Insular Decision-making in the Board Room: Why Boards Retain and Hire Sub-Standard CEOs

Meg Sato
JEL codes: 
Asia Pacific Economic Paper No. 384

It is widely believed that corporate boards are overly reluctant to fire their CEOs. The conventional explanation for retaining a CEO regardless of his/her talent is that a CEO chooses the board members and has the power to fire them. However, very few studies have investigated how a new CEO is chosen. This paper explores an unexamined cause of board reluctance in removing a CEO: the incentive to minimize the leakage from the decision-makers future surplus. I argue that this same logic provides the theoretical explanation for how a new CEO is chosen for both voluntary and forced CEO replacements. I show that this incentive of the incumbent board and CEO often departs from the shareholders interest. In short, if the net surplus of the incumbent board and CEO is expected to be larger under an incumbent sub-standard CEO, or under an internal candidate rather than an external candidate, then they retain the incumbent sub-standard CEO or promote an internal CEO candidate, even though the expected corporate profit generated by appointing an external candidate is likely to have been greater.