CEO Turnover and Compensation: An Empirical...

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CEO Turnover and Compensation: An Empirical Investigation

Rachel Graefe-Anderson Krannert Graduate School of Management

Purdue University West Lafayette, IN 47907

[email protected]

September 2009

Abstract

Because CEO turnover events provide a the board of directors with a unique opportunity to potentially completely restructure CEO compensation packages, changes to CEO compensation following a turnover event could prove to inform the ongoing debate regarding CEO compensation. This paper investigates what happens to CEO compensation when a turnover event occurs. Specifically, I examine CEO compensation levels and pay-performance sensitivity for incoming and outgoing CEOs involved in turnover events at public companies in the United States. My main findings are as follows: 1) incoming CEOs are paid as much as or more than those they replace, 2) outsider replacements are paid more than their predecessors even after controlling for education and skills, and 3) CEOs who are forced out are not paid differently from those who replace them, while CEOs who leave voluntarily are paid significantly less than their replacements. Further analysis reveals that proxies for managerial power including CEO tenure, CEO centrality, founder status, and high CEO ownership cannot explain these results. Overall, these findings are difficult to reconcile with the view that managerial power is the primary determinant of CEO compensation.

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1. Introduction

CEO turnover events provide a unique opportunity for boards of directors to restructure

CEO compensation packages. As such, adjustments to CEO compensation packages occurring

around such events can provide information regarding the ongoing debate concerning CEO

compensation. This paper investigates the determinants of CEO compensation by exploring

what happens to CEO compensation when turnover events take place. Specifically, I examine

CEO compensation levels, pay-performance sensitivity, and “excess pay” (measured as the

residual from a standard model of compensation) for a sample of 1,232 incoming and outgoing

CEOs involved in turnover events in U.S. public companies between 1993 and 2006.

Executive compensation has been a widespread and hotly debated topic for over a

decade. Nonetheless, no consensus has been reached regarding whether CEO compensation

reflects an effective mechanism through which managers’ interests are aligned with those of their

shareholders. The two main views of executive compensation -- managerial discretion and

optimal contracting -- offer competing explanations for the dramatic rise in executive pay over

the past several decades. Under optimal contracting, contracts are the efficient result of arms’

length bargaining between the board of directors and the CEO and the rise in compensation

simply reflects appropriate adjustments in response to market factors. A large literature supports

this view, finding corroborative evidence by looking for compensation behavior that would be

consistent with market forces such as outside employment opportunities or a shift in the types of

qualities desired.1 Alternatively, under the managerial discretion view, managers exercise power

over the board to expropriate from shareholders by overpaying themselves and the overall rise in

executive pay reflects an increase in their power to do so. An equally large literature documents

support for the “overpay” hypotheses by identifying behavior that appears to be inconsistent with

efficiency such as asymmetric benchmarking or stock option re-pricing.2

This paper contributes to the ongoing debate in its evaluation of a relatively unique event.

Because the board of directors is contracting with the presumably less powerful new CEO for the

1 See, for example, Fama (1980), Abowd and Kaplan (1999), Murphy (1999), Core and Guay (1999), Core, Guay, and Larcker (2003), Himmelberg, Hubbard, and Palia (1999), Core, Guay, and Thomas (2005); Rajgopal, Shevlin, and Zamora (2006), Oyer (2004), Himmelberg and Hubbard (2000); Murphy and Zabojnik (2007) 2 See, for exampe, Morck, Shleifer, and Vishny (1988), Crystal (1991), Jensen (1993), Bebchuk, Fried, and Walker (2000); and Mullainathan (2001), Garvey and Milbourn (2004); Brenner, Sundaram, and Yermack (2000), Chance, Kumar, and Todd (2000), Pollock, Fisher, and Wade (2002)

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first time, turnovers give the board the option to structure their CEO’s compensation package as

they see fit. In a sense, turnovers provide boards with an opportunity to “start over” regarding

the ways in which they compensate managers and align managers’ incentives with those of

shareholders. Thus, turnovers have the potential to have a dramatic impact on the level and

structure of compensation packages.

This paper focuses on the following question: what is the impact of a turnover event on

CEO compensation? My primary purpose is to describe what we observe when a turnover event

occurs. To a lesser degree, I also try to address whether or to what extent the empirical evidence

allows me to distinguish between competing views of executive compensation. I investigate

these questions by examining the compensation packages of incoming and outgoing CEOs. In

particular, I examine differences in levels of cash pay (salary and bonus), total compensation

(total of salary, bonus, Black-Scholes value stock options granted, restricted stock, payouts from

long-term plans, and benefits), pay-for-performance sensitivities, and “excess pay” for a sample

of 1,232 paired incoming and outgoing CEOs around turnover events occurring between 1993

and 2006. Following the approach used by Hartzell, Ofek, and Yermack (2004), I measure

“excess pay” as the residual from a standard model of CEO pay as a function of firm size, firm

performance (3-year stock price performance), industry, and year.

Overall, I find that incoming CEO levels of pay and pay-for-performance sensitivities are

greater than or do not differ significantly from that of the CEOs they replace. The difference in

total compensation is positive and greater for outsider CEO replacements than for insider CEO

replacements. This is consistent with Murphy (2002) and Murphy and Zabojnik (2007), who

look at just the incoming CEOs and find that outsider CEO replacements receive higher

compensation than insider CEO replacements. I further find that when the CEO is forced out,

there is no significant difference between the total compensation of the incoming and outgoing

CEOs. In contrast, when the CEO leaves voluntarily, the incoming CEO is paid substantially

more than his predecessor.

In distinguishing between the competing perspectives on CEO compensation, the views

discussed above offer predictions for what we expect to observe when an incumbent CEO leaves

and is replaced. For instance, under the assumption that an outgoing CEO’s long-term

involvement as the highest executive within a firm represents enhanced power (over that of his

replacement), the managerial discretion view would predict that, in the event of a turnover, the

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outgoing CEO’s pay and “excess pay” should be higher than that of his replacement while his

pay-performance sensitivity should be lower. Furthermore, managerial discretion hypotheses

predict that these effects will be augmented (dampened) for situations in which we expect a

CEO’s bargaining power to be high (low). The overall results listed above appear to contradict

this hypothesis. That is, since I expect outgoing CEOs to have more power than their

replacements, on average, I expect their compensation levels to be higher than those of their

replacements, but find the opposite. When the replacement CEO is an insider, I presume that

since he has already been an executive at the firm for at least a few years, he would have an

existing relationship with the board of directors. This relationship, under the managerial

discretion view, should thus lead to a higher bargaining power for insider replacements than for

outsiders. Thus the results regarding outsiders are also opposite of what is expected. Further, I

interpret a forced turnover based on poor performance as representative of a situation in which

the outgoing CEO’s power over the board has been undermined. Thus, in comparison to

outgoing CEOs leaving voluntarily, the forced out CEOs have relatively less power.

Digging a little deeper, I try to determine whether the baseline results hold because

incoming CEOs are systematically higher quality CEOs. I also try to determine whether

outgoing CEOs’ power over the board has an impact on observed changes in CEO compensation

surrounding a turnover. I find that outsider replacements are paid more than their predecessors

even after controlling for skills using relative educational backgrounds (that is, the education

background of the incoming CEO compared to that of his predecessor) and previous employers’

return on assets (ROA). I further examine differences between incoming and outgoing CEO pay

and pay-performance sensitivities based on outgoing CEO founder status, ownership levels, CEO

centrality3, CEO tenure, board composition, and the firm’s governance index.4

3 Measured as in Bebchuk, Cremers, and Peyer (2007) as the percentage of total top-five executive pay received by the CEO.

I find that

incoming CEOs are paid more in option-based pay and total compensation regardless of whether

the outgoing CEO was the founder and that the differential is larger when the outgoing CEO was

the founder. Incoming CEOs are also paid more in total compensation and option-based pay

when the outgoing CEO’s tenure is greater than 4 years, when his ownership levels are high

(above average, above 5%, and above 10%), and when the board composition indicates fewer

4 The Gompers, Ishii, and Metrick (2003) G-index

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than average independent outsiders on the board.5

Taken together, the results are difficult to reconcile with the managerial power view of

executive compensation. On the one hand, we have a number of inconsistencies with the

managerial discretion hypotheses as we partition the data on the basis of managerial power.

However, as we further partition the data to classify additional distinctions of power, some

results tend to become consistent with those hypotheses while others do not. If, as is purported

by the managerial power view, a CEO’s power over the board is a primary driver of both levels

and structures of compensation, much stronger results in line with managerial power hypotheses

would be needed.

However, when the outgoing CEO’s measure

of centrality is above average and when the firm has a very high G-index, the results move in the

opposite direction – with the outgoing CEO’s pay moving to equal or exceed his replacement’s.

As yet, I am aware of only limited research that has explicitly and comprehensively

examined compensation contracts around turnover events. Rather, most papers examine

turnover in the context of its being a potential component of the overall governance package that

is designed to align managers’ incentives and curb rent extraction – that is, the threat of turnover

is typically viewed as playing a disciplinary role in the context of the manager-shareholder

agency problem. These studies typically examine the occurrence of management turnover in

relation to firm performance and other firm or market characteristics.6

In spirit, this paper resembles a varied set of studies regarding CEO compensation.

