As corporate boards at Mattel, Hertz, Symantec, and other companies have recently learned, few things rankle investors more than CEOs exiting the corner office with hefty payouts after presiding over poor firm performance.
Agreements to make generous payments to chief executives upon their termination have been growing more prevalent for some time. But do such deals merit the outrage they so often provoke? Some new research suggests otherwise.
According to a study in the current issue of the American Accounting Association journal The Accounting Review, chief executives whose contracts protect them from being terminated without cause or grant them generous severances in that event “are less likely to engage in myopic behavior compared to those without contractual protection.”
Unpopular though it may be, “such contractual protection can expand managers’ horizons and address the agency problem of short-termism,” which, the study explains, “refers to cutting long-term investments, such as research and development, to meet or beat short-term performance targets.”
And the difference these CEO severance agreements make in this regard can be quite considerable, the study finds. In situations where the chiefs are under particular pressure to cut R&D, “the marginal effect of CEO contractual protection ranges from 21.1 to 24.3 percentage points.” In other words, the agreement lowers by almost one fourth the probability of cuts in investments likely to be essential to future company growth.
As the study explains, “The fundamental driver of managerial short-termism is the pressure on managers to deliver short-term performance. CEO employment contracts can ease such pressure by protecting CEOs from short-term performance swings and downside risk.”
Collaborating on the paper were Xia Chen and Qiang Cheng of Singapore Management University, Alvis Lo of Boston College, and Xin Wang of the University of Hong Kong.
“Even though contractual protection of chief executives may anger shareholders and on occasion may encourage CEO entrenchment or complacency, its effect on short-termism represents a benefit for investors that should not be underestimated,” says Lo. “Short-termism, after all, is widely regarded as one of the most serious shortcomings of present-day corporate governance, so much so that a report from the Aspen Institute asserts that it has ‘eroded faith in corporations continuing to be the foundation of the American free enterprise system.’ ”
So serious is the problem of short-termism, Lo observes, that an influential U.S. law firm, Wachtell, Lipton, Rosen & Katz, recently recommended that the SEC no longer require public companies to issue quarterly financial reports. And a large U.K.-based institutional asset-management firm, Legal & General Investment Management Ltd., sent a letter to the boards of the 350 largest companies on the London Stock Exchange proposing much the same.
Which would most investors prefer as a way of combating short-termism, Professor Lo wonders: job protections for CEOs, or doing away with quarterly reports?
The study’s findings derive from an analysis of financial and governance data from S&P 500 companies from 1995 through 2008. The data comprised 2,027 firm-years, about 70% of which involved companies where the CEO had a comprehensive fixed-term employment contract or stand-alone severance pay agreement, and 30% of which involved firms where the CEO had neither.
Both comprehensive employment contracts and severance agreements specify that chief executives cannot be dismissed without a severance payout except for good cause, which, the authors note, would include fraud or gross malfeasance but “usually does not include CEO incompetence or poor firm performance.”
Firm-years were divided into three groups: those in which earnings 1) increased from the previous year, 2) declined by an amount smaller than the previous year’s R&D expense, or 3) declined by an amount larger than the previous year’s R&D. The professors chose cutting R&D as a proxy for short-termism because, in their words, “the tradeoff between meeting current earnings targets and increasing long-term firm performance is particularly salient in the case of cutting R&D.”
Of greatest interest were firm-years in the second group, where managers “have particularly strong incentives to engage in myopic behavior,” since they can return earnings to the previous year’s level by cutting R&D. And indeed, as indicated earlier, the presence or absence of contractual protection made a considerable difference, reducing the probability of an R&D cut by almost a fourth.
In addition, contractual protection was associated with significantly higher return on assets and cash flow from operations in the subsequent three years. Neither effect was seen in the other two groups.
The study also reveals that the effect of contractual protection against short-termism was significantly influenced by several factors, including the following:
■ The amount of severance pay compared to the CEO’s base salary, with the effect increasing with higher ratios
■ The duration of protection, with the effect greater the longer it will be in force
■ The amount of stock owned by transient institutional investors, whose short investment horizons are likely to sharpen a CEO’s desire for contractual protection
■ The degree of independence of the company board, with greater independence entailing closer monitoring of management and less need to counter myopia through contractual protection.
Entitled “CEO Contractual Protection and Managerial Short-Termism,” the study is in the September/October issue of The Accounting Review.