Is a CEO Turnover Good or Bad News?

Transcription

1 Is a CEO Turnover Good or Bad News? Axel Kind Yves Schläpfer April 2010 Abstract We investigate the information content of CEO turnovers by analyzing abnormal stock returns and abnormal trading volumes in the surrounding of the announcement date. The sample consists of 208 CEO turnovers between January 1998 and June 2009 for companies belonging to the Swiss Performance Index. The single most important variable in assessing the value of a CEO-turnover news is found to be the performance of the departing manager as proxied by the prior relative stock-price performance. In line with economic intuition and in accordance with previous studies, the departure of outperforming (underperforming) managers represents bad (good) news for shareholders. Outside successions and forced turnovers yield significant positive abnormal returns. However, a forced turnover does not per se represent a positive signal to shareholders. On the contrary, investors seem to critically assess the quality of the board s firing decision by considering the performance of the departing manager. When an outperforming CEO is dismissed or forced to leave, shareholders appear to disesteem the board s decision. This finding is confirmed in multivariate cross-sectional regressions and is robust to time subperiods and alternative test statistics. Trading volume is found to consistently increase for all types of CEO turnovers. However, the size of the reaction crucially depends on the characteristics of the turnover event, with forced turnovers generating the largest impact on the turnover announcement day ( %). Finally, the operating performance significantly increases (decreases) in the years following (preceding) CEO turnovers and reflects on average the short-term stock-price reaction around the announcement date. Keywords: Corporate governance; CEO turnover; Firm performance; Trading volume JEL codes: G14; G30; G34; M51 Contact information: A. Kind: axel.kind@unibas.ch; Y. Schläpfer: yves.schlaepfer@unibas.ch. A special thanks goes to Marco Poltera for his excellent research assistance. Department of Finance, University of Basel and Swiss Institute of Banking and Finance, University of St. Gallen. Department of Finance, University of Basel.

2 Is a CEO Turnover Good or Bad News? Abstract We investigate the information content of CEO turnovers by analyzing abnormal stock returns and abnormal trading volumes in the surrounding of the announcement date. The sample consists of 208 CEO turnovers between January 1998 and June 2009 for companies belonging to the Swiss Performance Index. The single most important variable in assessing the value of a turnover news is found to be the quality of the departing CEO as proxied by the prior stock-price performance relative to the market. In line with economic intuition and in accordance with previous studies, the departure of outperforming (underperforming) managers represents bad (good) news for shareholders. Outside successions and forced turnovers yield significant positive abnormal returns. However, a forced turnover does not per se represent a positive signal to shareholders. On the contrary, investors seem to critically assess the quality of the board s firing decision by considering the quality of the departing manager. When a talented CEO is dismissed or forced to leave, shareholders appear to disesteem the board s decision. This finding is confirmed in multivariate cross-sectional regressions and is robust to time subperiods and alternative test statistics. Trading volume is found to consistently increase for all types of CEO turnovers. However, the size of the reaction crucially depends on the characteristics of the turnover event, with forced turnovers generating the largest impact on the turnover announcement day ( %). Finally, the operating performance significantly increases (decreases) in the years following (preceding) CEO turnovers and reflects on average the short-term stock-price reaction around the announcement date. Keywords: Corporate governance; CEO turnover; Firm performance; Trading volume JEL codes: G14; G30; G34; M51 1

3 Is a CEO Turnover Good or Bad News? Abstract We investigate the information content of CEO turnovers by analyzing abnormal stock returns and abnormal trading volumes in the surrounding of the announcement date. The sample consists of 208 CEO turnovers between January 1998 and June 2009 for companies belonging to the Swiss Performance Index. The single most important variable in assessing the value of a turnover news is found to be the quality of the departing CEO as proxied by the prior stock-price performance relative to the market. In line with economic intuition and in accordance with previous studies, the departure of outperforming (underperforming) managers represents bad (good) news for shareholders. Outside successions and forced turnovers yield significant positive abnormal returns. However, a forced turnover does not per se represent a positive signal to shareholders. On the contrary, investors seem to critically assess the quality of the board s firing decision by considering the quality of the departing manager. When a talented CEO is dismissed or forced to leave, shareholders appear to disesteem the board s decision. This finding is confirmed in multivariate cross-sectional regressions and is robust to time subperiods and alternative test statistics. Trading volume is found to consistently increase for all types of CEO turnovers. However, the size of the reaction crucially depends on the characteristics of the turnover event, with forced turnovers generating the largest impact on the turnover announcement day ( %). Finally, the operating performance significantly increases (decreases) in the years following (preceding) CEO turnovers and reflects on average the short-term stock-price reaction around the announcement date. 1 Introduction The duty of a Chief Executive Officer is to maximize shareholders wealth by taking sensible management decisions. Given the scope and importance of this mission, it is evident that a CEO turnover represents a major event in the history of any corporation, with possibly far reaching consequences for the company and its shareholders. The aim of this paper is to assess the information content of CEO turnovers from the stockholders perspective. In particular, we aim at explaining the cross-sectional variation of abnormal returns by considering crucial characteristics of the turnover, such as the departure type (forced or voluntary), the successor origin (insiders or outsiders), the prior performance of the incumbent manager, and combinations thereof. A real-world example should best illustrate how investors interpret the information related to a CEO turnover for determining the value of a stock. The example refers to Mr. Fred Kindle, former CEO of ABB Ltd, a global leader in power and automation technologies. 1 Under his leadership, 1 Despite the fact that the story of Mr. Kindle motivates very well this study and is a prime example of a CEO turnover that achieved broad media attention and had a shocking impact on investors, we should remark that 1