Gilson and Vetsuypens (1990) examine the nature of compensation packages for financially

distressed firms and include a discussion of changes observed when a turnover event occurs

within this set of firms. They find that, within a small sample of financially distressed firms,

when a turnover occurs, insider replacement CEOs are paid substantially less than their

predecessors, but outsider replacement CEOs are paid substantially more. Murphy (2002)

compares levels of CEO pay for insider and outsider replacement CEOs, finding that outsider

replacements are typically paid more than insider replacements. This study expands upon

Murphy (2002) in two major ways. First, I examine differences between the incoming and

outgoing CEOs in turnover events, rather than differences between replacement CEOs’ pay

5 I use 4 years as a threshold based on evidence found by Gregory-Smith, Thompson, and Wright (2009) that probabilities of CEO dismissal decline after the 4th year and this appears to be due to entrenchment effects. 6 See, for example, Denis, Denis, and Sarin (1997); Coughlan and Schmidt (1985); Murphy and Zimmerman (1993); Huson, Parrino, and Starks (2001); Goyal and Park (2001); Lehn and Zhao (2006)

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based on whether they are insiders or outsiders. Second, in an attempt to explain observed

changes in compensation surrounding turnover events, I extend the investigation to incorporate

CEO skills and additional measures of a CEO’s power over the board. Two other papers directly

expand upon Murphy (2002). Blackwell, Dudney, and Farrell (2007) examine changes in

compensation structure following turnover events and relate those changes to firm performance.

Theyfind that incoming CEOs’ compensation is comprised of significantly more equity-based

pay and a positive association between post-turnover performance and new stock grants. Elsaid

and Davidson (2009) examine differences between incoming and outgoing CEO pay and the

percentages that salary and “pay-at-risk” (i.e. stock and option grants) contribute to total

compensation surrounding turnover events.

This paper complements and extends these papers along several lines. First, I examine a

much more comprehensive set of potential CEO compensation determinants and attempt to

differentiate between CEO, turnover, and firm characteristics that may contribute to managerial

power in a positive way and those that may contribute to some types of “inappropriate”

managerial power (i.e. power over the board based on relationships and/or entrenchment effects).

Second, a large part of the focus in both papers is on changes in the structures of compensation

packages. This paper examines compensation structure as well as changes in levels of pay and

relates them to relative managerial power. Finally, I seek to distinguish between competing

views of executive compensation within the literature, as discussed above. Thus, there is some

emphasis on managerial power and examining its impact on executive compensation.

The remainder of this paper is organized as follows: Section II describes the sample;

Section III contains the preliminary results; Section IV contains additional analysis regarding

what we happens to CEO compensation when a turnover event occurs; and Section V concludes.

II. Sample Selection and Summary Statistics

II.1 Sample Selection

The initial sample is collected from the Standard & Poor’s ExecuComp database, which

provides information on firms in the S&P 500, the Midcap 400, and the Smallcap 600, between

1993 and 2006. Data collected includes CEOs’ cash pay, total compensation including the value

of option grants and other forms of pay, tenure as CEO, and CEO percent equity ownership in

the firm. ExecuComp provides information regarding the years during which an executive

becomes the CEO and leaves office as CEO. Outgoing CEOs are identified by the year in which

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they leave office as CEO. Incoming CEOs are identified by the year in which they become

CEO. The sample of turnovers is then constructed by matching outgoing and incoming CEOs on

firm and year. The sample is then limited to those observations for which salary, bonus, and

total compensation data is available for the last full year of pay of the outgoing CEO and the first

full year of pay of the incoming CEO. This results in 1,232 turnover events over the 13 year

period.

II.1.1 Nature of Turnover

To identify the nature of the sample turnovers, I search the Factiva and LexisNexis

databases for news articles around the time period and announcements of CEO appointments.

Forced turnovers are identified by searching through news around the time period and

announcements of CEO appointments. A turnover is classified as forced if an article is found

describing an ouster of the outgoing CEO or a pressured resignation amidst any of the following:

federal or state investigations, shareholder lawsuits, or poor firm performance. Overall,

approximately 15% are forced turnovers, either as direct firings or pressured resignations. The

rest of the turnovers’ natures breakdown as follows: approximately 70% represent planned

retirements or normal successions, approximately 5% represent resignations that were not forced

(for various reasons, such as “to pursue personal interests”), 2.3% represent deaths or

incapacitating illnesses, 4% represent CEOs leaving for to take new positions, 2% represent

CEOs leaving due to a merger or spinoff. The remainder represent various other reasons with

very few cases, such as the firm deciding to separate the positions of CEO and chairman.

It is quite possible that within the 75% of turnovers listed above as being either planned

retirements, normal successions, or resignations not classified as forced, some have been mis-

classified. As discussed by Denis and Denis (1995) and previously noted by Warner, Watts, and

Wruck (1988) and Weisbach (1988), press releases often do not specifically state that a CEO has

been fired or ousted even when this is the case. Thus I further analyze the sample of forced

turnovers to determine whether they compare with those classified as voluntary in a way that

would be expected. First, prior literature has classified forced turnovers as a percentage of all

sample turnovers in percentages ranging from 7.3% to 24%. It is important to note here that this

rather significant variation stems from alternative specifications of forced turnovers. Here, the

classification of a forced turnover is relatively conservative and results in a sample for which I

am confident that the change is forced. This classification is consistent with Denis and Denis

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(1995). Others classify turnovers as forced on slightly looser criterion: Parrino (1997), Parrino,

Sias, and Starks (2003), and others classify additional turnovers as forced if the CEO is under 60

years of age and the news announcements regarding the turnover do not specify the cause as

being death, illness, or departure for a new position. This typically results in a slightly higher

sample representation for forced turnovers.

To further check my sample of forced turnovers, I compare firm performance,

prevalence of outsider replacements (specification of these is discussed below), and CEO age for

forced vs. voluntary turnovers to ensure that the differences are consistent with expectations. For

forced turnovers, we expect to observe significantly worse firm performance, more outsider

replacements, and younger outgoing CEOs. The differences are as expected: Average 3 years

stock price performance of firms involved in forced turnovers is approximately -5.3% while that

for firms involved in voluntary turnovers is approximately 9.6%; on average, outsiders are

appointed as CEO 44.7% of the time when the turnover is forced and approximately 30% of the

time when the turnover is voluntary; and the average age of forced-out CEOs is 56 years of age

in comparison to 63 years of age for voluntarily leaving CEOs. The differences between these

values for forced vs. voluntary turnovers are all significant at the .01 level.

II.1.2 Insider/Outsider Status

Data regarding the CEOs specifically are collected from Bloomberg People Search.

Bloomberg People Search provides profiles including educational history, career history, and

board memberships. CEOs are classified as insiders if they have a prior employment history

with the firm in which they become CEO. Specifically, where available, if the Bloomberg

People Search career history indicates employment with the firm in positions other than CEO

prior to the appointment, they are considered insiders. If the career history indicates that the

individual has worked for the firm for less than 3 years and that they came in at a high-level

executive rank, he is considered a “recent insider”. Otherwise, he is considered an outsider.

“Recent insiders” deserve a brief discussion here. Where possible, these are verified

through news announcements of the appointment. They represent cases in which the

replacement CEO was hired away from another firm with the likely outcome that he would take

over as CEO, but start off as COO or CFO. Since they were almost all hired specifically for the

purpose of fulfilling a normal succession plan and since, prior to their hire, they had no

employment through the firm, in the subsequent analysis, I combine the set of “recent insiders”

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with outsiders. Where Bloomberg People Search career histories are unavailable, Execucomp

data is used to determine insider/outsider status. This occurs in few cases, but represents

approximately 5% of the sample of incoming CEOs. In this case, CEOs are considered insiders

if 1) the first year of the CEO’s employment at the firm (according to ExecuComp) differs from

the year in which he becomes CEO and 2) the executive appears in the ExecuComp database for

that firm for the year prior to the year in which he becomes CEO.

II.2 Summary Statistics

II.2.1 Turnover Characteristics

Table 1 and Figure 1 present a time profile of the turnover events. With the exception of

1993, each year represents at least 5% of the sample of turnovers, with proportional

representation rising to over 10% in 2000. Overall, there were more turnovers during the

subperiod 2000-2005 than the earlier subperiod 1993-1999. The percentage of turnovers that

were forced in any given year is typically between 10% and 15%.

II.2.2 Compensation Characteristics

Table 2 presents summary statistics regarding the compensation of the CEOs in the

turnover sample. Overall, mean (median) CEO cash pay and total pay are, respectively, $1.36

million ($957,526) and $4.39 million ($2.24 million). Median CEO ownership of the firm for

outgoing CEOs is 1.4%, almost double the median for their replacements of .76%. At a glance,

the figures in Panels B and C do not appear, other than ownership, to be significantly different

from each other, including option grants. Figure 2 presents the percentage of total CEO

compensation that is option-based. As a form of equity-based pay whose use has increased

dramatically over the last several decades (both domestically and internationally), stock options

are a main component of incentive-based pay and a large contributor to pay-performance

sensitivities7

III. Baseline Results

. The data in Figure 2 show that incoming CEO option-based pay as a percentage of

total compensation is higher in every year.

