Transcript Marital Prenups? A Look at CEO Severance Agreements

The causes and consequences of
CEO severance agreements
Peggy Huang
Department of Finance
A.B. Freeman School of Business
Tulane University
2013 IFS, SWUFE
CEOs with Severance Agreements
60%
50%
40%
% with agreement
30%
% with equity agreement
20%
10%
0%
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
The causes and consequences of CEO severance
agreements
July 16, 2015
Research Questions
 Why do firms offer severance contracts to their executives?
 What are the consequences of executive severance contracts?
 Do severance agreements affect :
 firm performance?
 CEO risk-taking behavior?
 CEO investment policy?
 Does the structure of severance contracts matter?
The causes and consequences of CEO severance
agreements
July 16, 2015
Hypothesis (1)
Severance agreements & firm performance
 Hypothesis 1A: Agency problem perspective (-)
Severance agreements decrease the difference in a CEO’s
payoffs between a good and bad performance  reduce firm
value
(Jensen and Murphy, 1990; Bebchuk and Fried, 2003)
 Hypothesis 1B: Human capital incentive (+)
Severance agreements induce CEOs to take actions that are
costly for the CEOs, but increase the effectiveness of their
management  beneficial to investors
(Almazan and Suarez, 2003)
The causes and consequences of CEO severance
agreements
July 16, 2015
Hypothesis (2)
Severance agreements & Investment
 Hypothesis 2A: Severance as put options (+)
Severance agreements are put options  induce
managers to take more risks
(Ju, Leland and Senbet,
2002)
 Hypothesis 2B: Prevent excess risk-taking (-)
Severance packages prompt CEOs to choose to be
terminated (receive severance amount)  prevent
excess risks
(Van Wesep, 2008)
The causes and consequences of CEO severance
agreements
July 16, 2015
Results: Preview
 Why do firms offer severance contracts to their executives?
Peer group (location/industry), risk preferences, fit, firm culture &
corporate governance
 What are the consequences of executive severance contracts?
 firm performance?
(-) Firm performance & (-) Shareholder reactions
 CEO risk-taking behavior?
(+) CEO’s risk-taking behavior
 CEO investment policy?
(+) Riskier policy choices
 Does the structure of contracts matter?
“Cash-only contracts firms” perform worse than “Contracts with equity
firms”
Marital Prenups? A Look at CEO Severance Agreements
Peggy Huang, Indiana University
July 16, 2015
Data
 Collect a sample of firms with coverage on CRSP, Compustat,





RiskMetrics and Execucomp
Then select a sub-sample of S&P 500 firms in year 1993 through
2010
In total: 5,142 observations
SEC Regulations S-K, 17 CFR229.601 (1990): require firms to
disclose any severance contracts
Hand collect severance agreements from firms’: 10-Q, 10-K, 8-K,
and proxy statement
Locate the severance contract by searching for the terms:
“employment agreement”, “severance contract”,
“severance
agreement”, “separation agreement”, “termination of employment”,
“severance”, “separation”, “contract”, “agreement”, “executive
agreement”, “employee agreement”, and “termination arrangement”
The causes and consequences of CEO severance
agreements
July 16, 2015
Structure of Severance Agreements
 A standard severance contract contains:
 Cash:
One-time cash payment and/or multiples of salary and/or
bonus;
 Equity:
Continue/immediate vesting of stock and/or options;
 Others:
Continue usage of corporate jet, access to golf club, office
support, etc;
 Restrictions:
Non-Compete and/or Non-Solicit EE
The causes and consequences of CEO severance
agreements
July 16, 2015
Severance Agreements & Payments
 Payments are owed to CEOs as compensation by firms when
CEOs are terminated without “for cause” or when CEOs
resign due to “good reason” (both specifically defined in the
contract):
 “For cause”: includes conditions such as willful misconduct
(such as intentional battery, assault, or sexual harassment) or
breach of fiduciary duties
 “Good reason”: include conditions such as involuntarily
relocating CEOs or decreasing CEO base salary by a certain
amount
The causes and consequences of CEO severance
agreements
July 16, 2015
Literature review
 Document features of severance agreements:
 Schwab and Thomas (2004) document legal aspects of agreements
 Who gets an employment agreement?
