Contractual Versus Actual Severance Pay Following CEO Turnover

The following post comes to us from Eitan Goldman of the Department of Finance at Indiana University and Peggy Huang of the Department of Finance at Tulane University.

In our paper, Contractual Versus Actual Severance Pay Following CEO Turnover, which was recently made publicly available on SSRN, we analyze the bargaining game between the CEO and the board of directors at the time of CEO departure. We find that about 40% of S&P500 CEOs who leave their firm receive separation payments that are in excess of what the firm is legally required to give them based on their existing contract. Furthermore, we find that the average discretionary separation pay is around $8 million – close to 242% of a CEO’s annual compensation. The analysis in the paper aims to uncover the reasons behind this discretionary pay and the source of CEO power exactly at the point in time when the CEO is least likely to have any ability to bargain.

Specifically, we investigate whether CEOs who receive discretionary pay are those who have control over the board of directors or whether discretionary pay represents a tool used by the board of directors in order to help and facilitate an amicable and efficient departure of the incumbent CEO. We hypothesize that in cases when the CEO departure is voluntary, discretionary separation pay represents a governance problem. By contrast, we hypothesize that when the CEO is forced to depart, discretionary separation pay is used to help the company move on from the failed ex CEO to a better one, specifically by reducing the likelihood of a prolonged battle with the departing CEO.

The empirical methodology we use is a multivariate logit in which we separately analyze the determinants of the level of discretionary pay for CEOs who were forced out and for CEOs who left voluntarily. Our main results are as follows: We find that for CEOs who are forced out, discretionary separation pay is awarded to the poorly-performing CEOs who have created the most damage for shareholders. This is consistent with the idea that poorly-performing CEOs are the ones who can cause the most damage to their companies by making the replacement process long and contentious. In addition, we find that discretionary pay is more likely to be given when the firm has high debt levels, which means that any costly battles with the ex CEO will push the firm closer to potential bankruptcy. As for CEOs who leave voluntarily, we find that discretionary separation pay is associated with poor corporate governance, as indicated by lower levels of board independence, busier boards, and lower ownership by active institutional investors. We also find that CEOs who leave voluntarily receive higher discretionary separation pay during good economic times when shareholders are less likely to monitor. Finally, we find that for both groups, higher discretionary pay is awarded in cases where the firm is concerned about the departing CEO going to a competitor, as indicated by the existence of non-compete and/or non-solicitation clauses in the initial contract.

Our analysis of the difference between actual and contractual severance pay shows that discretionary pay is sometimes indicative of weak internal corporate governance, but is other times used wisely by boards that are acting in the interest of shareholders. Thus, our results suggest that shareholders are not always disadvantaged by the use of discretionary separation pay and that the reality of separation pay is a bit more subtle. Overall, these results help to shed light on the dual role played by severance compensation and on the bargaining game played between the board and the departing executive.

The full paper is available for download here.

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