When the CEO is also the Chair of the Board

Aloke Ghosh*

and

Doocheol Moon

June 2009 __________________________________________ *Corresponding author Professor of Accountancy Zicklin School of Business Box B12-225, 55 Lexington Avenue New York, NY 10010 Phone: 646.312.3184 Fax: 646.312.3148 E-mail: Aloke_Ghosh@baruch.cuny.edu We thank Jay Dahya, Masako Darrough, Val Dimitrov, Rong Huang, Prem Jain, Srini Krishnamurthy, Christine Mashruwala, Dae-Hee Yoon, Ying Li, Christine Petrovits, Bill Ruland, Steven Young and the participants at the AAA Annual Meetings for their helpful comments and suggestions.

When the CEO is also the Chair of the Board

Abstract

A fundamental concern is that CEOs serving as chairs of the board (Chair) might use their power to “extract rents.” In contrast, under efficient contracting theory, depending on the firms’ information and contracting environment, firms can also benefit from one individual holding both positions. Consistent with efficient contracting theory, we find that the prospect of a CEO serving as the Chair increases with the riskiness of a firm, industry concentration, CEOs’ ability and track record, and stronger governance. We also directly test the rent extraction hypothesis by examining whether CEOs use their managerial power from holding the two top positions to derive personal benefits. We find no evidence of adverse consequences from CEOs holding dual positions in the form of excessively high CEO compensation, use of financial reporting discretion to manage earnings, or lower market valuations. There is also no evidence to suggest that CEOs with dual positions build empires through frequent acquisitions or that they pay less dividend. Finally, examination of the stock market returns around the announcement date indicates that investors do not react negatively to the news about an expansion or contraction in the role of a CEO, which is again inconsistent with the rent extraction theory. Overall, our results support the view that the organization of the leadership in U.S. firms is optimally determined for a typical large firm.

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1. Introduction

In corporate hierarchy, the Chief Executive Officer (CEO) heads the management team

while the governing board is led by the chair of the board (Chair). Empirical evidence suggests

that the CEO of large U.S. public companies also tends to be the Chair.1 Because of the recent

corporate scandals, regulators and reformers are increasingly demanding that the role of the

CEO be separated from that of the Chair (Wilson 2008, Lorsch and Zelleke 2005). Advocates

claim that having an independent Chair results in superior monitoring by the board. CEOs

become more effective leaders when the two positions are separated because it allows them to

concentrate on the firm’s operations while empowering the board (Wilson 2008).2

Our study examines several inter-related issues with the purpose of providing input to

the debate on the dual role of CEOs: (1) we test whether the appointment of a CEO as the Chair

is an efficient response to firms’ contracting and information environment (efficient contracting

theory), (2) because CEOs with dual positions can misuse their power for personal gains, we

investigate whether CEO-Chairs, relative to firms with independent Chairs, have higher

compensation, use accounting discretion to manipulate earnings, acquire more frequently, are

reluctant to pay out cash to shareholders (rent extraction theory), and (3) we examine whether

the stock market perceives dual leadership structure as a symptom of agency problems.

While the benefits of the separation of the CEO-Chair positions have been publicized

recently, firms can profit from one individual holding dual position in several ways (Pozen 2006).

First, a CEO who is also the leader of the board is in a powerful position to oversee the

directions of a firm relatively unopposed. Conflicts situations are more likely to arise when a

1According to a 2004 study on governance by Corporate Library, 75% of the CEOs of the S&P

500 companies are also the board’s chair. For 25% of the companies that did not combine the two jobs, 65 firms had a chairman who was the company’s former CEO.

2 However, these claims are largely unsupported by empirical evidence. Having an independent

Chair does not seem to increase boards’ ability to replace poorly performing CEOs (Dahya et al. 2002) or increase the performance of the company (Dahya and McConnell 2007, Romano 2001, Brickley at al. 1997).

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CEO is at odds with an independent Chair about the future of the company. A CEO-Chair faces

less opposition from the board when initiating major changes within the company than when the

two top leadership positions are separated.3 Second, one of the fundamental duties of a board

as outside experts is to advise and monitor the top management team (Linck et al. 2008, Raheja

2005). However, outside directors are less effective in their monitoring and advising roles when

firm-specific information is high (Coles et al. 2008). Firms with high R&D expenditures,

substantial growth opportunities, and high volatility are harder to monitor unless outside board

members are privy to the firm’s investment opportunity set. Similarly, they are most effective in

their advisory role when management communicates its specific needs to the board (Hermalin

and Weisbach 1988). Because directors mostly receive company-specific information from the

CEO (Finkelstein and D’Aveni 1994), firms with high insider information benefit from having the

CEO communicate directly to the board rather than go through an independent Chair who is

much less informed about the firm’s constraints and opportunities. Third, firms are expected to

exploit the skills of long-serving successful CEOs by combining the two top positions. This is

because CEOs with a proven record of excellence have more to lose when they misuse their

power to the detriment of the shareholders.

While there are potential benefits from having a dual leadership structure, such

arrangements also impose costs. As the Chair, the CEO is more powerful because he/she has a

strong say in matters of governance in deciding the agenda, setting board meetings, re-

appointment decisions, and selection of various sub-committees such as audit, compensation

and nominating committees. A common perception is that CEO-Chairs exploit their power to

extract private benefits including increasing compensation or other forms of perquisite

3For instance, while a CEO is often responsible for formulating mergers and acquisitions policies,

sale of subsidiaries, and dividend and financing policies, these decisions are typically ratified by the board members (Florou 2005). The chairman of the board frequently plays a critical role in either advocating or opposing these policies as they are presented to the board thereby influencing the ultimate decision of the board members. Thus, there is less opposition from the board when the CEO is also the Chair.

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consumption (Jensen 1993). We posit that CEO-Chairs are less likely to use their power for

personal reasons when firms have strong corporate governance mechanisms.4 While powerful

CEOs are given a free hand in the firm’s operating decisions for firms with dual leadership

structures, having strong governance ensures that CEOs do not misuse the power to enhance

their personal welfare. Thus, strong governance is optimal for firms with dual leadership

structure because it exploits potential benefits while minimizing costs (efficient contracting). An

opposing view is that dual leadership structure is sub-optimal because CEO-Chairs use their

added power from holding two top positions to extract rents for themselves (rent extraction).

Our results from a large sample of firms from 1998 to 2005 are mostly consistent with

the efficient contracting and inconsistent with the rent extraction proposition. We find that the

likelihood of CEOs holding a dual position increases with volatility, industry concentration,

liability, firm size, firm age, CEO tenure, CEO ownership, institutional ownership, board

independence, and audit committee size. Thus, consistent with the prediction that CEO-Chair

appointment is an efficient response to the firm’s contracting environment, our results suggest

that the prospect of a CEO serving as the Chair increases with the riskiness of a firm, industry

concentration, CEOs’ ability and track record, and strong governance.

A more direct test of the rent extraction hypothesis is to examine whether there are

adverse consequences from CEOs holding dual positions including excessively high CEO

compensation, use of financial reporting discretion to manage earnings, lower market valuation,

more likely to engage in acquisitions, or paying out less cash to shareholders. First, controlling

for other determinants of executive compensation (e.g., Core et al. 1999) and CEO-Chair, we

find no evidence to suggest that CEOs’ compensation is higher when they hold dual positions

compared to what they earn when they do not hold dual positions. Second, controlling for

factors that influence financial reporting decisions (Ashbaugh et al. 2003, Klein 2002a) and

4Firms with strong corporate governance have larger and more independent boards and audit

committees, CEOs with greater percentage of ownership in the firm, and larger institutional ownership.

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CEO-Chair, we find very little evidence to suggest that the CEO-Chair uses the enhanced power

to manipulate earnings. Third, controlling for taxes, investment and financing decisions

(Pinkowitz et al. 2006, Fama and French 1998), we do not find that the market valuation is

different between the two groups of firms.5 Finally, we find no evidence to suggest that CEO-

Chairs are more acquisitive or that they pay less cash to shareholders. Thus, our examination

does not support claims that CEO-Chairs extract rents or adversely affect shareholder welfare.6

A key contribution of our study is not that we find no evidence of rent extraction by CEO-

Chairs but that we provide explanations for why they do not extract rents, which is linked to the

governance structure. CEOs have a relatively difficult time extracting rents (even if they want to)

when boards are more independent, stronger, and more effective, and when institutional

presence is larger. Also, because the cost of value-reducing actions is high to CEOs, they are

less likely to extract rents as CEO-Chairs when their ownership is high. Further, reputation is

another factor that ensures that capable CEOs will use their added power judiciously and not to

the detriment of the shareholders.

Finally, assuming that our CEO-Chair prediction model is a parsimonious representation

of the firms’ underlying optimal economic decision to have CEOs hold dual positions, this model

can identify circumstances when CEOs are more likely to use their power to extract rents.

According to our model, CEOs with dual positions are expected to extract rents when they serve

as CEO-Chairs even though our estimates indicate low probability of a dual leadership structure.

The reverse is true when the estimated probabilities are high. Consistent with our expectation,

5Because market valuation tests are association regressions prone to the omitted variables problem, we also analyze the stock market reactions to announcements of changes in the leadership structure as market assessment of the rent extraction theory. Examination of the stock market returns around the announcement date indicates that investors do not react negatively to the news about an expansion or contraction in the role of a CEO, which is again inconsistent with the rent extraction perspective.