4 ABB recovered from financial distress and achieved a record result in In January 2005, the date of Kindle s appointment as CEO, ABB s stock price was around 6 Swiss francs. Under his leadership the stock price rose to around 25 Swiss francs in February According to the Financial Times, ABB s recovery qualifies as a prime case study of successful company restructuring. 2 Nevertheless, on February 13, 2008, ABB surprisingly announced in an official statement that Fred Kindle would leave ABB due to irreconcilable differences about how to lead the company. 3 The CFO of ABB, Michel Demaré, was appointed interim CEO, but at that time was also considered as a potential candidate for the position of permanent CEO. Several news agencies 4 speculated that this decision was mainly caused by a power struggle with the president of the board, Hubertus von Gruenberg, regarding ABB s acquisition strategy. The departure of Fred Kindle was a big surprise to the financial community as everybody agreed that he was doing an outstanding job at ABB. Strikingly, the Financial Times referred to him as the wunderkind chief executive. The fact that investors shared the same perception about Fred Kindle s work performance is crucially captured by the stock-price reaction on the announcement date of his departure. In spite of the simultaneous announcements of a record result for the year 2007, a doubling of the dividend, and upcoming share repurchases, the stock price dropped sharply by 5.14% on that very same day. According to Bloomberg, ABB s stock price lost interim about 10%, which was the worst drop of the previous three years. This example highlightens two key insights that go along with this paper. First, investors may attribute a great importance to the information of a CEO departure. Second, the valuation consequences of a CEO turnover strongly depend on the characteristics and circumstances of this event. While the academic literature has already stressed the beneficial effects of forced turnovers, the example of Mr. Kindle suggests that the prior performance of the departing manager may convey equally important information. These insights motivate us in studying the stock-price impact of CEO turnovers by considering a variety of characteristics associated with these events. A large part of prior research on CEO turnovers focuses on the relation between the CEO s performance and the turnover probability (Coughlan and Schmidt, 1985; Weisbach, 1988; Warner, Watts, and Wruck, 1988; Parrino, 1997; Suchard, Singh, and Barr, 2001). This strand of literature comes to the conclusion that there is a negative relation between performance and the probability of a (forced) turnover. However, while statistically significant, this negative relation is found to be economically weak. A second strand of literature which is of immediate relevance for the hypotheses studied in this paper investigates the impact of CEO turnovers on the company s performance. Contributions differ with respect to the performance measures employed (stock price reactions vs. accounting performance measures) and the characteristics of the turnovers considered: (i) outside vs. inside successions, (ii) forced vs. voluntary turnovers, (iii) governance differences, (iv) gender differences, this event could not be included in the empirical analysis due to a no-confounding-event criterion applied in the construction of the sample. More precisely, the release of other valuation-relevant news (dividends and earnings announcement) on the date of the dismissal of Mr. Kindle prevents us from using this data point ABB Press Release: ABB CEO Fred Kindle leaves company, available at 4 Amongst others Reuters, Bloomberg, Timesonline, Financial Times, Financial Times Deutschland, Handelsblatt and Handelszeitung covered the news regarding the departure of Fred Kindle at ABB. 2

5 etc.. Table 1 presents an overview of the most important contributions in this field together with a summary of the main empirical findings. The majority of studies (Reinganum, 1985; Furtado and Rozeff, 1987; Warner, Watts, and Wruck, 1988; Bonnier and Bruner, 1989; Borokhovich, Parrino, and Trapani, 1996; Dherment-Ferere and Renneboog, 2002; Huson, Parrino, and Starks, 2001; Dahya and McConnell, 2005; Adams and Mansi, 2009) detect significant positive abnormal returns following turnovers with company-outsiders as successors. Notable exceptions are Worrell, Davidson, and Glascock (1993) and Khanna and Poulsen (1995). The former find mixed results and the latter do not report significant abnormal returns by examining companies eventually filing for Chapter 11 protection, neither for outside nor inside successions. The majority of studies that also investigate the subsample of forced turnovers find that abnormal returns following firings are higher than those following voluntary turnovers (Furtado and Rozeff, 1987; Denis and Denis, 1995; Huson, Parrino, and Starks, 2001; Dherment-Ferere and Renneboog, 2002; Adams and Mansi, 2009). Borokhovich, Parrino, and Trapani (1996) report significant positive abnormal performance for forced turnovers in combination with outside successions. Only Dedman and Lin (2002) detect significant negative abnormal returns on average after a CEO s dismissal. Weisbach (1988) investigates the relation between the composition of the board of directors (insider- vs. outsider-dominated boards) and CEO turnovers. He reports positive announcement effects but no difference in the impact between the firing decision of outsider- and insider-dominated boards. Similarly, Fisman, Khurana, and Rhodes-Kropf (2005) examine the role of managerial entrenchment for the board s firing decision and its consequence on the stock-price, finding a weakly significant relation between entrenchment and abnormal returns. Lee and James (2007) and Coxbill, Sanning, and Shaffer (2009) study gender effects by comparing the price impact of male vs. female CEO appointments. While the former detect significantly lower (and negative) abnormal returns for women CEOs, the latter report a negative but insignificant impact on the stock price. Finally, Johnson, Magee, Nagarajan, and Newman (1985) and Worrell, Davidson, Chandy, and Garrison (1986) measure the stock-price reaction in the aftermath of key-executives deaths. The latter report negative and significant effects in association with sudden deaths and the former significantly positive (negative) reactions following the death of company founders (non-founders). As mentioned, accounting performance measures can be used as an alternative way to assess the value of a CEO turnover. Several papers (e.g. Denis and Denis, 1995; Khurana, 2001; Dedman and Lin, 2002; Huson, Malatesta, and Parrino, 2004; Fisman, Khurana, and Rhodes-Kropf, 2005; Hillier and McColgan, 2005; Dezso, 2007) investigate the impact of CEO changes on key accounting performance measures. Typically, the papers evidence that a CEO-turnover is preceded by deteriorating accounting figures, which improve after the new CEO takes up his/her position. The described pattern is generally more pronounced for forced than for voluntary turnovers. CEO turnover in relation to manager quality (proxied by prior company or stock performance) is investigated in Weisbach (1988) and Bonnier and Bruner (1989). Weisbach (1988) finds a strong and negative relation between the intersection of prior stock performance with outside boards and abnormal returns around the CEO turnover. Bonnier and Bruner (1989) investigate underperform- 3

