalton and Kesner 1983; Guthrie and Datta 1997). Our model offers another factor that can contribute to the CEO selection choice: the firm’s financial reporting controls. Financial reporting plays an important role to the extent that the board relies on accounting information for incentive contracting and CEO retention decisions. Stronger reporting controls make it harder for the CEO to manipulate performance information, which increases the board’s ability to assess the CEO and replace him if necessary. The board’s enhanced ability to detect and replace poorly-performing CEOs, in turn, increases its willingness to take risks by appointing an outside candidate. The model therefore predicts that boards are more likely to recruit an outsider when the performance measures with which the new CEO is assessed are harder to manipulate. The CEO’s cost of manipulating financial reports is likely to differ from country to country due to differences in accounting standards and legal enforcement. The model suggests a higher percentage of outsider CEOs in countries with stricter accounting standards and stronger legal enforcement, all else being equal.
Effects of CEO selection.
Our second set of predictions relates CEO origin (insider versus outsider) to accounting manipulation and CEO compensation. Specifically, the model predicts that CEOs appointed from the outside (i) engage in higher levels of manipulation, (ii) obtain steeper incentive pay, and (iii) receive greater expected compensation than those promoted from within. The prediction that CEO compensation is greater for outsiders than for insiders is consistent with empirical evidence by Harris and Helfat (1997) and Murphy and Zábojník (2007). To the best of our knowledge, the other two predictions have not yet been tested. Given the many potential explanations for why outsiders receive higher compensation than insiders, our third set of predictions can help to distinguish our theory from alternative explanations. Our model predicts that the differences in terms of manipulation, the size of the bonus, and expected compensation between insiders and outsiders are greater in environments in which CEOs can more easily manipulate performance information than in those in which manipulation is more difficult.
Our model also relates the origin of the CEO to the likelihood of early termination. Specifically, the model predicts that, as long as reporting controls are sufficiently strong, externally recruited CEOs have a shorter expected tenure than internally promoted CEOs. In contrast, when reporting controls are relatively weak, the model suggests that outsiders have a longer expected tenure than insiders. Shen and Cannella (2002) and Zhang (2008) provide empirical evidence that outsider CEOs are more likely to be dismissed, and thus have a shorter tenure than insider CEOs. This finding is not inconsistent with our model because these studies do not distinguish between firms with weak and strong reporting controls. A test of our model therefore requires the partitioning of the data into firms with strong reporting controls, where the effects documented by Shen and Cannella (2002) and Zhang (2008) should be strong, and firms with weak reporting controls, where the effects should be weak or even reversed.
