CEO origin and stock price crash risk: Insider versus outsider CEOs

• Published date: 01 January 2023
• Author: Heeick Choi,Khondkar Karim,Anqi Tao
• Date: 01 January 2023
• DOI: http://doi.org/10.1111/corg.12442

ORIGINAL ARTICLE

CEO origin and stock price crash risk: Insider versus outsider

CEOs

Heeick Choi

1

| Khondkar Karim

1

| Anqi Tao

2

1

Manning School of Business, University of

Massachusetts Lowell, Lowell, MA, USA

2

Nichols College, Dudley, MA, USA

Correspondence

Heeick Choi, Manning School of Business,

University of Massachusetts Lowell, MA, USA.

Email: heeick_choi@uml.edu

Abstract

Research question/issue: The recent market trend in the United States has drawn

attention to the fact that new chief executive officers (CEOs) are increasingly being

recruited from outside rather than getting promoted from within. This study exam-

ines the influence of CEO origin on stock price crash risk.

Research findings/insights: Using a sample of 13,331 firm-year observations during

the 1997–2017 period, we find that CEOs promoted from inside the firm are less

likely to trigger stock price crashes than CEOs hired from outside. Further, we show

that the negative relation between insider CEOs and stock price crash risk is more

pronounced for firms with more conservative accounting policies. Additional analyses

document that the difference in stock price crash risk between insider and outsider

CEOs is stronger in the early years of their tenure and for CEOs with higher pay-

for-performance sensitivity and higher turnover risk.

Theoretical/academic implications: Our study contributes to the research on stock

price crash risk, especially the recent studies investigating the impact of managerial

behavior and traits on stock price skewness. The findings are consistent with the bad

news hoarding theory of stock price crashes. Our findings also lend further empirical

support to the horizon problem of CEO origin by showing that the relatively short

average horizon for outsider CEOs incentivizes them to withhold bad news, leading

to higher stock price crash risk.

Practitioner/policy implications: Our study adds to the debate on whether to choose

a CEO from inside or outside the firm. The potential higher risk of stock price crashes

might help boards of directors rethink their approaches to succession.

KEYWORDS

corporate governance, CEO origin, CEO tenure, accounting conservatism, stock price

crash risk

1|INTRODUCTION

Top managers are responsible for making operational decisions,

balancing the needs and interests of shareholders and employees, and

orienting the firm toward future growth. Accordingly, chief executive

officer (CEO) succession is one of the most significant decisions that

boards of directors make, and deciding whether to hire a CEO from

outside or inside has profound implications for the firm. According to

the Annual CEO Success Study conducted by PwC (2017), which

covers 2500 of the largest public companies around the world, new

CEOs are increasingly coming from outside rather than being pro-

moted from inside the firm in recent years.

Given the importance of top manager turnover and this trend of

outsider hiring, a growing number of studies have examined how CEO

Received: 8 July 2020 Revised: 15 February 2022 Accepted: 17 February 2022

DOI: 10.1111/corg.12442

Corp Govern Int Rev. 2023;31:105–126. wileyonlinelibrary.com/journal/corg © 2022 John Wiley & Sons Ltd. 105

origin might influence firm performance and operational decisions.

However, the question of whether CEO origin, insider versus outsider,

affects a firm's post-succession performance positively or negatively

is still under debate, and empirical results are highly mixed (Karaevli,

2007). Some studies argue that insider CEOs outperform outsider

CEOs due to their firm-specific knowledge. For example, Zajac (1990)

finds that insider CEOs are associated with greater firm profitability

than are outsider CEOs. Furtado and Rozeff (1987) also find a positive

market effect for internally promoted CEOs. Other studies provide

contradictory results, arguing that outsider CEOs with more external

knowledge are better able to initiate strategic and innovative changes

(Zhang & Rajagopalan, 2010). For example, Huson et al. (2004) show

that operating performance improves more significantly when succes-

sor CEOs are from outside rather than inside. A final group of studies

find no significant differences between outside and inside succes-

sions. Beatty and Zajac (1987) show that both insider and outsider

successions are associated with a reduction in firm value. Overall, the

extant literature provides critical insights into the post-succession per-

formance of insider versus outsider CEOs but fails to reach a consis-

tent conclusion. While several studies have examined the impact of

CEO origin on financial performance, like return on assets (ROA) and

stock price, limited research has been done on the influence of CEO

origin on extreme capital market performance. The recent capital mar-

ket turbulence further emphasizes the importance of predicting

potential risk from the extreme capital market outcomes. Thus, we

investigate a previously unexplored topic: whether and how the origin

of the CEO, from inside or outside the firm, is associated with stock

price crash risk.

