In recent years, large severance payouts to executives who have been fired from poorly performing firms have attracted a great deal of attention in the popular press. There is a considerable degree of popular outrage on what seem to be egregious ex post payments that are unrelated to the executive’s performance during his tenure at the firm. However, though severance agreements are potentially important elements of executives’ compensation contracts, there is little empirical evidence on the incidence and terms of ex ante severance agreements negotiated by executives, let alone on how these contracts fit into executives’ overall incentive compensation schemes.

In our paper, How Do Ex-Ante Severance Pay Contracts Fit into Optimal Executive Incentive Schemes?, forthcoming in the Journal of Accounting Research, we analyze a unique hand-collected sample of 3,688 severance contracts in place at 808 firms in 2004. Based on the full list of S&P1500 firms, this sample is the most comprehensive of any work in this area, including firms of all sizes, ages, and industries, and executives of a wide range of ranks including the Chief Executive Officer (CEO), Chief Financial Officer (CFO), Chief Operating Officer (COO), and other executives. Around 68% of the firms list explicit severance contract terms with their executives. Most contracts list up to three sets of benefits: explicit cash payments as multiples of salary and bonus (most common benefit); medical and life insurance benefits, and benefits covering the payment of legal fees, outplacement, and other perks.

…continue reading: Ex-Ante Severance Pay Contracts and Optimal Executive Incentive Schemes

Scenario

A large corporation is sued over the alleged breach of a substantial contract. Due to the complex nature of the contract, the corporation’s business executives frequently sought advice from in-house counsel when entering into, and performing under, the agreement. The corporation’s in-house counsel has concerns that sensitive documents reflecting attorney-client communications—or even in-house counsel’s own work product—may be produced by mistake, given the volume of email and electronic documents that must be reviewed quickly.

Clawback Provisions Provide Protections and Cost Savings

Even when a party to a litigation employs precautions to prevent the inadvertent disclosure of privileged documents, some privileged materials are likely to slip through. Recognizing this likelihood, litigants commonly enter into “clawback agreements” at the start of discovery. Typically, a clawback agreement permits either party to demand the return of (that is, to “claw back”) mistakenly produced attorney-client privileged documents or protected attorney work product without waiving any privilege or protection over those materials.

Clawback agreements allow parties to specifically tailor their obligations (if any) to review and separate privileged or protected materials in a manner that suits their needs. For example, before discovery begins, the parties can agree on how they will search for and separate privileged or protected materials from their document productions. So long as the parties abide by the agreement, they will be permitted to take back any privileged or protected material inadvertently produced. Thus, parties can reduce their exposure to costly and time-consuming discovery disputes over whether the protection of privileged material was waived by its production.

…continue reading: Best Practices for Preparing a Clawback Agreement

Risk allocation provisions (RAPs) are an important part of M&A contracts. In a new research paper, Allocating Risk Through Contract: Evidence from M&A and Policy Implications, I analyze those provisions in the contracts for a representative sample of deals for US targets, and find both wide variation but also clear patterns in when they are used and how they are designed. The patterns I observe reflect multiple economic theories: they show that RAPs are used and designed in light of the information different parties to a deal are likely to have, their incentives during and after the deal, and also transaction costs, especially the costs of enforcing contracts. Despite these patterns, the contracts also show enormous variation in how risk is allocated — and some of this residual variation correlates with the experience of deal lawyers — suggesting that some choices are better than others. Practitioners can benefit from better understanding economic theories, and academics can benefit from better understanding how varied and complex real-world contracts are.

Among the basic patterns I find are the following:

…continue reading: Allocating Risk Through Contract: Evidence from M&A and Policy Implications

Acquisition agreements often contain provisions that restrict or prohibit the payment of “consequential,” “special,” or “incidental” damages for breach. [1] Principals and their counsel may intend that these provisions prevent liability arising from unknown and unforeseeable future events; however, because these terms are poorly understood in the context of acquisition agreements, the exclusion of these categories of damages may have unexpected consequences for the parties to a transaction. Buyers and sellers should carefully weigh the effect of these damage-limiting provisions and consider alternative, more clearly defined provisions to limit damages under their acquisition agreements.

General Contract Damages

Before examining contract provisions limiting damages, it is important to review briefly the basic principles for recovery of damages due to breach of contract. Damages arising out of the breach of a contract are generally limited by the principles set forth in the English case of Hadley v. Baxendale. [2] Hadley created a rule with two branches: (i) a party may recover for losses that directly and naturally arise from the breach of a contract and (ii) a party may recover for losses arising from special circumstances surrounding the breach to the extent that the breaching party knew of the circumstances at the time the contract was made. [3] Consistent with Hadley, under the default rules of most jurisdictions, recoverable losses arising under a breach of contract are limited to those damages that are reasonably foreseeable to the breaching party. [4]

…continue reading: Avoiding Unintended Consequences of Damage Waiver Provisions

In the paper, Does Reputation Limit Opportunistic Behavior in the VC Industry? Evidence from Litigation against VCs, forthcoming in the Journal of Finance, we use a hand-collected database of lawsuits filed against U.S. venture capitalists (VCs) to examine the role of reputation in limiting opportunism in the VC industry. The lawsuits in our sample serve as a proxy for alleged opportunistic behavior by the defendant VCs. Based on the lawsuit plaintiff, we further identify whether the defendant VCs allegedly behaved opportunistically against founders, limited partners, other VCs, buyers of VC-backed startups, or other parties (angels, creditors, employees, etc.).