6It is possible that CEO-Chairs extract rents by giving themselves more perquisites rather than higher pay (e.g., Rajan and Wulf 2006). Some examples of perquisite consumption include the use of private jets, signing bonuses, chauffer-driven car etc. However, given that typically market valuation does not vary between the two sets of firms, our results suggest that investors are unaware of rent extraction even when CEO-Chairs abuse their perquisite consumption.

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we find that CEO compensation and earnings management are economically and statistically

higher for firms with low probabilities compared to those with high probabilities.

The rest of the paper is structured as follows. Section 2 provides an analysis of the

CEO-Chair dual positions, Section 3 discusses the research design, and Section 4 discusses

the sample selection process. Section 5 presents the empirical findings and Section 6

concludes the paper.

2. Analysis of CEO-Chair Dual Positions

2.1. Background

Since the high profile corporate scandals over the recent years, regulatory institutions

have initiated many reforms intended to protect investors by trying to strengthen the quality of

the corporate boards. For instance, the Securities and Exchange Commission adopted several

new rules and approved proposals by the American Stock Exchange (ASE), New York Stock

Exchange (NYSE), and National Association of Securities Dealers (NASD) to change their

listing requirements and confirm with some of the recommendations of the Blue Ribbon

Committee (BRC 1999, SEC 2003a & 2003b) primarily to strengthen boards and audit

committees. The recent regulatory changes following the Sarbanes-Oxley Act (SOX, 2002) have

further enhanced the role of boards and audit committees.

One of the more controversial issues in corporate governance in the post-SOX era is

whether the CEO should also serve as the Chair. Most large U.S. companies have the CEO

also serving as the Chair. Regulators, practitioners, and shareholder advocates have argued in

favor of separating the roles of a CEO and Chair as a solution to some of the corporate

problems. In a recent op-ed article in the Wall Street Journal (July 9, 2008), Gary Wilson, a

former director of Disney and the Chairman of Northwest Airlines, writes that the most serious

corporate governance problem in the U.S. is the imperial CEO who is both the chairman of the

company’s board of directors as well as its CEO. He argues that the dual position creates a

conflict of interest because the chairman, who is also the CEO, is accountable to no one. The

primary responsibility of the board is to hire, oversee and, if required, fire the CEO. However, if

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the CEO is also the chairman of the board, then he leads a board that is charged with

evaluating, compensating and possibly firing himself.

The January 2003 report of the Conference Board’s Commission on Public Trust and

Private Enterprise also recommended separating the role of the CEO and Chair as a

requirement for best practices in corporate governance (Allen and Berkley 2003).7

2.2. Benefits from CEOs holding joint positions

There are several explanations for firms benefiting from CEOs holding dual positions.

The duties of a chairperson include presiding board meetings, ultimate approval over the

information sent to the board members, final approval over the meeting agenda, serving as the

principal liaison to the independent directors, and setting meeting agendas. A CEO-Chair is in a

powerful position of managing a firm’s operations and also overseeing the direction of the firm.

The added power from the dual responsibilities can be effectively used by the CEO to provide

stronger leadership especially when boards and management are at odds with each other

(Baliga et al. 1996). Further, a consolidation of the two positions establishes a unity of command

at the top with unambiguous leadership (Finkelstein and D’Aveni 1994).

Other things remaining constant, the benefits to shareholders from CEOs holding joint

positions are expected to be large for firm with certain attributes. The two broad activities of the

board grouped along functional categories are monitoring and advising tasks (Linck et al. 2008,

Adams and Ferreira 2007, Raheja 2005). The monitoring function requires directors to (1)

review and approve management actions including operating and financing decisions, and other

corporate strategies and plans, and (2) protect shareholders from managerial expropriation in

the form of shirking, fraud or earnings management. The advising function involves drawing

7 In the U.K., the value of this arrangement has become an article of faith (see the

recommendations of the Committee on Corporate Governance (2000) and the Cadbury Report (1992)). Around 82 percent of the British companies have an independent chairman of the board and 95 percent of the FTSE 100 companies have an independent chair (Pozen 2006, Florou 2005).

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upon the expertise of the directors to council management on the firm’s strategic direction

(Adams and Ferreira 2007).

Both monitoring and advising functions become more difficult for firms with high insider

information (Adams and Ferreira 2007). Typically, the job of analyzing and reviewing the

performance of management or advising management is more difficult for independent board

members when firm specific knowledge is high. For instance, R&D intensive firms, those with

abundant growth opportunities, and volatile firms are hard to review, analyze or monitor without

adequate input from insiders. Because CEOs in these types of firms have firm specific

knowledge, especially those with long tenure, the benefits from the CEO also serving as the

Chair can be large. The CEO-Chair can set the agenda of the board in areas where the firm

needs the most advice, share inside information with board members, and thereby match the

needs of the firm with the expertise of the board.

Similarly, firms with complex operations are also expected to benefit from having one

individual serve as the Chair and CEO of the company. Firms with complex operations benefit

from the insights of board members with relevant experience and expertise in specific areas.

However, the areas that a firm is in particular need of strategic advice are known to the CEO. A

CEO who is also the Chair can set the meeting agenda, and prioritize the agenda to meet the

needs and demands of the firm. Also, as the Chair, the CEO is likely to nominate board

members who have unique strengths and expertise that match the needs of the company.

Finally, able CEOs with a strong track record are less likely to misuse the added power

from also serving as the Chair because of reputational concerns. Thus, benefits are larger from

having a dual position when firms have superior performance attributable to the CEO or when

CEOs have served over a period of time and their ability can be assessed more accurately.

2.3. Costs from CEOs holding joint positions

A key concern with one individual holding a dual position is that it creates a conflict of

interest within the board. The principal function of the board of directors, according to agency

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theorists, is to monitor the management and to protect investors from potential expropriation by

management. Board of directors tends to concentrate on performance as a crucial element of

their monitoring task and they are more likely to dismiss CEOs following poor performance.

Because outside directors are more concerned about protecting their personal reputations as

directors, they are considered superior monitors (Fama and Jensen 1983). Further, outside

directors are expected to perform their monitoring task more effectively in the presence of large

shareholders or institutional ownership with a large stake in the company who are likely to

demand more from the board.

Conventional wisdom suggests that having one individual holding two positions leads to

a concentration of power because of the following reasons. A CEO who is also the Chair has

the final say in nominating directors (Shivdasani and Yermack 1998). They are more likely to

nominate those who are loyal to the CEO. A CEO as the Chair also has the ultimate decision in

setting the agenda and the direction of the company. Therefore, there is likely to be less

opposition from independent directors when the CEO is also the Chair than when the two roles

are separated. Also, because of a fear of losing their jobs, outside directors are less likely to

challenge the agenda when the CEO is the Chair as well. Consequently, granting the CEO an

influential role in the board’s oversight responsibilities compromises its effectiveness and

independence.

The fundamental concern is that CEOs might use their added power that comes from

holding two positions to further their own interests rather than the interests of the shareholders.

For instance, they could work less, increase their perquisite consumption, use the accounting

flexibility to mislead shareholders in the short term to inflate stock prices, or give themselves

excessive compensation.

2.4. Efficient contracting versus rent extraction hypotheses

Under the efficient contracting perspective, companies contract to maximize benefits

while reducing their transaction costs. Therefore, on average, firms with high insider information,

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those with complex operations and firms having CEOs with successful track record are

expected to combine the two positions because the benefits are larger from having one

individual serve both positions rather than separating the two roles.

Efficient contracts aim to optimize net benefits. Firms intending to harness the benefits of

having one individual serve dual positions would also minimize the potential costs arising from

CEO-Chairs having concentrated power. One way to neutralize the added power that stems

from combining the positions is to have strong supporting corporate governance mechanisms

that deter CEOs from using the power for personal gains. Examples of strong governance

include higher proportion of independent directors on boards and on audit committees, bigger

boards and audit committees, presence of institutional shareholders, and giving CEOs more

equity in the company compared to when the roles are separated. Finally, because CEOs use

their power to enhance shareholder value rather than extract rents for themselves, there are no

adverse consequences. Thus, there are no reasons to expect that CEO compensation is higher,

there is more earnings management, or market valuations are lower when CEO is also the

Chair than when the two jobs are separated.

In stark contrast, under the rent extraction viewpoint, there are no reasons to presume

that firms contract to optimize benefits while minimizing transaction costs. Therefore, firm

attributes are not expected to be associated with the probability of firms combining or separating

the two top jobs. Moreover, CEOs are predicted to prefer weaker forms of corporate governance

to minimize opposition from outside monitors. Thus, firms combining the two jobs will have lower

proportion of independent directors on boards and audit committees, smaller boards and

smaller audit committees, fewer institutional shareholders, and less CEO ownership compared

to when the roles are separated. Finally, because CEOs use their power for personal gains,

some of adverse consequences are higher CEO compensation, more earnings management,

and lower market valuations compared to when the two jobs are separated.