6 ing firms jointly identified by the criteria of negative earnings and dividend omission prior to the management turnover. The reason to select this particular sample of management turnover is that the abnormal return at the announcement of a (forced) management turnover comprises two effects as described by Warner, Watts, and Wruck (1988). First, if the turnover signals managerial quality that is worse than anticipated then the information effect is negative. Second, the real effect is positive if the (board-initiated) turnover is appreciated by the shareholders. Therefore, positive abnormal returns are observed only if the real effect outweighs the information effect. By using a sample of companies for which the bad performance has already recognized they try to reduce the negative information effect and estimate a more accurate real effect. In this paper, we investigate stock returns, operating return on assets, as well as trading volumes in the surrounding of CEO turnover events. The sample consists of CEO turnovers at companies in the Swiss Performance Index during the period between January 1998 and June The final sample comprises 208 CEO turnovers. It is survivorship-bias free since it also includes CEO turnovers at companies that exited the index. The CEO-turnover variables considered in the investigation are the successor origin, the departure type, and the prior stock performance. This paper contributes in three ways to the existing literature. First, it corroborates the findings of the existing literature on CEO turnovers by employing a new hand-collected data sample. In particular, we are able to show that the most important results reported for the US also apply to the Swiss market. This is interesting because - as shown in LaPorta, de Silanes, and Shleifer (1999) and Faccio and Lang (2002) - the Swiss market is characterized by a less atomistic ownership structure with more family-controlled companies and fewer active investors. Second, the paper classifies turnovers with respect to (i) the departure type of the CEO (voluntary vs. forced), (ii) the successor origin (internal or external), (iii) the prior performance (outperformance or underperformance), and all the interactions of those variables. Most importantly, in contrast to previous research, the paper emphasizes that forced turnovers do not always constitute a positive signal to shareholders: Forced turnovers of underperforming managers trigger significantly positive abnormal returns, while forced turnovers of overperforming managers are associated with negative abnormal returns. This suggests that shareholders assess the quality of the board s firing decision by considering the performance of the departing CEO. Third, instead of solely focusing on abnormal returns, the paper analyzes the impact of CEO turnover announcements on trading volumes 5 and long-term accounting performance measures. The results obtained in this paper indicate that outside successors, forced turnovers, and prior underperformance of the company under the departing manager lead to significant positive abnormal returns: +1.85%, +2.74%, and +1.94% on average for the [-2 0] event window. The largest average abnormal returns are detected for the following two categories of CEO turnovers: (i) forced departures in conjunction with an outside successor (+6.71%) 6 and (ii) forced departures of underperforming managers (+5.73%). Interestingly, while forced turnovers of underperforming managers trigger positive and significant abnormal returns (+5.73%), forced turnovers of outperforming CEOs are associated with negative abnormal returns ( 2.24%). This suggests that shareholders assess 5 To the best of our knowledge, the only study that investigates abnormal returns and trading volumes around management-turnover announcement is Cools and van Praag (2007). 6 When not otherwise stated, the abnormal returns reported in parethesis refer to [-3 0] event windows 4

