The Relation between Top Management The Relation between Top Management

Turnover and the Firms’ Default RiskTurnover and the Firms’ Default Risk

Wei TingWei Ting (( 丁 緯丁 緯 ))Chung Yuan Christian UniversityChung Yuan Christian University

INTRODUCTION INTRODUCTION China has sustained economic growth since China has sustained economic growth since

its economic reform. its economic reform.

One of the important policies for the Chinese One of the important policies for the Chinese security market was rapid facilitation from a security market was rapid facilitation from a socialist planned economy into a market socialist planned economy into a market economy. economy.

Many studies indicated the development of an Many studies indicated the development of an improved system of managerial resource improved system of managerial resource allocation that is responsive to market forces allocation that is responsive to market forces is important in the Chinese economic reform is important in the Chinese economic reform (Groves et al., 1995). (Groves et al., 1995).

INTRODUCTIONINTRODUCTION Groves, et al. (1995) further show that those firms with poorly Groves, et al. (1995) further show that those firms with poorly

performing were more likely to have a new top manager. performing were more likely to have a new top manager.

Many empirical studies connect the reason of top management Many empirical studies connect the reason of top management turnover with firm performance and provide the evidence that the turnover with firm performance and provide the evidence that the likelihood of management turnover is negatively related to firm likelihood of management turnover is negatively related to firm performance (Weisbach, 1988). performance (Weisbach, 1988).

Stiglitz and Weiss (1983) explore the termination of the contract Stiglitz and Weiss (1983) explore the termination of the contract of management and indicated that the probability of top of management and indicated that the probability of top management turnover should depend on current and past relative management turnover should depend on current and past relative performance. performance.

Warner et al. (1988) also find that firms with low stock returns are Warner et al. (1988) also find that firms with low stock returns are more likely to change their top management than other firms. more likely to change their top management than other firms.

INTRODUCTIONINTRODUCTION Although there are complete studies exploring Although there are complete studies exploring

the relation between top management turnover the relation between top management turnover and firmsand firms’’ performance, performance, little research explored little research explored the relations between top management turnover the relations between top management turnover and the probability of firmsand the probability of firms’’ default default..

Recently, many famous accounting scandal Recently, many famous accounting scandal cases, such as Enron and WorldCom, have made cases, such as Enron and WorldCom, have made the public pay more attention to the default risk. the public pay more attention to the default risk.

These corporate scandals These corporate scandals in the emerging in the emerging markets are more seriousmarkets are more serious..

INTRODUCTIONINTRODUCTION In ChinaIn China, Sun and Zhang (2006) pointed out , Sun and Zhang (2006) pointed out

that about 20 percent of publicly listed firms that about 20 percent of publicly listed firms have been convicted by the CSRC for serious have been convicted by the CSRC for serious frauds and scandals since the Chinese stock frauds and scandals since the Chinese stock market was established in the early 1990s. market was established in the early 1990s.

Accordingly, in this study we explore the Accordingly, in this study we explore the relations between top management turnover relations between top management turnover and the probability of firmsand the probability of firms’’ default in the default in the biggest emerging market, China, which has biggest emerging market, China, which has extensive fraud and with less mature extensive fraud and with less mature securities regulations to protect investors. securities regulations to protect investors.

INTRODUCTIONINTRODUCTION In addition to the poorly performing firms that are In addition to the poorly performing firms that are

more likely to have a new manager, many studies more likely to have a new manager, many studies show that show that after replacing top managementafter replacing top management a a potential improvement in firm performance and potential improvement in firm performance and subsequently firm value follows. subsequently firm value follows.

Denis and Denis (1995) and Huson, Malatesta, Denis and Denis (1995) and Huson, Malatesta, and Parrino (2004) document substantial and Parrino (2004) document substantial improvements in firm performance after the improvements in firm performance after the incumbent top management are removed after incumbent top management are removed after poor performance. poor performance.

Therefore, in our study we also realize the Therefore, in our study we also realize the impacts of the probability of firmsimpacts of the probability of firms’’ default after default after replacing top management. replacing top management.

INTRODUCTIONINTRODUCTION Our study makes several contributions to the Our study makes several contributions to the

literature in this field. literature in this field. First, we provide evidence of the relationship between First, we provide evidence of the relationship between

top management turnover and the probability of firmstop management turnover and the probability of firms’’ default risk.default risk.

Second, we examine listed firms in the Chinese stock Second, we examine listed firms in the Chinese stock market to explore such relationships. Companies in the market to explore such relationships. Companies in the unsafe and deficient security markets have higher risk; unsafe and deficient security markets have higher risk; therefore, the investors hope to find a good top therefore, the investors hope to find a good top management to not only to understand firmsmanagement to not only to understand firms’’ performance but also default risk. performance but also default risk.

Lastly, we also explore after the incumbent top Lastly, we also explore after the incumbent top management are removed could decrease the probability management are removed could decrease the probability of firmsof firms’’ default. default.

