Severance Agreements and the Cost of Debt
44 Pages Posted: 14 Jan 2012 Last revised: 26 Feb 2020
Date Written: July 26, 2017
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 document a significant positive relation between the use of severance agreements and the cost of debt (10% higher yield spreads for firms with severance agreements). The results hold after controlling for the probability of takeover, the probability of CEO turnover, and whether the firm has investment or non-investment grade debt. These results can be explained by an increase in firm risk and a higher likelihood of CEO turnover associated with severance agreements. 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.
Keywords: Golden parachutes, cost of debt, takeover probability, firm risk, CEO turnover
JEL Classification: G32, G34, G38, K22
Suggested Citation: Suggested Citation