7 the quality of the firing decision by the board of directors by considering the prior performance of the company under the departing CEO. The results are robust with respect to time subperiods and a wide range of parametric and non-parametric test specifications. The trading volume of the average company affected by a CEO turnover is found to increase by almost 130% on the announcement day. Particularly large increases in trading volume are observed for forced-turnover announcements (mean: %) and forced turnovers of underperforming CEOs (mean: %). In accordance with theoretical papers on the release of public information, absolute abnormal stock returns are found to be positively correlated with abnormal trading volumes. The long-term relation between CEO turnovers and operating performance, which is measured as the ratio of operating income and book value of total assets, shows that a CEO turnover is typically preceded by deteriorating operating performance and followed by a steady increase in operating performance. Besides for the total sample, this pattern is particularly evident for the subsamples of outside successions, forced departures, departures of underperforming CEOs, and the intersection of forced departures with underperforming CEOs. The remainder of this paper is structured as follows. Section 2 develops hypotheses regarding the expected stock-price reaction following different types of CEO turnovers. Section 3 deals with the sample construction and describes the final sample of CEO turnovers. Section 4 presents the empirical analysis of this paper. After addressing the setup of the event-study and presenting general results related to the impact of CEO turnovers on abnormal stock returns (Subsection 4.1), we perform a cross-sectional analysis of the results by regressing abnormal returns against selected CEO-turnover variables (Subsection 4.2) and provide extensive robustness checks (Subsection 4.3). Subsection 4.4 focuses on the impact of CEO turnovers on the trading volume and Subsection 4.5 investigates the long-term impact of turnovers on the companies operating performance. Section 5 provides a summary of the paper and concludes. 2 Theory, Prior Empirical Results, and Hypotheses In this section we formulate hypotheses regarding the impact of CEO turnovers on the corresponding stock prices. In particular, we are interested in differentiating between various characteristics of the turnover, such as (i) the successor origin (inside vs. outside successions), (ii) the departure type (forced vs. voluntary departures) and, (iii) the relative performance of the company under the departing CEO. Such hypotheses are meant to reflect explicit theories proposed in the CEO-turnover literature, plausible extensions thereof, and empirical results from previous studies. 2.1 Outside Succession It is a well established empirical fact that in the majority of CEO turnovers the successor is a company insider. The corporate-finance literature has proposed a number of plausible reasons for 5

8 the Board s preference for inside over outside CEOs. These are (i) the company-specific human capital accumulation theory of Dherment-Ferere and Renneboog (2002), (ii) the quality-measurement theory, (iii) the tournament theory of Chan (1996). Dherment-Ferere and Renneboog (2002) argues that inside candidates have two main advantages over outsiders. First, over the years they have the opportunity to accumulate valuable companyspecific knowledge about processes and technologies. Second, they can exploit an already existing social network to acquire specific internal information. Thus, the accumulation of company-specific human capital naturally makes insiders more attractive than outsiders for a CEO position. Another explanation for the reluctance to appoint outside candidates to the CEO position arises from the less accurate estimation of their quality. The history of an insider in the company automatically generates a performance track record that can be easily used by the Board of Directors to assess the insider s quality. Conversely, the information basis to estimate the quality of an outsider is much smaller, which makes this choice intrinsically more risky. Finally, Chan (1996) argues that considering outsiders for the CEO position can reduce the incentives and hence the motivation of lower-level executives. Clearly, if outsiders are included into the circle of potential successors the chance for insiders to become CEOs diminishes. Thus, Chan (1996) suggests that the preference for inside successors may represent a natural attempt to motivate employees by strengthening the link between performance and reward. By considering the general preference for insiders as CEO successors, we argue that the board of directors will appoint an outsider as CEO only if his/her quality exceeds by far that of the best available insider. In this light, we might expect the stock price to react positively once the information about a CEO turnover with an outside succession is released, which leads us to the formulation of the following hypothesis. Hypothesis 1: The announcement of an outside succession yields positive abnormal returns. By considering the empirical evidence reported in Table 1, column 6, the above hypothesis seems to be backed by the majority of previous studies. 2.2 Forced Turnovers The board of directors has the non-transferable and indefeasible duty of nomination and dismissal of the management of the company. Ideally, we would expect the board to act in the best interest of shareholders when deciding about a CEO s dismissal. The improved management hypothesis presented by Huson, Malatesta, and Parrino (2004) states that forced management turnovers induce a higher expected company performance through increased managerial quality. Since the quality of the CEO is not directly observable, company directors will infer the quality of a CEO from his/her past performance. A CEO will be replaced 6