3. Research Methodology

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3.1. Economic determinants of CEOs holding dual positions

Drawing on the recent studies, we partition the determinants of CEOs holding joint

positions into four categories: (1) firms with high insider information (R&D, ΔSales, VolatilityROA,

Intangible, and Concentration), (2) firms with complex operations (Liability, Size, Age, and

Segments), (3) firms with able CEOs with a proven track record (Tenure and ROA), and (4)

proxies for agency costs (OwnershipCEO, OwnershipIns, IndependenceBoard, Board-size,

IndependenceAudit, and Audit-size).

The two measures of growth are R&D (R&D expenditures normalized by sales) and

ΔSales (change in sales between the current year and the prior year deflated by sales of the

prior year). VolatilityROA is the standard deviation of industry-adjusted ROA over the previous

seven years, where ROA is income before extraordinary items scaled by total assets at the

beginning of the year. Intangible is intangible assets scaled by total assets. Concentration is

Herfindahl Index measured as the sum of the squared market share of all firms in an industry.

Liability is the ratio of total liability to total assets. Size is the logarithm of fiscal year-end total

assets. Age is the number of years that the firm is publicly traded as of the fiscal year-end.

Segments is an indicator variable set to one when a firm has more than one segment. Tenure is

the number of years that the CEO has been in office as of the firm’s fiscal year-end.

OwnershipCEO (OwnershipIns) is the percentage of outstanding common stock held by the CEO

(financial institutions) at the fiscal year-end. IndependenceBoard is the percentage of

independence directors on the board and Board-size is the number of members on the board.

IndependenceAudit is the percentage of independence directors on the audit committee and

Audit-size is the number of members on the audit committee.

Under the efficient contracting hypothesis, firms benefit from having one person hold

both positions when insider information is high, firms have complex operations, CEOs are

successful with a proven track record, and firms have few agency problems. In sharp contrast,

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according to the rent extraction hypothesis there are no reasons to expect an association

between firm characteristics and the likelihood of CEOs also serving as the Chair. Further,

under this perspective, the likelihood of CEOs holding joint positions increases with higher

agency costs.

Therefore, our tests of the economic determinants of CEOs holding dual positions are

based on the following logistic regression model.8

CEO-Chair = β0 + β1R&D + β2ΔSales + β3VolatilityROA + β4Intangible + β5Concentration + β6Liability + β7Size + β8Age + β9Segments + β10Tenure + β11ROA + β12Tenure×ROA + β13OwnershipCEO +β14OwnershipIns + β15IndependenceBoard + β16Board-size + β17IndependenceAudit + β18Audit-size + Industry/year dummy + ε (1)

Where CEO-Chair is a dichotomous dependent variable which equals one when the

CEO is also the board chairman, and zero when the two roles are separated. To mitigate

concerns about endogeneity, we measure all the independent variables one year prior to the

year the CEO either holds joint or single position.

3.2. Adverse consequences under rent extraction hypothesis

One of the central predictions of the rent extraction hypothesis is that there are adverse

consequences from CEOs holding dual positions. Under this hypothesis, CEOs exploit their

added power to further their own interests rather than take decisions in the interest of the

shareholders. We directly test three crucial consequences under the rent extraction hypothesis:

(a) CEOs holding dual positions earn excessive compensation, (b) CEOs with dual positions

engage in earnings management to inflate stock prices in the short run, and (c) firms with CEO-

Chair are penalized by the stock market relative to firms that separate the two top positions in

the company because of a perception that they extract rents.

(a) CEO-Chair and executive compensation

8Other related studies use a similar approach to investigate the economic determinants of board

size, board independence, and audit committee independence (e.g., Linck et al. 2008, Coles et al. 2008, Raheja 2005, Klein 2002b).

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We re-examine the relationship between CEO compensation and CEO-Chair using the

following augmented model.

Pay = β0 + β1Sales + β2Market-to-Book + β3ROA + β4Return + β5VolatilityROA + β6VolatilityReturn + β7CEO-Chair + β8IndependenceBoard + β9Board-size + β10OwnershipCEO +β11OwnershipIns + β12R&D + β13ΔSales + β14Intangible + β15Concentration +β16Liability + β17Size + β18Age + β19Segments + β20Tenure + Industry/year dummy + ε (2)

Where Pay measures CEO compensation (cash, stock, and total). Cash compensation

is the CEO’s salary and bonus during the fiscal year, and Stock compensation is the sum of the

Black-Scholes value of stock options granted and the value of restricted stock grants during the

year. Total compensation is the sum of Cash and Stock compensation. Sales is measured one

year prior to the year compensation is awarded. Market-to-book is a firm’s market value of

equity divided by book value for the prior year. Return is the buy-and-hold abnormal returns

measured as the difference between the buy-and-hold raw returns and the buy-and-hold equal-

weighted CRSP market returns over the previous twenty-four months. VolatilityReturn is the

standard deviation of Returns over the previous twenty-four months. All the other variables are

as previously defined.

As in Core et al. (1999), the CEO compensation regression includes a broad set of

governance variables (CEO-Chair, IndependenceBoard, Board-size, OwnershipCEO, and

OwnershipIns), and the economic determinants of executive compensation which include

constructs for size, growth, performance, and risk (Sales, Market-to-Book, ROA, Return,

VolatilityROA, and VolatilityReturn). To ensure that the compensation regression is correctly

specified, we additionally include the economic determinants of the CEO-Chair (R&D, ΔSales,

Intangible, Concentration, Liability, Size, Age, Segments, and Tenure). If the economic

determinants of CEO-Chair capture dimensions of a firm’s size, growth opportunity,

performance, and risk that are not fully captured by the constructs included as the economic

determinants of CEO-pay, including the economic determinants of CEO-Chair improves the Pay

regression specifications.

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Our emphasis is on the coefficient on CEO-Chair. A positive coefficient is consistent with

rent extraction hypothesis because it indicates that CEOs use their power to increase their

compensation beyond levels that are based on the firm’s operating and information environment,

and the demand for a high quality CEO.

(b) CEO-Chair and earnings management

We test whether earnings management is larger for firms where the CEO is also the

chair of the board relative to firms that separate the two roles using the following regression.

Discretionary accruals9 = β0 + β1Large-auditor + β2SizeMVE + β3Leverage + β4Market-to-Book + β5Litigation + β6Loss + β7Cash-flow + β8CEO-Chair + β9IndependenceBoard + β10Board-size + β11IndependenceAudit + β12Audit-size + β13OwnershipCEO +β14OwnershipIns + β15R&D + β16ΔSales + β17VolatilityROA + β18Intangible + β19Concentration + β20Liability + β21Age + β22Segments + β23Tenure + β24ROA + Year dummy + ε (4)

Where the Large-auditor is an indicator variable that equals one when the client’s auditor is a

large accounting firm. SizeMVE is the natural logarithm of fiscal year-end market value of equity.

Leverage is the ratio of total debt to total assets. Litigation is 1 if the firm operates in a high-

litigation industry, and 0 otherwise (high-litigation industries are industries with SIC codes of

2833-2836, 3570-3577, 3600-3674, 5200-5961, and 7370-7370). Loss is 1 if the firm reports a

net loss and 0 otherwise. Cash-flow is cash flow from operations scaled by beginning of the

year total assets. All other variables are as previously defined.

We include several variables including firm characteristics (SizeMVE, Leverage, Market-

to-Book, Loss, Cash-flow), ownership structure (OwnershipIns), Industry (Litigation), and auditor

size (Large-auditor) that are determinants of Discretionary accruals. We also include the

governance variables because prior studies find that these variables to be correlated with

9We use discretionary accruals from the modified Jones (1991) model with additional controls for

firm performance as a surrogate for earnings management. Discretionary accruals are estimated as the error term from the following regression.

Accruals = β0 + β1 (ΔSales - ΔAR) + β2 PPE + β3 Earnings + η (3)

where Accruals are income before extraordinary items less operating cash flow, ΔSales is changes in sales, ΔAR is changes in accounts receivable, PPE is the gross level of plant, property, and equipment, and Earnings controls for performance (earnings before extraordinary items). We scale all the variables including the intercept by total assets at the beginning of the year. As in prior research, regressions are estimated for each industry and each year.

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Discretionary accruals. Finally, we include the CEO-Chair determinants because these variables

also might be correlated with accounting accruals.

(c) CEO-Chair and firm valuation

Finally, as in Pinkowitz et al. (2006) and Fama and French (1998), we examine

differences in market valuation between firms having CEOs also serving as the Chair compared

to those with separate positions using the following regression:10

FV = β0 + β1CEO-Chairt + β2Et + β3∆Et + β4∆Et+1 + β5∆ASTt + β6∆ASTt+1 + β7R&Dt + β8∆R&Dt + β9∆R&Dt+1 + β10INTt + β11∆INTt + β12∆INTt+1 + β13DIVt + β14∆DIVt + β15∆DIVt+1 + β16∆FVt+1 + Industry/Year dummy + ε (5)

Where FV is the sum of the market value of equity, the book value of preferred stock, book

value of short-term debt, and the book value of long-term debt scaled by the book value of total

assets. E is earnings before extraordinary items plus interest, deferred tax credits, and

investment tax credits. AST is the fiscal year-end total assets. R&D is research and

development expense. When R&D is missing, we set it equal to zero. INT is interest expense

and DIV is dividends defined as common dividends paid. Δt is a change operator measuring the

change in a variable from year t-1 to year t. Similarly, Δt+1 is the change in a variable from year t

to year t+1. All earnings, investment, and financing variables are all scaled by the total assets in

year t. The future period variables are introduced to absorb changes in expectations. CEO-Chair

is as previously defined.