 Rusticus (2006), Gillan, Hartzell and Parrino (2009), Rau and Xu (2012) & investigate
the likelihood that a CEO has an agreement
 Golden handshakes:
 Yermack (2006) shows that CEO dismissals lead to larger exit package than voluntary
retirements
 CEOs decision-making:
 Xu (2012) studies the effects of contracts’ durations on CEOs’ investment policies
 What determine the difference btw contractual and actual severance pay?
 Goldman and Huang (2013) find that for voluntary departures: corporate governance
problem & for forced departures: a need to facilitate a smooth transition
 Change-in-control agreements:
 Lambert & Larcker (1985) shows that “Golden Parachutes have a favorable effect on the
reaction of executives to takeover bids”
The causes and consequences of CEO severance
agreements
July 16, 2015
Descriptive Statistics
Total sample
(N=5142)
Mean
Std
Severance Agreement Characteristics
Severance Base Salary Multiple (N=1902)
Severance Bonus Multiple (N=1501)
Median Cash Severance (N=1945)
# of Contracts with Equity
Median Total Severance Amount
CEO Compensation (000)
Salary
Bonus
Total Compensation
Firm Characteristics
Gindex
Assets (millions)
CEO Characteristics
Number of CEOs
Forced
# of CEOs w/o a contract in the 1st yr and
have one later
W/O an Agreement
(N=3101)
Mean
Std
With an Agreement
(N=2041)
Mean
Std
2.55
2.48
3,423,425
1,232
7,000,000
1.36
1.18
880
416
1,216 1,999
8,855 35,741
836
1,139
7,484
430
2,011
18,793
946
1,334
10,938
385
***
1,975 ***
51,720 ***
9.52
2.55
34,943 117,498
9.28
35,163
2.59
118,501
9.88
34,608
2.43 ***
115,981
0.35
407
0.28
1,015
0.19
608
The causes and consequences of CEO severance
agreements
0.39
608
0.15
550
0.45
***
58
July 16, 2015
Industry Composition
Number of Firms Number of Severance % of Total Severance % of Agreements with
in the industry
Agreements
Agreements
the Equity component
7 Telcm Telephone and Television Transmission
87
55
63%
55%
12 Other Mines, Constr, BldMt, Trans, Hotels, Bus Serv, Entertainment
488
226
46%
63%
9 Shops Wholesale, Retail, and Some Services
535
243
45%
53%
6 BusEq Business Equipment -- Computers, Software, and Electronic Equipment
767
327
43%
60%
10 Hlth Healthcare, Medical Equipment, and Drugs
365
155
42%
70%
8 Utils Utilities
445
179
40%
68%
11 Money Finance
760
305
40%
65%
3 Manuf Manufacturing -- Machinery, Trucks, Planes, Off Furn, Paper, Com Printing
616
232
38%
51%
4 Enrgy Oil, Gas, and Coal Extraction and Products
250
84
34%
70%
5 Chems Chemicals and Allied Products
220
70
32%
44%
1 NoDur Consumer NonDurables -- Food, Tobacco, Textiles, Apparel, Leather, Toys
473
138
29%
57%
2 Durbl Consumer Durables -- Cars, TV's, Furniture, Household Appliances
Total Number of Severance Agreements
136
5142
27
2041
20%
67%
The causes and consequences of CEO severance
agreements
July 16, 2015
Severance Contracts
Severance Agreement(0/1)
3-year
Previous CEO being forced out (=1)
0.4718
Outsider (=1)
1.0262
Gindex
0.0582
% of independent directors
0.4372
Incentive to total compensation
0.3236
Total Compensation (Mill)
