Here’s why: The first reason is that high severance pay creates an incentive for risk-taking. Let’s say you’re the CEO of Corporation X and you’ve got a whole lot of shares in the company. In fact, you have so much money riding on the success of the company, you decide to pass on a risky yet potentially very rewarding project that winds up on your desk. Rather than going for the 60-yard field goal to win the game, you play it safe and opt for the punt.
Severance pay, the study argues, offers a kind of indemnity to the CEO that allows for daring. Without a certain degree of risk, Columbus wouldn’t have landed in The Bahamas. Had Apple (AAPL) not risked an investment in touch technology, there’d be no iPhone. In this case, severance pay insures that CEOs “accept ambitious projects when they are concerned with their own wealth preservation.”
The second reason is the so-called “insurance effect.” CEO jobs are inherently more risky than middle-management positions. Incoming CEOs may bring with them strategies or philosophies that conflict severely with the status quo and, more often than not, new CEOs have left more secure jobs than the one they’re about to start. As a result, guaranteed severance pay offers a buffer against the high probability of a volatile career.
Lastly, most CEOs sign strict confidentiality agreements upon getting hired. According to the study, when an executive gets the proverbial boot, he or she “suffers costs due to an inability to fully utilize their human and intellectual capital” as a result of these agreements.
Take former Starbucks (SBUX) CEO Jim Donald. From April, 2005 until January 7th of this year, Donald oversaw the coffee-chain’s explosive growth. But as the economy slowed, Starbucks’s share price dropped 42%, and Donald was shown the door, $1.25 million in severance in his pocket.
In the grand scheme of CEO severance, Donald’s departing gift was small. But he also agreed not to compete against Starbucks for 18 months. Now, here’s a guy who knows a lot about selling coffee who’s suddenly forbidden from getting anywhere near a coffee bean for over a year. According to the Northwestern study, Donald’s severance pay isn’t excessive - it’s entirely warranted.
Still not convinced? You’re not alone. As of April 2007, activist shareholders had submitted close to 300 resolutions condemning excessive executive compensation. In 2006, that number was only 178. Public tolerance for exorbitant CEO severance pay is at an all-time low.
In rare cases, public outrage mirrors reality. Earlier this week, the Federal Housing Finance Agency notified Fannie and Freddie’s Mudd and Syron that they would not be eligible for their severance packages now the companies are under federal control.
Sometimes losers… well, lose.
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