How do ex-ante severance pay contracts fit into optimal executive incentive schemes?

P. Raghavendra Rau† University of Cambridge

Jin Xu Purdue University

September 2012

† Corresponding author Cambridge Judge Business School, Trumpington Street, University of Cambridge, Cambridgeshire, CB2 1AG United Kingdom, 310-362-6793; [email protected]

We would like to thank an anonymous referee, Philip Berger (the editor), Dave Denis, Diane Denis, Alex Edmans, Mara Faccio, Stu Gillan, Marc Goergen, Eitan Goldman, Jay Hartzell, Hayne Leland, John McConnell, Christine Parlour, Joshua Rauh, Vivek Sharma, Richard Stanton, Peter Swan, Hongfei Tang, David Yermack, and seminar participants at the University of California at Berkeley, the 2010 Conference on Managerial Compensation at Cardiff University, the Third Singapore International Conference on Finance, the Midwest Finance Association, 2009, the Financial Management Association, 2010 and the American Finance Association, 2012 for helpful comments. We would also like to thank Micah Allred, Clarke Bjarnason, Rahsan Bozkurt, Amanda Thompson, and Jing Wang for able research assistance.

How do ex-ante severance pay contracts fit into optimal executive incentive schemes?

ABSTRACT

We analyze a sample of over 3,600 ex ante explicit severance pay agreements in place at 808 firms and show that firms set ex ante explicit severance pay agreements as one component in managing the optimal level of equity incentives. Younger executives are more likely to receive explicit contracts and better terms. Firms with high distress risk, high takeover probability and high return volatility are significantly more likely to enter into new or revised severance contracts. Finally, ex post payouts to managers are largely determined by the ex ante contract terms.

JEL Classification: G32, G34

Keywords: Managerial compensation; Severance pay; Optimal contracting

1. Introduction

“Léo Apotheker’s short, turbulent reign as the chief executive of Hewlett-Packard was by nearly all accounts a disaster. The board demanded his resignation, and if ever there was a case for firing someone for cause, this would seem to be it. So why is H.P. paying Mr. Apotheker more than $13 million in termination benefits? Just three years after the financial crisis generated widespread public outrage that Wall Street chief executives walked away with hundreds of millions in bonuses and other compensation after driving their companies into insolvency and plunging the nation’s economy into crisis, multimillion-dollar pay for failure is flourishing like never before. H.P. is simply the latest example, albeit an especially egregious one. It’s hard to fault Mr. Apotheker for taking what H.P. offered. But among the many questions shareholders should be asking the board is why it approved an employment agreement for Mr. Apotheker that arguably made it more lucrative for him to fail — and the sooner the better — than to succeed.”1

In recent years, large severance payouts to executives who have been fired from poorly performing firms have attracted a great deal of attention in the popular press.2 As the quote above suggests, there is a considerable degree of popular outrage on what seem to be egregious ex post payments that are unrelated to the executive’s performance during his tenure at the firm. However, though severance agreements are potentially important elements of executives’ compensation contracts, there is little empirical evidence on the incidence and terms of ex ante severance agreements negotiated by executives, let alone on how these contracts fit into executives’ overall incentive compensation schemes. In this paper, we analyze a unique hand-collected sample of 3,688 severance contracts in place at 808 firms in 2004. This sample is the most comprehensive of any work in this area,

1 Stewart, James B. “Let’s stop rewarding failure”, New York Times, 30 September 2011, p. B1. 2 See for example, Dash, Eric, 2011, “Outsize severance continues for executives, even after failed tenures”, New York Times, 29 September 2011. Similarly, when discussing new rules on executive compensation in 2009, President Barack Obama remarked “Companies receiving federal aid are going to have to disclose publicly all the perks and luxuries bestowed upon senior executives, and provide an explanation to the taxpayers and to shareholders as to why these expenses are justified. And we're putting a stop to these kinds of massive severance packages we've all read about with disgust; we're taking the air out of golden parachutes.” (see http://www.whitehouse.gov/blog_post/new_rules/).

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including firms of all sizes, ages, and industries, and executives of a wide range of ranks including the Chief Executive Officer (CEO), Chief Financial Officer (CFO), Chief Operating Officer (COO), and other executives. We analyze contracts granted to new executives and revisions of contracts to existing executives. We examine contracts that are contingent on a breach of contract with the executive (golden handshakes), contracts that are contingent on a transfer of control of the company (single-trigger golden parachutes) and contracts that are contingent on a breach of contract after a change in control (double-trigger golden parachutes). In theory, the optimal executive contract, consisting of a mixture of cash and bonus payouts, equity and option-based incentives, and severance pay, should be designed as a whole to attract talented executives and incentivize them to exert effort on behalf of shareholders. Two important managerial incentives are incentives to increase stock price (i.e., portfolio delta) and incentives to take risk. As we discuss in the next section, option pay alone is insufficient to optimize incentives to managers in all states of the world. By modifying the payout to executives in periods when delta is low, severance pay complements the role played by options and other incentive mechanisms in the optimal compensation contract. While a large literature has examined the determinants and effects of incentive compensation from cash and bonus payouts, equity-based compensation and other forms of incentives, to the best of our knowledge, there are only two working papers that explicitly examine the determinants of ex ante CEO severance contracts. Rusticus (2006) and Sletten and Lys (2006) both pick random samples of new CEOs hired at S&P500 firms during 1994-1999 and 1992- 2003, respectively, and document the proportion of sample CEOs that negotiate severance contracts and firm-specific determinants of these contracts. There is little evidence on how these results generalize to the larger universe of listed firms, to executives other than the CEO, to contracts that take effect under different contingent situations, and to contracts granted to incumbent (as opposed to new) CEOs. Understanding these extensions is important. Rusticus (2006) and Sletten and Lys (2006) find for example, weak to no relationships between severance pay and firm and executive level characteristics. In contrast, our tests suggest that there are significant differences between

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severance contracts given to new CEOs and new or renegotiated contracts given to incumbent CEOs. In particular, the relation between the incidence and magnitude of severance pay contracts and firm and executive level risk characteristics is highly significant only for incumbent CEOs, while, consistent with Rusticus and Sletten and Lys, it is weak to non-existent for new CEOs, suggesting that focusing only on new CEOs may lead to biased conclusions. Our analysis consists of five steps. First, we document the incidence of explicit contracts in the population of S&P1500 firms and describe their terms. Second, we examine the determinants of the existence of the severance contract. Third, we examine the determinants of the magnitude of the contract. Fourth, we analyze the incidence and magnitude of different contract specifications separately. Finally, we examine how ex post severance payouts are related to ex ante severance contract terms. Our initial analysis focuses on the entire population of contracts. While this analysis provides details on the incidence of contracts in the population in equilibrium, it is important to note that it does not shed light on the determinants of these contracts, if the contracts were granted in the past under different executive- and firm-specific circumstances and the adjustment costs (costs of granting new or revising old severance contracts) are relatively large. Hence most of our analysis centers on a subsample of firms that issue new or revised contracts in 2004 to their (new and incumbent) executives. More specifically, we begin by documenting the incidence and terms of explicit severance contracts in equilibrium across the population of firms listed on the COMPUSTAT Executive Compensation Database (Execucomp) in 2004 (largely composed of the S&P1500 firms). About 68% of the firms list explicit severance contract terms with their executives, a much larger percentage than those documented in prior studies. Most contracts list up to three sets of benefits. The most common set of benefits are those related to explicit cash payments – describing the minimum and maximum number of years severance will be paid after the executive is terminated from the firm. Next is a set of benefits describing how long executives can continue to be covered by medical and life insurance after they are terminated. Least common is a set of benefits describing the payment of legal fees, outplacement, and other perks.

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Next, we examine why severance contracts are granted. We find that executives with explicit contracts are likely to be younger, have significantly lower lagged equity incentives (using the Core and Guay, 1999, model of incentive residuals3) and higher contemporaneous equity grants, than executives without contracts. This is not entirely surprising since younger executives are likely to have accumulated significant equity grants or options relative to older executives. In addition, firms with explicit contracts have significantly higher distress risk (defined as the negative of the first principal component of four variables – return on assets (ROA), excess stock returns, Z-scores (Altman and McGough, 1974), and C-scores (Campbell, Hilscher, and Szilagyi, 2008)) than firms with no explicit severance contract terms. Importantly, these results persist and are usually more significant in economic magnitude when we restrict the set of severance contracts to new or materially revised contracts. In addition, these results hold for all executives and for the CEO in particular, and are robust to various regression specifications including a probit, hazard, and a simultaneous equation framework where we endogenize both the incidence of the severance pay contract and new equity-based incentive grants. Overall, consistent with Core and Guay (1999), our evidence suggests that firms set optimal incentive levels and grant severance pay and options in a manner consistent with economic theory. To keep the paper to a reasonable length, in our subsequent analyses, we focus our attention on the CEO while noting that the results are similar when all executives are included. Contrasting new and revised contracts given specifically to new (and in particular to externally-hired) CEOs and incumbent CEOs (who negotiate a new contract or a revision to their existing contract) respectively shows that most of the results above hold only for incumbent CEOs. Firm risk characteristics, specifically distress risk, and changes in takeover probability are significant in explaining why firms grant new or revise contracts for incumbent CEOs. Incumbent CEOs are also more likely to obtain new or revised contracts when they receive contemporaneous incentive grants and their prior incentives are low. In contrast, new CEOs

3 Core and Guay (1999) argue that CEOs’ portfolio holdings of equity incentives can be explained by a mixture of firm and executive characteristics and industry effects. They use a regression model to model the expected optimal level of incentives for an executive. The incentive residual is the residual value from this regression model and captures the deviation of the executive’s current portfolio incentives from the optimal level.