0.0007
Leverage
0.0345
Log(Sales)
-0.0206
R&D
-0.9590
CAPEX
-0.8563
State Tax Rate
-0.0283
% of other CEOs with agreement
1.1760
(same industry)
***
***
***
**
***
***
*
**
***
5-year
0.4071
0.9979
0.0602
0.7599
0.4493
-0.0012
0.0520
-0.0683
-0.8243
-1.2750
-0.0428
1.2553
***
***
***
***
***
**
**
**
***
**
% of other CEOs with agreement
(same geographic area)
2.8540 *** 3.1951 ***
Previous CEO has an agreement (=1)
Observations
Adjusted R2
1.2061 *** 1.1845 ***
3426
2212
0.3177
0.3308
The causes and consequences of CEO severance
agreements
July 16, 2015
Endogeneity Issue
 The issue (selection bias: yes; measurement errors: no):
 Reverse causality and omitted variable bias
 whether severance agreements  firm performance &
volatility, or
 other variables  existence of the agreements and firm
performance & volatility
 Address the potential selection bias issue through 3 methods:
 Fixed effects
 Two-stage Least Square (2SLS)
 Switching firms
The causes and consequences of CEO severance
agreements
July 16, 2015
Research Design
 Fixed effects:
Firm performances (or volatilities) =f(Severance agreements
(existence/structure), control variables, fixed effects)
 2SLS:
1st s stage: Prob(Severance Agreements)=f(IVs, explanatory variables)
IVs: State tax, % peer group (industry, location)
2nd stage A: Firm performances (or volatilities) =f(Severance agreements,
explanatory variables, fixed effects)
2nd stage B1: Firm performances (or volatilities) =f(Severance agreements,
cash-only severance agreements, explanatory variables, fixed effects)
2nd stage B2: Firm performances (or volatilities) =f(Severance agreements,
equity severance agreements, explanatory variables, fixed effects)
 Switchers
The causes and consequences of CEO severance
agreements
July 16, 2015
Severance Contracts & Firm Performance
Intercept
Severance agreement (0/1)
Severance agreement with
cash only (0/1)
Severance agreement with
equity (0/1)
RM-RF
SMB
HML
MOM
Industry-fixed effect
Observations
Adjusted R2
3-Year Stock Return
5-Year Stock Return
Model 1
Model 2
Model 3
Model 4
Model 5
Model 6
0.0732 *** 0.0788 *** 0.0785 *** 0.0027
0.0178
0.0179
-0.0163 * -0.0041
-0.0409 *** -0.0206 ** -0.0068
-0.0261 **
-0.0384 ***
-0.0210 **
0.0373 ***
0.2944
-0.3038
0.1001
0.0796
No
3426
0.0623
***
***
***
***
0.3002
-0.3088
0.1037
0.0839
Yes
3426
0.0801
The causes and consequences of CEO severance
agreements
*** 0.3001 *** 0.2415
*** -0.3087 *** -0.2070
*** 0.1036 *** 0.0381
*** 0.0840 *** 0.0932
Yes
No
3426
2212
0.0801
0.0844
0.0041
***
***
***
***
0.2456
-0.2115
0.0410
0.0945
Yes
2212
0.1159
***
***
***
***
0.2454
-0.2111
0.0410
0.0944
Yes
2212
0.1158
***
***
***
***
July 16, 2015
Severance Contracts & Firm Performance
Stock Sharpe Ratio
3-year
Model 1
Severance agreement with Cash only(0/1)
Severance agreement with Equity (0/1)
Severance agreement (0/1)
Incentive to total compensation
Total Compensation (Mill)
Leverage
Log(Sales)
Outsider (=1)
Previous CEO being forced out (=1)
Previous CEO has an agreement (=1)