9 if the realized performance is sufficiently low and the expected benefit of a turnover exceeds the expected cost. More precisely, the resulting costs from the turnover have to be more than offset by the quality differential separating the new and the incumbent CEO. Following this argument, investors should interpret the firing decision by the board as a positive signal about the quality of the appointed CEO and the value of the firm. Under the scapegoat hypothesis based on Holmström (1979), Shavell (1979), and Mirrlees (1976) firings of CEOs occur even though all managers are assumed to be identical in terms of quality. The threat of a dismissal merely serves to ensure adequate effort by the incumbent CEO. In equilibrium, all CEOs provide the same effort and low performance arises just by chance. In case of poor performance, the board of directors will fire a CEO just to maintain the threat of dismissal thereby creating the incentive to supply the optimal level of effort. Since in this model the poor performance leading to the dismissal of a CEO is simply the result of luck and not poor managerial quality or lack of effort, the fired CEO can be viewed as a scapegoat. Also in this case, it is conceivable that investors will interpret the dismissal of the CEO as a positive signal that testifies the responsibility of the board in providing adequate effort incentives for CEOs. Since the majority of empirical studies (cf. Table 1, column 9) associates a positive stock-price reaction with the announcement of a CEO dismissal, thus providing supportive evidence for the theoretical predictions, we formulate our second hypothesis as follows. Hypothesis 2: The announcement of a forced CEO turnover yields positive abnormal returns. In case of a voluntary retirement, a responsible board of directors should appoint the manager with the highest quality as CEO successor. However, this does not imply a specific quality differential of the new CEO over the departing one. Further, voluntary departures due to the age of the CEO can be anticipated, which should suggest small price reactions. Negative returns could occur if the departure of the incumbent CEO is associated with a loss of valuable company-specific human capital or if the voluntary decision to leave the company is motivated by superior (negative) information of the departing CEO about the future development of the company. The empirical literature offers a very mixed picture concerning the impact of voluntary CEO turnovers on abnormal returns. While the majority of papers do not find significant abnormal returns (cf. Table 1, column 10), Adams and Mansi (2009) and Hillier and McColgan (2005) report positive and significant ARs and (Neumann and Voetmann, 2005) negative and significant ARs. While in view of the theory and previous empirical evidence, we expect voluntary retirements to cause smaller stock-price reactions than forced departures, we do not see compelling theoretical arguments to formulate a specific hypothesis. 2.3 Performance Previous studies show an inverse relation between the stock performance and the probability of a CEO turnover (e.g. Warner, Watts, and Wruck, 1988; Weisbach, 1988, among others). In this 7

10 paper, we investigate the impact of the company s prior performance under the departing CEO (which can be seen as a proxy for his/her skills) on the abnormal stock returns in the surroundings of the announcement of the CEO departure. When an underperforming CEO leaves the company, we expect shareholders to benefit from the turnover. Hypothesis 3: In case of prior underperformance of the stock relative to the market index, the announcement of a CEO turnover yields positive abnormal returns. In case of prior overperformance, the turnover announcement is expected to cause negative abnormal returns because the value of all future projects should be reduced to take into account the departure of a talented and successful CEO. Hypothesis 4: In case of prior overperformance of the stock relative to the market index, the announcement of a CEO turnover yields negative abnormal returns. 2.4 Combinations of Turnover Characteristics In this paper, we consider the three above variables (successor type, departure type, and company s prior relative stock performance) not only as stand-alone characteristics but also in connection with each other. More precisely, we investigate whether the interaction of those variables conveys additional valuation-relevant information. While we refrain from discussing all possible combinations to be constructed by pairs and triples of those variables, some considerations regarding specific intersections are useful. First, based on the previously mentioned theoretical considerations and the available empirical findings, the combination of forced turnovers with outside successions - the two characteristics that in previous studies are found to deliver the highest abnormal returns - is expected to yield positive abnormal returns. Hypothesis 5: The announcement of a forced turnover with an outside successor yields positive abnormal returns. Second, we challenge the notion that forced turnovers per se represent positive news to shareholders on average. We believe that forced turnovers have to be examined in connection with the skills of the departing CEO (proxied by the company s relative stock performance). In particular, we expect to observe positive abnormal returns for forced turnovers of underperforming managers and negative abnormal returns for forced departures of overperforming managers. While the first event reflects a wise decision by the company s board of directors, the latter does not. 8

11 Hypothesis 6: The announcement of a forced turnover of an underperforming manager yields positive abnormal returns. Hypothesis 7: The announcement of a forced turnover of an overperforming manager yields negative abnormal returns. 2.5 Trading Volume Analyzing trading volumes in addition to abnormal returns can likely add an important dimension to the analysis of CEO turnovers. As noted by Beaver (1968), trading volume of a given security indicates a lack of consensus among investors regarding the price of that security. Along these lines Holthausen and Verrecchia (1990) conclude: If one defines information content as the ability of an information signal to alter investors beliefs, evidence on volume reactions is as relevant for assessing information content as evidence on unexpected price changes. To derive testable hypotheses related to the trading volume, we follow Kim and Verrecchia (1991b). In their theoretical study 7 on the relation between abnormal returns and abnormal trading volumes after the release of public information, they argue as follows: Volume reflects the sum of differences in traders reaction; the change in price measures only the average reaction. As a result, volume is proportional to both the absolute price change and the measure of differential precision. The first part of their conclusion motivates us to state the following hypothesis: Hypothesis 8: The higher the absolute abnormal returns caused by the announcement of a CEO turnover, the higher the abnormal trading volume. Further, we conjecture that out of the different subsamples of CEO turnovers, the one that conveys the highest degree of surprise will likely relate to forced turnovers of overperforming CEOs. Hypothesis 9: The announcement of a forced turnover of an overperforming manager triggers the highest abnormal trading volume. 2.6 Operating Performance If we assume markets to be efficient, the abnormal returns in the surrounding of a CEO-turnover announcement date reflect investors perceptions about fundamental changes in the value of the company. From finance 101, we know that the fundamental value of a company results from the sum of all the expected future free-cash flows discounted by the appropriate risk-adjusted interest 7 Other papers that address in a theoretical framework the trading volume around news releases include Holthausen and Verrecchia (1990), Kim and Verrecchia (1991a, 1994), and Demski and Feltham (1994). 9