We choose proxies for VC reputation (or alternatively the intensity of VC relationships) with each of the four main types of plaintiffs as follows. First, the number of deals that a VCs invests in serves as proxy for the VC’s reputation with founders. Second, we use the amount of funds under management to proxy for the VC’s reputation with limited partners. Third, the VC’s network centrality, defined as the scaled number of relationships that a VC has with other VCs, serves as proxy for the VC’s reputation with other VCs. Last, we use the percentage of companies in the VC’s portfolio that go public to proxy for the VC’s reputation with buyers of VC-backed startups.

…continue reading: Reputation and Opportunistic Behavior in the VC Industry

The large modern business corporation is frequently organized as a complex cluster of hundreds of corporate subsidiaries under the common control of a single corporate parent. General Electric, for example, has over 1500 subsidiaries, most of them wholly-owned. What is the purpose of all these subsidiaries? Do they exist only as a means of avoiding taxation and regulation? Or are there real efficiency gains that subsidiaries can help unlock?

In our paper, Legal Entities as Transferable Bundles of Contracts, which was recently made publicly available on SSRN, we provide new theory and supportive evidence that help explain a relatively unexplored benefit of subsidiaries. We focus, in particular, on the advantages of subsidiary entities in enhancing the transferability of a business unit. The theory not only sheds light on corporate subsidiaries, but illuminates a basic function of all types of legal entities, from partnerships to nonprofit corporations.

Many of the modern firm’s key assets come in the form of bilateral contracts, in which both parties to the contract are exposed to performance risk from the other party. Take, for example, the movie rental company, Redbox, which is a wholly-owned subsidiary of Coinstar. Many of Redbox’s key assets are contractual, including agreements with movie studios to acquire DVDs, and revenue sharing agreements with companies like Wal-Mart that house Redbox kiosks. Real estate, such as corporate headquarters and processing facilities, are frequently acquired through long-term leases.

…continue reading: Legal Entities as Transferable Bundles of Contracts

In Broken Promises: Private Equity Bidding Behavior and the Value of Reputation, a paper recently made public on the SSRN, we examine the relation between reputation and financial contracting.

Beginning in August 2007, a number of private equity (PE) firms attempted to strategically default on pending acquisitions of publicly-traded targets. These attempts succeeded in a number of notable instances. We document that bidder-initiated terminations accounted for over $168 billion of transaction values announced in 2007 alone, representing an economically sizeable 39% of total announced private equity bids in 2007.

The large number of defaults represented a collapse of the prior relationship between the PE industry and targets. Prior to this wave of contract terminations, a promise between a private equity partner and target management set in motion a tacit relationship based primarily on trust and reputation but not contract. An unwritten rule held that private equity firms do not back out of their arrangements to acquire takeover targets despite the ability to do so under their formal contractual agreements. In other words, the private equity relationship with a target was one in which reputation played an important role. The trade-off between reputation and buyout losses reached a tipping point in 2007-2008 as many financial sponsors faced potential losses in the $billions on their bids for target firms of declining value. The extreme circumstances faced in the recent financial crisis thus provide a natural experiment to examine PE bidding behavior in relation to the value of reputation and contract design.

…continue reading: What Price Reputation?

In the paper, Risk and Incentive: An Event Study Approach, which was recently made publicly available on SSRN, we take an event study approach to reexamine the standard principal-agent model prediction with respect to executives who have likely experienced an exogenous risk shock. Existing empirical studies of the relationship between risk and incentives provide mixed results, some positive, some negative, and some showing no relationship. We analyze not only the relation between level of pay-performance-sensitivity and firm risk subsequent to a litigation event, but also incremental incentives (changes in pay-performance-sensitivity embedded in executives’ annual compensation) occasioned by a litigation event.

…continue reading: Risk and Incentive: An Event Study Approach

In our paper, Internal Control Weakness and Bank Loan Contracting: Evidence from SOX Section 404 Disclosures, forthcoming in The Accounting Review, we compare various features of loan contracts between firms with ICW and those without ICW. To provide evidence of the impact of ICW on various features of loan contracts, we construct a sample of 3,164 loan facility–years for borrowers that filed SOX 404 disclosures with the SEC during 2005–2009. We then compare various features of loan contracts with ICW borrowers with those with non-ICW borrowers, after controlling for borrower- and loan-specific characteristics deemed to affect the contract terms.

…continue reading: Internal Control Weakness and Bank Loan Contracting

Executive pay has skyrocketed in recent decades, in absolute terms and compared to average wages. The area of largest growth has been in stock-based components, including stock options, often tending to focus on the short-term, with associated risks we’ve seen. A vigorous academic debate has run for more than a decade, becoming a popular political discussion amid the financial crisis that arcane debate to public scrutiny.

Growth could be laudable, explained as creating proper incentives to align manager interests with shareholder interests and to promote optimal risk taking. In this view, if there is a problem, it is narrow and limited. Critics are skeptical whether this story holds up. They worry that managerial power has strengthened to enable top executives to control setting their own compensation. In this view, the problem is pervasive and warrants a comprehensive response—and proposals abound.

…continue reading: A New Legal Theory to Test Executive Pay: Contractual Unconscionability