Year-fixed effects
Industry-fixed effects
Observations
Adjusted R2
The causes and consequences of CEO severance
agreements
5-year
Model 2
Model 3
-0.0827 **
0.0562
0.0416
-0.0231
0.0462
0.0473
0.0006
0.0006
-0.0512 *** -0.0514
-0.0187 *
-0.0187
-0.0805 ** -0.0789
-0.1087 ** -0.1050
0.0029
0.0026
Yes
Yes
Yes
Yes
3426
3426
0.1594
0.1585
Model 4
-0.1006 **
***
*
**
**
0.0437
-0.0138
0.0026
-0.0369 **
-0.0272 **
-0.0871 **
-0.0478
0.0637
Yes
Yes
2212
0.1694
0.0976
-0.0522
-0.0136
0.0026
-0.0369
-0.0273
-0.0868
-0.0439
0.0619
Yes
Yes
2212
0.1693
**
**
**
**
July 16, 2015
Robustness:
Severance Contracts & Firm Performance
State Tax Rate
% of other CEOs with agreement
(same industry)
% of other CEOs with agreement
(same geographic area)
Severance agreement with Cash only(0/1)
First-stage regressions
Severance Agreement
3-year
5-year
-0.0283 ** -0.0428 ***
1.1760 *** 1.2553 **
Second-stage regressions
Stock Sharpe Ratio
3-year
5-year
2.8540 *** 3.1951 ***
-0.0830 **
-0.1016 **
0.0570
Severance agreement with Equity (0/1)
Severance agreement (0/1)
0.0236
-0.0416
0.0978 **
0.0323
-0.0637
Gindex
% of independent directors
0.0582 *** 0.0602 ***
0.4372 ** 0.7599 ***
-0.0152 *** -0.0153 *** -0.0169 *** -0.0170 ***
-0.0213
0.0835
-0.0211
0.0827
Incentive to total compensation
Total Compensation (Mill)
Leverage
Log(Sales)
0.3236 ***
0.0007
0.0345
-0.0206
0.0318
0.0006
-0.0524 ***
-0.0173
Previous CEO being forced out (=1)
Previous CEO has an agreement (=1)
0.4718 *** 0.4071 ***
-0.1168 ** -0.1128 ** -0.0568
-0.0525
1.2061 *** 1.1845 ***
-0.0374
-0.0362
0.0207
0.0206
3426
0.3177
Yes
Yes
3426
0.1611
Yes
Yes
3426
0.1602
Yes
Yes
2212
0.1699
Yes
Yes
2212
0.1698
Year fixed effects
Industry fixed effects
Observations
Adjusted R2
The causes and consequences of CEO severance
agreements
0.4493 ***
-0.0012
0.0520
-0.0683 **
2212
0.3308
0.0329
0.0006
-0.0526 ***
-0.0174
-0.0221
-0.0216
0.0027
0.0027
-0.0383 ** -0.0383 **
-0.0263 ** -0.0265 **
July 16, 2015
Severance Contracts & Firm Volatility, R&D
Severance agreement (0/1)
Gindex
% of independent directors
Incentive to total compensation
Total Compensation (Mill)
Leverage
Log(Sales)
Surplus Cash
Sales Growth
R&D
CAPEX
Outsider (=1)
Age
Previous CEO being forced out (=1)
Previous CEO has an agreement (=1)
Year-fixed effects
Industry-fixed effects
Observations
Adjusted R2
The causes and consequences of CEO severance
agreements
Panel A
Firm Risks (Stock)
3-year
5-year
0.0901 ** 0.0874
-0.0192 ** -0.0198
-0.1657
-0.1605
0.0900 *
0.0698
0.0000
0.0027
0.0616 *** 0.0636
-0.1222 *** -0.1309
-0.2373
-0.0639
0.0268
0.0316
1.0508 *** 0.9362
1.3287 *** 1.4488
-0.0108
-0.0276
-0.0020
-0.0022
0.1318 ** 0.1351
-0.0472
-0.0462
Yes
Yes
Yes
Yes
3426
2212
0.5957
0.5957
**
**
**
***
***
*
***
***
**
Panel B
R&D/Sales
3-year
5-year
0.0041 *
0.0047
-0.0002
-0.0004
-0.0105
-0.0131
0.0083 ** 0.0103
0.0000
0.0000
0.0006
0.0012
-0.0039 *** -0.0038
0.0829 *** 0.1038
0.0062 ** 0.0054
0.3294 *** 0.2026
0.0233
0.0358
0.0031
0.0009
0.0001
0.0001
-0.0037
-0.0055
-0.0051
-0.0058