III.1 Univariate Analysis: Differences in Pay

Table 3 presents the differences from paired CEOs surrounding the sample turnover

events. The outgoing CEO’s last full year of pay is subtracted from the incoming CEO’s first

7See Jensen and Murphy (1990); Yermack (1995); Hall and Liebman (1998); Hall (2003); Bebchuk and Grinstein (2005); Murphy (2003); Bryan, Nash, and Patel (2006); Bechman and Jorgensen (2004

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full year of pay. Univariate analysis is then run on the differences. The first column shows the

differences for the entire sample of turnovers. Overall, there does not appear to be a significant

difference between incoming and outgoing CEO pay levels. Both mean and median cash pay as

well as mean total pay are not significantly different.8

Consistent with Murphy (2002), the second two columns show that outsider replacement

CEOs, at the median, typically make $335,360 more than their predecessors while insiders are

typically paid only $126,156 more than their predecessors. Table 3 also shows that there is no

significant difference between incoming and outgoing CEO total compensation when the

turnovers are forced. However, we observe significantly higher total compensation for incoming

CEOs when the turnovers are voluntary. Again, this contradicts the managerial discretion

hypotheses, presuming that the poor performance resulting in a forced turnover has undermined

the outgoing CEO’s power over the board.

However, median total pay differences

indicate that replacements make a statistically significant $159,560 more in total compensation

than those whom they are replacing. Both option-based pay and its relative contribution to total

compensation are significantly higher for replacement CEOs than for those whom they are

replacing. Incoming CEOs are paid, at the median, $296,130 more in options than the CEOs

they are replacing. Furthermore, the percentage of total compensation that is option-based for

incoming CEOs is almost 8% higher than that for their predecessors.

The last two columns of Table 3 show differences between incoming and outgoing CEO

pay based on whether the outgoing CEO received “excess pay”. Using an approach similar to

Hartzell, Ofek, and Yermack (2004), I calculate “excess pay” as the residual from a basic

regression model. That is, using the entire universe of ExecuComp data, I run the following

regression:

CEO Pay = log(MktCap) + 3-year stock returns + Industry Dummies + Year Dummies.

CEO Pay represents total compensation including restricted stock, payouts from long-

term plans, benefits, and stock options valued at the grant-date using ExecuComp’s modified

Black-Scholes methodology. Log(MktCap) is the log of number of shares outstanding

8 Total pay and total compensation are terms used interchangeably throughout this analysis and represent the total compensation figures provided by ExecuComp including total cash pay, stock options, restricted stock, payouts from long-term plans, and benefits. Stock options are valued at the grant-date using ExecuComp’s modified Black-Scholes methodology.

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multiplied by the year-end stock price. The residuals for the sample of turnover CEOs are

retained and used as an estimate of “excess pay”.

Interestingly, Table 3 shows that when the outgoing CEO’s “excess pay” ≤ 0, his

replacement is much more consistently paid more than he was and vice versa. That is, when the

outgoing CEO’s “excess pay” ≤ 0, the median replacement CEO is paid $490,343.50 more than

his predecessor. When the outgoing CEO’s “excess pay” > 0, his replacement is paid $275,269

less than his predecessor. This suggests that “excess pay” may very well be a good proxy for

managerial bargaining power and also provides some support for the managerial power theory.

Alternatively, this could be a function of mean reversion in levels of compensation.

Core, Guay, and Larcker (2008) document “strong mean reversion in pay among the general

population of highly paid CEOs.” Examining non-turnover years relative to “excess pay” does

reveal some evidence of mean reversion. That is, approximately 67% of CEOs who receive

“excess pay” > 0 in a given year subsequently see a drop in their pay the following year. When a

CEO receives “excess pay” > 0, the median change in pay for the following year is $-158,408.

When a CEO receives “excess pay” ≤ 0, approximately 50% subsequently see a drop in the pay

the following year, but the median change in pay for the following year is $298,174.50. For the

entire sample of 15,996 CEO-year observations, I observe that approximately 36% receive

“excess pay” > 0. Of those observations, approximately 40% receive “excess pay” ≤ 0 the

following year while the remaining 60% continue to receive positive “excess pay”. So, it is clear

that, at best, “excess pay” can be a rough proxy for managerial power. Consequently, I do not

focus additional analysis on “excess pay”, but rather try to examine other potential proxies for

managerial power in subsequent sections.

III.2 Multivariate Analysis: Levels of Pay

Table 4 presents multivariate analysis of CEO compensation surrounding the turnover

event. The outgoing CEOs’ last full year of pay and the incoming CEOs’ first full year of pay

are used. The regression follows similar lines and uses determinants identified in several prior

studies including Core, Holthausen, and Larcker (1999), Brick, Palmon, and Wald (2006), and

Graham, Li, and Qiu (2008). The regressions specification is as follows:

sYearDummiemmiesIndustryDuExcessNewceoInsiderNewceoNewceoevceoNummtgs

InterlockTenureipCEOOwnershExecDirAssetsCEOPay

++++++

++++++=**Pr

)log(109876

543210

βββββββββββ

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Here log(assets) is the log of total assets, ExecDir is a dummy which equals 1 if the CEO

is on the board of directors. Ownership is the shares owned by the CEO. Tenure is the number

of years the CEO has been active in his current position. Interlock is a dummy which equals 1 if

the CEO is listed as a member of the executive compensation committee. Num Mtgs is the

number of board meetings during the year. Prevceo is a dummy variable which is equal to 1 if

the CEO has previously been a CEO at another firm. Newceo is a dummy variable equal to 1 if

the CEO is an incoming CEO, Insider is a dummy variable equal to 1 if the CEO is an incoming

CEO who came from within the firm, and Excess is a dummy variable equal to 1 if the outgoing

CEO was paid “excess pay” > 0. As we expect, the coefficient on log(Assets) is positive and

significant, consistent with the literature. Tenure has a positive and significant impact on cash

pay, but is insignificant in the total compensation regressions. Interlock is negative and

significant, indicating the CEO participation in the executive compensation committee actually

has a negative impact on both his cash pay and his total compensation. The coefficient on

Prevceo is positive and significant in the total compensation regressions, indicating that prior

experience at the level of CEO results in higher subsequent levels of pay. Results here, as above

in the univariate analysis, also indicate that there is little of significance in the difference

between replacement CEO pay and outgoing CEO pay. The coefficient on Newceo is significant

for only two of the cash pay regressions and not significant for total compensation. The

coefficient on Newceo*Insider is negative and significant for both cash pay and total

compensation. Thus, it appears that insider status has a negative impact on levels of pay.

III.3 Multivariate Analysis: Pay-Performance Sensitivities

Thus far, I have examined pay-performance sensitivities by comparing option-based pay,

as in Table 3, and found that they are consistently higher for replacement CEOs than for

outgoing CEOs. However, as pay-performance sensitivities broadly incorporate any adjustments

made to pay in response to firm performance, option-based pay is not the only way through

which pay-performance sensitivities can be impacted. Virtually all components (salary, bonus,

stock grants, and stock holdings in addition to option grants) of a CEO’s compensation can be at

least partially tied to firm performance. Furthermore, though compensation is potentially tied to

various accounting measures of firm performance, the ultimate goal of a compensation package

is to ensure that managers behave in the shareholders’ best interests. Thus, the most appropriate

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way to link pay to performance is often considered to tie compensation to stock price

performance. One way to examine pay-performance sensitivities is to quantify the impact that

changes in shareholder wealth have on changes in CEO pay from year to year. Jensen and

Murphy (1990) and a multitude of subsequent papers quantify this impact by regressing changes

in CEO pay on changes in shareholder wealth.

Table 5 presents multivariate analysis of pay-performance sensitivities measured in this

way surrounding the turnover event. Change in pay between the last two full years of pay for the

outgoing CEO and the first two full years of pay for the incoming CEO are used to perform the

following regression:

InsiderNewceorWealthShareholdeNewceoExcessrWealthShareholdeNewceorWealthShareholdeipCEOOwnershExecdirrWealthShareholdeCEOPay

*****

6

54

3210

∆+∆+∆+

++∆+=∆

βββ

ββββ

If anything, the overall evidence in Table 5 indicates pay-performance sensitivities

measured in this manner appear to be lower for replacement CEOs. The coefficients on

Newceo*ΔShareholder Wealth is negative and significant for changes in cash pay and not

significant for changes in total pay. However, insider replacement CEOs do appear to be

subjected to higher pay-performance sensitivities, as evidenced by the significant and positive

coefficient on Newceo*Insider*∆Shareholder Wealth.

IV. Additional Analysis

IV.1 A Closer Look at CEOs

The initial results described above show mixed results with regards to what happens to

CEO compensation when a turnover event occurs. We have seen that levels of total

compensation are higher for incoming CEOs overall, that the differential between incoming and

outgoing CEO pay is greater for outsider CEO replacements than for insider CEO replacements,

and that there is no significant difference between incoming and outgoing CEO pay when the

turnover is forced. These results are difficult to reconcile with the managerial discretion view of

CEO compensation. As discussed in previous sections, I expect an outgoing CEO to have more

managerial power than his replacement simply by virtue of his standing position and relationship

with the board of directors. Furthermore, insiders (who have served as other high level

executives of the firm and are also expected to have a relationship with the board of directors)

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are expected to have higher managerial power than outsiders and outgoing CEOs who are forced

out are expected to have lower managerial power than outgoing CEOs who leave voluntarily.

Thus, managerial discretion hypotheses predict the opposite result to those listed above.