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obtain explicit contracts in firms with significantly lower distress risk, higher return volatility, and lower ex ante takeover probabilities. These results are likely due to a selection effect during the CEO hiring process. Specifically, potential CEOs differ in risk aversion and less risk-averse CEOs are hired by firms with high distress risk. Because CEOs with lower risk aversion also require fewer risk-taking incentives, severance contracts are not necessarily offered. Our findings contrast with results in prior papers that examine ex ante severance contracts negotiated by CEOs new to the firm (Rusticus, 2006 and Sletten and Lys, 2006), suggesting that examining only new contracts may lead to incorrect conclusions. In the third step of our analysis, we examine the determinants of the magnitude of severance contracts. Consistent with our results on the incidence of severance agreement contracts, Tobit regressions show that firm distress risk is significantly positively and executive age is significantly negatively related to the magnitude of expected severance pay. In addition, as before, the Core-Guay incentive residual remains significantly negatively related while total compensation is positively related to the magnitude of expected severance pay. The difference between new CEOs and incumbent CEOs also persists with most of our results only holding for incumbent CEOs. In the fourth step, we analyze variations in contract types, specifically golden handshakes and golden parachutes. Distress risk is significantly related to the likelihood that firms revise golden handshake contracts to incumbent executives while return volatility is significantly positively related to the likelihood that firms revise golden parachute contracts to incumbent executives. Note that both these results may be driven by the actions of the executive. For example, it is possible that takeover target returns become more volatile once the firm is in play and managers then ask for a golden parachute in response. Similarly, distress risk may be increased by managerial actions. Across both types of contracts, younger executives are significantly more likely to receive explicit contract terms. Examining the magnitude of these contract terms, firms with higher distress risk offer more generous golden handshake contracts. The analysis so far has examined ex ante severance contract arrangements. However, the initial quote and much of the recent popular press focus on what appear to be egregious ex post

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payouts that have been described as evidence of rent extraction by CEOs (Goldman and Huang, 2010). 4 In addition, as we note above, the executive’s actions may affect the trigger for a severance payout. Since the usefulness of an ex ante contract would be hampered if ex post renegotiations occur too often (Fudenberg and Tirole, 1990), in our final test, we examine if firms and executives renegotiate actual severance payouts when the executive leaves the firm. In a hand collected sample of 219 firms, we compare the ex ante contract terms to the ex post payouts executives received when they left the firm. We find that the value of ex ante contracted severance pay is the only variable that consistently explains the ex post payouts to CEOs across all our regression specifications. Exogenous factors, both macro-economic and industry variables (real GDP growth, industry growth, and industry stock returns) are significantly negatively related to the magnitude of the difference between contracted severance pay amout and the actual severance pay (what we term “excess severance pay”). In other words, firms compensate CEOs for losses in ex ante contract amounts that are likely to be driven by factors that are largely out of the CEO’s control. Overall, our evidence suggests that firms treat severance pay as they treat other equity incentives and structure their contracts to provide executives with optimal incentive levels. The rest of the paper is structured as follows. Section 2 reviews the literature on severance pay and motivates our hypotheses. Section 3 discusses the data and summary statistics on severance pay contracts. Section 4 reports results for our empirical tests and Section 5 concludes.

2. Literature review and hypotheses development

When a firm hires an executive, it chooses to establish the terms of this relationship either explicitly or implicitly. An explicit contract requires codifying the executive’s responsibilities, compensation, and the conditions under which either party can sever the relationship, among other considerations. In this paper, we focus on one specific aspect in this contract - the terms

4 For additional examples, see Maremount, Mark, 2011. “A very rich adieu for Nabors CEO”, Wall Street Journal, October 31, 2011, page B1 and Thurm, Scott, 2011, “Mergers open ‘golden parachutes’”, Wall Street Journal, November 1, 2011, page B1.

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and conditions under which the firm and executive can choose to sever their relationship – and relate it to the overall compensation scheme to the executive. This is an important topic. Gillan, Hartzell and Parrino (2009) note that in 2000, less than half of the firms in the S&P 500 had a comprehensive written (or explicit) employment agreement (EA) with their CEOs that covered all aspects of the executive’s relationship with the firm. Many of the other firms chose to write agreements that covered only limited aspects of their relationship with the CEO, such as change of control or other types of severance agreements (Schwab and Thomas, 2006). These firms did not have an explicit EA and were not analyzed by Gillan, Hartzell, and Parrino (2009). However, as the introductory quotes suggest, it is arguably the existence of severance pay agreements that have raised the largest amount of public ire.

2.1. Reasons for severance pay contracts

There are several reasons why firms enter into severance agreements with their executives. Apart from the severance pay arrangement, the executive’s incentive contract typically contains both cash components (salary and bonus) and equity-based components (stock and options). The two primary incentives relevant for shareholders are incentives to increase stock price (i.e., portfolio delta) and incentives to take risk (i.e., vega). Because the cash component of executive incentive contracts in the US is typically temporally invariant and unrelated to the evolution of the firm’s stock price, it is less likely to incentivize the CEO to increase the stock price. Severance pay complements the incentives provided by options in the optimal compensation contract. This is because the risk-taking incentives generated from the executive’s option holdings can be mitigated by the possibility of job termination when performance is poor. For example, when the adverse consequences from job termination are extremely large, the executive will not want to take on additional risk even with large option holdings. Therefore, severance pay should be used by the firm as a supplementary incentive device to motivate risk taking. The following numeric example serves to illustrate this point. A firm can choose to invest in a Safe (S), Low Risk (LR) or High Risk (HR) project. The safe project, S, earns a certain cash flow of $500, the low risk project, LR, earns either a high cash flow of $1,000 or a low cash flow of

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zero with equal probabilities. The high risk project HR earns either a high cash flow of $2,000 or a low cash flow of -$1,000 with equal probabilities. With limited liability, shareholders prefer Project HR because their payoff is bounded at zero when cash flow is -$1,000.5 However, the executive does not have limited liability. Assume that the CEO has a compensation package that consists of a fixed salary of $5 and an option that pays nothing, $5, or $15 when cash flow is $500, $1,000 or $2,000.6 When the cash flow is -$1,000, the CEO is fired and has to search two years before finding a comparable job, equivalent to a one-time loss of $10 (2 times salary). Because the CEO will always receive the salary for the year regardless of the project chosen, we analyze only her payoff in excess of salary. Under Project S, the CEO will receive nothing. Under Project LR, the CEO will receive either the $5 option payment or nothing extra with equal probabilities. Finally, under Project HR, the CEO will receive either the $15 option payment or -$10 with equal probabilities. A risk-averse CEO chooses Project LR, which deviates from shareholders’ optimal choice. Depending on the degree of risk aversion of the CEO, it may be cheaper to motivate the desired level of risk through severance pay than through additional option payments. For example, suppose we add a promised severance pay equal to 2 years of salary when termination occurs. To keep the overall compensation package at the same level, we reduce the number of options held to 80% of the original level. This means that the options pay nothing, $4 or $12 when cash flow is $500, $1,000 or $2,000. This alters the CEO’s payoffs. Under Project S, the CEO will receive nothing extra. Under Project LR, the CEO will receive either $4 or nothing extra with equal probabilities. Finally under Project HR, the CEO will receive either $12 or nothing extra with equal probabilities. A risk-averse CEO will choose Project HR, which also maximizes shareholders’ value.

5 For simplicity, we ignore bankruptcy costs in this analysis although the intuition carries through if we include bankruptcy costs. 6 We assume that the option is issued at a strike price of $5. Assuming a fixed ratio between total firm cash flow and price per share of 100, the stock price is $5, $10 or $20 when cash flow is $500, $1,000 or $2,000 respectively. We ignore bonus and stock holdings without affecting the intuition.

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More formally, Ross (2004) notes that a convex fee schedule (such as those provided by options) does not necessarily lead to lower risk aversion for managers. He divides the effect of a convex fee schedule on managers’ risk aversion into three separate components: the translation effect, the magnification effect, and the convexity effect. The translation effect results from shifting the risk-averse manager’s decision to a different part of her utility function where she may be more or less risk averse. The magnification effect is the result of an increase in the sensitivity of the manager’s payoff to firm performance (i.e., delta), which tends to increase risk aversion. The convexity effect comes from the shape of the fee schedule itself. A convex fee schedule has a negative convexity effect, i.e., it makes risk taking more appealing. For a manager with decreasing absolute risk aversion, although call options have a negative translation effect (by adding wealth and thus bringing payoffs into a range where risk aversion is lower) and a negative convexity effect (because the payoff of an option is convex on stock performance), they have a positive magnification effect (because options increase portfolio delta and a higher delta corresponds to higher risk aversion). Thus, the overall effect of option compensation on executive risk aversion can be either negative or positive, resulting in either more or less risk taking. Since severance pay offers a payoff similar to a digital barrier put option 7 , it is nonnegative, convex, and has a largely invariant payoff triggered by relatively low firm performance. Thus it has negative translation and convexity effects and therefore induces more risk taking. Similarly, Ju, Leland and Senbet (2002) analyze firm incentives to grant severance pay to compensate for the prospects of job loss for the executive. Job termination can be triggered by poor firm performance under either internal shareholder pressure or external takeover activities, a form of implicit incentives according to Tirole (2006). The threat of job termination is equivalent to a short position in a digital barrier put option that is concave in firm performance.

7 A digital barrier put option is an option which pays $1 at the first time the stock process hits a termination value. The dynamics are largely similar to those of a regular put option but once triggered, the payoff received does not vary with ex post firm performance, but only depends on the salary and bonus in the previous year and the pre- specified severance pay multiples in the contract.

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The concavity in the implicit fee schedule reduces the executive’s incentives to take risk. In this context, termination costs are equivalent to negative severance pay. Contingent on the same triggering event (job termination), severance pay mitigates or overturns the concavity and increases the executive’s risk-taking incentives. Admittedly, severance pay also reduces managerial incentives to exert effort, but these disincentives can be controlled through other compensation mechanisms such as stock ownership.8 Severance pay is related to the delta from the executive’s current portfolio of options through two channels. Options increase delta and severance pay reduces delta. Particularly at low performance levels, severance pay therefore decreases the executive’s level of risk exposure and hence increases her incentives to take risks. To the extent that more risk taking is beneficial to shareholders, the grant of severance pay should be more likely when current incentives (measured by delta) are low, that is, severance pay and the current portfolio delta should be negatively correlated. However a countervailing effect is that severance pay also reduces managerial incentives to exert effort, requiring more incentives from other compensation mechanisms. The relation between severance pay and portfolio vega is slightly more complex. Both options and severance pay increase convexity (vega) and induce risk-taking. However, the portfolio vega, evaluated at the current stock price, reflects an executive’s risk-taking incentives from her current portfolio of options (including options granted at different times and at different prices), while the risk-taking incentives from severance pay are the highest when job termination is likely to occur. How the grant of severance pay relates to existing portfolio risk-taking incentives in the executive’s option portfolio depends on whether the risk-taking incentives provided by severance pay substitute for or complement the incentives from options. Following relatively poor stock performance, executive termination risk is high. Since this is also when the payoff from

8 Tirole (2006) also offers an additional reason for severance pay which is outside the scope of this paper to analyze. Considering an environment in which top managers can manipulate performance signals sent to shareholders, Tirole (2006) argues that manipulation is more likely when managers’ job continuation depends more on these signals. Because golden parachutes “create more ‘balanced’ incentives for the manager by increasing her payoff in the case of liquidation” (Tirole, 2006, pp. 304-305), they reduce managers’ tendency to manipulate information. This reduction is beneficial to shareholders.

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severance contracts is the most convex, severance pay is most likely to act as a substitute for options in that it increases convexity when the risk-taking incentives (vega) provided by options are low. We thus hypothesize that severance pay should be negatively correlated to portfolio vega following relatively poor stock performance. The balance is quite different at higher stock levels. When the firm is doing well, the option’s delta and vega are likely to be significantly more important than the delta and vega provided by severance pay.

