Generous severance can hamper firm performance, says study

But packages needed to attract, retain CEOs, say experts
By Sarah Dobson
|Canadian HR Reporter|Last Updated: 01/31/2012

Canada has seen its share of generous severance agreements for departing CEOs. In 2011, former Enmax CEO Gary Holden walked away with more than $4.6 million in severance pay while Tim Hortons paid outgoing president and CEO Donald Schroeder a $5.75-million severance package.

But the existence and structure of such agreements can negatively influence subsequent firm performance, according to Peggy Huang, a professor in the department of finance at the A.B. Freeman School of Business at Tulane University in New Orleans.

“In general, firms that offer their CEOs severance contracts tend to underperform… but what’s interesting is that the component or structure of the severance contract makes a huge difference,” she said.

Severance contracts have become a key component of CEO compensation, according to Huang. In looking at S&P 500 CEO severance agreements (but not change-in-control agreements) between 1993 and 2007, the median amount is about US$7 million and, on average, the cash amount is 2.5 times the CEO’s annual cash compensation.

And the percentage of firms that award top executives severance agreements grew from 20 per cent in 1993 to more than 55 per cent in 2007, she said.

About 40 per cent of the contracts contain only a cash component — such as a one-time cash payment or multiples of salary and bonus — while 60 per cent include an equity component, such as vesting of stock options.

“If stock options are not vested at the time of a CEO’s departure and his contract doesn’t include the equity component (which means either it’s not explicitly in the severance contract or the firm doesn’t have a clause for the equity vesting in the event of termination), then he would not be able to obtain the equity compensation that’s not vested,” said Huang.

In looking at the performance data of S&P 500 firms under 5,142 CEOs, Huang found firms that awarded cash-only severance contracts underperformed compared to firms that included the vesting of the equity component in the agreement.

This make sense because with a cash-out severance contract the CEO is basically guaranteed a lump sum no matter what happened, she said.

“But if you have an equity component in the contract, CEOs’ final payout basically will be dependent on the firm’s performance as well.”

The standard setup for an employee stock option plan is that as soon as an employee ceases to be employed, she typically has about 90 days to exercise all vested options and then the options expire — essentially they’re cancelled, said Geoffrey Howard, at partner at law firm Gowlings in Vancouver.

But some executives override that rule to have accelerated vesting of some of those option tranches that would have vested long after they’re gone.

“(That’s) the most common equity kicker in a severance clause,” he said.

But it does not make sense to accelerate vesting of non-vested options on termination since a departing executive will not be contributing to any future success of the company or corresponding increase in share price, nor does the company want to retain the executive, he said.

“It really amounts to accelerating future potential equity compensation for someone who is leaving the company. Arguably… from a shareholder’s perspective, a departing executive should not be given such an additional perk and it is contrary to the normal rule (invariably applied to employees lower down in the company) that you lose non-vested options on departure.”

In a compensation program, equity is extremely important in mitigating risk — it is the core of why people run stock programs, to try to align management with shareholders, said Ken Hugessen, a partner and founder of Hugessen Consulting in Toronto. But to isolate it as to what happens in the event of severance, it’s hard to form that conclusion, he said.

And generally all severance agreements are a multiple of salary and an annual bonus while accelerators on the option program are generally separate, said Hugessen.

It’s also not clear why no agreement is necessarily a shareholder’s best friend, he said, as suggested in Huang’s study that found firms that award CEOs severance agreements have lower subsequent stock returns.

“A person with no agreement will understandably resist losing their job or doing anything that might result in the loss of their job,” said Hugessen.

So if someone offers to buy a struggling company but it’s clear the current CEO’s services will no longer be required, the CEO may not be willing to sell. But if there’s a reasonable severance agreement, the CEO might be more amenable, he said.

However, when these compensation programs became even more generous in the United States, such as three times the salary with generous long-term incentives, the concern came up that what was started as essentially insurance against a bad event turned around and became incentive for what an executive sees as a good event, said Hugessen.

“In other words, ‘If I make so much money if someone takes us over, why the hell do I want to sit here working?’ That’s where recently there has been a real pushback on these agreements, saying they’re bad for shareholders.”

And if all the executives are sitting on relatively large severance packages, that can be a challenge for potential buyers, said Howard.

“Overly generous severance packages can be a deterrent to economically efficient takeover activity. These types of agreements can be a real burden on companies in a number of ways,” he said.

“You’re talking a lot of money, even for one senior executive, and certainly if it’s two or three that go at the same time — and often, of course, the whole C-suite will be sitting on variations of the same formula — so it’s not just one person that could potentially trigger a major liability.”

Severance agreements can also lead to risk-taking behaviour, including investing heavily — 13 per cent, on average — in research and development, according to Huang. A severance contract can act as a safety net or insurance so a CEO takes on more risk compared to the optimal level shareholders want.

But Howard doesn’t really buy that, as most people prefer to keep their job and see a company succeed. That’s why severance packages are used for attraction and retention, particularly when an organization is recruiting someone who is already employed.

“In order to secure top talent, we have to provide for assurances of severance packages that will provide an adequate bridge in the event that things don’t work out,” he said.

“You’ve got an environment where you’re going after people who are employed, you want to bring them into a new situation, which is always higher risk — they’ve got a new board, they’ve got new accountabilities, perhaps a new industry — and then you have increasingly more demanding boards, owners who are going to terminate executives perhaps sooner than they used to.

“Maybe it’s no surprise you see more and more executives getting these severance agreements in place in advance.”

Huang’s study seems to suggest severance agreements cause poor performance, with a presumption about causality or direction, said Hugessen.

But it’s equally likely the expectation of less-than-great performance causes severance agreements, he said. If a CEO is considering employment and anticipates things might not go well, she will want a severance agreement.

“There’s always the risk when you observe these things to get your causality backwards. It’s actually the expectation of poor performance that causes severance agreements, not severance agreements that creates poor performance.”

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