In our paper, CEO Job Security and Risk-Taking, which was recently made publicly available on SSRN, we use the length of employment contracts to estimate CEO turnover probability and its effects on risk-taking. Protection against dismissal should encourage CEOs to pursue riskier projects. Indeed, we show that firms with lower CEO turnover probability exhibit higher return volatility, especially idiosyncratic risk. An increase in turnover probability of one standard deviation is associated with a volatility decline of 17 basis points. This reduction in risk is driven largely by a decrease in investment and is not associated with changes in compensation incentives or leverage.
Posts Tagged ‘Management contracts’
Although much has been written and discussed in the past few years about the impact of “Say on Pay” and Dodd-Frank on CEO compensation practices (including the narrowing or elimination of employment agreement provisions such as excise tax and other tax gross-ups and automatic “evergreen” renewal terms which have not been viewed as shareholder friendly), there has been less discussion as to whether employment agreements remain a viable option in a Say on Pay world. In spite of the complicated relationship between a CEO hire and the company, some companies, as a policy matter, do not put the terms of such relationship in writing. Complexities that are often spelled out in a written agreement include duties and responsibilities of the CEO, compensation (including formulaic increases during the term), the duration of the term of employment, termination provisions, severance payments under certain termination scenarios, and post-employment restrictive covenants. As discussed below, in our view, written employment agreements continue to be viable and recommended, particularly in the case of CEOs hired from outside the company.
In our paper, CEO Contract Design: How Do Strong Principals Do It?, forthcoming in the Journal of Financial Economics, we contribute a new perspective on executive compensation research by studying changes to CEO employment contracts implemented by some of the most sophisticated and financially savvy principals in U.S. capital markets: private equity sponsors. If the changes in a firm’s governance structure following a leveraged buyout (LBO) allow for arm’s-length bargaining between private equity (PE) sponsors, as ‘‘strong principals,’’ and the CEOs of the portfolio companies as their agents, we may observe changes to contract features of importance to the private equity sponsors.
Our objective in this paper is to answer three questions. First, do the strong principals redesign CEO contracts? If they do, which contract features do they change? We examine a comprehensive set of features of CEO contracts in addition to cash pay, such as perquisites, equity incentives, vesting conditions, and severance pay. Second, how do the CEO contracts designed by PE sponsors square with contracting theories? Finally, do the CEO contracts we study avoid some of the most criticized compensation practices in U.S. public firms? Regulators and shareholder interest groups should be interested in whether their proposals differ markedly from contracts where a shareholder with significant ownership and financial expertise bargains with a CEO.
In our recent working paper, When Do CEOs Have Covenants Not to Compete in Their Employment Contracts?, we undertake the first comprehensive study of contractual restrictions on CEOs’ post-employment competitive activities. The large random sample of nearly 1,000 CEO employment contracts for 500 companies was selected from the S&P 1500 from the 1990s through 2010. We find that about 70% of CEO contracts have post-employment competitive restrictions. We also find more covenants not to compete (CNCs or noncompetes) in longer-term employment contracts and at profitable firms. In addition, our study uses a nuanced state-by-state CNC strength of enforcement index to test the variance of CEO noncompetes across jurisdictions.
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.
In the paper, Relative Performance Evaluation and Related Peer Groups in Executive Compensation Contracts, forthcoming in The Accounting Review, we examine the explicit use of relative performance evaluation (RPE) and related peer groups based on S&P 1500 firms’ first proxy disclosures under the SEC’s 2006 executive compensation disclosure rules. Prior empirical research offers mixed evidence on the use of RPE in executive compensation contracts based on an implicit approach. The implicit approach infers RPE use by regressing executive pay on industry performance across a population of firms, and thus relies on simplified assumptions concerning RPE contract details. We demonstrate that a lack of knowledge of both RPE peer group composition and the link between RPE-based performance targets and future peer performance cloud inferences drawn from implicit tests. These findings highlight the limitations of the implicit approach and underscore the importance of incorporating explicit RPE contract details in testing for RPE use.