2.2. Relation between severance pay and new incentive grants, simultaneity and instrumental variables

A priori, it is unclear if the firm determines new equity-based incentive grants first and severance pay second or vice versa or if both are determined by the current level of incentives to the executive. For this reason, we test if new equity incentive grants and severance pay are jointly determined in a simultaneous equations framework. As instruments for severance pay that are unrelated to the equity incentive grants paid to the executive, we use proxies for the termination probability of the executive. The termination probability is related to the performance of the firm both in an absolute sense and relative to its peers. Theoretically, it is possible that equity grants to the executive will depend on stock volatility to the extent that volatility affects monitoring costs (Core and Guay, 1999; Demsetz and Lehn, 1985). However, controlling for volatility, the probability that absolute and relative performance (relative to the firm’s peers) worsens, (and hence termination occurs) is unlikely to be directly related to equity grants. Therefore, we use distress risk and the takeover probability as instrumental variables for severance pay in the simultaneous equations system. We use lagged equity incentive grants to instrument for equity incentive grants. Because compensation arrangements made in a certain year often specify equity grants over the next few years, equity grants in adjacent years are likely to be positively correlated. However, controlling for the overall lagged equity incentive residual, lagged incentive grants should not be a separate determinant of severance pay.

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2.3. Cross-sectional predictions on severance pay

Executive age: The adverse consequence from job termination is especially large for younger executives because, once fired and without an established track record, it takes more time for younger executives to find another job with similar pay. Therefore, severance pay should be negatively related to executive age. Distress risk: The likelihood of executive job termination should also play an important role in determining the grant of severance pay. Because severance pay aims at mitigating the adverse effects of the threat of job termination, a greater likelihood of termination should lead to a higher incidence and magnitude of promised severance payments. We predict that severance pay should be positively related to the distress risk of the firm. Takeover probability: An increase in takeover probability is more likely to result in excutive job termination. Thus the takeover probability should be positively related to severance pay. Return volatility: Being employed at a firm with greater performance volatility is also likely to increase the threat of termination, suggesting a positive correlation between severance pay and firm idiosyncratic volatility. It might appear that these predictions are more likely to be relevant for a new executive than an incumbent, since distress risk and takeover probability are more likely to be exogenous for a new executive than for the incumbent. For an incumbent executive, the firm’s distress risk and takeover probability at the time of recontracting is likely in part due to the executive’s actions. However, for the new executive, a selection effect (as we describe next) is likely to complicate the empirical relationship between firm risk characteristics and the executive’s contract. New versus incumbent CEOs: To the best of our knowledge, there are only two working papers that explicitly examine the determinants of ex ante executive severance agreements. Rusticus (2006) and Sletten and Lys (2006) both examine initial employment contracts between firms and a randomized sample of newly-hired CEOs in large firms. They obtain only weak results that severance pay is positively related to firm risk. We argue that focusing on severance agreements contracted by new CEOs

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when they are hired does not provide the most powerful tests of the determinants of severance pay. This is because a selection effect exists when a new CEO joins the firm, complicating the empirical relation between her contractual terms and firm characteristics. Consider two types of potential new CEOs that differ in their level of risk aversion. These CEOs also have differential abilities in turning around a company in financial distress or fighting off takeover attempts. If the level of aversion to firm level idiosyncratic risk is negatively correlated with the ability of the manager to turn around the company, more risk-averse CEOs are more likely to require severance agreements when they sign up with new companies. However, they are also more likely to be attracted to companies with lower distress and takeover risk. Because the selection effect and optimal contracting imply opposite relations between severance pay and firm risk, it is difficult to detect a strong empirical relation in the data if we only examine new CEOs. In contrast, selection is unlikely to be an issue for incumbent CEOs and, therefore, the link between the grant of severance pay and firm risk should be easier to detect empirically when examining only incumbent CEOs. Among new CEOs, the selection issue is also less likely to be important for those internally promoted because they are already matched with the firm (albeit in different positions). In our analysis therefore, we distinguish externally hired CEOs from internally promoted CEOs. It is important to note that selection is not a problem per se, but rather that selection on unobservable (i.e., correlated omitted) variables is problematic and can lead to biased coefficient estimates. In other words, selection is not a problem if the specification includes the variables along which selection occurs. However, this is typically infeasible in an executive contracting setting where many of the variables on which selection occurs (e.g., executives’ risk- tolerance and talent) are difficult to measure. We also note that we do not dismiss the possibility that new CEOs may face greater risk of job termination than incumbent CEOs. For example, this may occur if both the firm and the CEO learn over time whether there is a good match between them. CEOs that are poorly matched to their firms are dismissed over time. Hence, a new CEO and especially an external CEO may be more likely to receive a severance agreement.

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2.4. The empirical literature on severance pay

The extant empirical literature largely examines the effect of severance pay on shareholder value. Some papers document that the presence of severance pay contracts improves shareholder value while others argue that they are used to extract rents from shareholders in firms with weak corporate governance. For example, while Lambert and Larcker (1985) document that the adoption of a golden parachute is associated with a significantly positive security market reaction, Lefanowicz, Robinson, and Smith (2000) show that the presence of a golden parachute reduces the incentive of target firm managers to negotiate for higher acquisition gains in completed acquisitions. Similarly, Yermack (2006) and Goldman and Huang (2010) document that in several cases, CEOs obtain separation pay even though they do not have severance agreements or the pay is in excess of their contracted amounts. While Goldman and Huang (2010) interpret their results as being driven by weak external governance increasing both severance levels and excess severance pay, Heen (2008) shows that firms pay the contracted separation pay amount to executives who sign non-compete agreements years before they leave the firm while paying executives discretionarily at separation if they sign non-compete agreements only at the point of departure. He argues that “gratuitous departure payments” do not seem to play a significant role in the cross-section of firms he studies. With the exception of Rusticus (2006) and Sletten and Lys (2006), there is little evidence in the literature on the incidence and terms of ex ante severance contracts negotiated by executives when they are hired or during their tenure, nor is there much evidence on how these contracts fit into the overall compensation contract offered to the executive. Rusticus (2006) and Sletten and Lys (2006) both examine initial employment contracts between firms and a randomized sample of newly-hired CEOs in large firms.9 They find that half the sample CEOs have some form of severance agreement. However, the results on the determinants (and size in some cases) of severance agreements are weak. Rusticus (2006) finds, in some specifications, that ROA is

9 Huang (2010) uses a probit regression in a panel framework to estimate the incidence of a severance contract in step 1 of a 2SLS model where the second stage involves a regression of the severance contract on the subsequent Sharpe ratio of the firm. However, her focus is on the changes in risk-taking behavior of the executives after they receive a contract. She does not analyze the determinants of the terms of the contract.

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negatively related while return volatility and firm book-to-market ratios are positively related (in one specification each) to the likelihood of getting an explicit severance contract. An outside CEO is more likely to get a contract and in some specifications, higher paid CEOs are likely to receive severance contracts. Sletten and Lys (2006) find, in one specification, that return volatility is significantly positively related to the likelihood of getting a contract.

3. The data

In our paper, we define a severance agreement as a contractual agreement between the executive and the company which specifies the executive’s benefits and obligations in the event that the executive leaves the firm. These contracts may be differentiated into several different types (Nussbaum, 2005). A garden leave severance agreement is typically used to terminate a fixed term employment contract. In return for terminating a fixed-term contract early, the firm commits to pay out an immediate lump-sum payment equivalent to the amount of all wages outstanding till the end of the contract. We do not analyze these contracts since they are usually more common for non-executive employees. For executives, a breach of contract severance agreement specifies all benefits and payments (lump sum payments, bonuses, vesting of options, additional pension rights) to be made to an executive in the event the firm breaches the contract with the executive. Typically breaches of contract occur when the firm terminates the executive without cause or the executive leaves for good reason. The common definition of “cause” is either failure to perform the designated duty or misconduct that hurts the firm. Voluntary terminations for “good reason” are also eligible for severance pay. “Good reason” usually includes a change of duty, diminution of pay, or relocation. These contracts are sometimes referred to as golden handshakes though there is still a considerable lack of clarity as to the precise meaning of the term. A specific form of a breach of contract severance agreement is a contingent agreement that occurs within a limited time after a specific corporate event, typically a change in control (CIC) of the company. A change-in-control situation is typically specified in the severance agreement as a transfer of the firm’s ownership over a certain percentage, a merger or consolidation, a

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major change in board composition or the liquidation of the firm. Within a limited period (typically two or three years) after the change in control, an executive can leave the firm if the new firm breaches the contract with the executive, usually for the same reasons (good reason or without cause) as for the non-contingent agreement (double-trigger contracts). Some contingent contracts are however, single-triggered, with the executive receiving the benefits as soon as the change in control occurs, regardless of whether the executive’s contract is terminated. Both types of contingent contracts are sometimes called golden parachutes though again there is some ambiguity about the term. In this paper, we will refer to standard breach of contract agreements as golden handshake contracts and contingent breach of contract agreements as golden parachute contracts. To collect the data, we examine the universe of Execucomp firms, largely the S&P1500 firms, in a single year, 2004.10 We choose 2004 as the year of analysis since Congress enacted Internal Revenue Code (Code) § 409A as part of section § 885 of the American Jobs Creation Act of 2004 to provide rules regarding the taxation of deferred compensation, including certain severance pay arrangements. For such agreements to comply with § 409A, the time, form and triggering event for deferred compensation payments needed to be established at the outset. Once established, subsequent changes in the form, the time of payment, or the payment itself, were heavily restricted. Non-compliant deferred compensation was to be included in gross income immediately, even if not yet paid; and that non-compliant compensation was subject to a special tax of at least 20% of the amount of compensation at issue, in addition to normal income taxes. Later clarifications established conditions under which separation pay arrangements were not

10 Collecting data on the incidence of severance contracts for many years for a panel regression does not add appreciably to restricting the data to one year. In a standard probit framework, the researcher modeling the incidence of a severance contract typically codes the first appearance of an executive-severance contract dyad as a 1 (or 0 if the executive has no severance contract). However, once an executive gets a severance contract, he is unlikely to relinquish it in later years unless he leaves the firm. Effectively this implies that once the severance contract is granted, the subsequent dependent variables are identical to those of prior years, making an ordinary probit or logit model unsuitable for estimating the values in a panel dataset with correlated dependent variables (Beck, Katz, and Tucker, 1998). Since Execucomp and other data go back only to 1993, the data is also left-censored. However, a hazard analysis, accounting for how changes to firm- and executive-specific variables affect the time the severance agreement is negotiated by an incumbent executive, is appropriate and we use it to model the time to the first grant of a contract. Analysis of changes in the terms of severance contracts, which is appropriate for a panel regression, is prohibitively time consuming, given the amount of hand collection required. See also footnote 13.