However, the initial results do not address the possibility that observed differences in

CEO pay between outgoing and incoming CEOs are driven by CEO characteristics not yet

examined. That is, I posit that there are two sources of managerial power: 1) managerial skill,

ability, and effort (skill-based power) and 2) power over the board of directors (board-based

power). Both sources of managerial power are expected, under the managerial discretion view,

to cause increases in executive compensation. However, only the second results in inefficient

levels of pay or inefficient compensation structures. Thus far, the analysis has made no

distinction between the two sources of managerial power. It may be possible, however, that

managerial skill overwhelms managerial power over the board of directors in many cases. If this

is the case, then what we observe above reflects systematically higher quality replacement CEOs

(than the managers they replace), that outsider replacements are systematically higher quality

replacements than insider replacements, and that firms recruit higher quality CEOs when their

own CEOs leave voluntarily than when they fire their CEOs

In this section, I more closely examine CEO characteristics to see whether they can

explain what we observe in the preliminary analysis section. In an effort to determine which

contributor to CEO compensation (skill-based power or board-based power) seems to drive my

results, I examine characteristics expected to be tied to CEO skill alongside characteristics

expected to be tied to the CEO’s relative power within the organization (i.e. power over the

board). In particular, for skill-based power, I examine the impact of education and the

insider/outsider specification and prior firm performance where possible on the pay of incoming

and outgoing CEOs surrounding a turnover. For board-based power, I examine the impact of

founder status, tenure, high equity ownership, board composition, the GIM-index, and CEO

centrality.

These are all considered throughout the literature to be associated either directly with

managerial power (as in founder status, tenure, and CEO centrality) or indirectly via their impact

on the quality of governance mechanisms. Donaldson and Lorch (1983), Finkelstein (1992), and

Adams, Almeida, and Ferreira (2005) are just a few of the papers that discuss the increased

influence of ownership and founder status on the board of directors. Tenure as CEO

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undoubtedly is positively associated with a CEO’s influence over the board. Furthermore,

Gregory-Smith, Thompson, and Wright (2009) find that the likelihood of CEO departure drops

dramatically after a CEO’s fourth year in office and that this appears to be due to CEO

entrenchment.

Bebchuk, Cremers, and Peyer (2007) find that CEO centrality (measured as the

percentage of top five executive total pay received by the CEO9

The GIM index constructed by Gompers, Ishii, and Metrick (2003) has largely been used

to measure the quality of corporate governance. It is constructed by summing indicators for

various 24 charter provisions, bylaw provisions, and other firm-level rules associated with hostile

bidders, voting rights, director/officer protection, other takeover defenses, and state laws. A

higher index score represents greater managerial power and weaker shareholder rights.

) is negatively associated with

firm value and correlated with a broad set of firm behavior and performance including higher

“pay-for-luck” (either in the form of a “lucky” option grant at the lowest price of the month or in

a lower tendency for the firm to filter out industry and/or market-wide returns before rewarding

the CEO for performance) and lower likelihood of CEO turnover. Independent (or outside)

board members are expected to be farther removed from the CEO (and have a more tenuous

relationship with the CEO) and thus are expected to have a negative impact on managerial

power. However, Cyert, Kang, and Kumar (1997) find a positive association between CEO

compensation and percentage of outside directors on the board.

I also examine the compensation of both outgoing CEOs who obtain subsequent positions

as high level executives at other firms as well as outsider replacement CEOs who had recent

prior high level executive positions at other firms.

IV.1.1 Insider/Outsider and Founder Summary Statistics

Before examining the impact of certain CEO characteristics on CEO pay, I first examine

the composition of my set of CEOs and their characteristics. 25.4% of insider replacements have

an MBA, 4.3% have participated in an executive management program, 4.2% are CPAs, 10.3%

have master’s degrees, 4.4% have PhDs, and 7% have law degrees. On average, it appears that

the education levels are higher for outsider replacement CEOs. 27.9% of outsider replacements

have an MBA, 6.1% have participated in an executive management program, 4.1% are CPAs,

9 As in Bebchuk, Cremers, and Peyer (2007), CEO centrality is measured by aggregating the total compensation of the top 5 executives at each firm. CEO centrality is then calculated as the total compensation of the CEO divided by the aggregated total of the top 5 executives.

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16.8% have master’s degrees, 7.4% have PhDs, and 3% have law degrees. Outsider CEOs also

appear to have more board memberships, both at the time of the turnover (1.8 vs 1.5) and over

their lifetimes (4.8 vs 3.5). Where available, “excess pay” is determined for outsider CEOs at

their previous firms. Approximately 36% of these CEOs received “excess pay” > 0 at their

previous jobs. The average return on assets (ROA) at the previous companies the outsider CEOs

were employed at is 4.82%. On average, insider CEO replacements own a higher percentage of

the firm than outsider CEO replacements in the year following the appointment (1.2% vs. .83%),

but measure approximately the same CEO centrality as outsiders (~24%).

Founder status is identified via a combination of Bloomberg People Search, news

searches, online company histories, and company web-sites. Specifically, when Bloomberg

specifies that a CEO is a founder, this is used. If the CEO is not identified as a founder, the news

search regarding the turnover event is double-checked for any background information on the

individuals. This allows for a designation of both founder status and family status. If founder

status is still not found through either of these sources, I search for company histories online

using Google. If founder status is still not found, I go directly to the company’s web-site.

Regarding CEO characteristics of founder vs. non-founder outgoing CEOs, only 8.8% of

founders have MBAs, less than 1% are CPAs, 9.9% have Master’s degrees, 7% have earned a

PhD, and 4.1% have earned law degrees. On average, they hold 1.7 board seats at the time of the

turnover and 3.6 board seats over their careers. Average tenure for founders is 12 years, a

statistically significant (at the .01 level) 5 years greater than for non-founders. Founders also

own a significantly larger proportion of the firm in comparison to non-founders (3.98% vs. 1.02).

This difference is also significant at the .01 level. CEO centrality is also higher for founders, but

this difference is only significant at the .1 level and is only 1%. Only 25.7% of founders have

“excess pay” > 0. In contrast, among non-founders, 36.5% have “excess pay” > 0. Almost twice

as many non-founders have MBAs. More non-founders also hold master’s degrees, participated

in an executive management program, or are CPAs. Non-founder CEOs also hold more board

memberships both at the time of the turnover (2.3) and over their careers (4.9).

IV.1.2 Univariate Analysis: Skill-Based Managerial Power

IV.1.2.1 Education

Table 6 shows additional univariate analysis of differences in pay based on

insider/outsider status and education. Prior literature has established a potential shift in the

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relative desirability of general managerial skills and specific managerial skills. Murphy and

Zabojnik (2007) argue that such a trend has occurred, making the “skills critical in leading a

complex modern corporation but not specific to any organization” more important over recent

years than the “skills, knowledge, contacts, and experience valuable only within the

organization.” In support of their argument, they document a parallel between rises in CEO pay,

increases in CEOs holding MBA degrees, and decreases in managerial firm-specific experience.

Thus, these two categorizations are made to distinguish between skills expected to be useful for

all high-level management regardless of firm and those that firm- or industry-specific.

Educational background is used as a rough proxy for these types of skills. As in Murphy

and Zabojnik (2007) and Palia (2000), I consider whether the CEO has obtained an MBA or law

degree. I additionally consider whether the CEO has completed an executive management

program and whether he is a certified public accountant to be representative of general

managerial skills. Firm- or industry-specific skills are proxied for by more specific educational

attainment including professional certifications (such as Professional Engineer) and master’s

degrees and PhDs in specific fields (such as engineering or computer science.

To aggregate the educational information acquired through Bloomberg PeopleSearch, I

construct two variables: general_skills and specific_skills. These variables are the sums of

dummy variables to indicate whether the CEO has completed these various degrees and/or

programs. Specifically,

• General_skills = mba + cpa + lawyer + executive management program

• Specific_skills = masters degree + phd + certification

These variables are constructed for each of the CEOs. Then, the value for incoming

CEOs is subtracted from that for outgoing CEOs to determine the relative education levels of the

CEOs involved in the turnover event.10

Panel A of Table 6 shows the differences in pay levels between incoming and outgoing

CEOs on the basis of “general” and “specific” skills. The first two columns show differences on

the basis of whether the replacement CEO has a higher level of “general_skills” than the

outgoing CEO. Interestingly, though the differential is higher for replacement CEOs with a

10 The literature handles education in a multitude of ways, none of which are identical to this method. There is some support for examining education in this way, however. Gottesman and Morey (2006) assume that higher levels of education equate with higher quality educations (that is, CEOs with graduate degrees have had a higher quality education than those without)

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higher level of “general_skills”, even those replacement CEOs who have lower or equal levels of

“general_skills” are paid more (at the median) than those they replace. Also interesting is that

only around 12.8% of the replacement CEOs have higher general skills/education than those they

replace. Options granted are higher for replacement CEOs regardless of relative

“general_skills”, but option-based pay (as a percentage of total compensation) is only higher for

CEOs with “general_skills” lower than or equal to the outgoing CEO.

The other columns in Panel A of Table 6 show the differences based on “specific_skills”.

It is interesting here to note that when the replacement CEO has higher “specific_skills” than the

CEO he is replacing, there is no difference in pay between the two, though he is still paid more

than the outgoing CEO if his “specific_skills” are lower than or equal to the outgoing CEOs.

