Corporate Culture and CEO Turnover
January 31st, 2013
Abstract
We study the effect of corporate culture on the relationship between firm performance and CEO turnover. Utilizing a measure of cultural dimension developed in Organization Behavior, we quantify corporate culture by assessing corporate documents using a text analysis approach. We employ this quantification to examine the impact of culture on the shareholders’ decision to fire the CEO, especially in the case of poor firm-specific performance. We show that the probability of a CEO change in the case of poor performance is greater for companies with a culture oriented toward control. Irrespective of performance, a culture oriented toward competition or innovation is positively related to the frequency of management turnover, whereas the contrary occurs for a culture oriented toward collaboration.
Keywords: Corporate culture, Text analysis, Corporate governance, CEO
JEL classification: G14, G21, G34, M14
Acknowledgements: We thank Arnoud Boot, Olivier DeJonghe, Alessandra Ferrari, Giorgio Gobbi, Emmanuel Mamatzakis, Roman Matousek, Phil Molyneux, Nikolas Papanikolaou, Enrico Sette, and Amine Tarazi for helpful comments. We are also thankful to participants at the seminars of the Financial Intermediation of European Studies (FINEST) at the University of Rome III, and the Free University of Bozen. We would like to give special thanks to Anjan Thakor for his continuous support and great suggestions. Franco Fiordelisi also wishes to acknowledge the support of the Fulbright Commission and the Olin Business School of the Washington University in St. Louis, U.S. We alone are responsible for any remaining errors.
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* Corresponding author: Via S. D’Amico 77, 00145 Rome, Italy, tel. +39 06 57335672; fax. +39 06 57335797; e-mail: .
1. Introduction
The threat of CEO change after poor performance is one of the main instruments available to shareholders to align managers’ interests to their goals. It is widely believed that corporate culture plays an important moderating role in linking corporate culture and past performance. Surprisingly, we are not aware of any large-sample empirical evidence to show whether and how corporate culture influences the link between firm performance and the probability of CEO change. This lack of research is perhaps because the notion of culture is somewhat nebulous and raises several measurement issues in empirical research (Guiso et al., 2006). Nonetheless, recent research has begun to explore the empirical link between culture and various economic phenomena using novel approaches to measuring culture (Fang, 2001; Guiso et al., 2006; Bernhardt et al., 2006; Guiso et al., 2009; Luttemer and Singhal, 2011), but this research has not addressed CEO turnover.
What role does corporate culture play in the decision to fire a CEO after bad performance? Is there a specific firm culture that increases (decreases) the probability of changing a CEO after bad performance? These questions are critical for assessing the credibility of the CEO change threat as a corporate governance instrument. The purpose of this paper is to empirically address these questions by focusing on a large sample of US listed companies between 1994 and 2011. Our approach involves obtaining a quantitative measurement of corporate culture by assessing corporate financial statements (e.g., 10-K reports). Text analysis has recently been used in various finance papers (e.g., Antweiler and Murray., 2004; Tetlock, 2007; Li, 2008; Tetlock et al., 2008; Loughran and McDonald, 2011). This method allows us to link the probability of a CEO change to the extent of various corporate culture orientations.
Our main result is that corporate culture influences the probability of a CEO change. Specifically, the probability of CEO change increases in the case of a corporate culture oriented toward enhancing competitiveness and emphasizing organizational effectiveness and fast response. In the case of bad performance, the probability of a CEO turnover increases in companies with a high control-oriented culture, i.e., companies focusing on internal improvements in efficiency through the implementation of better processes. These results are consistent with different definitions of CEO change, different time periods (bad performance are 1 and 2 years before the CEO change) and performance indicators (ROA and ROS).
The rest of this paper is organized as follows. Section 2 provides a literature review, and Section 3 illustrates our definitions of corporate culture and formulates our research hypotheses. The econometric framework appears in Section 5. Section 6 discusses the empirical results and robustness checks, and Section 7 concludes.