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subject to 409A – for example, as long as the payment did not exceed two times the compensation limit for qualified retirement plans or two times salary, whichever was less, and was payable within two and a half years after separation. Good reason resignations, while initially treated as a suspect form of voluntary resignations, were clarified as involuntary terminations in 2010. Under the new rules, the right to separation pay becomes vested when the “good reason” event takes place, allowing employees who resign for “good reason” to avail themselves of the 409A exceptions.11 Analyzing the universe of severance contracts at place at Execucomp firms allows us to draw conclusions on the incidence and characteristics of severance contracts in the population in equilibrium. In a check on the generality of our results, we also examine the incidence of explicit severance contracts across all Compustat firms in 2004. However, the equilibrium analysis does not tell us why executives negotiate these contracts. We therefore also examine a subset of Execucomp firms that grant new or materially revise existing severance contract terms to their executives in 2004. Around 16% of the severance contracts fall into this subset. Prior to 2007, though firms were required to disclose any severance contracts in place, the SEC did not specify a consistent reporting format.12 Hence, using an extensive keyword search13, we manually search all SEC filings for severance agreements for all firms listed on Execucomp in 2004 with available data on certain key firm characteristics including book assets, market-to- book ratio, ROA, return volatility, takeover probability, and institutional ownership. We are able to locate the proxy statements for 1,189 of the 1,237 firms with non-missing key firm variables. These firms constitute our Execucomp universe of firms. Most firms list summaries of the severance terms in their proxy statements (DEF-14 or DEF-14A) though in some cases, we

11 See Relief and Guidance on Corrections of Certain Failures of a Nonqualified Deferred Compensation Plan to Comply with § 409A(a), IRS notice 2010-6 (www.irs.gov/irb/2010-03_IRB/ar08.html). 12 See Executive compensation and related person disclosure, Securities and Exchange Commission, 17 CFR Parts 228, 229, 232, 239, 240, 245, 249, and 274 (at http://sec.gov/rules/final/2006/33-8732a.pdf). 13 We initially search each 10K report for variants of keywords such as “Employment agreement” or “Change of control” or “Severance contract”. In each contract, we identify any additional keywords not previously used in our searches and search again. Most of our contracts have one or more variants of seven keywords: “Employment agreement”, “Change of control”, “Severance plan”, “Retention arrangement”, “Severance policy” or “Termination of employment”.

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collect missing data from the severance agreements listed in attachments to the 10-K, 10-Q, and 8-K forms. Our hand-collected sample consists therefore, of almost the entire universe 14 of 3,688 severance contracts in place at 808 firms listed on Execucomp in 2004.15 For each severance agreement, we collect data on who the agreement applies to and the characteristics of the severance package. In many cases, the severance agreement refers to a prior contract granted in previous years and its terms are not available in the 2004 filings. In these cases, we trace the original contract and gather details on the contract when it was first granted. Overall, 9.9% of the contracts are new and 5.8% of the contracts are materially revised from the previous year. We obtain executive compensation data and stock ownership data from Execucomp for firms with available data. Finally, we obtain corporate governance variables from the Riskmetrics (formerly IRRC) Database for firms with available data. We supplement this data using Compact Disclosure for firms not covered by Riskmetrics.

3.1. The sample

As noted earlier, executives of the firm may have multiple contracts in place specifying severance payouts under different circumstances. The two most common are breach of contract agreements, i.e., golden handshakes, and breach of contract agreements contingent on a change in control, i.e., golden parachutes. Golden parachutes can also be single-triggered or double- triggered. Our final sample consists of 3,688 executive-severance agreement observations for 808 firms and 2,734 executives. 63% of our sample contracts (2,326 contracts) stipulate explicitly that severance pay only applies to terminations for breach of contract, either without “cause” or for “good reason”. Of the 2,326 breach of contract agreements, 984 of them list

14 While it is possible that we misclassify firms as not having severance contracts as a result of our keyword searches, we note that the proportion of CEOs we identify with explicit severance contract terms (59%) is considerably higher than estimates for the proportion of CEOs with explicit employment agreements (37%) (Gillan, Hartzell and Parrino, 2009) and the proportion of CEOs who receive severance contracts (40%) (Huang, 2010). 15 The only commercially available database that supplies this data (from 2007-2009), the Corporate Library, covers considerably fewer firms than our dataset. Of the 768 firms covered by Corporate Library in 2007, data is available on severance contracts for only about 200. In 2008, of the 3246 firms covered, 900 have severance contracts while there are less than 200 contracts for the 3375 firms covered in 2009. Overall, comparing the firms in our sample to Corporate Library, less than 50% of our contracts are covered by Corporate Library.

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“diminution of responsibility”, 880 of them list “diminution of pay”, and 706 list “relocation” as constituting the “good reason”. 62% of the executive agreements (2,303 contracts) in our sample are golden parachute agreements, of which a little over half are double-triggered. The average ownership transfer that triggers a change of control clause is 27%. 876 executives have both a golden parachute agreement and a golden handshake agreement. We do not report these numbers in tables for brevity. Table 1 describes the job position of executives characterized by the presence and absence of explicit severance agreements in 2004. About 29% of the explicit contracts in our sample are offered to CEOs, 14% are offered to CFOs and 50% pertain to other officers. Of all the contracts, about 17% involve the CEO when he is also Chairman of the Board (dual CEO). Of the S&P1500 firms listed on Execucomp, CEOs have explicit severance contracts in around 59% of the firms. This percentage is considerably higher than that documented in prior literature. Gillan, Hartzell, and Parrino (2009) document that only 184 CEOs (37%) had explicit employment agreements for the 494 firms in the S&P500 in 2000. Huang (2010) documents that 40% of the CEOs in her sample had an explicit severance contract. The proportion of executives of other ranks with severance agreements is significantly smaller than for CEOs.

3.2. Details of the severance contracts

A severance agreement often specifies various components of severance pay. We classify each severance agreement into three components. The first is a cash-related component. A severance agreement usually specifies a pecuniary pay component as a multiple of the executive’s base salary in the year or years immediately preceding the year of severance. In addition, severance packages sometimes specify the number of years of bonus to be paid, based on the average (or in some cases, the highest) bonus to the executive in the year(s) preceding the severance year. Usually the number of years over which the bonus payment is paid (if offered) is the same as the number of years for the base salary. A severance agreement may also have a long-term component in terms of restricted stocks or options and allow immediate vesting upon severance. Therefore, our first set of variables characterizing the cash-related component of the

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severance agreement are the minimum and maximum years of base salary, the minimum and maximum years of bonuses, and indicator variables on whether restricted stocks and options are vested upon severance. Our second set of severance variables includes insurance and retirement benefits. A severance agreement often grants life, medical, dental, accident, or disability insurance for a number of months. Sometimes a severance agreement grants a number of months of extra service to count toward the executive’s pension plan. Finally, the severance package may also contain other benefits such as excise tax gross-ups paid by the company on the severance pay, legal fees during any severance dispute, and an outplacement service, and indicators for these benefits constitute our third set of severance variables. Table 2 Panel A reports descriptive statistics on the various components of severance pay. There are relatively few contracts that specify a specific cash value on which the severance is based (70 observations averaging about $1.7 million). The majority of agreements specify the minimum and maximum number of years over which severance pay will be paid out. Roughly speaking, including bonuses specified in the contract, the average minimum severance pay is $2.1 million and the average maximum severance pay is $2.4 million (computed based on the salary and bonus in 2004 and including any specific cash severance pay). A significant proportion of the agreements also include some kind of long-term compensation. For example, 31% of the sample contracts allow the vesting of restricted stocks upon severance and 43% of the sample allows the vesting of restricted stock options. More than half of the sample also includes some sort of insurance after severance. For instance, the severance contracts which specify insurance provide a median of around two years of life, medical, dental, accident and disability insurance. In addition, in around 10% of the cases, the firm grants a median of three years of extra service to the sample executives to be counted toward their pension plans. Finally, about 10% to 42% of the sample executive agreements also include some sort of extra benefit, such as excise tax gross-ups, legal fees and outplacement service.

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The firms offering explicit severance contracts are reasonably evenly distributed by industry (not reported in tables). Across the ten one-digit SIC industry sectors, the proportion of CEOs with explicit severance contracts is mostly between 60% and 70%, with the public administration sector (SIC code 9) as an exception (only 50% of their CEOs have severance contracts). The most generous severance terms are offered by health, legal, and accounting services (SIC code 8) with an average of 3.09 years of minimum base salary and bonus offered. Panel B of Table 2 summarizes the components of severance agreements by type of executive. We report the median severance pay for the different types of executives. However, since the median values of indicator variables are often 0 for all groups, for these variables we report the percentage of observations with the value of 1 (vested restricted stock, vested restricted options, insurance, and all other benefits variables). Since not all contracts contain the same terms, the numbers are not always directly comparable. The numbers that are most directly comparable are the minimum and maximum number of years, the number of years of bonuses granted, and indicators for the vesting of stock or options, insurance, other perks and excise tax gross-ups. Interestingly, apart from the CEO who is typically offered a higher level of base salary and bonus, the median level of years of base salary and bonus is about similar across the other types of executives, suggesting that firms tend to use a single severance type agreement across junior executives. Differences also show up in the proportion of contracts that describe vesting of restricted stock and options, though this is not entirely surprising since the CEO is more likely to be receiving options and restricted stock grants than other executives. Dual CEOs receive slightly better severance agreements than non-chairman CEOs. We also examine if firms trade off the components of severance pay by studying the correlations between each pair of components. For example, a firm that offers a high minimum number of years of severance pay might offer a lower bonus, which would imply that the firms keep the overall level of pay constant and emphasize different components of pay depending on the situation. The answer is almost predominantly no. There are almost no negative correlations between the severance variables (not reported in tables). Within each of the three components of

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severance pay, the correlations are always positive – and the positive correlations are usually quite high and statistically significant. For example, firms that offer a high minimum (or maximum) number of years of severance pay are also likely to offer a high minimum (or maximum) bonus. Similarly, firms that pay insurance are comprehensive about the types of insurance they pay – the contract usually covers all types of insurance. Between components, the correlation is lower though usually still positive. Overall, it appears that firms decide the components of benefits as sets but then choose to offer sets of benefits or not.

