Executive Severance Agreements

Severance agreements provide an interesting exception to the pay-for-performance paradigm. Not only do executives get paid after being fired, but frequently the payments are already contracted upon at the time the CEO is appointed. The main objective of this paper is to investigate the reasons why firms would commit to pay large amounts to CEOs that are fired. We distinguish between the need to provide insurance against uncertainty about the (continued) fit between the CEO and the firm and the need to provide incentives to the CEO. The theoretical literature on severance has proposed that severance provides incentives to take on more risky projects, to make more relationship specific investments and to increase the timely disclosure of bad news. We use a random sample of S&P 1500 firms, and investigate which hypothesis can best explain which firms adopt severance agreements, and for which amounts. Second, we investigate whether the future actions by the CEO and the firm are consistent with the effects predicted by the theories. Overall, our results are most consistent with severance being used as insurance against poor fit and firm risk.