Under the rent extraction hypothesis, the coefficient on CEO-Chair is expected to be

negative and significant. Because of a common perception that CEOs use their power from

holding the two top positions in the firm to extract rents, the market valuation of firms is likely to

be lower than those that separate the two top positions.

4. Data and Descriptive Statistics

4.1. Sample selection

10Fama and French (1998) developed this specification which subsequently has been used in other studies largely because this specification is able to explain large variations in firm values in the cross section.

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Our initial sample is based on corporate governance data obtained from RiskMetrics with

annual shareholder meetings from 1998 to 2006. RiskMetrics examines the proxy statements

for firms listed in the Standard and Poor’s (S&P) 500 index, the S&P MidCap 400 index, and the

S&P SmallCap 600 index. We obtain data on board characteristics (composition, size, and

leadership) and audit committee characteristics (composition and size) from RiskMetrics. Since

the RiskMetrics data are based on the proxy meeting year, we obtain the fiscal year

corresponding to the proxy meeting year by comparing the fiscal year-end and the meeting

date.

We get CEO stock ownership and tenure data from Compustat’s ExecuComp which

includes data for firms listed in the S&P 1500 index. We also obtain institutional stock holdings

data from CDA/Spectrum gathered from 13F forms filed with the SEC. The data on firm

characteristics are collected from the Compustat annual files. We compute the age of the firm

based on information included in CRSP files. We then merge the governance data with the CEO

ownership, accounting, and firm age data. To remove the effect of outliers, we winsorize the top

or bottom 1 percent of observations for R&D, ΔSales, VolatilityROA, Intangible, Liability, and

ROA. This sample selection procedure results in 7,926 firm-year observations over fiscal years

from 1998 to 2005.

4.2. Descriptive statistics

Table 1 provides the descriptive statistics for the variables used in Equation (1). All data

are for, or as of, the year-end prior to the proxy date. The majority of the boards have the same

chairman and CEO (CEO-Chair); the CEO is also the board chairman in 67.4 percent of the

sample firms, which is consistent with prior findings. R&D investments for the average firm are

3.6 percent of sales. The mean (median) sales growth (ΔSales) is around 11.1 (8.1) percent.

The mean (median) volatility of earnings (VolatilityROA) is 5.5 (3.4) percent. The mean (median)

industry concentration (Concentration) is 0.21 (0.16). The mean (median) intangible assets

16

(Intangible) and liabilities (Liability) relative to total assets are 13 (7) percent and 56 (57) percent,

respectively. Firms in our sample tend to be larger than the Compustat population, with mean

(median) total assets of $15.4 (1.9) billion. Our sample includes mature firms with the mean age

of the firm (Age) being 26.2 years. Of all the firm years, 55.6 percent have more than one

business segment (Segments). The mean (median) CEO tenure (Tenure) is about 8.1 (5) years,

whereas the mean (median) industry-median adjusted return on assets (ROA) is about 5.7 (3.2)

percent.

Descriptive statistics for stock ownership and board characteristics are also reported in

Table 1. The distribution of CEO stock ownership (OwnershipCEO) is skewed; CEOs hold about

2.2 (0.3) percent of their firm’s shares, on average (median). Institutional ownership is very high

for our sample firms; the average (median) value of institutional ownership is about 67 (69)

percent. The average (median) board has around 68 (70) percent of outside directors

(IndependenceBoard) with about 10 (9) board members (Board-size). On average (median), the

audit committee has around 91 (100) percent of outside directors (IndependenceAudit) and about

4 (4) members make up a committee (Audit-size).

5. Empirical Findings

5.1. Economic determinants of CEOs holding dual positions

Table 2 presents the results from estimating Equation (1) using the pooled sample. Our

logistic regressions include observations from years from 1999 to 2005 because explanatory

variables are measured one year prior to the year the CEO either holds a joint or single position.

The dichotomous dependent variable (CEO-Chair) equals one when the CEO is also the

chairman of the board and zero otherwise.

Regression 1 reports the effect of firm characteristics and stock ownership variables on

having CEO-Chairs. We proxy for insider information using R&D, ΔSales, VolatilityROA,

Intangible, and Concentration. The coefficient on VolatilityROA is positive and significant (1.161,

χ2=4.32), indicating that the likelihood of CEOs holding a dual position is significantly larger as

17

earnings volatility increases. The coefficient on Concentration is positive and significant (0.448,

χ2=4.75), indicating that the likelihood of CEOs holding a dual position is significantly larger for

firms in highly concentrated industries. However, R&D expenditures, sales growth, and

intangible assets are not significant. Our results provide some support for the view that firms

with high insider information are more likely to have a combined leadership structure.

We proxy for complexity using Liability, Size, Age, and Segments. Although the

coefficient on the multiple segment dummy is insignificant, the coefficients on Liability, Size, and

Age are positive and significant; they are 0.648 (χ2=10.60), 0.215 (χ2=70.68), and 0.327

(χ2=49.12), respectively. The results suggest that the likelihood of having CEOs serve as the

Chair increases with firm complexity because the benefits are larger from combining the two top

positions. Firms with complex operations stand to benefit from the advice of board members

who have expertise in various areas of business. CEO-Chairs can set the agenda of the board

and share firm specific information in these meetings in areas where the firm needs council.

Thus, our results are consistent with the predictions that firms contract to enhance the efficiency

given the firms’ operating and information environment.

We also find that the coefficient on Tenure is positive and highly significant (0.493,

χ2=155.37), suggesting that long serving CEOs are more likely to hold dual positions. The

coefficient on ROA is -0.031 (χ2=0.01) and the coefficient on Tenure×ROA is positive and

marginally significant (0.493, χ2=3.24), indicating that firms with higher accounting performance

are more likely to have CEOs hold dual positions as CEO tenure increases. The coefficients on

OwnershipCEO and OwnershipIns are positive and significant; they are 0.045 (χ2=36.70) and

0.012 (χ2=42.64), respectively. These results indicate that the likelihood of CEOs holding a dual

position is higher for firms with larger CEO and institutional ownership.

Regression 2 in Table 2 additionally includes board and audit committee characteristics.

The results in regression 1 hold. We find that firms with higher board independence (0.023,

18

χ2=83.54) and larger audit committee size (0.075, χ2=4.76) are more likely to have CEOs

holding joint positions. The coefficient on board size is negative and significant. Contrary to our

prediction, firms with larger boards are less likely to have a combined leadership structure. The

coefficient on audit committee independence is insignificant. In summary, when we proxy for

agency costs using ownership, board and audit committee characteristics, the results support

the view that CEOs hold dual positions in firms with fewer agency problems.

The potential cost to firms from the CEO occupying two top positions is that the added

power can be used to enhance the welfare of the CEO rather than create shareholder wealth

(i.e., the potential for rent extraction). Firms can minimize transaction costs and shield

themselves from having CEOs use the added power to extract rents by having more effective

corporate governance mechanisms. Thus, Table 3 reports stock ownership by CEOs and

institutions, and board and audit committee characteristics for firms with CEOs holding joint

positions (5,342 observations) and those with single position (2,584 firm-observations).

We find that firms with CEO-Chairs have much higher CEO ownership than when roles

of the CEO and board chairman are separated. The mean (median) OwnershipCEO for firms with

joint positions is 2.69 (0.33) percent, while that for firms with separate positions is 1.28 (0.22)

percent. The difference in the means and medians of CEO ownership between the two groups

is statistically significant. On the other hand, the mean and median institutional ownership does

not appear to vary between the two groups. The mean (median) OwnershipIns is 67.54 (69.08)

percent and 66.22 (68.86) percent, respectively. The difference in institutional ownership

between the two groups is significant for the mean value only.

The mean and median board independence and size are also higher for firms with dual

positions; the mean (median) IndependenceBoard and Board-size for firms with CEOs holding

dual positions are 69.69 (72.7) percent and 9.72 (9), while those for firms with separate CEO

and board chairs are 65.24 (66.67) percent and 9.44 (9). The difference in the means and

medians of board independence and size between the two groups of firms is statistically

19

significant. We find similar results in audit committee size. Firms with CEOs holding joint

positions have significantly higher mean and median values of audit committee size than firms

that separate the two positions. Although the results on audit committee independence indicate

that firms with CEO-Chairs appear to have higher mean audit committee independence than

when roles of the CEO and board chairman are separated, differences in the means and

medians of audit committee independence are not statistically significant.

The individual measures of board structure effectiveness are consistent with our

conjecture that firms optimize benefits from having dual positions by constructing stronger and

more effective boards. We also construct a board index (Board-index) which is based on the

four individual board characteristics. We transform the raw measures (xi) into standardized

values (SVi) each year as follows: SVi = (xi – meanxi)/standard deviationxi. The index is

computed by summing the transformations of each of the four individual measures and is

constructed such that a higher (lower) value indicates a higher (lower) level of board

effectiveness. We find that the mean and median values of Board-index for firms with dual

positions are significantly higher than those for firms with a separate CEO and board chair.