3.3. Characteristics of firm and executives with explicit severance contracts

Table 3 summarizes the characteristics of executives and firms with explicit severance contracts in our Execucomp sample. We examine not only all firms that have outstanding severance contracts, but also those firms that offer new or materially revise severance contracts in 2004. These firms are compared with firms without an explicit severance contract in place. Panel A summarizes the characteristics of CEOs characterized by the presence (column group 1) or absence (column group 3) of an explicit severance agreement in 2004. Apart from executive characteristics and components of pay, we also report the total portfolio equity incentives to the CEO (delta) and the incentive residual. We measure equity incentives to an executive as the change in the dollar value of the executive’s stock and option ownership for a 1% change in the firm’s stock price. The incentives of executive stockholdings equal the number of shares held multiplied by 1% change in the stock price. The incentives of option holdings are estimated using the one-year approximation algorithm developed by Core and Guay (2002). This algorithm treats an option portfolio as the combination of three separate grants, i.e., newly granted options, previously granted unexercisable options and previously granted exercisable options and estimates the incentives in each grant. Once we obtain the equity incentives in each executive’s overall equity portfolio, we employ an OLS regression model similar to the model used by Core and Guay (1999) to construct the incentive residual. Core and Guay (1999) argue that CEOs’ portfolio holdings of equity

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incentives can be explained by firm and executive characteristics and industry effects. Therefore, the model we use is

/

(1) The incentive residual is the residual value from this regression model. Based on the presumption that the model captures the expected optimal level of incentives for an executive, the incentive residual captures the deviation of the executive’s current portfolio incentives from the optimal level. As in Core and Guay (1999), a negative (positive) residual from this model implies that the executive’s incentives are below (above) the optimal level. Hence the firm needs to provide more (less) incentives to take risks in the following year. CEOs with severance agreements hold portfolios with significantly lower equity incentives (both in the original incentives and the incentive residual) at the beginning of the year. During the year, as is evident in the high levels of new incentive grants and the high ratio of stock and option grants to total compensation, they also receive higher total compensation and their pay structure tilts more toward equity incentive compensation including stock and option grants. CEOs with severance agreements are also younger and have served fewer years in the company and in the CEO’s position, compared with CEOs without explicit severance agreements. In column group 2, we present summary statistics for CEOs that receive new severance agreements or whose agreements are materially revised in 2004. Since most contracts specify the minimum number of years of severance pay and since this variable is positively correlated with all other components of the severance contract, we define a contract as materially revised if the minimum number of years of severance pay changes in 2004 from prior years. Our prior conclusions remain largely unchanged in this sample. In fact, the differences between CEOs with and without severance agreements are generally greater in magnitude when we consider only CEOs getting new or revised agreements.

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In addition, to compare our results with those of Rusticus (2006) and Sletten and Lys (2006), we also separately report statistics for new CEOs and incumbent CEOs. For incumbent CEOs, all our previous conclusions remain unchanged - not only when we compare CEOs with and without severance agreements but also when we compare CEOs with new or revised severance agreements to CEOs without severance agreements. For new CEOs, those with severance agreements and those getting new or revised severance agreements receive higher total compensation and have served their firms for fewer years than CEOs without severance agreements. Interestingly, although new CEOs with severance agreements also receive a lower fraction of total pay in salary, their equity-based pay is not significantly different from new CEOs without a severance agreement. Overall, our univariate results suggest that CEOs are more likely to have explicit severance contracts if their potential loss of compensation upon severance is larger and if they are younger, have less experience with the company or the job, and are more concerned about potential reputation loss. Most importantly, the results suggest that a CEO is significantly more likely to be offered a severance agreement if her overall portfolio holdings of stocks and options contain inadequate equity incentives. CEOs who are offered explicit severance agreements are also more likely to receive concurrent incentives in equity and options. These patterns are consistent with the hypothesis that ex-ante severance contracts are granted to provide equity-like incentives to CEOs. In economic terms, the average equity incentive in the portfolios of CEOs getting new or revised severance agreements is on the order of $172,903 (i.e., e4.65-e5.63) lower than the incentives in the portfolios of CEOs without severance agreements. Panel B of Table 3 summarizes the characteristics of the firms offering explicit severance contracts in our Execucomp sample. We examine two sets of explanatory variables. Our first set of firm variables measure the ex ante riskiness of the firm’s business and are used to test our cross-sectional predictions on severance pay. Distress risk is the negative (so that larger numbers imply a higher probability of financial distress) of the first principal component of ROA, excess stock returns, Altman Z-score, and C-score. Altman’s Z-Score is calculated following Altman and McGough (1974). The C-Score is calculated based on Campbell, Hilscher and Szilagyi

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(2008) following the 1963-1998 bankruptcy model in column 1 of Table III. We use the level of ex ante takeover probability to measure the ex ante risk of the firm becoming a takeover target. Takeover probability is estimated following Billet and Xue (2007). Specifically, we first run a probit model over the period from 1984 to 2003 of whether a firm is a takeover target in a year on firm characteristic variables, including ROA, market capitalization, leverage, market-to-book ratio, sales growth, and Net PPE, measured at the end of the prior fiscal year and an indicator of industry takeover intensity. We then take the predicted value in 2004 to be the estimated ex ante takeover probability for 2004. Finally, the annual return volatility is used to measure the overall risk in performance. Aggarwal and Samwick (1999) show that return volatility is significantly negatively related to executive pay-for-performance sensitivity. Our second set of variables comprises firm size and corporate governance variables we control for in the regressions. Gabaix and Landier (2008) relate the increase of CEO pay to the increase in market capitalization of large companies. Since severance pay is typically granted in multiples of annual pay, we control for the log of total assets as a proxy for firm size. We also control for the quality of corporate governance at the firm though it is unclear how the incidence or magnitude of severance contacts are related to corporate governance of the firm. For example, an explicit severance contract might be offered by a weak board to commit to paying out only pre- agreed contract terms. However, as Almazan and Suarez (2003) argue, stronger boards might also agree to generous explicit severance contracts to commit not to replace the incumbent executive too frequently. Since our focus is on examining the contribution of the severance agreement to the overall incentives of the executive, we do not take a stance on the expected signs of the corporate governance variables but include them as controls. Consistent with the literature on board composition and CEO compensation (see for example Bizjak, Lemmon and Naveen, 2008), our corporate governance proxies include board size, board independence and institutional block ownership. The average firm in our sample has total assets of around $2 billion (log of total assets=7.60). This number is considerably smaller than the size of the firms examined by Yermack (2006) or Rusticus (2006), suggesting that our sample contains a significantly larger number of small firms

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than either of those studies. Firms with explicit severance contracts tend to be larger firms, have higher institutional block ownership and more independent boards. Most important, they also appear to be more risky than firms without explicit severance contracts in place in that they are likely to have higher distress risk. In unreported results, we note that these firms also tend to be riskier along each of the individual factors that go into the distress risk composite factor we use. They are less profitable, earn lower excess stock returns, and have lower Altman Z-scores and higher C-scores. Finally, firms with explicit severance contracts have higher return volatility. We next test how typical our firms are relative to the universe of Compustat firms. The firms not on Execucomp are considerably smaller than Execucomp firms. To test whether the Execucomp results are generalizable to these firms, we re-run our search terms on the entire universe of firms listed on Compustat. Using the same keywords, we isolate 1,745 firms which make reference to explicit severance terms in their annual filings and 1,207 firms which do not mention severance contracts at all. We compare these firms to Compustat firms without explicit severance contracts in the lower part of Table 3 Panel B. Around 59% of the Compustat firms list explicit severance contracts, a number broadly comparable to our main Execucomp sample. However, since we do not have information on executive compensation, age, and some corporate governance characteristics for the universe of Compustat firms, we treat this sample as a robustness check on our main results. In the Compustat sample, the comparison in characteristics between firms with severance agreements and those without are largely similar to that in the Execucomp sample. Firms with severance agreements are larger with higher institutional ownership. They are also likely to have higher distress risk and a significantly higher takeover probability than firms without explicit severance contracts in place. Board size and independence are not compared for the Compustat sample since this data is largely not available for firms outside of Execucomp.

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4. Results

4.1. Determinants of explicit severance contracts

4.1.1. Risk and portfolio incentive residuals

We first examine the determinants of explicit severance contracts in equilibrium in the universe of Execucomp and Compustat firms in a multivariate framework. Since Compustat does not report executive-level variables and the results for the two samples are largely similar for the firm-level variables, for brevity, we tabulate the results only for the sample of Execucomp firms. In all regressions unless otherwise indicated, we include 2-digit SIC industry fixed effects to control for omitted industry factors and base our statistical inferences on standard errors that control for heteroskedasticity and within firm correlations. The regression results are reported in Table 4. The probit regression results in column 1 of Table 4 are consistent with the univariate results in Table 3. Controlling for both executive- and firm-specific variables, CEOs are more likely to have an explicit severance contract in place when they also receive greater incentive grants. Younger CEOs and CEOs in firms with higher distress risk are more likely to have explicit severance contracts, consistent with the cross-sectional predictions. When we expand our sample to the universe of Compustat firms, we find broadly similar results (not reported for brevity). While the distress risk proxies are no longer significant, the firm’s return volatility is significantly positively related to the incidence of an explicit severance contract. As we argue earlier, while the equilibrium analysis provides details on the incidence of contracts in the population in equilibrium, it is important to analyze new and revised contracts separately to shed light on the determinants of these contracts. The rest of Table 4 therefore report results from regressions only for new and revised contracts. We add the annual change in ex ante takeover probability as an additional explanatory variable for the incidence of new or revised severance contracts to examine if a recent increase in takeover probability is associated with a greater likelihood of a firm granting or revising these contracts. Columns 2 and 6 report

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marginal effects of probit regression coefficients for CEOs and all executives, respectively. Consistent with our results in Table 3 Panel A, the results for executive age and distress risk continue to be statistically significant when we examine the sample of CEOs or executives who negotiate new or revisions to existing contracts. The year-on-year change in ex ante takeover probability is also significantly positively related to the probability that the CEO obtains a new or revision to her existing contract, though it is not significant for the average executive. This is not surprising since the CEO is likely to be far more influential than an average executive in influencing the terms and outcome of a merger bid. In addition, firm return volatility is also significantly positively related to the probability that a CEO or executive negotiates new or revisions to existing contracts. Most important, the lagged Core-Guay incentive residual is consistently negatively significant in predicting the granting of a new contract or the revision of an existing contract. A CEO with a lagged incentive residual one standard deviation (roughly 1.19) lower than other CEOs is about 6% more likely to have an explicit severance contract (-0.050×1.19). This is an economically large effect when we consider that the unconditional probability of a new or revised CEO severance contract is only roughly 9% (i.e., 16%×59%). The positive coefficient on contemporaneous log(new incentive grant) is much weaker in both economic and statistical significance. Few of the control variables, size or corporate governance proxies, are consistently significant. We next examine how changes in the independent variables affect the time to which an executive negotiates a new contract from the time she joins the firm. Specifically, the hazard model examines the determinants of the likelihood that she obtains a new severance agreement in 2004 given the time elapsed from her first year of service until the grant of the first severance agreement. Thus, only executives receiving a new severance agreement and executives without such agreements are included in this analysis. We expand the sample to include all past years of history for each executive from the first year she is hired by her current firm. The expanded sample thus allows time-varying covariates in the hazard analysis. To reduce the loss of observations in this model, we drop two control variables, board size and board independence,