2. Related literature
To be considered a valuable corporate governance instrument, CEO change must to be credible in the sense that the shareholders’ decision to fire the CEO is negatively related to firm performance. Early papers (Coughlan and Schmidt, 1995; Warner et al., 1988) find a negative link between firm performance and CEO change.
The relationship between performance and CEO change is not a simple and direct one. Since the 1990s, various authors (e.g., Zajac, 1990) have noted that neither the strategic management nor the financial economic literature offer a unified theoretical or empirical framework for topics related to CEO succession. Furthermore, these studieshave relied exclusively on archival data, with no attempt to collect or analyze primary data provided by the CEOs themselves. Consequently, the results are not always consistent, and past performance often explains only a very low portion of the turnover phenomenon (Pitcher et al., 2000). More recent papers (e.g., Wiersema and Zhang (2011) recognize that research has advanced our knowledge of the firm performance – CEO turnover linkage, but the relationship continues to appear complex and somewhat ambiguous amid the existence of several variables that may play a moderating role (e.g., CEOs’ influence on boards through direct ownership, as outlined in Easterwood et al., 2012).
Jenter and Kanaan (2012) have recently proposed a novel approach that splits firm performance into two components (systematic and firm specific), showing that CEOs are significantly more likely to be dismissed from their jobs after bad industry or bad market performance. Although there appears to be convergent evidence that CEO change is credible, there are no studies assessing the reason for this link, as noted by Jenter and Kanaan (2012, page 4) “more research is needed to identify the root cause of the peer performance effect on CEO turnover”.
The main contribution of our paper is that it is the first to provide empirical evidence (based on a large sample) that the relationship between performance and CEO turnover is strongly influenced by corporate culture. Although this finding is certainly logical and intuitive, there have been no studies documenting whether and how corporate culture influences the relationship between firm performance and shareholders’ decision to fire the CEO. We build a unique dataset of all US listed companies between 1994 and 2011 by obtaining a quantitative measurement (at the company level) of corporate culture by assessing financial statements. Our approach is based on text analysis (recently used in such finance papers as Antweiler and Murray, 2004; Tetlock, 2007; Li, 2008; Tetlock et al., 2008; Loughran and McDonald, 2011), which provides us an objective assessment of corporate culture.
As suggested by Jenter and Kanaan (2012), we use a two-stage regression approach to assess the sensitivity of CEO turnover to firm-specific performance. Jenter and Kanaan’s (2012) approach enables us to decompose firm performance into a systematic component (caused by peer group performance) and a firm-specific component that should reflect CEO ability. This approach fits our research needs very well. First, this approach is an effective instrumental variable estimation, with peer group performance serving as an instrument for firm performance (Jenter and Kanaan, 2012)[1]. Second, CEOs should be evaluated based on the firm-specific component of firm performance only and not on the performance of its reference group (e.g., the industry).
3. Theory and Hypotheses
Culture is a broad concept and represents the implicit and explicit contracts that govern behavior within an organization (Benabou and Tirole, 2002 and 2011; Tabellini, 2008). Corporate culture is traditionally considered to have an important influence on an organization’s effectiveness (Deal and Kennedy, 1982; Peters and Waterman, 1982; Schein, 1992; Wilkins and Ouchi, 1983), and, in a recent review of the literature, Sackmann (2010) suggests that some culture orientations have a positive effect on performance measures.
A first necessary step for our analysis is to define culture in a sufficiently narrow way within this framework so that it is possible to identify its influence on the relationship between CEO turnover and company performance change. We adopt the definition proposed by Cameron et al. (2006) who identify the following four types of corporate cultures (labeled as culture-dimensions): control, compete, collaborate and create.
3.1 Collaboration-oriented culture
A collaboration-oriented culture focuses internally on its employees and attempts to develop human competencies and to strengthen organizational culture by building consensus. The goal of this culture is to develop cooperative processes and attain cohesion through consensus and broad employee involvement, e.g., clarifying and reinforcing organizational values, norms, and expectations, developing employees and cross-functional work groups, implementing programs to enhance employee retention, and fostering teamwork and decentralized decision making. Companies with this culture usually succeed because they hire, develop, and retain their human resource base.