Overall, the results from Tables 2 and 3 are consistent with the efficient contracting

perspective that companies contract to maximize benefits while reducing transaction costs. Our

results indicate that firms with complex operations and CEOs with successful track record tend

to combine the two top positions and such firms also have strong supporting corporate

governance mechanisms that deter CEOs from using the power for personal gains.

5.2. Adverse consequences under rent extraction hypothesis

CEO Compensation

While our initial results are inconsistent with the managerial rent extraction hypothesis, a

direct test of this hypothesis is to examine whether CEOs use their power to increase their

compensation, inflate earnings using accounting discretion, and whether market valuations are

lower when CEOs hold dual positions. Table 4 reports the multivariate regression results of

20

CEO compensation on the indicator variable for CEO-Chair duality. Our analysis of CEO pay is

based on three alternative measures of compensation: cash compensation, stock compensation,

and total compensation. Cash compensation is the CEO’s salary and bonus during the fiscal

year, stock compensation is the sum of the Black-Scholes value of stock options granted and

the value of restricted stock grants during the year, and total compensation is the sum of cash

and stock compensation.

Our interest is in the sign and magnitude of the coefficient on CEO-Chair. In the first

column, the coefficient on CEO-Chair is 103.406 (t-stat=1.91) which is not significant at the 5

percent level. We find similar results in the second and third columns. The coefficient on CEO-

Chair is positive but insignificant when we use stock and total compensation as dependent

variables; it is 252.283 (t-stat=1.12) and 361.226 (t-stat=1.46), respectively. Controlling for other

firm characteristics that impact CEO compensation, we find no evidence to suggest that CEOs

holding dual positions are paid more than when the two positions are separated. Thus, the

direct test results using CEO compensation data are inconsistent with the rent extraction

proposition.

The results of the control variables are mostly consistent with prior studies (e.g., Core et

al. 1999). Based on the regression results presented in the third column, total compensation is

significantly related to firm size, growth opportunities, prior stock returns, earnings and return

volatility, board size, and CEO and institutional stock ownership. Larger firms, firms with a better

performance, risky firms, and firms with larger agency problems pay higher total compensation

when CEOs hold dual positions to align the interests between shareholders and management.

One major difference between our results and those of Core et al. (1999) is that CEO-Chair is

not statistically significant in our study while the variable is significant in their study. Because the

CEO-Chair decision is based on firm characteristics including R&D, ΔSales, Intangible,

Concentration, Liability, Size, Age, Segments, and Tenure, which are also likely to be key

21

determinants of CEO compensation for efficient contracting, CEO-Chair becomes insignificant

when we include these variables in the compensation regressions.11

Earnings Management

Using discretionary accruals estimated from Equation (3) as a proxy for earnings

management, we examine whether earnings management is larger for firms where the CEO is

also the Chair relative to firms that separate the two roles. Table 5 reports the regression results

of discretionary accruals on the indicator variable for CEO-Chair duality. However, some of the

determinants of CEO-Chair also determine the accruals generating process. For instance,

growth, performance, and CEO ownership are associated with the likelihood of firms’ using a

dual leadership structure but these variables are also associated with non-discretionary accruals

(e.g., Kothari et al. 2005, Warfield et al. 1995, DeFond and Jiambalvo 1994). Therefore, it is

important to control for these firm characteristics in the discretionary accruals regressions

before any conclusions can be drawn about the association between CEO-Chair and earnings

management.

After controlling for various factors associated with earnings management (firm specific,

governance, and CEO-Chair determinants), we find little evidence to suggest that CEOs holding

joint positions use the enhanced power to manipulate earnings. In Regression 1, the coefficient

on CEO-Chair is positive and significant (0.005, t-stat=2.57). However, the coefficient on CEO-

Chair becomes insignificant in the second regression when we include all the control variables

(0.001, t-stat=0.71).

The results of the control variables are generally consistent with prior studies (e.g.,

Ashbaugh et al. 2003). The coefficient estimates on Leverage, Market-to-book, and Litigation

are positive and significant, which indicates that discretionary accruals are higher for firms with

higher debt levels, firms with larger growth potential, and those operating in high-litigation

11In unreported results we find that the coefficient on CEO-Chair is positive and significant, as in

Core et al. (1999), when we do not include the additional determinants of CEO-Chair identified in Equation (1).

22

industries. In contrast, the coefficient estimates on Loss and Cash-flow are negative and

significant, which suggests that discretionary accruals are negative or lower for firms with losses

or those with superior operating performance. None of the corporate governance variables is

significant at the 5 percent level. Among the CEO-Chair determinants, R&D, ΔSales, Intangible,

Concentration, Liability, and Age are all negative and significant at the 5 percent level or below.

These results suggest that growing and complex firms generate more negative discretionary

accruals.

Firm Valuation

We use the valuation regressions used in Pinkowitz et al. (2006) and Fama and French

(1998) to examine whether the market valuation of the firm is lower for firms having CEOs also

serving as the board chair compared to those where the two positions are separated. Table 6

reports the regression results of firm value on the indicator variable for CEO-Chair duality. In the

first two columns, we measure firm value (FV) as the sum of the market value of equity, the

book value of preferred stock, and the book value of debt scaled by the book value of total

assets. The coefficient on CEO-Chair is positive but insignificant in the first (0.034, t-stat=0.94)

and second regression (0.011, t-stat=0.47).

In the last two columns, we use Industry-adjusted FV as an alternative measure of firm

value. Industry-adjusted FV is estimated as the difference between firm-level FV and the

corresponding industry median FV, where industry is defined using the two-digit SIC code. Our

results are similar when we use industry-adjusted FV.

The results in Table 6 indicate that, controlling for taxes, investments, and financing

decisions which impact firm values, the market valuation of a firm’s assets is neither statistically

nor economically different between firms with dual and single positions. Our results are not

consistent with the rent extraction perspective which predicts that the market valuation of firms

with dual positions is lower than those with separate positions because of a perception that

CEOs use their power to extract rents.

23

In summary, our exploration in Tables 4 to 6 indicates that there are no adverse

consequences from CEOs holding dual positions exercising power to increase their

compensation, managing earnings, or adversely affecting firm valuations. These results are

inconsistent with the implications of the rent extraction hypothesis that CEOs use their

managerial power from also being the board chair to extract rents or to adversely affect

shareholder welfare.

5.3. Stock market reactions to changes in leadership structure

Considering that market valuation tests in Table 6 are prone to the omitted variables

problem, we also use an event study methodology to examine how stock market reacts to

changes in leadership structure. Using Compustat’s ExecuComp database, we identify 185 firm

observations that initially had the CEO also serving as the chair of the board (Combined) but

eventually separated the two positions (Separate), and 16 firm observations that initially had

separate positions (Separate) but eventually combined the two positions (Combined). We

subsequently determine the exact date when these changes in leadership structure took place

by reading the Wall Street Journal Index.

Table 7 reports the event study results for firms with changes in leadership structure.

Excess returns capture the reaction of the stock market to news about changes in managerial

structure. Excess returns are defined as the difference between daily stock returns and value-

weighted CRSP market returns on the same day. Cumulative abnormal returns (CARs) are the

sum of excess returns over various time intervals around the announcement date (Day = 0). We

estimate CARs over a three-day (-1 to +1), and five-day (-2 to +2) window around the public

release date of changes in managerial structure.

Firms that eventually separated the two positions have a mean (median) three-day

CARs of 0.318 (0.58)%, whereas firms that eventually combined the two positions have a mean

(median) three-day CARs of -3.475 (-0.383)%. Each of the mean CARs is statistically

insignificant and the differences in the mean and median CARs between the two groups of firms

24

are also insignificant. The results are quite similar when we use the five-day window. The mean

and median five-day CARs for firms that eventually separated the two positions are 0.358% and

0.393%, respectively. The mean and median five-day CARs for firms that eventually combined

the two positions are -0.902% and 0.561%, respectively. Each of the mean CARs is statistically

insignificant and the differences in the mean and median five-day CARs between the two

groups are again insignificant. However, these results need to be interpreted with caution

because sample size for firms that eventually combined the two positions is relatively small.

The results in Table 7 generally indicate that investors react neither negatively nor

positively to news about an expansion or contraction in the role of a CEO. Our results are from

the stock market reaction to changes in managerial structure are inconsistent with the rent

extraction viewpoint that investors perceive CEOs with dual positions as using their managerial

power to adversely affect shareholder welfare.

5.4. Conditions when CEOs holding joint positions extract rents

In this section we examine conditions under which CEOs also serving as the board chair

are more likely to use their added power to extract rents. Assuming that our economic model

predicting the choice of a CEO-Chair is a parsimonious representation of the true underlying

economic model, firms with dual leadership structure having high predicted values based on our

model represent firms where contracting decisions outweigh agency-based decisions. On the

other hand, firms with dual leadership structure having low predicting values from our model

estimating the probability of a dual leadership structure represent firms where agency-based

reasons outweigh contracting decisions. Thus, the probability estimates from our model allows

us to isolate conditions when CEOs are more likely to use their added managerial power to

extract rents.

Using the predicted values of the likelihood of CEOs holding dual positions (from

Regression 2 in Table 2), we partition firms with dual positions into four groups. The low

probability sample consists of firms with the lowest 25 percentile of predicted probabilities while

25

the high probability sample contains firms with the highest 25 percentiles of the predicted

probabilities.