This counterintuitive result suggests that the parameters contributing to the “specific_skills”

variable do not drive compensation levels. Again, it is interesting to note that only

approximately 13% of the replacement CEOs have higher specific skills/education than those

they replace. Regarding option-based pay, we see a similar result to above regarding

“general_skills”. Overall, Panel A shows that neither differences in “general_skills” nor

differences in “specific_skills” can explain the overall positive differential between incoming

and outgoing CEO pay. That is, Table 6 shows not only that is it relatively rare for the incoming

CEO to possess higher “general” or “specific” skills than his predecessor, but that even when he

does not, he is still paid more than his predecessor. Next, I examine the impact of managerial

skill on the differentials we observe when replacement CEOs are insiders vs when they are

outsiders.

Though it appears to be inconsistent with the managerial discretion view of CEO

compensation that outsider replacement CEOs would be paid more than the CEOs they replace

and that the differential would be greater for outsider replacements than for insider replacements,

other forces could be driving this result. In particular, it could be the fact that outsider

replacements are systematically higher quality CEOs (than both those they replace and potential

insider candidates). If this is the case, we would expect to see some different results regarding

CEO characteristics and insider/outsider status. For instance, if general managerial skills are

highly valued and this drives the result regarding outsider replacements, then we would expect to

see both that outsider replacements have higher general managerial skills than those whom they

replace and that the differential results we have seen above hold only for the group of outsider

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replacements who have higher general managerial skills. We would also expect to see that there

are relatively less insider replacements with higher general managerial skills than outsider

replacements.

Panel B of Table 6 shows the differences in pay levels on the basis of insider/outsider

status and education levels. Interestingly, outsiders are paid more than their predecessors

regardless of whether their “general_skills” are higher than those of their predecessors, though

the differential is larger when the incoming CEO has a more comprehensive general education.

Furthermore, only 62 of the 332 outsider replacements have higher general skills/education than

those they replace. This represents approximately 15% of the outsider CEOs, slightly higher

than the 12.8% found overall for replacement CEOs, but is still remarkably low. One interesting

and counterintuitive result is that insider replacements are paid more than their predecessors only

if their “general_skills” or “specific_skills” are less than those of their predecessors. This seems

to indicate that skills (as proxied by education) does not drive pay differentials between

incoming and outgoing CEOs when the replacement is an insider.

IV.1.2.2 Outsider Replacements’ Prior Performance

In contrast to proxying for skills using relative education, an alternative is to examine the

prior performance of the outsider replacement CEOs. Though this allows for a limited analysis

of a much smaller subset of the turnovers, it may be able to shed light on whether, at least for

these outsider replacements, our differences in pay between the replacements and their

predecessors are driven by skill. I first obtain information about outsider replacement CEOs

prior compensation and compare that to the compensation they receive one year after the

turnover event. The prior compensation data is obtained through Execucomp. There are

approximately 160 outsider replacement CEOs for whom this data is available. On average,

these incoming CEOs receive a pay increase of $860,954 in total cash compensation (salary +

bonus) and a raise of $2,203,280 in total compensation. Approximately 37% of them received

“excess pay” > 0 at their previous jobs.

Panel A of Table 7 shows differences for just these outsider CEO replacements based on

the performance of the firm at which they were previously employed and based on whether they

received “excess pay” at the firm at which they were previously employed. On average, the

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ROA of these firms (at which outsider CEO replacements were previously employed) is 4.8%. I

thus use 4.8% as the threshold for above average performance.11

The first columns show that when the outsider replacements come from firms at which

the ROA > 4.8%, they are paid substantially more than the CEOs they are replacing, but when

their previous employer’s ROA < 4.8%, only cash compensation and option-based pay are higher

than the CEOs they are replacing, while total compensation is not significantly different. Thus, it

appears that prior firm performance for outsider replacements does indeed explain part of the

differential. However, the results regarding the CEOs whose prior performance was average or

worse are still inconsistent with the managerial power hypotheses. These CEOs still get paid as

much as their predecessors who should have more managerial power over the board and thus be

paid more. Furthermore, their cash pay is still higher than their predecessors’. Since a CEO’s

preference is, wherever possible, going to be certain cash pay over uncertain equity-based pay,

managerial power hypotheses predict that, as power increases, cash pay will increase and pay-

performance sensitivities will decline. Thus, under managerial power, we would expect this

subset to be paid less cash pay and more option-based pay than his predecessor. While option-

based pay is, indeed, higher for the replacements in this scenario, the differential is not

substantially different from the replacements whose prior firm performance is above average (at

the median, option-based pay for those whose prior firm performance is average or worse is

11.9% higher than their predecessors vs. 11% for those whose prior firm performance is above

average).

The latter columns show that when the outsider replacements did not receive “excess

pay” at their previous firm, they are paid significantly more than the CEOs whom they replace,

but when they did receive “excess pay” previously, only their cash compensation is higher than

the CEOs they replace. This is a somewhat puzzling result, particularly for the managerial

discretion hypotheses. Bebchuk, Fried, and Walker (2004) argue that outsider replacements who

are previously CEOs at other firms have already been exercising their discretion at these other

firms to extract rents and pay packages reflect this. They then further argue that, in order to

entice these executives to change employers, the rents extracted at the prior firm must be met by

the new firm. The expectation, then, is that those outsider CEO replacements who received

“excess pay” at their prior firms would be paid more than those who did not. This would then

11 However, the results listed below hold if industry-adjusted ROA is used instead with a threshold of 0%

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imply that differentials between incoming and outgoing CEO pay for these CEOs would be

greater than for those not receiving “excess pay” at their prior job. What we observe is the

opposite.

The final univariate check with regard to CEO skill-based power that I perform reflects

univariate differences in pay based on whether the outgoing CEO achieves subsequent

employment as a CEO elsewhere. This set may reflect outgoing CEOs with above average

abilities and thus may be able to shed some light on what we observe with regard to changes in

CEO pay surrounding turnover events. I first gather information about the compensation of

outgoing CEOs who subsequently obtain employment at other firms as CEOs. The subsequent

employment data is gathered through Execucomp. There are 80 CEOs for whom I find definite

new employment as a CEO within 3 years of the turnover event. Of these, subsequent

compensation data is available for half (40 outgoing CEOs). On average, the differences

between the total cash compensation and total compensation for the outgoing CEOs at the new

firm and at the turnover firm are $152,559.50 and $5,184,886. Approximately 35% of these

outgoing CEOs received “excess pay” > 0 at the turnover firms. Approximately 55% of them

receive “excess pay” > 0 at the subsequent employers. Panel B of Table 7 shows differences

between incoming and outgoing CEO pay surrounding the turnover event based on whether the

CEOs obtain subsequent employment. When the outgoing CEO does find subsequent

employment within 3 years of the turnover, there is no significant difference between his cash or

total compensation and that of his replacement. However, when he does not find subsequent

employment, the results more closely mirror our overall results (higher total compensation and

option-based compensation for the incoming CEO). We would have expected the opposite

results. Thus it appears that subsequent employment as a proxy for outgoing CEO skill also

cannot explain our overall results.

IV.1.3 Univariate Analysis: Board-Based Managerial Power

We have seen that the preliminary results regarding differences in pay can, at best, only

be partially explained by our proxies for CEO skill. Next we turn to whether they can be

explained by proxies for managerial power. For this analysis, we examine the impact of board

composition, founder status, CEO centrality, CEO tenure, CEO firm ownership, and GIM-index

on compensation surrounding the turnover events.

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Panel A of Table 8 shows differences between incoming and outgoing CEO pay when the

outgoing CEO is the founder and when he is not the founder. We would expect founders to have

more power over their boards. However, while in both categories outgoing CEOs are paid less

than their replacements, but the differential is larger when the outgoing CEO is the founder

rather than when he is not the founder. Whatever board-based power a CEO may derive via his

status as founder of the firm does not drive our results regarding overall differences in pay.

Thus, we again see results in direct opposition to what we would expect under the managerial

discretion view.

Another proxy for board-based managerial power is CEO centrality, as discussed above.

Panel A of Table 8 also shows univariate differences results based on whether CEO centrality is

above or below average. When CEO centrality is average or below average, the incoming CEO

makes significantly more in total cash pay, option-based pay, and total compensation. On the

other hand, when CEO centrality is above average, the outgoing CEO makes more in total cash

pay and slightly less option-based pay. Total compensation does not significantly differ between

incoming and outgoing CEOs within this set of turnovers. These results move in the direction

that the managerial discretion view would expect. However, only cash pay results match

predictions that would stem from the managerial discretion view. That is, here managerial

discretion would predict higher cash and total pay for the outgoing CEO based on his enhanced

power over the board (as reflected by his high value for CEO centrality). Furthermore, since any

manager will prefer riskless pay to risky pay, all else equal, we would expect the option-based

pay differential here to increase. That is, the managerial discretion view would also predict that

the incumbent CEO would exercise his power over the board to reduce his exposure to risk,

increasing any non-performance based pay and decreasing the performance-based pay. This

gives ambiguous predictions on levels of options granted, but not on option-based pay as a

percentage of total pay. But what we observe is that, while for average to low CEO centrality,

the difference in option-based pay is 9.5%, for above average CEO centrality, it is a mere .3%.

If founder status and CEO centrality cannot explain our results, perhaps a simple look at

tenure or ownership can. Table 8 displays univariate differences results for tenure and above and

below average levels of CEO ownership. Tenure-based results are based on whether or not CEO

tenure is greater than 4 years. I use 4 years as a cutoff based on Gregory-Smith, Thompson, and

Wright (2009), who find evidence of entrenchment effects and lower probabilities of forced

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turnovers after the fourth year in office. When CEO tenure is 4 years or less at the time of the

turnover, his replacement is paid more total cash pay and more options and option-based pay.