We posit that as the collaboration-orientation of corporate culture increases, there is a smaller probability of a CEO change. A greater collaboration-orientation of corporate culture implies that boards care about the development of human competencies and consensus on a daily basis rather than organizational effectiveness, resulting in a situation where CEO change is not used as a corporate governance tool and is less likely to occur relative to other companies.
Hypothesis 1 (H1): Firms with a greater collaboration-oriented corporate culture have a smaller probability of experiencing CEO change compared to other firms.
We also posit that as firm-specific profits decrease in a company with a greater collaboration-orientation culture, there is a smaller probability of a CEO change. In companies with greater collaboration-orientation of corporate culture, CEO change in the case of poor performance is less probable, as shareholders care less about poor performance than in other companies and will not punish the CEO for bad performance.
Hypothesis 2 (H2): In the case of poor performance, firms with a greater collaboration-orientation of corporate culture have a lower probability of experiencing CEO change compared to other firms.
3.2 Competition-oriented culture
A competition-oriented culture focuses on the organization’s external effectiveness by pursuing enhanced competitiveness and emphasizing organizational effectiveness, fast response, and customer focus. These companies usually attach the highest priority to customers and shareholders and judge success on the basis of indicators such as market share, revenues, meeting budget targets, and profitability growth. We posit that as the competition-orientation of corporate culture increases, there is a greater probability of a CEO change. A greater competition-orientation of corporate culture implies that boards care on a daily basis about the competitiveness and organizational effectiveness; thus, CEO change (i.e., a last-resort measure) is more likely than in other companies.
Hypothesis 3 (H3): Firms with a greater competition-orientation of corporate culture have a higher probability of experiencing CEO change compared to other firms.
Second, we assume that as the firm-specific profits decrease in a company with a greater competition-orientation culture, there is a greater probability of a CEO change. In companies with greater competition-orientation of corporate culture, a CEO change (i.e., a last-resort measure) in the case of poor performance is more probable because shareholders will punish the CEO for poor performance more than in other companies where competition is less important (H4).
Hypothesis 4 (H4): In the case of poor performance, firms with a greater competition-orientation of corporate culture have a higher probability of experiencing CEO change compared to other firms.
3.3 Control-oriented culture
A control-oriented culture refers to one that focuses on creating value through internal improvements in efficiency, the implementation of better processes (e.g., by the extensive use of processes, systems and technology) and quality enhancements (such as statistical process control and other quality control processes). Companies that have this culture usually make extensive use of standardized procedures and emphasize rule reinforcement and uniformity.
We posit that as the control-orientation of corporate culture increases, there is a greater probability of a CEO change. A greater control-orientation of corporate culture implies that boards care on a daily basis about the implementation of better production processes and thus that CEO change (i.e., a last-resort measure) is more probable than in other companies.
Hypothesis 5 (H5): Firms with a greater control-orientation of corporate culture have a higher probability of experiencing CEO change compared to other firms.
Second, we believe that as the firm-specific profits decrease in a company with a greater control-orientation culture, there is a greater probability of a CEO change. In companies with greater control-orientation of corporate culture, the CEO change (i.e., a last-resort measure) in the case of poor performance is more likely because shareholders will punish the CEO for poor performance more than in other companies where control is less important.
Hypothesis 6 (H6): In the case of poor performance, firms with a greater control-orientation of corporate culture have a higher probability of experiencing CEO change compared to other firms.
3.4 Creation-oriented culture
A creation-oriented culture focuses on creating future opportunities in the marketplace through innovation in the organization’s products and services of the organization. The organization encourages entrepreneurship, vision and constant change, e.g., allowing for freedom of thought and action among employees so that rule breaking and reaching beyond barriers are common characteristics of the organization’s culture. These companies usually aim to include innovative product-line extensions, radical new process breakthroughs, innovations in distribution and logistics that redefine entire industries and to develop new technologies.
