Another Major Downside to Large CEO Severance Packages

According to the Wall Street Journal, Tulane Professor of Finance Peggy Huang has conducted a terrific new study regarding CEO severance packages.  As you know, many journalists, investors, and analysts have expressed dismay at some of the large severance packages provided to dismissed CEOs in recent years.  Huang set out to examine the impact of such packages in more detail.   She explored whether such packages may have led to excessive risk-taking (since the cost of failure was substantially reduced by the generous severance).  More specifically, she examined whether companies whose CEOs had such packages underperformed the stock market during the CEO's tenure. 

Her findings suggest that Boards of Directors should proceed with caution when offering such packages, particularly cash-heavy packages.  Huang examined roughly 2,000 CEO severance agreements from S&P 500 companies between 1993 and 2007.  She discovered that these firms underperformed the market by 1.6% on average over a three-year period, when compared with firms that did not have CEO severance packages.  If the CEO had a cash-only severance package, the firms underperformed the market by 4% on average.  Looking at the CEO's actions in more detail, she found some evidence suggesting enhanced risk-taking by the CEOs with severance packages. 

Professor Huang offered a comment to the Wall Street Journal about her findings:  "With a severance contract, a company is basically saying that even if a CEO fails, there will be no penalty."

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Daredevil CEOs, Options, and Risk

Wharton Professor Todd Gormley, Northwestern's David Matsa, and Washington University of St. Louis' Todd Milbourn have published a new paper titled "CEO Compensation and Corporate Risk Taking: Evidence from a Natural Experiment."  Many scholars have argued that stock options increase executive risk-taking, since there is a huge upside with limited downside associated with options grants.  These scholars use a fascinating natural experiment to test this theoretical prediction.   The researchers looked at firms affected when the federal government added certain chemicals to the list of known carcinogens.   They looked to see whether firms took concrete steps to reduce cash flow volatility (i.e. cut risk) after this threat emerged.  The scholars found that executives with a high amount of option-based compensation were less likely to try to cut risk to offset the increased risk/threat from the carcinogen finding by the federal government.  

I find the study quite fascinating and persuasive in providing data to support its conclusion.  However, in the article on the Knowledge@Wharton website, I must dispute one key point.  Gormley addresses the question of whether risk-taking is always necessarily a bad thing for shareholders.  According to the article, "Gormley points to the case of defense contractor General Dynamics as an example of risk paying off."  He argues that executives there in the early 1990s took the risk of not diversifying, but rather than focusing on defense, after the national defense budgets began to be cut.    He's right that the risk paid off handsomely, as General Dynamics provided handsome shareholder returns through the 1990s.  

There's only one problem with this argument.  I worked at General Dynamics at the time, and I've taught a case study about the firm during that period.   When Bill Anders became CEO in 1991, a very aggressive pay-for-performance compensation scheme was put in place for the top 25 executives.  However, the compensation scheme was heavily weighted toward cash bonuses.  It became very controversial because the executives received large cash bonuses if the stock rose by $10 and stayed there for 10 days.  The incredible short-term orientation of that bonus scheme set off criticism from many quarters.  60 Minutes even did a very critical feature on the company.   After that, General Dynamics eliminated the cash bonus scheme and shifted to an option-based compensation structure.  However, the key decision to not diversify into commercial ventures, but instead to focus on defense, had already been made by Anders and the top team before the options scheme was put in place. 

Despite this slight inaccuracy, the paper provides a terrific look at a natural experiment with implications for how Boards compensate CEOs.   I recommend taking a look.

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Personal Use of Corporate Jets

The Wall Street Journal ran a major story today on the personal use of corporate aircraft by company executives.   They found that many CEOs spend a great deal of time using their corporate jets for personal travel.   Many executives consider the use of a corporate jet a major perk.   In my view, corporate jets can serve a very useful function in terms of allowing executives to travel much more efficiently than if they had to use commercial flights.   Some use of the jet for personal reasons may be appropriate as well, since the line between personal and business travel can be blurred at times.  However, it appears that some executives may be abusing this perk.  In addition, SEC rules require the honest reporting of personal usage by executives.  Moreover, personal use of a corporate jet is a taxable benefit.  If companies, as the Wall Street Journal suggests, are under-reporting the personal use of these jets, then shareholders and taxpayers rightfully should be upset. 

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