His total compensation does not significantly differ from that of his replacement. On the other

side, when tenure is greater than 4 years (and he is presumably entrenched), his replacement

makes slightly less in cash pay, more in options and option-based pay, and significantly more in

total compensation. If this enhanced power over the board results in managerial manipulation of

pay levels and structure, we would expect to see that the outgoing CEOs whose tenures were

longer than 4 years would be paid more than their replacements.

We observe similar results regarding CEO ownership in the firm. Using average

outgoing CEO firm ownership as a threshold, table 8 shows that incoming CEOs are paid more

than their predecessors regardless of whether the outgoing CEO has below average or average

levels of firm ownership or whether he has above average levels of firm ownership. The

differential, however, increases for the group for which CEO firm ownership is above average.

That is, if CEOs own 1.4% of the firm or less, their replacements make a statistically significant

$128,210 more than they do while if CEOs own more than 1.4% of the firm, their replacements

make a statistically significant $343,480 more. This, too, is inconsistent with managerial

discretion hypotheses. Presuming that higher levels of ownership result in higher managerial

power, we would expect to observe the opposite results under managerial discretion.

Admittedly, ownership is a slightly more complicated issue since it is also shown through

the literature to effectively align managers’ incentives with those of shareholders in a manner

similar to what compensation packages attempt to do. Thus, it is quite possible that

compensation levels are lower for CEOs with high levels of ownership in the firm because the

need to align their incentives with those of shareholders is reduced by their ownership levels.

Morck, Shleifer, and Vishny (1988), Hermalin and Weisbach (1987), and McConnell and

Servaes (1990) demonstrate a non-monotonic relationship between firm value and insider

ownership that is believed to reflect the trade-off between the incentives and entrenchment

effects of ownership. They all show that concentrated ownership first enhances firm value, but

then, at differing thresholds, starts to detract from firm value. It is important to note, however,

that none of this detracts from the expectations that higher levels of CEO firm ownership result

in higher managerial power over the board. However, in untabulated results, the analysis is run

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with higher thresholds (5% and 10% firm ownership).12

It could be that differences in pay are driven by firm-level governance characteristics

rather than CEO governance characteristics. To explore this possibility, I examine the impact of

the firms’ governance indices and board compositions. The governance index first introduced by

Gompers, Ishii, and Metrick (2003), commonly referred to as simply the Gindex, is acquired

through the RiskMetrics Governance database, which provides data regarding various

governance characteristics of firms, including the constructed gindex. Board size and

composition (measured as the percentage of directors who are independent) are obtained through

the RiskMetrics Directors database, which provides detailed data regarding board provides

detailed data regarding board members of a large number of firms.

The results from above hold and, in

fact, are even strong, reflected an even larger positive differential between replacement CEO pay

and outgoing CEO pay when outgoing CEO firm ownership is greater than 5% or 10%.

Panel B of Table 8 shows univariate differences results based on these two governance

proxies as well as based on financial distress (as discussed below). G-index results are based on

whether or not firm G-index is in the 75th percentile or higher (this equates to a G-index of 11 or

greater). When the G-index is below the 75th percentile, incoming CEO total compensation and

option-based compensation are both significantly higher than for the incumbent CEO. In

contrast, when the G-index is at or above the 75th percentile, only options and option-based pay

are higher for the incoming CEO. Neither cash nor total compensation are significantly

different. These results are similar to those regarding CEO centrality. That is, the differences in

pay between incoming and outgoing CEOs moves in the direction the managerial discretion

theories would predict based on increased incumbent CEO power over the board. But they do

not reach the predicted difference being significant and positive on the outgoing CEO side.

Board composition results are based on the percentage of independent outsiders on the

board of directors being above or below average. Here, we see that in both categories, total cash

and total compensation are both higher for the incoming CEO. However, the differential is

greater and significant when the percentage of independent directors is below average. So, again

here, we see that managerial power cannot be explaining our differentials. That is, an incumbent

12 Morck et al (1988) find that firm value rises as insider ownership increases up to 5%, then declines until insider ownership reaches 25%, then rises again. Thus, 5% appears to be one appropriate threshold to use. Further, 5% allows for the subsample for high CEO ownership to allow for meaningful statistical analysis (there are 117 outgoing CEOs whose ownership levels are above 5% and 64 CEOs whose ownership levels are above 10%).

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CEO can be expected to have more power over his board in firms where there are less

independent board members. If this is the case, then we would expect the outgoing CEO in these

firms to be paid more than his successor, but not necessarily so in firms where the board

composition represents a relatively higher proportion of independent directors. Table 8 shows

that this does not appear to be the case. Specifically, it shows differences in pay based on the

percentage of the board that is comprised of independent directors. When the board composition

indicates lower percentages of independent directors, the outgoing CEO’s total compensation is

significantly less than that of his replacement. When the board composition indicates higher

percentages of independent directors, the outgoing CEO total cash compensation and total

compensation are not significantly different from those of his replacement.

The final univariate check I perform related to board-based managerial power tests

univariate differences in pay on the basis of financial distress. Following Asquith, Gertner, and

Scharfstein (1994), I classify firms as being in financial distress based on interest coverage

ratios. A firm is in financial distress in the year of the turnover if its earnings before interest,

taxes, depreciation, and amortization (EBITDA) is less than 80 percent of its interest expense

(i.e. if the interest coverage ratio is less than .8). The average interest coverage ratio for all firms

surrounding the turnover event is 5.9. Approximately 15% of the firms are in financial distress

using this classification. In later sections, two alternative measures of financial distress are also

used: Altman’s Z scores and a measure based on firm performance and leverage ratio. The

average Altman’s Z-score13

Here, a similar argument can be made to the one for forced turnovers. If the firm is in

financial distress, it is likely that the manager is at a relative bargaining disadvantage (to

is 3.6 and the percentage of firms in danger of bankruptcy (with a Z-

score less than 1.8) is approximately 23%. As the final alternative measure, I use stockholder

returns, return on assets (ROA), and leverage ratios similar to Opler and Titman (1994). This

measure classifies firms with leverage ratios in deciles 8-10 for all firms’ leverage ratios and

negative stock holder returns and ROA as financially distressed firm. Using this measure,

approximately 4.5% of firms are in financial distress.

13 Calculated as Z-Score = A x 3.3 + B x 0.99 + C x 0.6 + D x 1.2 + E x 1.4 A = EBIT/Total Assets B = Net Sales/Total Assets C = Market Value of Equity/Total Liabilities D = Working Capital/Total Assets E = Retained Earnings/Total Assets

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managers of firms that are not in financial distress) due to the poor performance that

accompanies financial distress. Furthermore, the financial distress may be constraining firm

expenditures and have an additional restraining effect on CEO compensation. Thus, we expect

the compensation of incumbent CEOs of financially distressed firms to be lower than those of

non-financially distressed firms. We would further expect that the relative bargaining

disadvantage that financial distress should mean that CEOs of non-financially distressed firms

would be paid more than their replacements, but that this would not necessarily be the case for

CEOs of financially distressed firms. Panel B of Table 8 shows univariate differences on the

basis of financial distress (as indicated by the interest coverage ratio threshold discussed

above14

IV.2 Multivariate Analysis: Education, Insider/Outsider, Founder

). What we observe is similar to what we observe for voluntary vs. forced turnovers.

When we expect the relative managerial power to be lower (i.e. when turnovers or forced or

when firms are in financial distress), there is no significant difference between cash or total

compensation while when we expect relative managerial power to be higher, the incoming CEO

makes significantly more than his predecessor.

The final analysis performed is multivariate analysis of levels of CEO pay and

differences between incoming and outgoing CEO pay. I first examine CEO compensation levels

surrounding the turnover event incorporating CEO skill and board-based power characteristics.

The outgoing CEOs’ last full year of pay and the incoming CEOs’ first full year of pay are used.

The regressions are variations on the following:

sYearDummiemmiesIndustryDuprevExcessprevceoprevROAprevceorshipsBoardMembershipsBoardMembeistressFinancialD

sitionBoardCompoFounderillsSpecificSkllsGeneralSkiInsiderNewceoNewceoprevceoNummtgsInterlockTenureipCEOOwnershExecDirAssetsCEOPay

ct

+++++++

+++++++++

++++=

**

*)log(

1918

171615

14131110

98765

43210

βββββ

βββββββββ

βββββ

Here, the specifications for the first 10 variables are as listed above in the Baseline

Results section. General skills are the constructed variable from above based on general

educational achievements, specific skills are the constructed variable from above based on

specific educational achievements, board composition is the percentage of board members who

are independent, financial distress is a dummy for whether the firm is in financial distress as 14 Results are robust to alternative measures of financial distress as discussed above (Altman’s Z-Score and Opler and Titman’s measure of financial distress).

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defined above, board membershipst is the number of board seats held at the time of the turnover,

board membershipsc is the number of board seats held over the CEO’s career, PrevROA is the

ROA for the firm at which the incoming CEO was previously employed (if he is an outsider),

and PrevExcess is a dummy for whether the incoming CEO received “excess pay” from his

previous employer.