Yes
Yes
Yes
Yes
3426
2212
0.5594
0.4083
**
***
***
***
***
***
***
*
**
July 16, 2015
Robustness:
Severance Contracts & Firm Risks, R/D
State Tax Rate
First-stage regressions
Severance Agreement
3-year
5-year
-0.0289 **
-0.0312 **
% of other CEOs with agreement
(same industry)
% of other CEOs with agreement
(same geographic area)
Severance agreement (0/1)
1.3358 ***
1.4065 ***
2.8972 ***
3.0320 ***
Incentive to total compensation
0.3164 ***
Total Compensation (Mill)
Second-stage regressions
Firm Risks (Stock)
R&D/Sales
3-year
5-year
3-year
5-year
0.0770 *
0.0768 *
0.0046 *
0.0043 *
0.3727 ***
0.0791
0.0609
0.0087 **
0.0100 ***
0.0007
-0.0001
0.0000
0.0027 **
0.0000
0.0000
Leverage
0.0310
0.0384
0.0609 ***
0.0631 ***
0.0007
0.0012 ***
Log(Sales)
-0.0175
-0.0191
-0.1210 *** -0.1300 ***
-0.0039 ***
-0.0037 ***
Surplus Cash
-0.2291
-0.4187
-0.2223
-0.0450
0.0822 ***
0.1044 ***
Sales Growth
0.0046
0.0033
0.0257
0.0308
0.0062 **
0.0054 ***
R&D
-0.9691 ***
-0.8161 **
1.0753 ***
0.9556 ***
0.3277 ***
0.2034 ***
CAPEX
-0.7651
-1.2926 **
1.3666 ***
1.4897 ***
0.0212
0.0374 *
Previous CEO being forced out (=1)
0.4581 ***
0.4178 ***
0.1283 **
0.1323 *
-0.0030
-0.0055
Previous CEO has an agreement (=1)
Year-fixed effects
Industry-fixed effects
Observations
Adjusted R2
1.1719 ***
1.1595 ***
-0.0681
-0.0624
-0.0020
-0.0063
Yes
Yes
3426
0.3177
Yes
Yes
2212
0.3271
Yes
Yes
3426
0.5964
Yes
Yes
2212
0.5961
Yes
Yes
3426
0.5597
Yes
Yes
2212
0.4086
The causes and consequences of CEO severance
agreements
July 16, 2015
Robustness:
Severance Contracts & Overinvestment
State Tax Rate
% of other CEOs with agreement
(same industry)
% of other CEOs with agreement
(same geographic area)
Severance agreement (0/1)
Severance agreement*R&D
Gindex
% of independent directors
Incentive to total compensation
Total Compensation (Mill)
Leverage
Log(Sales)
Previous CEO being forced out (=1)
Previous CEO has an agreement (=1)
Year-fixed effects
Industry-fixed effects
Observations
Adjusted R2
First-stage regressions
Severance Agreement (0/1)
3-year
5-year
-0.0283 **
-0.0428 ***
1.1760 *** 1.2553 **
2.8540
0.0582
0.4372
0.3236
0.0007
0.0345
-0.0206
0.4718
1.2061
3426
0.3177
The causes and consequences of CEO severance
agreements
***
***
**
***
***
***
3.1951
0.0602
0.7599
0.4493
-0.0012
0.0520
-0.0683
0.4071
1.1845
2212
0.3308
Second-stage regressions
Stock Sharpe Ratio
3-year
5-year
***
***
***
***
**
***
***
0.0311
-1.2187
-0.0159
-0.0212
0.0397
0.0006
-0.0538
-0.0201
-0.1073
-0.0306
Yes
Yes
3426
0.1654
***
***
***
*
**
0.0218
-0.9490
-0.0173
0.0740
-0.0126
0.0027
-0.0382
-0.0299
-0.0459
0.0207
Yes
Yes
2212
0.1711
**
***
**
**
July 16, 2015
Firm Performance for Switch Firms
3-Year
5-Year
Stock Return Sharpe Ratio Stock Return Sharpe Ratio
Severance agreement (0/1)
-0.0514 **
-0.2020 *** -0.0308 **
-0.1242 ***
RM-RF
0.2435 ***
0.1632 ***
SMB
-0.2829 **
0.0247
HML
0.1806 **
0.1516 **
Incentive to total compensation
-0.1524
-0.0890
Total Compensation (Mill)
-0.0016
0.0062 ***
Leverage
-0.1063 **
-0.0690 *
Log(Sales)
