The Firing of CEOS and Severance Pay

Abstract:     
Stockholders and regulators question whether severance packages are beneficial to stockholders. We study an agency setting where, in period 2, the shareholder can either retain the manager or fire him if a suitable alternative candidate exists. The manager’s effort in period 1 not only determines his productive output but also the probability that a suitable candidate emerges in the second period.

We consider three model variations in which: (1) the shareholder can costlessly commit to a firing strategy, (2) severance pay has a duel role that includes commitment and motivational efficiency, and (3) severance pay influences the manager to choose a high-return, risky project. Generally, severance pay is more efficient than performance-based bonuses when the arrival of a suitable candidate is a better signal of the manager’s effort than the output generated by the manager. We also show that contract settings exist in which the shareholder optimally commits to severance pay for a low productive outcome. Although casual observers may interpret severance pay in such cases as paying the manager for poor performance, committing to severance pay helps motivate the manager to choose high effort and a high-return investment project.

Number of Pages in PDF File: 48

Keywords: Severance pay, CEO dismissal

JEL Classification: C71, J33, M41

working papers series