Table 8 reports the mean CEO pay and discretionary accruals for the low and high

probability samples, conditional on CEOs holding dual positions. We measure the three

compensation variables (cash, stock, and total compensation) scaled by sales to account for the

difference in firm size. We find that the mean CEO compensation is higher for the low probability

sample than the high probability sample. The mean cash, stock, and total compensation for the

low probability sample is 0.2%, 0.3%, and 0.5% of sales, while that for the high probability

sample is 0.1%, 0.1%, and 0.2%. Differences in the mean cash, stock, and total compensation

between the two samples are significant. The mean discretionary accruals for the low and high

probability samples are -0.014 and -0.004, respectively, and the difference in the mean

discretionary accruals is significant at the 1 percent level.

The results in Table 8 indicate that CEO compensation is larger and there is more

earnings management for firms with low probabilities of having a CEO serving as the Chair

compared to those with high probabilities. When corporate governance is weaker, CEOs are

more powerful. In these situations, CEOs are more likely to seek the role of the board chair to

further consolidate their managerial power in the firm. The decision to appoint the CEO also as

the board chair is unlikely to be related to the efficiency reasons. Because agency problems are

high in these types of situations, CEOs are more likely to use the consolidated power to extract

rents.

5.5. Additional tests

U.S. firms spent more than $3.4 trillion on over 12,000 acquisitions during the last two

decades (Malmendier and Tate 2008). Over this period, acquiring shareholders lost over $220

billion at the announcement of acquisition bids from 1980 to 2001 (Moeller et al. 2005). Prior

studies generally conclude that acquisitions lead to persistent value losses (e.g., Harford 1999,

Berger and Ofek 1996). A prominent agency based explanation for acquisitions is that CEOs

26

acquire other firms to increase the scale and scope of assets under their control.12 Because

acquisitions are frequently considered a manifestation of agency problems, a key implication of

the rent extraction hypothesis is that firms with dual positions acquire more frequently than other

firms.

Using a comprehensive sample of mergers and acquisitions obtained from the SDC

M&A database, we test this hypothesis using a logistic regression as follows.

Acquire = β0 + β1Market-to-Book + β2Cash-flow + β3Size + β4∆Sales + β5Cash + β6Leverage + β7Return + β8Concentration + β9CEO-Chair + β10IndependenceBoard + β11Board-size + β12OwnershipCEO +β13OwnershipIns + β14R&D + β15VolatilityROA + β16Intangible + β17Liability + β18Age + β19Segments + β20Tenure + β21ROA + Industry/year dummy + ε (6)

Acquire is a dichotomous dependent variable which equals one if a firm announces a

merger bid and zero otherwise. We include eight control variables that prior studies find as

important determinants of acquisitions including Market-to-book, Cash-flow, Size, ΔSales, Cash

(cash and short-term investments deflated by total assets), Leverage, Return, and

Concentration. We also include the governance and CEO-Chair determinants.

In unreported results, we find that CEO-Chair is positive and insignificant (0.121,

χ2=0.74) when we do not include the control variables. The coefficient continues to be

insignificant (-0.058, χ2=0.12) when we include all the control variables. Thus, the results are

again inconsistent with the rent extraction hypothesis. We do not find any evidence to suggest

that CEO-Chairs acquire more frequently than CEOs who do not serve as Chairs.

As yet another test of the agency based explanation for acquisitions, we directly

examine if the payout ratio is less when CEO serve as a Chairs compared to when the two

positions are separated. An implicit assumption of the agency based explanation for acquisitions

is that CEOs are reluctant to pay out cash to shareholders. We test this assumption by replacing

12 Under this form of rent extraction, CEOs are reluctant to pay out excess cash to shareholders

because of conflicts of interest between managers and owners. CEOs motivated to increase the assets under their control, because of greater pay from managing a larger firm, being more visible, and reducing their personal undiversified risk, are expected to acquire firms more frequently using the excess cash.

27

Acquire with Payout ratio in Equation (6) where Payout ratio is cash dividend to common

shareholders as a proportion of earnings. Our results indicate that CEO-Chair is positive and

significant (0.043, t-stat=3.02) when we do not include the control variables. Thus CEO-Chairs

have a higher payout ratio (and not lower as predicted under rent extraction perspective).

However, when we include all the control variables, the coefficient becomes insignificant (0.004,

t-stat=0.35). Overall, there is no evidence of systematic differences in investing and payout

decisions between the two groups of firms.

6. Conclusions

In the U.S., CEOs of large public companies also tend to be the chair of the board. In

this study, we explore contracting based explanations for CEOs holding dual positions (efficient

contracting versus rent extraction). Under the efficient contracting perspective, the leadership

structure of a firm is based on the firms’ operating and information environment, and the

demand for high quality CEOs. The monitoring and advising functions of independent board

members are more difficult for firms with considerable inside information. Therefore, under the

efficient contracting perspective, firms with growth opportunities, high volatility and high industry

concentration benefit from having a dual leadership structure because CEOs can match the

needs of the firm with the expertise of the board. Similarly, complex firms benefit from

combining the two top positions because the CEO stands to gain from the advisory role of the

board when dealing with complex situations. The CEO-Chair with access to firm specific

information can set the agenda in areas the firm needs most help. Further, benefits from a dual

leadership structure are larger when CEOs have successfully led firms over long periods.

Finally, because CEO-Chairs are more powerful than when the two positions are separated,

firms are more likely to have dual structures when governance (internal and external) is strong

to restrain the CEO from extracting rents (i.e., minimize transaction costs).

In contrast, the rent contracting hypothesis suggests that dual leadership structure is not

determined by a firm’s operating or information environment. Further, since CEOs have more

28

opportunities to extract rents when governance is weaker, under this hypothesis, firms with

weaker corporate governance are more likely to have dual positions. Finally, there are adverse

consequences of combining the two positions as CEOs exercise their managerial power to

extract rents for themselves.

Our results from a large sample of firms are generally consistent with the efficient

contracting hypothesis and inconsistent with the rent contracting hypothesis. We find that the

prospect of a dual leadership structure increases with the riskiness of a firm, CEOs’ ability and

track record, and the strength of the governance, which suggests that firms contract with the

CEO to maximize benefits while minimizing transaction costs.

We also directly test the rent extraction hypothesis by examining whether there are

adverse consequences from CEOs holding dual positions including excessively high CEO

compensation, use of financial reporting discretion to manage earnings, and lower market

valuations. Controlling for the other determinants of executive compensation, propensity to

manage earnings, and firm valuation, we find no evidence to support the claims of rent

extraction in any of these areas. We also do not find systematic differences in investing and

payout decisions between the two groups of firms. When we investigate stock market reactions

to announcements of changes in the leadership structure, we do not find negative stock market

reactions to these announcements.

Our results suggest that much of the recent debate on leadership structure is

misdirected. Rather than advocating a blanket policy of separating the dual leadership for all

firms as part of corporate governance best practices, it is important to consider the benefits and

costs of the alternative leadership structures while incorporating the firms’ operating and

information environment. Our results support the view that presently in the U.S., the

organization of the leadership is optimally determined for a typical large firm.

29

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31

Rajan R. G., and J. Wulf, 2006, Are perks purely managerial excess? Journal of Financial Economics 79, 1-33.

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32

TABLE 1 Descriptive Statistics

The sample includes all firm years with data on the listed variables available from RiskMetrics, ExecuComp, CDA/Spectrum, Compustat, and CRSP from 1998 to 2005 with a total of 7,926 observations. CEO-Chair is an indicator variable set to one when the CEO is also the board chairman and zero otherwise. R&D is R&D expenditures normalized by sales. ΔSales is the change in sales between the current year and the prior year deflated by sales of the prior year. VolatilityROA is the standard deviation of industry-median adjusted return on assets over the previous seven years. Intangible is intangible assets scaled by total assets. Concentration is the sum of the squared market shares (in fractions) of all firms in an industry. Liability is the ratio of total liability to total assets. Assets is the fiscal year-end total assets. Age is the number of years that the firm is publicly traded as of the fiscal year-end. Segments is an indicator variable set to one when a firm has more than one segment. Tenure is the number of years that the CEO has been in office as of the firm’s fiscal year-end. ROA is industry-median adjusted return on assets, where return on assets is income before extraordinary items scaled by total assets at the beginning of the year. OwnershipCEO and OwnershipIns are the percentage of outstanding common stock held by the CEO and financial institutions at the fiscal year-end, respectively. IndependenceBoard is the percentage of independence directors on the board and Board-size is the number of members on the board. IndependenceAudit is the percentage of independence directors on the audit committee and Audit-size is the number of members on the audit committee.