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from the model. We report coefficients from the hazard model in columns 3 and 7 of Table 4. The results are largely consistent with those from the probit model. The incentive residual remains a significant determinant of the time to the grant of a new severance agreement. In column 3, the hazard ratio on the incentive residual is 59% (i.e., e-0.532), suggesting that a unit increase in the incentive residual (roughly 83% of its standard deviation) corresponds to a 41% reduction in the hazard rate, which is the rate at which the CEO obtains a new severance contract conditional on not having received one before. The coefficients on executive age and the year- on-year change in takeover probability largely remain statistically significant in the hazard models. While its coefficient retains a positive sign, distress risk is no longer significant in the hazard model. We also explicitly analyze the simultaneity between the offer of a new/revised severance pay agreement and concurrent new incentive grants in a system of two simultaneous equations. We model log(new incentive grant) as a function of the incentive residual, lagged log(new incentive grant), the new/revised contract against no contract indicator, executive age, the CEO and Chairman indicator, return volatility, log(total assets) and governance proxies. Distress risk, takeover probability and year-on-year change in takeover probability are excluded from this model to allow them to be instrumental variables for severance pay.16 Our results from the simultaneous equations framework also broadly echo our results from the probit and hazard models. Distress risk and return volatility continue to be significant predictors of an explicit new or revised severance contract. Again, the incentive residual is significantly negatively related to the incidence of a new contract. Interestingly, controlling for the level of lagged new incentive grants (which is highly significant in predicting the current level of incentive grants) and the level of incentive residuals, the log(new incentive grant) and the revision of a severance contract

16 For robustness, we replicate the analysis using proxies for industry- and size-adjusted performance (including ROA and stock return) as instruments for severance pay based on relative performance evaluation. Specifically, for each firm, we treat the median firm in its 2-digit SIC industry and the same size quartile as its benchmark firm. We then calculate the firm’s relative performance as the difference between its performance and that of the benchmark firm. Our results are qualitatively similar.

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appear unrelated to each other. Hence in the remainder of the paper, we do not include new incentive grants as a determinant of severance pay. 4.1.2. Portfolio vega We next determine if the vega of the portfolio is related to the existence of a new and revised contract. As in Guay (1999), we define vega as the change in the value of the CEO’s option portfolio for a 0.01 change in the annualized standard deviation of the firm’s stock returns, estimated using the one-year approximation algorithm developed by Core and Guay (2002). We present results for the sample of all CEOs and two subsamples based on lagged excess stock returns in its first or fourth quartile in Table 5. According to our hypotheses, the incidence of severance pay should be negatively related to portfolio vega following relatively low stock performance. Following high stock returns, the effects on delta and vega from severance pay should be relatively less important than the effects from options. The results are consistent with our hypotheses. Controlling for executive and firm characteristics, the lagged log(portfolio vega) is not related to the grant of a new or revised severance pay contract in the full sample. However, it is significantly negatively correlated with the grant of severance contracts following low excess stock returns (column 2). This relation holds even after controlling the level of portfolio delta (column 5). While vega is positively correlated with the grant of severance contracts following high excess stock returns (column 3), column 6 shows that there is no relation between vega and severance pay after controlling for delta following high levels of stock performance, further supporting the optimal contracting hypothesis. 4.1.3. New CEOs and incumbent CEOs To contrast our results with Rusticus (2006) and Sletten and Lys (2006), we compare new CEOs to incumbent CEOs in Table 6. The table reports marginal effects from probit regressions.17 The contrasts are striking. For new CEOs, firm distress risk is negatively related (though marginally insignificant at conventional significance levels) (column 1) in explaining

17 Lack of observations on new contracts for incumbent CEOs prevent us from running a hazard analysis here.

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why new CEOs obtain explicit agreements. This result is likely a result of the selection effect discussed earlier - CEOs with greater risk aversion demand more severance pay and avoid high distress risk firms at the same time. Similarly, while return volatility is significantly positively related, the takeover probability is significantly negatively related to the probability of a new CEO receiving a new contract. In contrast, firm distress risk and the year-on-year change in takeover probability are significantly positively related to the grant of new severance contracts or the revision of existing contracts to incumbent CEOs. Although insignificant at conventional significance levels, the coefficient on the lagged incentive residual is similar in sign and magnitude to that in column 2 of Table 2. Since internally promoted CEOs are likely to be similar to incumbent CEOs in that they are already matched with the firm, the selection effect is likely to be less important for them. Hence in model 3, we include only new CEOs that are hired externally and in model 4, we include both incumbent CEOs and new CEOs that are promoted internally. The reclassification strengthens our results. Distress risk and both the level and year-on-year change in takeover probability are all negatively related to the probability of a new externally-hired CEO receiving a new severance contract. Return volatility is insignificantly related to the probability. In contrast, firm distress risk, the year-on-year change in takeover probability and return volatility are all significantly positively related to the grant of new contracts or the revision of existing contracts to new CEOs promoted internally or incumbent CEOs. Overall, consistent with Core and Guay (1999), our evidence suggests that firms set optimal incentive levels and grant severance pay and options in a manner consistent with economic theory. It also suggests that examining new CEOs (as prior literature has done) leads to significantly different inferences from examining incumbent CEOs.

4.2. Determinants of the level of severance pay

We next examine the determinants of the level of severance pay. We calculate severance pay upon termination as the minimum number of years of severance pay (as multiple of the salary amount) times 2004 salary, plus the minimum number of years of bonus multiple times 2004

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bonus. We then multiply this number by either the ex-ante probability of CEO dismissal (for golden handshake severance contracts) or ex-ante takeover probability (for golden parachute severance contracts) to obtain the expected severance pay. The ex-ante probability of CEO dismissal is estimated following Parrino (1997). We first estimate a probit regression of CEO dismissal on contemporaneous and up to four years of lagged stock returns, ROA, logarithmic CEO age and logarithmic firm sales. We then take the predicted value to be the estimated ex-ante probability of CEO dismissal. We define CEO dismissal to be a case in which a CEO leaves the office at an age younger than 60 and the reported reason for leaving is other than “Deceased”. In addition to this dollar value of severance pay, we also construct an expected severance pay multiple, which equals the minimum number of years of severance pay times the probability of CEO dismissal or takeover depending on the type of the contract. We use the minimum number of years of severance pay in these calculations since this variable is largely available for all executives and positively correlated with all other components of the severance contract. We assign a value of 0 to both variables when a CEO does not have a severance contract. Finally, we define an above-median expected severance pay indicator over all CEOs with severance contracts as 1 when expected severance pay exceeds its sample median and 0 if expected severance pay is below its sample median. This last indicator variable is constructed to examine the size of severance contracts conditional on the grant of such contracts. Table 7 presents simple pairwise correlations between the three expected severance pay proxies and other components of regular CEO compensation including log(total compensation) and the ratios of salary, bonus, stock grant and option grant to total compensation. The results show that expected severance pay is significantly positively correlated with log(total compensation). Expected severance pay is also significantly negatively correlated with the salary ratio and largely positively correlated with the bonus, the stock, and the option ratio. These results suggest that firms offer higher levels of expected severance pay in conjunction with lower salaries and higher incentive pay, consistent with firms using severance pay as an important component of their optimal compensation mechanisms.

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We next conduct Tobit regression analyses of the determinants of the magnitude of severance contracts, since both the log(expected severance pay) and the expected severance pay multiple variables are bounded from below at 0.18 We separately examine contracts given to new CEOs and incumbent CEOs as in Table 6 and control for level of CEO total compensation.19 Table 8 summarizes our results. As in the previous analysis, the incentive residual and executive age are significantly negatively while distress risk is significantly positively related to the magnitude of both expected severance pay and the expected severance pay multiple for incumbent CEOs. Takeover probability is also significantly positively related to the expected severance pay multiple for incumbent CEOs. In contrast, distress risk is unrelated to either the magnitude of expected severance pay or the severance pay multiple for new CEOs while executive age is only negatively related to the expected severance pay multiple. The relation between firm size and the magnitude of contracts for incumbent CEOs is significantly negative, which is consistent with the hypothesis that smaller firms are more likely to be at risk.

4.3. Golden parachutes and golden handshakes

We next examine the incidence and magnitude of golden handshakes and golden parachutes, two specific types of severance contracts. We first use a multinomial logit model regression model to estimate the incidence of a golden handshake or a golden parachute. We define a categorical variable with a base category of executives without severance contracts, a second category of executives with golden handshake severance contracts and the third category of executives with golden parachute severance contracts. The multinomial logit model assesses the

18 The decision on the magnitude of the contract payment is conditional on the firm choosing to pay a grant in the first place, so it might appear that a more appropriate analysis would use a Heckman model. However, as Core and Guay (1999) note, the Heckman model reduces to the Tobit model when the independent variables explaining the grant of the severance contract are the same as the variables explaining the magnitude of the contract. They also note that the Tobit model allows for a more compact and intuitive presentation of the results. 19 We include all contracts (including new, revised and existing contracts) in this analysis since the sample size is reduced greatly if only new and revised contracts are examined. However, when we compute the correlations between severance pay variables and pay structure variables (similar to Table 7) for the subsample of CEOs receiving new or materially revised severance agreements and CEOs without severance agreements, we are largely able to confirm the correlations pattern in Table 7, except that the above-median expected severance pay indicator is not significantly correlated with stock or option grants. These results suggest that while the likelihood of receiving a new or materially revised severance agreement increases with the extent that new incentive grants are given to a CEO, the size of such a severance agreement does not monotonically increase with the size of new equity incentive grants.