12 rate. Thus, changes in the value of a company either reflect changes in the relevant discount rate or changes in the expected future cash flows (or both). If we rule out that a CEO turnover has an impact on the relevant discount rate, 8 the different company valuation before and after the CEOturnover announcement will solely reflect changes in the expected cash flows and thus in the future operating performance of a company. Based on this line of reasoning, we formulate the following hypothesis. Hypothesis 10: The higher the abnormal returns caused by the announcement of a CEO turnover, the greater the increase in the future operating performance. 3 Data 3.1 Sample Construction The data investigated in this paper comprises CEO turnovers of companies in the Swiss Performance Index (SPI) between 1998 and June The sample is hand-collected and initially consists of 347 turnovers at 184 companies. To cover all CEO turnovers, we apply the following procedure. First, the complete list of CEO changes is obtained by collecting the annual reports of all companies included in the SPI since January Second, to verify the event and obtain the exact CEO-turnover announcement date, the following sources are screened: (i) ad-hoc disclosures at the SIX Swiss Exchange, (ii) articles in leading Swiss financial and business newspapers (in particular, NZZ, Finanz und Wirtschaft, and Handelszeitung ), (iii) company-specific news provided by Bloomberg, (iv) company Internet sites, and (v) selected Internet news sites. 9 To be included in the final sample, we require CEO-turnover events to cumulatively satisfy the following criteria: (i) The date of the announcement, i.e. the first day investors can trade on the CEO-turnover information, has to be identifiable (this also includes the information on whether the announcement was made before or after the closing of the market); (ii) The relevant details regarding the departing and the incoming CEO (age, succession type, and successor origin) have to be known; (iii) There must be no confounding events, such as earnings or dividend announcements or mergers and acquisitions, in a three-day time period around the turnover announcement; (iv) The CEO turnover may not be directly related to the takeover of the company; (v) Furthermore, there has to be a sufficiently long stock-price history before the CEO-turnover announcement date and the stock must be traded at least at 100 days (40%) in the estimation period to guarantee a reasonably accurate estimation of the market model. 8 This would be the case if the average successor reduces the systematic risk of a company or has an impact on the market premium. An analysis of betas before and after the event date rules out the first hypothesis and the latter appears highly implausible. 9 Internet sites include and 10

13 The number of events that had to be excluded due to the criteria (i) to (v) are reported in Table 2. [Table 2 about here] 3.2 Explanatory Variables For all CEO-turnover events, we gather detailed information regarding the company, the departing CEO, the new CEO, and the turnover characteristics. The main explanatory variables in this study are the successor origin (inside vs. outside successions), the departure type (forced vs. voluntary departures), and the prior performance relative to a broad stock-market index. In the related literature, the classification of the successor origin is measured by applying two alternative rules. According to the first rule, the new CEO is classified as an outsider if the appointment as CEO occurs on the same date as he/she joined the company; All other successors are classified as insiders. According to the second rule, the new CEO is considered as an outsider if he/she has a working history in the relevant company of less than a year (see e.g. Parrino, 1997). In this paper, successors are classified as insiders or outsiders according to the former rule. However, applying the latter method does not qualitatively alter the major findings of the paper. In our sample, 75 CEO turnovers (36% of the total sample) are classified as outside successions and 133 turnovers (64% of the total sample) are classified as inside successions. The division into forced and voluntary departures is carried out following the methodology of Denis and Denis (1995). Based on the information provided by diverse media reports, such as leading Swiss financial and business newspapers, ad-hoc news, and company statements, a CEO turnover is classified as forced if it is accompanied by an internal conflict with the Board. In those cases in which the turnover cannot be directly assigned to the sample of forced or voluntary turnovers on the basis of the available data, we apply the following decision scheme: If the departing CEO is not over 64 years old and the new appointed CEO is an outsider, the CEO turnover is assigned to the subsample of forced turnovers. By applying this procedure, the sample of forced turnovers consists of 60 events (29%) and the sample of voluntary turnovers includes 148 events (71%). The companies relative stock performance is calculated against the Swiss Performance Index over the same time period that is used to estimate the market model, i.e. over a 250 trading-day period from day 260 to day 11 prior to the CEO-turnover announcement. Depending on the sign of the prior relative performance, the event is assigned either to the over- or the underperforming subsample: 118 turnovers (57%) are preceded by prior underperformance and 90 turnovers (43%) prior overperformance. Table 3 provides a breakdown of the final sample by year and turnover characteristics. While there seem to be an overall increase in the total number of CEO turnovers over the years, this development is far from being steady and smooth. [Table 3 about here] 11