Mean 25% Median 75% Std. Dev. CEO-Chair 0.674 0.000 1.000 1.000 0.468 Insider information R&D 0.036 0.000 0.000 0.031 0.075 ΔSales 0.111 0.001 0.081 0.184 0.226 VolatilityROA 0.055 0.016 0.034 0.068 0.062 Intangible 0.130 0.004 0.065 0.205 0.157 Concentration 0.205 0.079 0.160 0.270 0.173 Complexity Liability 0.560 0.404 0.570 0.717 0.220 Assets ($ billion) 15.408 0.678 1.929 6.965 72.590 Age (year) 26.203 11.416 21.083 33.250 18.830 Segments 0.556 0.000 1.000 1.000 0.496 Ability Tenure 8.082 3.000 5.000 11.000 7.711 ROA 0.057 0.000 0.032 0.095 0.099 Agency costs OwnershipCEO (%) 2.232 0.089 0.292 1.201 5.787 OwnershipIns (%) 67.104 54.513 68.981 79.765 18.669 IndependenceBoard (%) 68.237 57.143 70.000 80.000 16.139 Board-size 9.629 8.000 9.000 11.000 2.674 IndependenceAudit (%) 91.277 83.333 100.000 100.000 16.828 Audit-size 3.807 3.000 4.000 4.000 1.115

33

TABLE 2 Economic Determinants of CEOs Holding Dual Positions

The table reports the logistic regression results from 1999 to 2005. The dichotomous dependent variable equals one when the CEO is also the board chairman and zero otherwise. R&D is R&D expenditures normalized by sales. ΔSales is the change in sales between the current year and the prior year deflated by sales of the prior year. VolatilityROA is the standard deviation of industry-median adjusted return on assets over the previous seven years. Intangible is intangible assets scaled by total assets. Concentration is the sum of the squared market shares (in fractions) of all firms in an industry. Liability is the ratio of total liability to total assets. Size is the natural logarithm of fiscal year-end total assets. Age is the number of years that the firm is publicly traded as of the fiscal year-end. Segments is an indicator variable set to one when a firm has more than one segment. Tenure is the number of years that the CEO has been in office as of the firm’s fiscal year-end. ROA is industry-median adjusted return on assets, where return on assets is income before extraordinary items scaled by total assets at the beginning of the year. OwnershipCEO and OwnershipIns are the percentage of outstanding common stock held by the CEO and financial institutions at the fiscal year-end, respectively. IndependenceBoard is the percentage of independence directors on the board and Board-size is the number of members on the board. IndependenceAudit is the percentage of independence directors on the audit committee and Audit-size is the number of members on the audit committee. We report the coefficients and the corresponding χ2–statistics in parenthesis. All the independent variables are measured one year prior to the year the CEO either holds joint or single position.

Dependent Variable: CEO is also the board-chair Explanatory Variables Regression 1 Regression 2

Intercept -5.428 (217.01)** -6.123 (209.30)**

Insider information R&D -0.271 (0.20) -0.511 (0.63)

ΔSales -0.205 (2.18) -0.122 (0.69)

VolatilityROA 1.161 (4.32)* 0.970 (3.94)*

Intangible -0.192 (0.76) 0.019 (0.01)

Concentration 0.448 (4.75)* 0.447 (4.48)*

Complexity Liability 0.648 (10.60)** 0.479 (5.33)*

Size 0.215 (70.68)** 0.245 (71.88)**

Age 0.327 (49.12)** 0.279 (32.19)**

Segments -0.064 (0.96) -0.096 (2.00)

Ability

Tenure 0.493 (155.37)** 0.512 (160.24)**

ROA -0.031 (0.01) 0.142 (0.05)

Tenure×ROA 0.493 (3.24) 0.380 (2.26)

Agency costs

OwnershipCEO 0.045 (36.70)** 0.053 (45.53)**

OwnershipIns 0.012 (42.64)** 0.009 (20.78)**

IndependenceBoard 0.023 (83.54)**

Board-size -0.062 (13.97)**

IndependenceAudit 0.002 (1.44)

Audit-size 0.075 (4.76)*

Industry/Year dummy Yes Yes

Observations 5,960 5,754 Nagelkerke R2 16.98% 20.16% Superscripts ** and * denote significance at the 1 percent and 5 percent level, respectively, for a two-tailed test.

34

Table 3 Ownership Structure and Board Characteristics

The sample consists of 7,926 firm-year observations with available variables from 1998 to 2005. OwnershipCEO and OwnershipIns are the percentage of outstanding common stock held by the CEO and financial institutions at the fiscal year-end, respectively. IndependenceBoard is the percentage of independence directors on the board and Board-size is the number of members on the board. IndependenceAudit is the percentage of independence directors on the audit committee and Audit-size is the number of members on the audit committee. We transform the four individual board/audit committee measures (xi) into standardized values (SVi) each year as follows: SVi = (xi–meanxi)/standard deviationxi. Board-index is computed by summing the four transformed measures.

CEO-Chair

Same ( haCEO-C ir = 1) D ferent Chif (CEO- air = 0) Difference

Variable N Mean

Median n

Median

Mea MediN Mean an

ucture = at Ownership str t-stat z-st =

O

Ownership EO 5,34 2.69 0.33 2,58 1.27 0.21 11.99** 12.04*C

2 3 2 4 8 7 *

OwnershipIns 5,342

67.535

69.075

2,584

66.215

68.858

1.97* 1.61

cteristics

IndependenceBoard

5,342

69.686

72.700

2,584

65.243

66.667

11.68** 12.99*

Board chara

*

Board-size 5,342

9.722

9.000

2,584

9.438

9.000

4.55** 4.77**

IndependenceAudit

5,342

91.481

100.000 2,584

90.857

100.000 1.52 1.22

Audit-size 5,342

3.891

4.000

2,584

3.634

3.000

10.03** 10.16**

Board-index 5,342

0.211

0.358

2,584

-0.437

-0.395

10.69** 11.69**

Superscripts ** and * denote significance at the 1 percent and 5 percent level, respectively, for a two-tailed test.

35

Table 4 Adverse Consequences: CEOs Holding Dual Positions and Executive Compensation

The table reports the regression results of CEO compensation on CEO duality. Cash compensation is the CEO’s salary and bonus during the fiscal year, and Stock compensation is the sum of the Black-Scholes value of stock options granted and the value of restricted stock grants during the year. Total compensation is the sum of Cash and Stock compensation. Sales is measured one year prior to the year compensation is awarded. Market-to-book is a firm’s market value of equity divided by book value for the prior year. ROA is industry-median adjusted return on assets for the prior year, where return on assets is income before extraordinary items scaled by total assets at the beginning of the year. Return is the buy-and-hold abnormal returns measured as the difference between the buy-and-hold raw returns and the buy-and-hold equal-weighted CRSP market returns over the previous twenty-four months. VolatilityROA (VolatilityReturn) is the standard deviation of ROA (Returns) over the previous seven years (twenty-four months). CEO-Chair is an indicator variable set to one when the CEO is also the board chairman and zero otherwise. IndependenceBoard is the percentage of independence directors on the board and Board-size is the number of members on the board. OwnershipCEO (OwnershipIns) is the percentage of outstanding common stock held by the CEO (financial institutions) at the fiscal year-end. R&D expenditures are normalized by sales. ΔSales is the percentage change in sales between the current and prior year. Intangible is intangible assets scaled by total assets. Concentration is the sum of the squared market shares (in fractions) of all firms in an industry. Liability is the ratio of total liability to total assets. Size is the natural logarithm of fiscal year-end total assets. Age is the number of years the firm is publicly traded as of the fiscal year-end. Segments is an indicator variable set to one when a firm has more than one segment. Tenure is the number of years that the CEO has been in office as of the firm’s fiscal year-end. We report the coefficients and the corresponding t–statistics in parenthesis. Dependent Variable: CEO compensation (in thousands)

Explanatory Variables Cash compensation Stock compensation Total compensation Intercept -1897.785 (-9.50)** -7999.018 (-10.80)** -9882.536 (-11.58)**

Economic determinants Sales

0.044 (21.25)** 0.065 (8.57)** 0.111 (12.53)**

Market-to-book 34.320 (2.34)* 621.463 (11.43)** 653.786 (10.44)**

ROA 338.309 (1.63) 947.092 (1.23) 1243.969 (1.41)

Return 166.657 (7.67)** 518.875 (6.44)** 730.608 (7.88)**

VolatilityROA 907.721 (2.93)** 3145.687 (2.74)** 4442.126 (3.36)**

VolatilityReturn -84.466 (-0.18) 4014.905 (2.36)* 3861.949 (1.97)*

Governance structure CEO-Chair 103.406 (1.91) 252.283 (1.12) 361.226 (1.46)

IndependenceBoard -3.966 (-4.17)** 1.127 (0.32) -4.616 (-1.14)

Board-size 5.499 (0.81) -106.244 (-4.20)** -116.616 (-4.00)**

OwnershipCEO -9.764 (-3.68)** -47.093 (-4.79)** -58.702 (-5.18)**

OwnershipIns 4.978 (5.64)** 5.968 (1.82) 10.518 (2.79)**

CEO-Chair determinants R&D

-222.845 (-0.73) 3898.692 (3.44)** 3587.490 (2.75)**

ΔSales -111.401 (-1.75) 183.398 (0.78) 140.407 (0.52)

Intangible 253.004 (2.51)* 754.421 (2.02)* 864.959 (2.01)*

Concentration 242.514 (2.75)** -194.991 (-0.60) 193.029 (0.51)

Liability 97.988 (1.05) -1089.668 (-3.14)** -1053.801 (-2.64)**

Size 330.899 (20.77)** 1398.683 (23.68)** 1806.793 (26.56)**

Age 77.498 (3.36)** -243.434 (-2.85)** -191.091 (-1.94)

Segments 136.317 (4.67)** 236.988 (2.19)* 371.814 (2.98)**

Tenure 125.297 (6.56)** 129.880 (1.84) 256.488 (3.15)**

Industry/Year dummy Yes Yes Yes Observations 6,481 6,481 6,481 Adjusted R2 45.88% 31.67% 38.90% Superscripts ** and * denote significance at the 1 and 5 percent level, respectively, for a two-tailed test.