We posit that as the creation-orientation of corporate culture increases, there is a smaller probability of a CEO change. A greater creation-orientation implies that boards care about products and service innovations on a daily basis more than they do organizational effectiveness and thus that CEO change is not used as corporate governance tool and is less likely than in other companies.
Hypothesis 7 (H7): Firms with a greater creation-oriented corporate culture have a smaller probability of experiencing CEO change compared to other firms.
We also assume that as firm-specific profits decrease in a company with a greater creation-orientation of corporate culture, there is a smaller probability of a CEO change. In companies with a greater creation-orientation, the probability that the CEO will be fired in the case of poor performance (i.e., a last-resort measure) is lower than in other companies, as shareholders care more about vision and constant change than about performance.
Hypothesis 8 (H8): In the case of poor performance, firms with a greater creation-orientation of corporate culture have a lower probability of experiencing CEO change compared to other firms.
Table 1 summarizes the attributes of the corporate culture orientations proposed by Cameron et al. (2006).
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4. Empirical Approach
This section describes the data we use in our analysis, the econometric approach and the testable hypotheses.
4.1 Data
To answer our research questions, we build a unique dataset by collecting information from three different sources to have a comprehensive and careful profile of each company.
First, we obtained information on top executive officers (and specifically, on CEOs’) from the Execucomp database. Data were available for the period 1992-2011, resulting in 209,840 year-observations. We excluded all cases of inconsistent or missing data (i.e., if the CEO annual flag was in conflict with the dates when the interested manager joined or left the company or if the information about the identity of the CEO was available only for a specific year but not for the previous one, rendering it impossible to know whether there was a turnover).
Second, we obtained financial data by extracting 247.796 simplified balance sheets from Compustat between 1990 and 2011. As in the previous case, we removed all companies with missing data.
Third, we obtained 128.489 company filings by downloading the 10-K reports (available from 1994 to 2011) from the SEC’s Edgar database, and for each of these filings, we ran a text analysis to estimate each cultural dimension identified by Cameron et al. (2006) (513,956 texts analyzed overall).
Our final sample includes all US listed companies between 1994 and 2011 for which it was possible to a) collect information on top managers, b) determine accounting-based performance, and c) measure the relevant cultural dimensions. Information relative to the same company and drawn from different databases was matched using the GVKEY code. As a result, we have a unique dataset of 19.453 year-observations, combining managerial, accounting and cultural information. A CEO change occurs at a frequency of approximately 10% (see Table 2). We distinguished financial from non-financial companies on the basis of the SPINDEX code and the industry group definitions: observations for financial and non-financial companies represent, respectively, approximately 15% and 85% of our sample. We considered the following industry groups as financial groups: Asset Management and Custody banks; Consumer finance; Diversified banks; Diversified REITs; Industrial REITs; Insurance brokers; Investment banking and brokerage; Life and health insurance; Mortgage REITs; Multi-line insurance; Office REITs; Other diversified financial services; Property and casualty insurance; Real investment trust; Regional banks; Reinsurance; Residential REITs; Retail REITs; Specialized finance; Specialized REITs; and Thrifts and mortgage finance. Companies without an assigned industry group were excluded from the sample.
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4.2. Corporate culture estimation
We now describe our corporate culture variables. First, we outline our text analysis approach to estimate Cameron et al.’s (2006) corporate culture dimensions and then present our variables to measure culture homogeneity and heterogeneity.
To quantitatively measure Cameron et al.’s (2006) four dimensions of corporate culture, we use text analysis. Text analysis is a technique used to examine, in a systematic and objective manner, the characteristics specific to a text (Stone et al., 1966). The idea underlying our approach is based on the assumption that the words and expressions used by the members of an organization (labeled “vocabulary”) represent the outcome of the culture they develop over time (Levinson, 2003).