14 Figure 1 is a Venn diagram that splits the sample according to the main CEO-turnover characteristics (together with their intersections): outside successions, forced departures, and turnovers of underperforming managers. It is worth noting that the percentages of outside successions and forced departures are, with 36% and 29% of the sample respectively, higher than those reported in earlier studies. For instance, Adams and Mansi (2009) report for the period between 1990 and % of outside replacements and 19.6% of forced turnovers; Parrino (1997) classifies only 15% of all turnovers in his sample as outside successions and only 13% as forced departures; Finally, Clayton, Hartzell, and Rosenberg (2005), examining the impact of CEO turnovers on stock-price volatility, classify 20.6% as outside successions and 17.4% as forced departures. [Figure 1 about here] 3.3 Control Variables Abnormal stock returns induced by a turnover announcement might be influenced by a number of variables besides the origin of the new CEO, the performance of the departing CEO, and the turnover type. For instance, a blue-chip stock might react stronger to a CEO-turnover announcement because investors follow the company news more attentively or the media offer a stronger coverage. Conversely, small companies might get less attention because they are often owned by families, weaker media and analysts coverage or are simply too risky for investors to take action after a turnover announcement. To account for the existence of such effects related to the size of a company, we include as a control variable in our regressions the logarithm of company s total assets (SIZE) which we obtain from Datastream. Other variables that will likely play an important role in determining the magnitude of the stock-price impact are the age of the departing and the appointed CEO. If the incumbent CEO is close to retirement age, his/her departure might be anticipated and thus lack a strong surprise effect. In this case, the age of the departing CEO will have a dampening effect on the news impact. The appointment of a young CEO which is relatively unknown and potentially less experienced could also have a material effect on the stock-price reaction. To control for age-related effects, we include in the cross-sectional regressions the variables AGEDEP and AGEINC, i.e. the logarithm of age of the departing and incoming CEO, respectively. 12

15 4 Empirical Analysis 4.1 Abnormal Returns In order to investigate the impact of CEO-turnover announcements on stock prices, we apply standard event-study methodology. As usual, the tests rely on the assumption of market efficiency, i.e. that stock prices reflects all relevant information and thus quickly incorporate the effect related to CEO-turnover news. Consequently, we choose a short-term event window to measure the impact on stock prices. Following Brown and Warner (1985) and McWilliams and Siegel (1997) this event window should be long enough to capture the impact of the event, but short enough to minimize the influence of confounding effects unrelated to the event. Consequently, we choose to employ different event windows ranging from one to five days. To account for potential information leakage, we let some event windows start before the CEO-turnover announcement date. In accordance with the bulk of the literature on short-term event studies, we calculate abnormal stock returns in the event window by subtracting from realized stock returns the normal returns obtained by the market model. The parameters of the market model are estimated over a 250 trading-day period ending 11 days before the CEO-turnover announcement date. To make sure that the findings of the paper are not driven by inaccurate parameter estimates, the estimation of the market model is performed both by simple OLS and robust linear regressions (Huber, 1973). The latter approach is an iteratively re-weighted least squares algorithm (Holland and Welsch, 1977). In particular, in each iteration the weights are calculated by applying the bisquare function to the residuals from the previous iteration. Since the results of the two estimation procedures do not lead to qualitatively different results, for the sake of brevity, only the robust regression results are reported in the paper. In addition to measuring the magnitude of mean and median abnormal returns, it is critical to determine their statistical significance. For this purpose we employ the Standardized Cross-Sectional test by Boehmer, Musumeci, and Poulsen (1991) (henceforth simply denoted by Boehmer test). In addition, we also consider the Wilcoxon Signed Rank test by Wilcoxon (1945) (henceforth simply denoted by Wilcoxon test) which is a non-parametric test and thus does not rely on specific assumptions about the distribution of stock returns. We start the empirical investigation of this paper by measuring abnormal returns (ARs) for the whole sample and for selected subsamples defined by the key turnover characteristics: successor origin (insider or outsider), departure type (forced or voluntary), and CEO s prior performance (underperformance or overperformance). Table 4 reports both average and median abnormal returns together with test statistics obtained by the Boehmer, Musumeci, and Poulsen (1991) test and the non-parametric Wilcoxon Signed Rank test by Wilcoxon (1945). 10 When considering the results related to the whole sample (Panel A), we observe that for all event windows considered, the average and median abnormal returns are positive (the only exception is the median AR two days before the event). In the period [-2 0] both the Boehmer and the 10 While standardized residuals from the market model - and not abnormal returns - are used in the calculation of the test statistics of Boehmer, Musumeci, and Poulsen (1991), in Table 4 we still report mean abnormal returns because of their easier interpretation. 13