36

TABLE 5 Adverse Consequences: CEOs Holding Dual Positions and Discretionary Accruals

The table reports the regression results of discretionary accruals on CEO duality. Discretionary accruals are estimated from the cross-sectional modified Jones model that also accounts for performance. Large-auditor is an indicator variable that equals one when the client’s auditor is a large accounting firm. SizeMVE is the natural logarithm of fiscal year-end market value of equity. Leverage is the ratio of total debt to total assets. Market-to-book is a firm’s market value of equity divided by book value. Litigation is 1 if the firm operates in a high-litigation industry, and 0 otherwise (high-litigation industries are industries with SIC codes of 2833-2836, 3570-3577, 3600-3674, 5200-5961, and 7370-7370). Loss is 1 if the firm reports a net loss and 0 otherwise. Cash-flow is cash flow from operations scaled by beginning of the year total assets. CEO-Chair is an indicator variable set to one when the CEO is also the board chairman and zero otherwise. IndependenceBoard is the percentage of independence directors on the board and Board-size is the number of members on the board. IndependenceAudit is the percentage of independence directors on the audit committee and Audit-size is the number of members on the audit committee. OwnershipCEO and OwnershipIns are the percentage of outstanding common stock held by the CEO and financial institutions at the fiscal year-end, respectively. R&D is R&D expenditures normalized by sales. ΔSales is the change in sales between the current year and the prior year deflated by sales of the prior year. VolatilityROA is the standard deviation of industry-median adjusted return on assets over the previous seven years. Intangible is intangible assets scaled by total assets. Concentration is the sum of the squared market shares (in fractions) of all firms in an industry. Liability is the ratio of total liability to total assets. Age is the number of years that the firm is publicly traded as of the fiscal year-end. Segments is an indicator variable set to one when a firm has more than one segment. Tenure is the number of years that the CEO has been in office as of the firm’s fiscal year-end. ROA is industry-median adjusted return on assets, where return on assets is income before extraordinary items scaled by total assets at the beginning of the year. We report the coefficients and the corresponding t–statistics in parenthesis.

Dependent Variable: Discretionary accruals Explanatory Variables Regression 1 Regression 2

Intercept -0.013 (-8.01)** 0.028 (2.66)**

Accruals determinants

Large-auditor -0.001 (-0.37)

SizeMVE -0.001 (-1.54)

Leverage 0.019 (3.23)**

Market-to-book 0.003 (9.10)**

Litigation 0.004 (2.07)*

Loss -0.067 (-26.01)**

Cash-flow -0.428 (-39.64)**

Governance structure

CEO-Chair 0.005 (2.57)* 0.001 (0.71)

IndependenceBoard -0.000 (-0.79)

Board-size 0.000 (0.41)

IndependenceAudit 0.000 (0.81)

Audit-size -0.001 (-1.24)

OwnershipCEO -0.000 (-0.57)

OwnershipIns 0.000 (1.80)

CEO-Chair determinants

R&D -0.013 (-5.41)**

ΔSales -0.006 (-2.43)*

VolatilityROA -0.003 (-1.45)

Intangible -0.056 (-10.98)**

Concentration 0.014 (3.17)**

Liability -0.039 (-6.99)**

Age 0.004 (4.36)**

Segments -0.000 (-0.01)

37

Tenure -0.000 (-0.37)

ROA -0.004 (-0.62)

Year dummy No Yes

Observations 6,133 6,133 Adjusted R2 0.09% 27.07% Superscripts ** and * denote significance at the 1 percent and 5 percent level, respectively, for a two-tailed test.

38

Table 6 Adverse Consequences: CEOs Holding Dual Positions and Market Valuation

The table reports the regression results of firm value on CEO duality. FV is the sum of the market value of equity, the book value of preferred stock, the book value of short-term debt, and the book value of long-term debt scaled by the book value of total assets. Industry-adjusted FV is the difference between firm-level FV and the corresponding industry median FV, where industry is defined using the two-digit SIC code. CEO-Chair is an indicator variable set to one when the CEO is also the board chairman and zero otherwise. E is earnings before extraordinary items plus interest, deferred tax credits, and investment tax credits. AST is the fiscal year-end total assets. R&D is research and development expense. When R&D is missing, we set it equal to zero. INT is interest expense and DIV is dividends defined as common dividends paid. Δt is change operator measuring the change in a variable from year t-1 to year t. Similarly, Δt+1 is the change in a variable from year t to year t+1. All Earnings, Investment, and Financing variables are scaled by the total assets in year t. We report the coefficients and the corresponding t–statistics in parenthesis. Dependent Variable: Firm value

Explanatory Variables FV Industry-adjusted FV Intercept 1.953 (64.62)** 0.846 (16.55)** 0.395 (13.68)** -0.531 (-10.12)**

CEO-Chairt 0.034 (0.94) 0.011 (0.47) 0.042 (1.21) 0.007 (0.31)

Earnings Et

10.150 (42.03)** 9.853 (39.79)**

ΔEt -1.448 (-6.41)** -1.379 (-5.95)**

ΔEt+1 5.714 (27.30)** 5.633 (26.25)**

Investment ΔASTt

0.626 (6.78)** 0.441 (4.66)**

ΔASTt+1 0.750 (10.62)** 0.602 (8.31)**

R&Dt 10.268 (22.70)** 8.320 (17.94)**

ΔR&Dt 2.588 (1.75) 2.899 (1.91)

ΔR&Dt+1 10.317 (7.62)** 9.577 (6.90)**

Financing INTt

-15.060 (-13.63)** -13.840 (-12.22)**

ΔINTt -4.970 (-1.97)* -3.291 (-1.26)

ΔINTt+1 -15.136 (-6.43)** -12.651 (-5.24)**

DIVt 7.731 (8.62)** 7.123 (7.74)**

ΔDIVt 6.475 (1.74) 5.878 (1.54)

ΔDIVt+1 14.007 (4.83)** 12.461 (4.19)**

ΔFVt+1 -0.259 (-14.37)** -0.242 (-13.08)**

Industry/Year dummy No Yes No Yes Observations 5,527 5,527 5,527 5,527 Adjusted R2 0.01% 56.59% 0.01% 50.05% Superscripts ** and * denote significance at the 1 percent and 5 percent level, respectively, for a two-tailed test.

39

Table 7 Stock Market Reactions to Changes in Managerial Structure

The sample includes 185 firm observations that initially had the CEO also serving as the chair of the board (Combined) but eventually separated the two positions (Separate) and 16 firm observations that initially had separate positions (Separate) but eventually combined the two positions (Combined). Excess returns capture the reaction of the stock market to news about changes in managerial structure (Combined or Separate). Excess returns are defined as the difference between daily stock returns and value-weighted CRSP market returns on the same day. Cumulative excess returns (CAR) are the sum of excess returns over various time intervals around the announcement date (Day = 0). The numbers in parenthesis are t-statistics.

Cumulative Changes in Managerial Structure

Abnormal C ed to Sombin eparate S te to Cepara ombined Difference

Returns (CAR) Mean Median Mean Median Mea Medin an

Day -1 to +1 t-at= s =

st

z-tat

CAR 0.318%

(0.75)

-3.475%

(-1.17)

1.26

0.580% -0.383% .990

Day -2 to +2

CAR 0.358%

(0.67)

-0.902%

(-0.24)

0.33

0.393% 0.561% -0.25

Superscripts ** and * denote significance at the 1 percent and 5 percent level, respectively, for a two-tailed test.

40

Table 8 Predicted Probability, CEO Compensation and Earnings Management

The predicted probability of a CEO serving as the chair of the board is based on the economic determinants from Regression 2 in Table 2. Firm years with CEOs holding dual position are partitioned into four groups based on the predicted probability. The “low probability sample” consists of firms with the lowest 25 percentile of predicted probabilities while the “high probability sample” contains firms with the highest 25 percentiles of the predicted probabilities. Cash compensation is the CEO’s salary and bonus during the fiscal year, and Stock compensation is the sum of the Black-Scholes value of stock options granted and the value of restricted stock grants during the year. Total compensation is the sum of Cash and Stock compensation. All compensation variables are scaled by sales. Discretionary accruals are estimated from the cross-sectional version of the modified Jones model that also controls for performance.

CEO-Chair

High probabili plety sam Low probability le samp Difference

Variables Observatio Mea Observatio Mea Mean

t tat ns n ns n

-s

CEO compensation 1,012 1 12

0 0 0 0 .001 -1

Stock com ensation 0.00 0.00 -0.002 -9.48**

mpensation 0.002

0.005

-0.003 -12.46**

Earnings management

,0

Cash compensation .01

.02

-05.98**

p1 3

Total co

972 973

Discretionary accruals -0.004

-0.014

0.010 3.34**

Superscripts ** and * denote significance at the 1 percent and 5 percent level, respectively, for a two-tailed test.

41