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  • The Cost Of Entrenchment: Why CEOs Are Rarely Fired

    When I talk to my friends outside of finance and read the popular press, you find a knee-jerk reaction that not enough CEOs are fired.

    Wharton finance professor Luke Taylor has heard the conventional wisdom many times: Boards of directors often fail to do their jobs when it comes to firing underperforming CEOs. “When I talk to my friends outside of finance and read the popular press, you find a knee-jerk reaction that not enough CEOs are fired,” says Taylor. The data shows that “2% of Fortune 500 CEOs on average are fired every year, but we have no benchmark for judging whether¬†[that figure]¬†is a lot or not enough.”

    Taylor set out address that question. His goal: To model the decision to fire a CEO and quantify the forces at work. His work was published in the December 2010 issue of The Journal of Finance in a paper titled, “Why are CEOs Rarely Fired? Evidence from Structural Estimation.” Taylor’s model contained two costs of firing a CEO. Direct costs, such as severance, make up the first component. The second component is what Taylor terms “entrenchment” costs, which are intangible costs that board members feel but shareholders do not — for instance a personal relationship between board members and the CEO. If there are any entrenchment costs, then boards fail to get rid of CEOs whom shareholders would like to see fired — in short, creating an environment where fewer top executives are let go than should be, based on performance.Taylor’s model found that the entrenchment cost per firing was, on average, $1 billion — far more than the $300 million in direct costs.

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    http://knowledge.wharton.upenn.edu/article.cfm?articleid=2674

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