The management literature has long been interested in the topic

of CEO origin. Much of this research centers on whether insider or

outsider CEOs benefit or hurt firm performance. However, the per-

formance implications of outsider versus insider CEO appointments

remain unclear, mixed (Helmich & Brown, 1972; Lauterbach

et al., 1999; Zhang & Rajagopalan, 2010). Prior research suggests that

insider CEOs possess better firm-specific knowledge and their risk of

adverse selection is relatively low (Furtado & Rozeff, 1987;

Zajac, 1990). However, outsider CEOs have fresh perspectives

and abilities to initiate significant strategic changes (Cannella &

Lubatkin, 1993; Zhang & Rajagopalan, 2010). These differences

between insider and outsider CEO characteristics may attribute to the

mixed evidence on the performance impact of CEO origin. For exam-

ple, although insider CEOs' better firm-specific knowledge and lower

risk of adverse selection can have positive impacts on subsequent firm

performance, their lack of implementing significant strategic changes

can impede their operational performance. We view these differences

in firm-specific knowledge, the risk of adverse selection, and strategic

change initiatives between insider and outsider CEOs as the potential

source of stock price crash risk that captures another dimension of

firm performance. In other words, this study reframes the impact of

CEO origin on firm performance by examining how these differences

between insider and outsider CEOs affect managers' incentives to

withhold bad news, which will consequently affect stock price

crash risk.

Furthermore, since the publication of Jin and Myers (2006)'s

pioneering paper, burgeoning literature has studied the determinants

and consequences of stock price crash risk in not only the U.S.

context but also in regions' outside of the United States. One

stream of this literature has studied the impact of managerial charac-

teristics on the future stock price crash risk and has tried to figure out

whether managerial traits could be an explanation for a future stock

price crash risk (Andreou et al., 2017; Cui et al., 2019; Kim

et al., 2016). We enrich this stream of study by examining the relation

between stock price crash risk and CEO origin, which is an important

research topic in the management literature. In addition, a recent

study, CEO Succession Practices in the Russell 3000 and S&P 500:

2021 Edition, reviews the succession event announcements about

chief executive officers made at Russell 3000 and S&P 500 companies

in 2020. According to its findings, the appointment of insider CEOs

continues to be prevalent among Russell 3000 and S&P 500 compa-

nies, which represent about 66.7% and 74.5%, respectively. Although

insider CEO succession is more prevalent than outsider succession,

there has been inconsistent evidence on the performance impact of

insider CEO succession. We attempt to enhance our understanding of

the implications of insider CEO succession on extreme outcomes in

the capital market, that is, stock price crash risk.

Our expectation about the relation between CEO origin and stock

price crash risk stems from three streams of literature. The first is

based on horizon theory. Previous studies on CEO succession provide

evidence that outsider CEOs anticipate that they will have a shorter

tenure at the helm than insider CEOs (Brady et al., 1982). Conse-

quently, outsider CEOs have greater incentives to act in ways that

maximize their own value rather than that of shareholders. The sec-

ond stream of research observes that outsider CEOs are often

selected when firms are in trouble (Finkelstein & Hambrick, 1996).

Compared with insider CEOs, outsider CEOs face more pressure to

initiate strategic change and improve operational performance. Thus,

outsider CEOs are more focused on boosting near-term financial per-

formance. Finally, the established networks of insider CEOs mitigate

the information asymmetry between the executive and the board,

facilitating information flows among top management. With sufficient

information, boards can mitigate the incentive and ability of insider

CEOs to withhold bad news and inflate financial performance. Taken

together, these three streams of the literature lead us to expect that

insider CEOs will be less likely to withhold bad news and boost their

reported earnings, leading to a lower risk of a stock price crash. Thus,

we hypothesize that firms led by insider CEOs are less likely to experi-

ence stock price crashes than those led by outsider CEOs.

To examine the association between CEO origin and stock price

crash risk, we proxy for firm-specific stock price crash risk using the

likelihood of extremely negative firm-specific weekly returns, CRASH,

from Kim et al. (2011). We also use two alternative measures of stock

price crash risk in additional tests. Consistent with previous studies of

CEO origin (Harris & Helfat, 1997; Zhang & Rajagopalan, 2010), we

define an insider CEO as a person who worked for the firm for more

than 1 year before being appointed CEO. Furthermore, we investigate

the moderating effect of conditional conservatism on the relation

106 CHOI ET AL.