In the paper, Private Equity in the 21st Century: Cash Flows, Performance, and Contract Terms from 1984-2010, which was recently made publicly available on SSRN, we use a large, proprietary database of private equity cash flows and management contract terms over the period 1984-2010, comprising close to 40% of the U.S. Venture Economics universe, to provide new evidence on the determinants of private equity performance, cash flow behavior, and contract terms. The data are the first available for academic research to include cash flow information for a large sample of private equity funds extending beyond 2003, to include information on general partner capital commitments, and to combine cash flow information with the terms of the management contracts.
Our analysis is centered around two interrelated themes. First, we investigate the impact of broader market conditions on private equity markets. While it is well known that public and private equity markets are correlated through time, with shared periods of boom and bust, the implications of this correlation for private equity investors and managers are not well understood.
On Aug. 6, 2010, Mark Hurd stepped down as chairman, president and chief executive officer of Hewlett-Packard Company. His resignation was at HP’s request. He was provided, among other things, a severance payment of approximately $12 million. Today’s column considers whether the severance payment, given the circumstances involved in Mr. Hurd’s departure, can be reconciled with the HP Severance Plan for Executive Officers pursuant to which it was paid. Specifically, the question is whether the separation qualified as one “not for cause,” a condition to payment under that plan.
A severance of another HP CEO, Carly Fiorina, involving entirely different circumstances, was the subject of this column on March 24, 2005.
In our paper, Comparing CEO Employment Contract Provisions: Differences between Australia and the U.S., forthcoming in the Vanderbilt Law Review, we compare and contrast CEO employment contracts across two very different common law countries.
In the wake of the global financial crisis, executive compensation is front page news, with soaring rhetoric about excessive pay to ungrateful bank employees and personal attacks on CEOs and other executives. Frequently missing from the discussion, however, are basic facts surrounding the terms and conditions of the executives’ relationships with their firms. While several recent studies in the United States have begun to fill in some of the details surrounding American executive employment contracts, or the lack thereof, none have fully captured the U.S. experience, particularly from a legal perspective. Likewise, none of these studies even touch on Australian CEOs’ contractual employment relationships.
In Explicit vs. Implicit Contracts: Evidence from CEO Employment Agreements, which was recently accepted for publication in the Journal of Finance, we report evidence on the determinants of whether the relationship between a firm and its CEO is contractually defined in an explicit agreement. Our sample consists of the 494 U.S.-based firms in the S&P 500 on January 1, 2000 and their CEOs as of that date. We construct the sample by combining a set of explicit CEO EAs provided to us by The Corporate Library with agreements identified by searching the SEC filings of all remaining S&P 500 firms for any mention of an explicit EA. We define explicit EAs to include only comprehensive written agreements that specify the relationship between a firm and its CEO. We find that fewer than half of the CEOs of S&P 500 firms have comprehensive explicit employment agreements.
We find that comprehensive explicit EAs are used more frequently at firms operating in more uncertain business environments and at firms that are likely to face lower costs from altering the agreement with the CEO. This is consistent with the idea that firms facing greater uncertainty are more likely to encounter situations in which the benefits from altering an EA outweigh the costs. CEOs that have been hired from another firm (outside CEOs) are also more likely to have explicit EAs. These CEOs tend to face greater uncertainty about the sustainability of their relationships with their firms than CEOs who have been promoted from within. We find strong evidence that CEOs who can expect to earn greater abnormal compensation at their firms, both in the near future and over the estimated remainder of their career, are more likely to have an explicit EA. In addition, CEOs who receive a larger fraction of their pay as incentive-based compensation, which tends to be at greater risk if their employment agreement is altered, are more likely to have an explicit EA. Lastly, we find that the factors that explain the presence of an explicit EA also explain contract duration.
On balance, the evidence supports theoretical literature on the choice between explicit and implicit agreements and is consistent with optimal contracting.
The full paper is available for download here.