LITERATURE REVIEW : KMV LITERATURE REVIEW : KMV Default Risk Default Risk

Many related models have been developed in an attempt to Many related models have been developed in an attempt to forecast the probability of business failure. ( Z-score forecast the probability of business failure. ( Z-score model ;Altman, 1968). model ;Altman, 1968).

However, there has been a general tendency in these However, there has been a general tendency in these studies to use historical data to predict the default risk, studies to use historical data to predict the default risk, which may not be capable of adequately reflecting the which may not be capable of adequately reflecting the actual probability of bankruptcy (Hillegeist et al., 2004).actual probability of bankruptcy (Hillegeist et al., 2004).

The KMV model is based upon compelling and intuitive The KMV model is based upon compelling and intuitive theory, and since it uses equity market data, it incorporates theory, and since it uses equity market data, it incorporates the most up-to-date information available on a firmthe most up-to-date information available on a firm’’s s financial health conditionfinancial health condition. .

Dacorogna et al. (2003) demonstrated that the forecasting Dacorogna et al. (2003) demonstrated that the forecasting ability and time-varying characters of the KMV model were ability and time-varying characters of the KMV model were superior to other models. superior to other models.

LITERATURE REVIEW : CEO LITERATURE REVIEW : CEO Replacement and the Default Replacement and the Default

Risk Risk There is a general consensus that the likelihood of top There is a general consensus that the likelihood of top

management turnover is negatively related to firmsmanagement turnover is negatively related to firms’’ past past performance (Gilson and Vetsuypens 1993). performance (Gilson and Vetsuypens 1993).

Desai et al. (2004) consider that the revelation of fraud Desai et al. (2004) consider that the revelation of fraud results in a large decline in firm value, and then it may results in a large decline in firm value, and then it may benefit the firm to initiate the change of top management. benefit the firm to initiate the change of top management.

Sun and Zhang (2006) examine the management turnover Sun and Zhang (2006) examine the management turnover associated with fraud, and find that firms associated with associated with fraud, and find that firms associated with fraud have higher management turnover than matching fraud have higher management turnover than matching non-fraud firms. non-fraud firms.

Gilson (1989) investigates top management turnover in Gilson (1989) investigates top management turnover in financially distressed firms and finds in the investigative financially distressed firms and finds in the investigative year 52% of firms with top management turnover are in year 52% of firms with top management turnover are in default on their debt or bankrupt. default on their debt or bankrupt.

LITERATURE REVIEW : LITERATURE REVIEW : CEO Replacement and the CEO Replacement and the

Default RiskDefault Risk Although these studies find that the top management Although these studies find that the top management

turnover is closely related to the bankruptcy, they only turnover is closely related to the bankruptcy, they only focus on the focus on the bankrupt or fraud firmsbankrupt or fraud firms. .

In our studies, we use KMV model to estimate In our studies, we use KMV model to estimate all all firmsfirms’’ probability of default probability of default to more accurately explore to more accurately explore the relation between top management turnover and the relation between top management turnover and firmsfirms’’ default risk. default risk.

Following Sun and Zhang (2006) and Gilson (1989), Following Sun and Zhang (2006) and Gilson (1989), we predict that there will be a positive correlation we predict that there will be a positive correlation between top management turnover and the risk of between top management turnover and the risk of bankruptcy for a firm. Thus, our first hypothesis is as bankruptcy for a firm. Thus, our first hypothesis is as follows: follows:

Hypothesis 1 Hypothesis 1 : Ceteris paribus, the relationship : Ceteris paribus, the relationship between top management turnover and default risk between top management turnover and default risk will be positive.will be positive.

LITERATURE REVIEW : LITERATURE REVIEW : CEO Replacement and the CEO Replacement and the

Default RiskDefault Risk Top management replacement leads to Top management replacement leads to

higher default risk, the probability of default higher default risk, the probability of default will decrease with lower levels of top will decrease with lower levels of top management turnover. Accordingly, in our management turnover. Accordingly, in our studies we also document this relationship studies we also document this relationship and our second hypothesis is as follows:and our second hypothesis is as follows:

Hypothesis 2 Hypothesis 2 :: Ceteris paribus, after Ceteris paribus, after replacement of the top management, the replacement of the top management, the probability of firmsprobability of firms’’ default will decrease. default will decrease.

DATA AND METHODOLOGY DATA AND METHODOLOGY : : Data Description Data Description

Our discussion of the relationship between top Our discussion of the relationship between top management turnover and the probability of firmsmanagement turnover and the probability of firms ’’ default is based upon data obtained from the default is based upon data obtained from the Chinese Chinese Stock Market and Accounting Research (CSMAR) Stock Market and Accounting Research (CSMAR) databasedatabase. .

This sample is comprised of all publicly-listed enterprises This sample is comprised of all publicly-listed enterprises in the in the Shanghai and Shenzhen Stock ExchangeShanghai and Shenzhen Stock Exchange. .

