Severance Agreements, Incentives, and the Cost of Debt

Abstract:     
Upon examining the language used in recent SEC filings, we find that severance agreements are often paid whether or not the CEO leaves the firm due to a change in control. We hypothesize that since severance agreements compensate CEOs in the event of termination, CEOs with these agreements will have an incentive to increase firm risk and decrease effort. Consistent with this hypothesis, we find that the adoption of a severance agreement is associated with an increase in firm risk, a higher likelihood of CEO turnover, and a lower operating performance. We also document a significant positive relation between the use of severance agreements and the cost of debt; firms in which the CEO has a severance agreement have yield spreads which are approximately 10% higher than firms without these agreements. The results hold after controlling for endogeneity, the probability of takeover, and whether the firm has investment or non-investment grade debt. Overall, the evidence suggests that the effects of severance agreements extend beyond takeovers, and that these additional implications are primarily negative for the firm and for debt holders in particular.

Number of Pages in PDF File: 49

Keywords: Severance agreements, cost of debt, takeover probability, firm risk, CEO turnover

JEL Classification: G32, G34, G38, K22

working papers series