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determinants of each category relative to the base category jointly which, in contrast to pairwise probit regressions, allows for direct comparisons between golden handshakes and golden parachutes. Our results are reported in Table 9. Overall, the results are very similar to those for all contracts in Table 4. In particular, the incidence of a new or revised golden handshake contract to CEOs is significantly positively related to distress risk, and negatively related to the incentive residual and executive age. The results for distress risk and executive age continue to hold for all executives. For golden parachutes, distress risk becomes a weaker explanatory variable while the incentive residual and executive age continue to be significantly negatively related to the incidence of a golden parachute for CEOs. The CEO indicator is significantly positively related to the incidence of a golden parachute but not a golden handshake, presumably because CEOs are significantly more important than the average executive in the event of a merger. Finally, return volatility is significantly positively related to the incidence of a golden parachute but not that of a golden handshake. Many firms in our sample list explicit contract terms both for contingent change in control situations and non-contingent situations, most commonly for good reason or without cause. According to Section 280G of the Internal Revenue Code (IRC), if the present value of a change- in-control payment exceeds the safe harbor (defined as three times the average taxable compensation over the five most recent calendar years preceding the change-in-control, less $1), the company loses tax deductions for these excess amounts. In addition, the executive is required to pay a 20% excise tax on the excess payment. Given this tax rule, it would be reasonable to assume that most firms would set the multiple used to value a parachute to three. However, consistent with Fich, Tran, and Walkling (2010), this multiple shows considerable variability. Panel A of Table 10 shows that, while the median target firms does use a maximum multiple of 3, the mean is lower than the median, suggesting there are a significant proportion of firms that pay a multiple of less than 3. The 95th percentile of the maximum parachute valuation multiple in

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our sample is 420 while the 5th percentile is 1. The standard deviations of the minimum and maximum multiples are 1.1 and 1.5, respectively. In addition, the company frequently offers a tax gross-up payment on the multiple. Panel B compares double-trigger and single-trigger golden parachute contracts. Double- trigger parachutes are usually more generous than single-trigger parachutes in terms of cash- related compensation items and other perks. For example, double-trigger golden parachutes pay an average of a minimum of 2.6 years of salary and bonus but single-trigger golden parachutes pay an average of a minimum of only 2 years of salary and bonus. Conditional on the grant of a severance contract, we next examine the determinants of the magnitude of contracted payments when the contract is a golden handshake severance contract or a golden parachute severance contract and, for the latter, whether it is a double- and single- trigger golden parachute. The results are summarized in Panel C of Table 10. Total compensation is significantly positively related to the magnitude of all the contracts. Executive age is negatively related to the magnitude of a golden handshake but not a golden parachute. In contrast, the incentive residual is significantly negatively related only to the magnitude of a double-trigger golden parachute. Interestingly, takeover probability is significantly positively related to the magnitude of a golden parachute but less so to the magnitude of a golden handshake, suggesting that larger size golden parachute contracts are used to motivate the CEO to facilitate the sale of the firm.

4.4. Comparing ex ante contract terms to ex-post severance payouts

The analysis so far has examined ex ante severance contract arrangements. However, the initial quote and much of the recent popular press focus on what appear to be egregious ex post payouts that have been described as evidence of rent extraction by CEOs (Goldman and Huang, 2010). Severance payments may not provide very powerful incentives if ex post payouts differ systematically from the ex ante contract terms. In our final test, we therefore examine if firms

20 In an extreme case, Michael Eisner at Walt Disney Co. maintained a golden parachute contract that paid six times annual salary for a minimum of 3 years and a maximum of 8 years as severance pay.

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also grant actual severance payouts in a manner consistent with economic theory. Fudenberg and Tirole (1990) show that, in a moral hazard setting when contract renegotiations are allowed between the principal and the agent after the agent takes action but before the outcome is observed, the agent will not choose the level of effort desired by the principal. In this case, the initial contract loses its incentive purposes. Anticipating the possibility of renegotiation, the principal will design a “renegotiation-proof” contract that will not be “renegotiated in any equilibrium of the renegotiation stage” (p.1280, Fudenberg and Tirole). Following the above logic, ex-ante severance contracts and their incentives are only useful if they are not renegotiated after managerial actions are taken, i.e., they are renegotiation-proof. Thus, it is important for us to compare ex-ante and ex-post severance pay and examine the extent to contracts are renegotiated. To evaluate the link between ex ante severance contract value and ex post severance payout, we therefore collect additional data. Starting from our sample of executives with ex ante severance contracts in place as of 2004, we first identify cases between 2004 and June 2008 where a CEO leaves her office, using the Execucomp database as well as firm proxy statements. We find 269 such cases. In 198 of these cases, the CEO also left the company within one year of stepping down from the CEO position. Focusing on these instances, we then search the proxy statements in and after 2004 to gather information on the executives’ actual severance payouts when they leave the company, as well as the reason for termination21. We exclude 7 cases where the reason for termination was death. We also exclude another 36 cases where we are either unable to find any information on actual severance payouts or be sure there is no such payment. For the remaining 155 cases, we are able to find non-zero actual severance payout information for 99 CEOs.

21 We collect the reason for termination as is, i.e., as is taken from Execucomp or as is mentioned in the proxy statement. Therefore, we cannot definitely distinguish between “retired” and “resigned” states. However, when we include an indicator variable for the reported reason in the regression, it does have strong predictive power for the amount of ex post severance pay, suggesting that it identifies true retirements in many cases. Excluding retirements from the sample does not qualitatively change our results.

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Ex post severance information is typically found either in the summary compensation table or a special severance or retention agreement entered during that year, listed in the proxy statement for the year of termination. We collect information on the total cash payout and the cash payment components such as salary and bonus multiples. We also record a dummy variable indicating whether the executive’s stocks and options are allowed immediate or accelerated vesting after severance. Finally, we record dummy variables for other perquisites such as insurance payouts etc. For most cases, while we have information on total cash payout, information on other components of the pay package is more sporadic. In the final sample, the average amount of actual severance pay is $3.8 million and the median amount is $2.2 million. In comparison, the average and median amounts of contracted severance pay is $3.8 million and $2.5 million, respectively. Our regression model examines whether and how ex post severance payout is related to the contracted dollar value. The dependent variable is the logarithm of total ex post cash payout. The contracted dollar value of severance pay is computed based on severance contracts in effect at the time of termination. All firm characteristics are measured in the year the payout is made, not in the year the contract was written. Table 11 reports the regression results. Across all our regression specifications in Panel A, the dollar value of ex ante contracted severance pay is significantly and positively related to the ex post payout. For example, the coefficient of 0.677 (column 1) indicates that a doubling of contracted pay is associated with a 67.7% increase in ex post dollar severance pay, which is economically and statistically significant. The coefficient remains statistically significant in all specifications when we add control variables. In contrast, none of the firm or executive risk characteristics are significant in the regressions. Finally, none of the governance characteristics except board independence are important in explaining ex post payments. Overall the results suggest that the contracts are largely paid out as per the original contract terms and not renegotiated ex post by powerful managers. This result is also broadly consistent with Goldman and Huang (2010) who find that a majority of CEOs get severance pay in accordance with their

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severance contracts, though there are cases when CEOs earn pay significantly in excess of their contracts. Finally, we examine circumstances under which severance pay is renegotiated. CEO incentives are likely to change if the external firm environment changes. Hence, although the board may attempt to make a severance contract renegotiation-proof in a specific firm environment, the optimal contract is likely to change if the firm environment changes between the agreement date and the departure date. This contract revision is different from an ex post contract renegotiation. To test whether firms are more likely to revise CEO severance payouts when the external environment changes, we directly examine the determinants of excess ex post severance pay, defined as the difference between the dollar values of the ex post severance payout and the ex ante contracted severance pay. As before, we include both executive and firm risk characteristics and control for governance variables in the regression model. Panel B summarizes the results. As in Panel A, with the exception of return volatility and board independence, none of the firm risk, executive risk, or governance variables are important in explaining the wedge between ex post and ex ante severance payments. To examine changes in the external firm environment, we include three macroeconomic and industry growth proxies, i.e., real GDP growth, industry growth and industry stock return, as independent variables to proxy for general economic conditions at the time of severance. All three variables are significantly negatively related to the magnitude of ex post “excess” severance pay. In other words, firms compensate CEOs for losses in ex ante contract amounts that are likely to be driven by factors that are largely out of the CEO’s control.22 Overall, our evidence suggests that firms treat severance pay as they treat other equity incentives and structure their contracts to provide executives with optimal incentive levels. We note however that our results do not mean that rent extraction does not exist. Our sample of payouts is drawn from the sample of firms with explicit severance contracts in place. If

22 Why the firm would choose to compensate a departing CEO for losses in ex ante contract amounts that are outside the CEO’s control is an open question that is beyond the scope of this paper to investigate. Possible reasons might include maintaining the firm’s reputation as a good employer to enable it to attract other CEOs in the future, or avoidance of lawsuits from the departing CEO.

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managers indeed extract egregious ex post severance payouts, perhaps these payouts are more likely in firms without explicit severance contracts in place, a sample we do not examine. In addition, the subset of CEOs who left the firm is a non-random subset of the initial and larger 2004 sample. There may be systematic reasons correlated with ex post payouts why certain CEOs would leave their jobs during the subsequent four years while other CEOs would not. For example, perhaps boards are less likely to fire marginal CEOs who are entitled to larger severance payouts. Alternatively, perhaps more entrenched CEOs who are more likely to negotiate a higher severance payout ex post are also more likely to keep their jobs (and therefore less likely to be terminated during the four year look-ahead window).

5. Conclusions

In this paper, we examine a comprehensive sample of 3,688 ex ante explicit severance contracts offered by 808 firms. Our evidence suggests that firms appear to set optimal incentive levels and grant severance agreements in a manner consistent with economic theory. Younger executives, especially CEOs, are more likely to receive explicit contracts and better terms. Incumbent CEOs at firms with high distress risk and high return volatility are significantly more likely to enter into new or revised severance contracts. These results are strikingly different from our results for new CEOs. For new CEOs, firm specific factors point in the opposite direction to the factors for incumbent CEOs, offering one explanation why extant papers examining the reason that new CEOs get contracts find weak or no results. Finally, ex-post payouts are also largely related to ex-ante contract agreements, suggesting that firms do not significantly revise these contracts ex post at the point when the manager leaves the firm. In our analysis, we take an ex ante contract design perspective, where the existence and features of severance agreements are the dependent variables of interest. The framework developed in the paper can be readily extended to examine the consequences of executive severance agreements, where the same contract features are modeled as independent variables, and certain actions or outcomes (such as the incidence of takeovers, risk-taking, or CEO turnover) are modeled as dependent variables. For example, controlling for factors determining

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the grant of ex-ante severance contracts, severance pay should lead to executives to undertake a greater number of acquisitions, and be willing to undertake more risky projects. Similarly, the circumstances under which a firm would choose to renegotiate ex ante contract terms deserves further investigation. Since examining the consequences and renegotiations of severance agreements is beyond the scope of the current paper, we leave these extensions to future research.

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Table 1: Positions held by CEOs and other executives with and without explicit severance contracts

This table reports the sample distribution by the positions held by executives as of 2004, categorized by whether or not the executive has an explicit severance contract in place in 2004.

With severance agreement? Yes No Percentage with Number of Percentage Number of Percentage in severance Position Held observations in total observations total agreement CEO 790 28.9% 547 10.7% 59% CEO and Chairman 466 17.0% 308 6.1% 60% CFO 371 13.6% 597 11.7% 38% COO 202 7.4% 269 5.3% 43% Other Officer 1,371 50.1% 3,677 72.2% 27% Total 2,734 100% 5,090 100% 35% Table 2: Details of explicit severance contracts Panel A reports details on the benefits specified in the contracts offered. Panel B reports median values for severance contracts by type of executive. Mean statistics are reported instead of the medians for indicator variables and the long term compensation variable.