In untabulated results, there is very little change in coefficients or interpretation from the

previous multivariate analysis. The one major difference is that the almost all coefficients of

Newceo and Newceo*insider become insignificant. The adjusted R2 for the new specifications

are higher than in the simpler specification, but do not represent a dramatic increase in

explanatory power (typical increase is around .5%). The analysis does find positive and

significant coefficients for both general and specific education. It also finds that founders

receive less cash and total compensation. Firms that are in financial distress pay their CEOs less

cash. Board seats held at the time of the turnover does not appear to impact compensation

around this time, but board seats held over the course of a career do positively impact total

compensation. Firm performance for previous CEOs at their prior firms has a positive and

significant coefficient for total compensation, but whether they received “excess pay” does not.

Finally, to confirm univariate results regarding differences in CEO pay, I regress the

incoming CEO’s compensation minus the outgoing CEO’s compensation on my proxies for

managerial power and skill. The specification is the following:

Here, cutoffs for the independent variables are defined as above in the univariate results.

In untabulated results, I find only two significant coefficients for this regression and a very low

adjusted R2 of .0155, indicating (as the univariate results suggest) that these proxies contribute

very little to differences in compensation when a turnover occurs. The two exceptions appear to

be that, financial distress and high CEO centrality for the outgoing CEO both have a positive

impact on outgoing CEO pay relative to that of his replacement. These results, as well as the

non-significance of the remaining coefficients, are consistent with my univariate findings.

V. Conclusion

of 34

In this study, I have empirically examined what happens to CEO compensation when

turnover occurs. Because turnover events involve the negotiation of a new contract for the newly

appointed CEO, they inherently provide opportunity for modification of compensation. Thus,

we may expect to find some dramatic changes in pay levels and/or structures surrounding a

turnover event. Turnovers can also be further instructive to the compensation debate because

they involve CEOs whose expected power over the board differ considerably. Thus, in this

study, I have examined changes in CEO compensation levels and structures to determine whether

or not boards of directors capitalize on the opportunity provided by a turnover event to change

the ways in which they pay their CEO. I further undertake to determine whether firm

characteristics or CEO characteristics have an impact on what is observed regarding

compensation surrounding turnover events.

Overall, I observe that option-based pay and total compensation increase from outgoing

CEO to incoming CEO. I further observe that the positive differential between replacement and

incumbent pay is larger for outsider replacements and when the turnover is voluntary (rather than

forced). Incorporating various measures of CEO skill/abilities and potential sources of influence

over the board, I find that these overall differences in pay between incoming and outgoing CEOs

largely cannot be explained by either of these factors.

To determine whether CEO skill can explain my overall results, such that the incoming

CEO receives more than his predecessor more so when measures of skill are higher, I examine

CEO education and outsider CEO prior firm performance and “excess pay”. I find that, whether

or not the incoming CEO has achieved a higher level of education relative to his predecessor, he

is still paid the same as or more than his predecessor. The same holds true for outsider

replacements regardless of prior firm performance or prior “excess pay”. I expect that all of

prior firm performance, “excess pay”, and relative education levels indicate higher levels of skill

for the incoming CEO. Thus skill cannot explain our overall results.

To determine whether an outgoing CEO’s power over the board can help to explain my

results, such that the outgoing CEO’s compensation is less than that of his replacement only

when his power over the board appears to be weak, I examine firm and CEO characteristics that I

expect to impact a CEO’s power over the board. Specifically, I propose that an outgoing CEO’s

power over the board is weakened when the turnover is forced, when the firm is in financial

distress, when the CEO is not the founder or a co-founder of the firm, when CEO centrality is

of 34

below average, when his “excess pay” ≤ 0, when the outgoing CEO has been at the firm for 4

years or less, when his firm ownership levels are low, and when the firm’s Gindex is low. I find

that replacement CEOs are paid more total compensation than their predecessors regardless of

whether the turnover is forced or voluntary, but the difference is only statistically significant

when the turnover is voluntary. Replacement CEOs are also paid more in option-based pay

regardless of the nature of the turnover and regardless of financial distress. Cash and total

compensation differences between incoming and outgoing CEOs are not significantly different

when firms are in financial distress.

When the outgoing CEO is the founder or a co-founder of the firm, I find that his

replacement also makes more than he did and that these differences are greater within this group

of outgoing CEOs than within the turnovers involving non-founder CEOs. Similar results hold

regarding tenure. That is, regardless of a tenure of 4 years or less or a longer tenure, the

incoming CEO receives more than his predecessor, but the difference is greater and more

significant when the outgoing CEO’s tenure is longer than 4 years. When the outgoing CEO has

relatively higher levels of firm ownership, this differential also lies on the incoming CEO side

and is larger than when his ownership levels are lower. All of these results contradict the notion

that managerial power over the board can explain observed differences in CEO pay in a way

predicted by the managerial discretion view of CEO compensation. Though results regarding

CEO centrality and the Gindex move more in the direction expected by the managerial discretion

view, they do not come inline with direct predictions. That is, hypotheses predict a clear positive

differential between outgoing and incoming CEOs within those for whom outgoing CEO

centrality is high or the firm’s Gindex is high. However, the results simply show no statistically

significant difference between the two CEOs’ compensation within these firms. Taken

altogether, the analysis suggests that managerial power is not driving observed changes in

compensation, but provide limited opportunity for explaining what is the driving force.

of 34

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Table 1

Turnovers by Year and Characteristics 1993-2005

This table presents frequencies and percentages of turnovers by year and turnover characteristics.

Outsiders indicates that the replacement CEO came from outside the firm. Forced indicates that

the outgoing CEO was fired or pressured out by the board of directors.

All Turnovers Outsiders Insiders Voluntary Forced

N % N % N % N % N %

1993 17 1.38% 7 41.18% 10 58.82% 16 94.12% 1 5.88%

1994 69 5.60% 17 24.64% 52 75.36% 57 82.61% 12 17.39%

1995 93 7.54% 20 21.51% 73 78.49% 85 91.40% 8 8.60%

1996 78 6.33% 17 21.79% 61 78.21% 66 84.62% 12 15.38%

1997 94 7.62% 25 29.60% 69 73.40% 84 89.36% 10 10.64%

1998 92 7.46% 27 29.35% 65 70.65% 84 91.30% 8 8.70%

1999 102 8.27% 26 25.49% 76 74.51% 92 90.20% 10 9.80%

2000 128 10.38% 45 35.16% 83 64.84% 108 84.38% 20 15.63%

2001 111 9.00% 39 35.14% 72 64.86% 98 88.29% 13 11.71%

2002 99 8.03% 33 33.33% 66 66.67% 86 86.87% 13 13.13%

2003 102 8.27% 36 35.29% 66 64.71% 84 82.35% 18 17.65%

2004 107 8.68% 47 43.93% 60 56.07% 95 88.79% 12 11.21%

2005 140 11.28% 54 35.85% 85 61.15% 118 84.89% 21 15.11%

Total 1232 100% 393 31.95% 839 68.05% 1073 87.10% 159 12.90%

Figure 1

Turnovers by Year and Characteristics 1993-2005

This figure presents percentages of the sample turnovers based on turnover characteristics.

Outsiders indicates that the replacement CEO came from outside the firm. Forced indicates that

the outgoing CEO was fired or pressured out by the board of directors.

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Outsiders

Forced

Table 2

CEO Compensation Surrounding Turnover Events 1993-2005

This table presents the summary statistics for CEO compensation of incoming and outgoing

CEOs when a turnover event occurs acquired through the Compustat ExecuComp database. Total

cash compensation represents salary + bonus. Shares owned is the number of shares owned by the

CEO. CEO ownership is the number of shares owned by the CEO multiplied by the stock price

(fiscal year-end closing price). Tenure is the number of years the CEO has been in his current

position. Total compensation includes total cash pay, stock options, restricted stock, payouts

from long-term plans, and benefits. Stock options are valued at the grant-date using

ExecuComp’s modified Black-Scholes methodology.

Mean Median

Number of

Observations

Panel A: All CEOs

Salary $ 664,119.3 $ 600,000 2464

Bonus $ 691,178.4 $ 345,750 2464

Total Cash Compensation $ 1,355,300 $ 957,526.5 2464

Value of Options Granted $ 3,502,000 $ 1,086,680 2348

Shares Owned (%) 3.75% 1.08% 2336

CEO Ownership $ 39,029,820 $ 3,583,000 2336

Total Compensation $ 4,390,370 $ 2,236,840 2464

Panel B: Incoming CEOs

Salary $ 655,253.1 $ 600,000 1232

Bonus $ 701,236.5 $ 354,500 1232

Total Cash Compensation $ 1,356,490 $ 950,699.5 1232


Shares Owned (%) 3.97% 1.125% 1176

CEO Ownership $ 19,730,910 $ 2,208,480 1176


Panel C: Outgoing CEOs

Salary $ 672,985.5 $ 600,000 1232

Bonus $ 681,120.4 $ 326,560 1232

Total Cash Compensation $ 1,354,110 $ 964,555 1232


Tenure 9.1 7 1232

Shares Owned (%) 4.83% 1.4% 1160

CEO Ownership $ 58,594,920 $ 5,850,450 1160


Table 3

CEO Compensation Around Turnover Events: Differences in Pay 1993-2005

This table presents the differences between incoming and outgoing CEOs around turnover events. P-values are in parentheses. Total cash

compensation represents salary + bonus. Total compensation includes total cash pay, stock options, restricted stock, payouts from long-term

plans, and benefits. Stock options are valued at the grant-date using ExecuComp’s modified Black-Scholes methodology. Options as a percentage

of total pay are measured by dividing Options Granted by Total Compensation.