-0.0059
-0.0076
Outsiders (=1)
-0.1639 **
-0.1205 ***
Previous CEO being forced out (=1)
-0.2964 ***
-0.2517 ***
-0.3780 ***
-0.1904 ***
Previous CEO has an agreement (=1)
Observations
632
632
632
632
R2
0.0749
0.1470
0.0869
0.1739
The causes and consequences of CEO severance
agreements
July 16, 2015
Severance Contracts &
Market Reaction to the Announcements
Panel A: Total Sample
Start offering severance
agreement (1)
Rest of Firms (2) (1)-(2)
(-4,+1)
Mean cumulative abnormal return
Observations
-0.37%
-0.04%
279
4863
-0.33% ***
Panel B: Severance Agreement with Cash only vs. Equity
Start offering cash-only
agreement (1)
Rest of Firms (2) (1)-(2)
Mean cumulative abnormal return
Observations
Mean cumulative abnormal return
Observations
-0.68%
-0.02%
-0.66% ***
134
5008
Start offering agreement
with Equity (1)
Rest of Firms (2) (1)-(2)
-0.07%
-0.03%
145
4997
The causes and consequences of CEO severance
agreements
-0.04%
Stop offering severance
agreement (1)
Rest of Firms (2) (1)-(2)
1.41%
-0.09%
353
4789
1.50% ***
Stop offering cash-only
agreement (1)
Rest of Firms (2) (1)-(2)
1.56%
-0.05%
1.61% ***
220
4922
Stop offering agreement
with equity (1)
Rest of Firms (2) (1)-(2)
1.19%
-0.04%
133
5009
1.23% ***
July 16, 2015
Severance Contracts & CEO Turnover Event
Active severance agreement (0/1)
Active cash severance agreement (0/1)
Active equity severance agreement (0/1)
Incentive to total compensation
Total Compensation (Mill)
Leverage
Log(Sales)
Outsider (=1)
Previous CEO being forced out (=1)
Previous CEO has an agreement (=1)
Observations
Adjusted R2
The causes and consequences of CEO severance
agreements
0.7561
0.3538
0.0060
0.0936
0.0729
0.4402
0.0328
0.1921
642
0.0950
Forced out (0/1)
*** 0.4848 ** 1.0209 ***
0.5503 *
-0.5724 **
0.3204
0.3370
0.0071
0.0060
*
0.0852
0.0857
0.0691
0.0722
*** 0.4164 *** 0.4168 ***
0.0400
0.0372
0.2080
0.1990
642
642
0.1001
0.1005
July 16, 2015
Other types of Compensation
Severance agreement (0/1)
Cash only Contract(0/1)
Contract with Equity (0/1)
Log(Sales)
Leverage
Past 1 yr stock return
Past 1 yr ROA
Past 1 yr stock volatility
Industry-Fixed effects
Year-fixed effects
Observations
Log Likelihood
% equity comp
0.0306 *** 0.0394 *** 0.0157
(3.63)
(4.04)
(1.34)
-0.0241 *
-(1.78)
0.0244 *
(1.83)
0.0379 *** 0.0377 *** 0.0376 ***
(10.54)
(10.47)
(10.45)
-0.0036
-0.0034
-0.0034
-(0.87)
-(0.82)
-(0.83)
0.0000
0.0000
0.0000
-(0.02)
-(0.12)
-(0.12)
0.0454
0.0445
0.0441
(1.26)
(1.24)
(1.23)
2.7035 *** 2.6550 *** 2.6644 ***
(4.39)
(4.31)
(4.33)
Yes
Yes
Yes
Yes
Yes
Yes
5142
5142
5142
133
134
135
The causes and consequences of CEO severance
agreements
Total comp
2.4829 *
4.0115 **
(1.66)
(2.32)
-4.2196 *
-(1.76)
-0.1510
-(0.07)
4.3045 *
(1.82)
3.5920 *** 3.5499 *** 3.5404 ***
(5.61)
(5.55)
(5.53)
-0.4146
-0.3792
-0.3836
-(0.57)
-(0.52)
-(0.53)
0.0131
0.0115
0.0115
(0.81)
(0.71)
(0.71)
2.5591
2.4086
2.3481
(0.42)
(0.40)
(0.39)
242.8041 ** 234.1880 ** 235.9138 **
(2.22)
(2.14)
(2.16)
Yes
Yes
Yes
Yes
Yes
Yes
5142
5142
5142
-17557
-17555
-17555
July 16, 2015