16 Wilcoxon test detect significant ARs at the 10% level with a mean ARs of +0.74% and a median ARs of +0.32%. The period [-1 1] is significant at the 5% level for the Boehmer test with a mean (median) AR of 0.65% (+0.35%). The mean AR of +0.42% on the announcement day is significant at the 10% level for the Boehmer test. Overall, CEO turnovers seem to convey good news for investors on average. This result finds grafical support in the development of the cumulative ARs displayed in Figure 2 (a). If we consider the subsample of turnovers with outside successors (cf. Table 4, Panel B), abnormal returns become larger and more significant. For instance, mean ARs for the periods [-2 0], [-1 0], and [-1 1] are all significant at the 5% level with values of +1.85%, +1.41% and +1.58%, respectively. By comparing in Figure 2 (b) the ARs of outside successions to the ARs of inside successions it becomes evident that the former convey positive news about the value of the company whereas the latter do not. 11 Furthermore, the difference in the cumulated AR of 1.96% for the two samples over the window [-3 0] is significant at the 10% level (see Table 5). The findings validate Hypothesis 1 of this paper and conform to the theory that an outside candidate for the CEO position must offer distinguishable better qualities than an inside candidate to be appointed CEO. According to Hypothesis 2, we expect the stock price to rise following the decision to fire a CEO. Also this hypothesis finds support in the event-study results reported in Table 4, Panel C and depicted in the ARs evolution in Figure 2 (c). The mean AR for the subsample of forced turnovers are significant at the announcement day and for all event windows longer than one day. We observe that the mean abnormal return is largest for the window [-2 0] with a value of +2.74%. By comparing in Figure 2 (c) the development of ARs for forced vs. voluntary turnovers one can visually capture the striking difference in the pattern of the two lines: increasing in correspondence of forced turnovers and very close to zero for unforced turnovers. For all tested event windows, ARs following unforced turnovers are found to be insignificant at all conventional confidence levels (results reported in Table B.1 in the Appendix). Table 5 shows that the difference in means of 3.12% between forced and voluntary turnover over the event window [-3 0] is significant at the 5% level. The impact of the departure of underperforming CEOs is shown in Table 4, Panel D. Strikingly, all the mean ARs for the event windows [-2 0], [-1 0], [-1 1], and 0 are statistically significant at the 1% level with values as high as +1.94%, +1.56%, +1.62%, and +1.25%, respectively. A very similar picture arises when focusing on median ARs and considering the Wilcoxon test. Accordingly, Hypothesis 3 stating that the information of the departure of underperforming CEOs will trigger significantly positive abnormal returns finds strong empirical support in our sample. Conversely, ARs related to departing CEOs with positive prior performance are found to be negative but insignificant (results reported in Table B.1 in the Appendix). Furthermore, we observe in Table 5 that the difference in means of 2.96% over the window [-3 0] is significant at the 1% level. Consequently, also Hypothesis 4 is confirmed in our sample. A direct comparison of the impact of the turnover of under- and overperforming CEOs is depicted in Figure 2 (d) with a clear upward trend for the former and a downward trend for the latter. The results obtained for outside successions and forced turnovers are in line with the findings reported by other authors in in the related literature (cf. Table 1). For both subsamples, positive 11 As reported in Table B.1 in the Appendix, ARs of inside successions are very close to zero and insignificant. 14

17 and significant abnormal returns could be detected. Conversely, voluntary turnovers and inside successions induce minor and insignificant stock-price reactions. Not reported in previous work, the impact of a CEO turnover on stock returns depends on the performance of the departing CEO. When underpeforming (overperforming) CEOs leave the company, the stock experiences a significantly positive (negative) price shock. The results for the samples restricted to one turnover characteristic are displayed in a compact form in Panel A of Table 7, where the ranking of ARs are based on the return period [-3 0]. We observe that forced turnovers, underperforming CEOs, and outside successors generate the largest and most significant ARs with respective values of +2.94%, +2.00%, and +1.98%. Conversely, the smallest AR is associated with overperforming CEOs. It amounts to 0.96% but is not statistically significant. At this point, it is natural to extend the current analysis and define further subsamples by combining different turnover characteristics. The goal of this exercise is to identify certain CEOturnover constellations that convey either particularly positive or negative news to shareholders. In a first step we calculate ARs for all 12 (( ) 3 ) (2 2) 2 possible subsamples (by using a [-3 0] event window) that can be constructed by pairwise interrelating the three selection criteria (turnover type, successor origin, and prior CEO performance) and rank them accordingly (cf. Panel B of Table 7). Some results deserve our attention. First, the subsamples obtained by the pairwise intersection of Outsider, Forced, and Underperformance generate the largest ARs: +6.71% (t-value = 2.68), +5.73% (t-value = 3.74), and +3.84% (t-value = 2.90) for Outsider & Forced; Forced & Underperformance; and Outsider & Underperformance, respectively. Even when considering alternative event windows (cf. Table 4, Panels E and H) those pairs of characteristics generate the strongest (and most significant) price reactions. According to Hypothesis 5 of this paper, the combination Outsider & Forced should generate positive ARs. Since this subsample is associated with the largest and most significant ARs, the data support Hypothesis 5. Second, it is of special interest to observe that forced turnovers rank both 2nd and 12th (last) in this list. In particular, when considering forced turnovers of underperforming CEOs a mean AR as large as +5.73% is achieved (associated with a t-value of 3.74). Conversely, when forced turnovers of overperforming CEOs are considered, ARs become negative! This finding is depicted in Figure 2 (f) and confirmed by alternative event windows in Table 4, Panels G and H (although the negative ARs associated with forced turnovers of overperforming CEOs are not statistically significant at low confidence levels). However, the reported results are further supported by the large and at the 1% level significant difference of 7.97% in the mean AR over the window [-3 0] reported in Table 6. This finding suggests that shareholders assess the quality of the firing decision by the board of directors by considering the quality and skills of the departing CEO. If the relative stock performance under the departing CEO is positive, shareholders seem to disfavour the decision and adjust downward their estimates about the value of the company. The double edged impact of forced turnovers is also apparent in Table 6, where we observe on the one hand mostly significant (9 out of 11 comparisons) negative differences in means of the other subsamples against the sample of forced turnovers of underperforming managers (FOR*UND) and, on the other hand exclusively positive differences against the sample of forced turnovers of overperforming managers (FOR*OVE), whereof four are significant at least at the 10% level. The sole exception of a larger cumulated AR than the one calculated for forced turnovers 15