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Rich severance for CEOs spells poor deal for companies (Karen Bleier/AFP/Getty Images/Karen Bleier/AFP/Getty Images)
Rich severance for CEOs spells poor deal for companies (Karen Bleier/AFP/Getty Images/Karen Bleier/AFP/Getty Images)

Leadership advice

Rich severance for CEOs spells poor deal for companies Add to ...

Severance deals that give big cash payouts to outgoing chief executives can not only outrage shareholders, they can clobber a company’s performance for years, according to a new study.

In fact, any stock or cash severance clause in a contract tends to be a drag on results during a top executive’s tenure, concluded the analysis by Peggy Huang, assistant professor of finance in Tulane University's Freeman School of Business in New Orleans.

One of the principal arguments in favour of severance agreements is that they provide a kind of insurance for CEOs that encourages them to take the risks required for company growth, Dr. Huang said. “Unfortunately, what I conclude from this study is that these agreements lead CEOs to take too much risk, as evidenced by stock volatility and over-investment in research and development. In other words, management swings too far in the direction of risk.”

Her conclusions are based on the stock performance of companies in the S&P 500 between 1993 and 2007. In an average year during that period, about 40 per cent of the 500 had CEOs whose contracts had severance clauses and 40 per cent of those deals provided for all-cash payouts.

The analysis found that the companies with cash-only severance contracts had annual stock returns that were on average 4.2 per cent lower than the average returns of firms whose CEOs had no severance provisions in their contracts.

The average return was also lower among companies whose CEO severance provisions specify payouts that were mostly in the form of stock, but only by an average of 0.3 per cent. Such agreements typically allow the CEOs to immediately sell stock options and restricted stock that they might not otherwise have been able to touch for years.

The underperformance can become chronic, Dr. Huang said. A case in point was the announcement last month that Eugene Isenberg, the CEO of drilling company Bermuda-based Nabors Industries Ltd., would get a severance of $100-million in cash. That outraged stockholders because the company had underperformed in the S&P 500 one-year, five-year and 10-year averages, she said.

Her advice to companies is: “If they can't avoid severance deals altogether, they should insist that equity be substantially represented, so that payouts depend substantially on how well the CEO performs.”

In addition, boards that make severance deals need to stay vigilant and question risky actions by executives. “Unfortunately, CEO severance contracts are generally associated with weak boards rather than strong ones.”

The study also found that all-cash severance deals are spreading more quickly than others.

Since 2003, the percentage of S&P-500 CEOs who have severance agreements with equity elements has stayed level at about 36 per cent, while the number of cash severance agreements has risen from about 14 per cent to 19 per cent.

In 1993, only 20 per cent of S&P 500 CEOs had severance agreements, so that means the total has almost tripled over the past two decades.

“The findings of this study suggest that is not a healthy development,” Dr.. Huang said. “If they really want to give them make sure they put a performance clause in the contract, they should set a benchmark and specify that a CEO gets nothing if the standard isn’t met. That way the incentive aligns to the company’s performance.”

She also found that Wall Street has an inkling of the problems. Stock prices fell an average of 0.37 per cent when companies announced CEO severance agreements, and rose an unexpected 1.41 per cent when companies eliminated them.

The results of her study will be presented at the Midwest Finance Association Conference in New Orleans in February.

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