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Authors:

• Thomas J. Chemmanur
  Boston College

• Viktar Fedaseyeuy
  Boston College

We develop a theory of corporate boards and their role in forcing CEO turnover. We consider a firm with an incumbent CEO of uncertain management ability and a board consisting of a number of directors whose role is to evaluate the CEO and fire her if a better replacement can be found. Each board member receives an independent private signal about the CEO's ability, after which board members vote on firing the CEO (or not). If the CEO is fired, the board hires a new CEO from the pool of candidates available. The true ability of the firm's CEO is revealed in the long run; the firm's long-run share price is determined by this ability. Each board member owns some equity in the firm, and thus prefers to fire a CEO of poor ability. However, if a board member votes to fire the incumbent CEO but the number of other board members also voting to fire her is not enough to successfully oust her, the CEO can impose significant costs of dissent on him. In this setting, we show that the board faces a coordination problem, leading it to retain an incompetent CEO even when a majority of board members receive private signals indicating that she is of poor quality. We solve for the optimal board size, and show that it depends on various board and firm characteristics: one size does not fit all firms. We develop extensions to our basic model to analyze the optimal composition of the board and the effect of board members observing imprecise public signals in addition to their private signals on board decision-making. Finally, we develop a dynamic extension to our basic model to analyze why many boards do not fire CEOs even when they preside over a significant, publicly observable, reduction in shareholder wealth over a long period of time. We use this dynamic model to distinguish between the characteristics of such boards from those that fire CEOs proactively, before such shareholder wealth reductions take place.