Median Differences in CEO Pay:

Incoming CEO – Outgoing CEO

All CEOs Replacement

Insiders

Replacement

Outsiders

Forced

Turnovers

Voluntary

Turnovers

Excess Pay ≤ 0 Excess Pay > 0

Total Cash Pay ($) 0 -35,256* 96,557** 79,640* -8,370 33,789* -47,279**

Total Compensation ($) 159,560*** 125,156** 335,360** 134,324 163,560*** 490,343*** -275,269***

Options ($) 296,130*** 79,230*** 1,103,390*** 723,600** 247,900*** 331,220*** 163,340*

Options (%) 7.91%*** 2.3%** 2.1%*** 12.5%* 7.4%*** 4%*** 13.3%***

Table 4

Multivariate Analysis of CEO Compensation Levels

This table presents multivariate analysis of CEO compensation levels around a turnover event. The logs

of total cash pay and total compensation are the dependent variables. Log(assets) is the log of total assets.

ExecDir is a dummy which equals 1 if the CEO is on the board of directors. Ownership is the shares

owned of the CEO. Tenure is the number of years the CEO has been active in his current position.

Newceo is a dummy which equals 1 if the CEO is a replacement CEO. Interlock is a dummy which

equals 1 if the CEO is listed as a member of the executive compensation committee. Num Mtgs is the

number of board meetings during the year. Excess is a dummy which equals 1 if the outgoing CEO has

Excess Pay > 0. Insider is a dummy which equals one if the replacement CEO is an insider. Prevceo is a

dummy variable which is equal to 1 if the CEO has previously been a CEO at another firm. T-stats are

clustered at the firm level and are in parentheses.

Total Cash Pay Total Compensation

(1) (2) (3) (4) (5) (6)

Intercept 4.82 4.80 4.81 4.68 4.67 4.63

(9.91) (9.89) (9.90) (13.27) (13.25) (13.18)

Log(Assets) .3167 .31986 .31909 .42987 .43192 .43664

(22.90) (23.10) (22.82) (42.88) (43.01) (43.16)

ExecDir .1884 .19842 .19653 -.01829 -.00645 .00519

(.94) (1.00) (.99) (-.09) (-.04) (.04)

Ownership -.00002 -.00002 -.00002 -.000009 -.000009 -.000009

(-7.33) (-7.28) (-7.27) (-4.2) (-4.15) (-4.19)

Tenure .0199 .01959 .0196 -.00014 -.00033 -.00038

(5.30) (5.22) (5.22) (-.05) (-.12) (-.14)

Interlock -.25187 -.24383 -.24371 -.25715 -.25197 -.25274

(-2.61) (-2.53) (-2.53) (-3.68) (-3.61) (-3.63)

Num Mtgs -.00758

(-1.21)

-.00832

(-1.33)

-.00813

(1.29)

.00327

(.72)

.0028

(.62)

.00165

(.36)

Prevceo .10392

(1.46)

.07621

(1.06)

.07712

(1.07)

.18745

(3.62)

.16962

(3.25)

.16398

(3.15)

Newceo .09405 .28066 .29179 -.02613 .09392 .02515

(1.77) (3.43) (3.37) (-.68) (1.58) (.4)

Newceo*Insider -.23437 -.23648 -.15077 -.13775

(-2.99) (-3.01) (-2.66) (-2.43)

Newceo*Excess

-.02616

(-.40)

.16154

(3.40)

Industry Yes Yes Yes Yes Yes Yes

Year Yes Yes Yes Yes Yes Yes

Adj-R2

.2349 .2372 .2370 .5039 .5050 .5070

p-value (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)

N 2695 2695 2695 2695 2695 2695

Table 5

Multivariate Analysis of Pay-Performance Sensitivities

This table presents multivariate analysis of pay-performance sensitivity around a turnover event. Total

cash pay and total compensation are the dependent variables. ExecDir is a dummy which equals 1 if the

CEO is on the board of directors. Ownership is the ownership level of the CEO. Newceo is a dummy

which equals 1 if the CEO is a replacement CEO. Resigned is a dummy which equals 1 if the CEO was

forced to resign the following year. Insider is a dummy which equals one if the replacement CEO is an

insider. T-stats are in parentheses.

∆Total Cash Pay ∆Total Compensation

(1) (2) (3) (4) (5) (6)

Intercept -44.98 -44.92 -40.79 2822.12 2819.71 2837.21

(-.22) (-.22) (-.20) (1.16) (1.16) (1.17)

∆Shareholder Wealth .03075 .03075 .03075 .0451 .0451 .0451

(13.30) (13.30) (13.39) (1.63) (1.63) (1.63)

ExecDir 83.485 83.475 78.735 -3679.1 -3678.9 -3711.8

(.41) (.41) (.39) (-1.5) (-1.50) (-1.51)

Ownership .00497 .00497 .00474 -.1178 -.11763 -.11858

(1.46) (1.46) (1.40) (-2.82) (-2.82) (-2.84)

Newceo*∆Shareholder Wealth -.01072 -.01054 -.02936 .04459 .03774 -.04349

(-3.62) (-3.43) (-6.94) (1.26) (1.02) (-.84)

Newceo*Excess*∆Shareholder

Wealth

-.00111

(-.22)

-.00701

(-1.38)

.04156

(.69)

.01755

(.29)

Newceo*Insider*∆Shareholder

Wealth

.02708

(6.43)

.11532

(2.24)

Adj-R2

.0885 .0883 .1003 .0082 .0080 .0093

p-value (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)

N 3025 3025 3025 3001 3001 3001

Table 6

CEO Compensation Around Turnover Events: Incoming - Outgoing 1993-2005

Education and Insider/Outsider Status





Panel A: General and Specific Education



Incoming CEO General

Education Lower or Equal


Education Greater

Incoming CEO Specific



Education Greater

Total Cash Pay ($) 1,667 -52,057 0 -6,861

Total Compensation ($) 155,960*** 260,524* 185,270*** 2,632

Options ($) 284,390*** 532,400* 296,130*** 219,190**

Options (%) 8.5%*** 3.8% 9.3%*** 1.3%

Panel B: Education and Insider/Outsider Status






Education Higher




Education Higher

Insider

Replacement

Outsider

Replacement

Insider

Replacement

Outsider

Replacement

Insider

Replacement

Outsider

Replacement

Insider

Replacement

Outsider

Replacement

Total Cash Pay ($) -26,343* 101,471** -87,425 22,401 -25,250* 90,000** -83,800 255,887**

Total Compensation ($) 126,156** 241,350* 113,999 961,030* 127,450*** 348,840** 27,193 -9,272

Options ($) 109,003*** 863,310*** 0 1,566,540** 92,905** 1,103,390*** 0 947,000

Options (%) 2.4%** 27.5%*** -2.5%*** 2.4% 3.3%** 23.3%*** 1.8% 3.6%

Table 7

CEO Compensation Around Turnover Events: Incoming - Outgoing 1993-2005

Prior Firm Performance and Pay





Panel A: Incoming CEO prior firm performance and pay



ROA > 4.8% ROA < 4.8% Prior Excess Pay > 0 Prior Excess Pay ≤ 0

Total Cash Pay ($) 256,616* 168,330* 229,890* 203,376**

Total Compensation ($) 693,800* 452,236 487,680 472,550*

Options ($) 1,630,690** 1,658,500** 3,145,000*** 774,570**

Options (%) 11%* 11.9%** 46.4%* 9.9%*

Panel B: Outgoing CEO Subsequent Employment



Outgoing CEO does not find a new job within 3 years Outgoing CEO does find a new job within 3 years

Total Cash Pay ($) -10,357 59,282*

Total Compensation ($) 194,070*** 66,824

Options ($) 299,390*** 223,250**

Options (%) 8.35%*** 5.8%

Table 8

CEO Compensation Around Turnover Events: Incoming CEO – Outgoing CEO 1993-2005

Managerial Power





Panel A: CEO-based managerial power proxies



Founder Non-Founder CEO

Centrality

High

CEO

Centrality

Low

CEO Tenure

> 4

CEO Tenure ≤

4

CEO Firm

Ownership >

1.4%

CEO Firm

Ownership <

1.4%

Total Cash Pay ($) 57,888* -10,178 -105,810*** 24,208* -27,809* 81,254** 26,917 -9,502

Total Compensation ($) 405,290*** 128,360** -48,449 204,140*** 207,330*** 55,660 343,480** 128,210**

Options ($) 431,440*** 243,360*** 63,120* 370,330*** 214,300*** 337,355*** 232,410** 261,060***

Options (%) 8.4%* 7.7%*** .3%* 9.5%*** 4.8%*** 12.3%*** 14.4%** 5.3%***

Panel B: Firm-based managerial power proxies



Gindex ≥ 11 Gindex < 11 Board Composition

< 50th

Percentile

Board Composition

> 50th

Percentile

Firm not in Financial

Distress

Firm in Financial Distress

Total Cash Pay

($)

-52,627 9,134 -464 2,072 -7,802 40,000

Total Compensation

($)

-17,600 214,260*** 250,810** 130,073 184,540*** -31,521

Options ($) 106,638* 327,570*** 188,470*** 297,750*** 190,530*** 1,120,890***

Options (%) 4.4%** 9.3%*** 6.4%*** 8.25%*** 5.7%*** 49%***

CEO Turnover and Compensation: An Empirical...

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