Our sample span covers the five-year period, Our sample span covers the five-year period, from 2001 from 2001 to 2005to 2005..

This selection process yields a total of 433 firms, and This selection process yields a total of 433 firms, and 2,165 firm-year observations. 2,165 firm-year observations.

DATA AND METHODOLOGY DATA AND METHODOLOGY : Empirical Models : Empirical Models

We employ the multivariate We employ the multivariate random effects balanced panel random effects balanced panel regression methodregression method to examine the effects of top management to examine the effects of top management turnover and the default risk for publicly-listed firms in China. turnover and the default risk for publicly-listed firms in China.

We begin by constructing an annual time series model of top We begin by constructing an annual time series model of top management turnover and corporate default risk using the management turnover and corporate default risk using the KMV model to assess the firmsKMV model to assess the firms’’ probability of default. The probability of default. The KMV model calculates the actual probability of default based KMV model calculates the actual probability of default based upon the option pricing theory of Black and Scholes (1973) upon the option pricing theory of Black and Scholes (1973) and Merton (1974). The computation of and Merton (1974). The computation of ‘‘expected default expected default frequencyfrequency’’ (EDF) is based on the company (EDF) is based on the company’’s capital structure, s capital structure, the volatility of its asset returns, and the current asset value. the volatility of its asset returns, and the current asset value.

Guided by related theories drawn from the aforementioned Guided by related theories drawn from the aforementioned prior studies, the control variables are comprised of the debt prior studies, the control variables are comprised of the debt ratio, return on assets, total assets, the same person ratio, return on assets, total assets, the same person occupying both the chairman of the board of directors and occupying both the chairman of the board of directors and CEO positions, and the number of board directors. CEO positions, and the number of board directors.

DATA AND METHODOLOGY DATA AND METHODOLOGY : Empirical Models: Empirical Models

The empirical model to explore hypothesis H1, The empirical model to explore hypothesis H1, we use the probability of we use the probability of ““priorprior”” firms default firms default as an independence variable, is described as as an independence variable, is described as follows: follows:

When the coefficient of When the coefficient of CEOCHANGECEOCHANGEitit is is positivepositive, the indication is that firms with , the indication is that firms with higher probability of default will change their higher probability of default will change their top management in the posterior. At these top management in the posterior. At these times the hypothesis H1 is supported. times the hypothesis H1 is supported.

DATA AND METHODOLOGY DATA AND METHODOLOGY : Empirical Models: Empirical Models

The empirical model to explore hypothesis H2, The empirical model to explore hypothesis H2, we use the probability of we use the probability of ““posteriorposterior”” firms default firms default as an independence variable, is described as as an independence variable, is described as follows: follows:

When the coefficient of When the coefficient of CEOCHANGECEOCHANGEitit is is negativenegative which shows that when the firms which shows that when the firms change their top managements, the probability change their top managements, the probability of default will decrease in the next period. of default will decrease in the next period. These results support hypothesis H2. These results support hypothesis H2.

EMPIRICAL RESULTS AND EMPIRICAL RESULTS AND ANALYSIS : Empirical ANALYSIS : Empirical

analysis (analysis (H1H1))

EMPIRICAL RESULTS AND EMPIRICAL RESULTS AND ANALYSIS : Empirical ANALYSIS : Empirical

analysis (analysis (H2H2))

CONCLUSIONS CONCLUSIONS In a country changing from a socialist planned In a country changing from a socialist planned

economy into a market economy, China, they need economy into a market economy, China, they need top management to have talented and professional top management to have talented and professional decision-makers to increase firm performance and decision-makers to increase firm performance and decrease risk.decrease risk.

The prior literature suggests that a firm with sub The prior literature suggests that a firm with sub par performance provides the board of directors to par performance provides the board of directors to have more incentive to change top management. have more incentive to change top management.

In China where financial crisis and fraud are In China where financial crisis and fraud are extensive, efficiently controlling the probability of extensive, efficiently controlling the probability of firmsfirms’’ default risk is another important mission for default risk is another important mission for the top management.the top management.

CONCLUSIONSCONCLUSIONS However, few studies explore the relation between However, few studies explore the relation between

top management turnover and firmstop management turnover and firms’’ probability of probability of default risk. default risk.

Therefore, in our studies we use KMV model, which Therefore, in our studies we use KMV model, which is the completed include both historical data and is the completed include both historical data and market data, to compute the actual probability of market data, to compute the actual probability of default to explore this relation and then default to explore this relation and then complement the findings of prior studies. complement the findings of prior studies.

We find that the firms with higher default risk are We find that the firms with higher default risk are more likely to change their top management. more likely to change their top management. Furthermore, we also explore that firms changing Furthermore, we also explore that firms changing the top management result in those firmsthe top management result in those firms’’ posterior posterior default risk lessening compared to other companies. default risk lessening compared to other companies.

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