Panel A: Severance pay variables Number of Standard Variable contracts Mean Median deviation Definition A. Cash-related compensation benefits Minimum # of years 3,544 2.1 2.0 1.2 Minimum number of years guaranteed by severance contract Maximum # of years 3,516 2.4 2.5 1.5 Maximum number of years guaranteed by severance contract Minimum bonus 3,482 1.8 2.0 1.3 Minimum number of years of bonuses guaranteed by severance contract Maximum bonus 3,465 2.0 2.0 1.4 Maximum number of years of bonuses guaranteed by agreement Long term compensation (Years) 479 0.6 0.0 2.2 Specified long-term compensation after severance (usually restricted stock or option Vested restricted stock indicator 3,688 0.31 0.00 0.46 Indicator that the restricted stock is vested and/or exercisable upon severance Vested restricted options indicator 3,688 0.43 0.00 0.50 Indicator that the restricted options are vested and/or exercisable upon severance B. Insurance and retirement benefits Minimum number of months of extra service executive will be credited with after Minimum defined benefit 323 37 36 27.59 severance to calculate pension benefits (usually based on the length of employment Maximum number of months of extra service executive will be credited with after Maximum defined benefit 324 38 36 27.85 severance to calculate pension benefits (usually based on the length of employment Insurance (general) Indicator 3,688 0.59 1 0.49 Indicator that the executive receives some insurance benefit after severance Life (months) 1,364 32 30 43.84 If explicitly stated, the duration in months of life insurance coverage. Medical (months) 1,844 32 24 49.34 If explicitly stated, the duration in months of medical insurance coverage. Dental (months) 1,129 34 24 57.39 If explicitly stated, the duration in months of dental insurance coverage. Accident (months) 633 29 24 43.60 If explicitly stated, the duration in months of accident insurance coverage. Disability (months) 745 30 24 40.37 If explicitly stated, the duration in months of disability insurance coverage. C. Other benefits Other random benefits such as financial counseling, early retirement benefits, Other perks indicator 3,688 0.10 0.00 0.30 office and secretarial support, and use of the company jet Indicator that the company will cover (under various circumstances) some of the Excise tax gross-up indicator 3,688 0.42 0.00 0.49 taxes associated with the CIC payment Legal fees indicator 3,688 0.11 0.00 0.32 Indicator that company will pay for executive's legal counsel in a severance dispute Outplacement indicator 3,688 0.12 0.00 0.32 Indicator that company will provide outplacement services to executive Panel B: Severance pay by type of executive

Executives classified by position Other CEO and CEO CFO COO executives Chairman (1) (2) (3) (4) (5) # Contracts (based on min # of years of severance pay) 1,030 487 270 1,773 607 A. Cash-related compensation benefits Minimum # of years 3 2 2 2 2.99 Maximum # of years 3 2 2 2 3 Minimum bonus 2 2 2 2 3 Maximum bonus 3 2 2 2 3 Long term compensation (Years) 0.93 0.66 0.22 0.52 0.77 Vested restricted stock indicator 0.36 0.29 0.26 0.30 0.37 Vested restricted options indicator 0.52 0.41 0.42 0.39 0.55 B. Insurance and retirement benefits Minimum defined benefit 36 36 36 36 36 Maximum defined benefit 36 36 36 36 36 Insurance (general) indicator 0.61 0.56 0.60 0.58 0.61 Life (months) 36 24 35 24 36 Medical (months) 36 24 24 24 36 Dental (months) 36 24 24 24 36 Accident (months) 36 24 24 24 30 Disability (months) 36 24 24 24 36 C. Other benefits Other perks indicator 0.11 0.09 0.09 0.10 0.12 Excise tax gross-up indicator 0.42 0.43 0.40 0.42 0.46 Legal fees indicator 0.13 0.10 0.09 0.11 0.15 Outplacement indicator 0.11 0.12 0.12 0.12 0.14 Table 3: Summary statistics by the incidence of explicit severance contracts Panel A summarizes the characteristics of CEOs that have explicit severance contracts in 2004, CEOs that negotiate new or materially revised contracts in 2004, and CEOs that do not have an explicit contract in 2004. In addition to descriptive statistics for all CEOs, separate statistics are also presented for new CEOs only and incumbent CEOs only. New CEOs are CEOs that come to office during the fiscal year 2004 and incumbent CEOs are CEOs that come to office before 2004. Total compensation is the sum of all compensation including salary, bonus, long-term incentive pay, restricted stock awards, option grants, and other compensation. All pay components are in thousands of U.S. dollars. Portfolio equity incentives is estimated using the approximation algorithm developed by Core and Guay (2002) and is defined as the sensitivity of the total value of stock and options held by an executive to a 1% change in firm stock price. Incentive residual is the residuals generated from the regression model / ′ Both the portfolio equity incentives and the incentive residual are in thousands of U.S. dollars. Age is the executive’s age. Years of service is the number of years from the hire of the executive to 2004. Years as CEO is the number of years from the CEO first takes office to 2004. Panel B compares the characteristics of the sample CEOs and firms offering explicit severance contracts and firms granting new or materially revising severance contracts to those with no explicit contracts in place for ExecuComp firms and Compustat firms respectively. All variables are measured in 2004. Distress risk is defined as the first principal component of four variables: ROA, excess stock return, Z score and C score with a negative sign. ROA is the ratio of operating income to total assets. Excess stock return is the annual buy-and-hold stock return in excess of value-weighted market return. Z score is calculated based on Altman (1968). C score is calculated based on Campbell, Hilscher, and Szilagyi (2008) following the 1963-1998 bankruptcy model in column 1 of Table III. Return volatility is the standard deviation of daily returns in 2003. Takeover probability is the ex ante probability of becoming a takeover target, estimated following Billet and Xue (2007). Specifically, we first run a probit model over the period from 1984 to 2003 of whether a firm is a takeover target in a certain year on explanatory variables measured at the beginning of the year. We then take the predicted value to be the estimated ex ante takeover probability for each firm-year. Total assets is the total book value of assets. Institutional block ownership is the fraction of outstanding shares held by all institutions holding 5% or more of total equity. Board size is the total number of members on the board. Board independence is the percentage of independent board members. Independent directors are directors that are not affiliated with the company according to the Riskmetrics (formerly IRRC) definition. IRRC generally considers any director to be affiliated if he is a former employee; is an employee of or is a service provider, supplier, customer; is a recipient of charitable funds; is considered an interlocking or designated director; or is a family member of a director or executive. *, ** and *** indicate statistical significance of differences in the mean by T Tests at the 10%, 5% and 1% levels, respectively.

Panel A: Characteristics of CEOs with and without explicit severance contracts Has contract New/revised contract No contract (1) minus (2) minus Subsample: (1) (2) (3) (3) (3) Variable N Mean Median N Mean Median N Mean Median Diff in mean All CEOs: Log(Portfolio equity incentives), lagged 690 5.40 5.43 52 4.65 4.91 465 5.63 5.63 -0.23*** -0.98*** Incentive residual, lagged 689 -0.05 -0.05 52 -0.48 -0.30 462 0.06 0.04 -0.12** -0.54*** Log(New incentive grant) 790 3.12 3.43 94 3.00 3.13 547 2.50 2.61 0.62*** 0.50** Log(Total compensation) 790 7.98 7.96 94 7.91 7.81 547 7.66 7.59 0.32*** 0.28** Salary/Total compensation 790 0.28 0.23 94 0.25 0.18 545 0.33 0.27 -0.05*** -0.09*** Bonus/Total compensation 790 0.20 0.17 94 0.17 0.11 545 0.20 0.16 0.00 -0.02 Stock grant/Total compensation 790 0.10 0.00 94 0.13 0.00 545 0.08 0.00 0.02** 0.05** Option grant/Total compensation 790 0.34 0.31 94 0.38 0.34 545 0.28 0.22 0.05*** 0.10*** Executive Age 788 54.8 55.0 93 52.6 53.0 540 56.9 57.0 -2.1*** -4.3*** Years of service 775 13.4 11.6 93 8.2 6.3 526 17.0 13.9 -3.6*** -8.8*** Years as CEO 771 6.1 4.3 93 3.0 1.0 524 8.3 5.6 -2.3*** -5.3*** New CEOs: Log(Total compensation) 99 7.9 7.8 46 8.08 8.13 65 7.5 7.7 0.4* 0.56** Salary/Total compensation 100 0.22 0.14 46 0.17 0.11 64 0.27 0.18 -0.05* -0.10*** Bonus/Total compensation 100 0.16 0.11 46 0.15 0.07 64 0.11 0.07 0.05** 0.04 Stock grant/Total compensation 100 0.16 0.00 46 0.18 0.02 64 0.14 0.00 0.02 0.04 Option grant/Total compensation 100 0.38 0.32 46 0.44 0.40 64 0.41 0.42 -0.03 0.03 Executive Age 102 52.9 52.0 47 52.5 52.0 59 54.1 54.0 -1.3 -1.7 Years of service 103 7.3 8.1 48 4.2 0.9 65 9.8 8.6 -2.5** -5.6*** Incumbent CEOs: Log(Portfolio equity incentives), lagged 642 5.49 5.53 40 4.80 5.15 440 5.69 5.67 -0.20*** -0.89*** Incentive residual, lagged 641 0.02 0.00 40 -0.25 -0.04 438 0.11 0.07 -0.09* -0.36** Log(Total compensation) 682 8.00 7.97 46 7.80 7.78 475 7.69 7.58 0.32*** 0.12 Salary/Total compensation 684 0.29 0.24 46 0.31 0.29 474 0.34 0.28 -0.05*** -0.03 Bonus/Total compensation 684 0.20 0.18 46 0.20 0.14 474 0.21 0.18 -0.01 -0.01 Stock grant/Total compensation 684 0.09 0.00 46 0.08 0.00 474 0.07 0.00 0.02** 0.00 Option grant/Total compensation 684 0.33 0.31 46 0.34 0.34 474 0.27 0.21 0.06*** 0.07** Executive Age 686 55.1 55.0 46 52.8 53.5 481 57.2 58.0 -2.1*** -4.5*** Years of service 672 14.3 12.4 45 12.5 10.7 461 18.0 14.8 -3.7*** -5.5*** Years as CEO 668 6.9 5.0 45 5.7 3.7 459 9.4 6.4 -2.5*** -3.7*** Panel B: Characteristics of firms offering explicit severance contracts Has contract New/revised contract No contract (1) minus (2) minus Subsample: (1) (2) (3) (3) (3) Variable N Mean Median N Mean Median N Mean Median Diff in Mean ExecuComp sample Distress risk 647 -7.32 -7.31 176 -6.85 -6.96 298 -8.28 -8.01 0.95*** 1.42*** Takeover probability 780 0.087 0.076 216 0.088 0.074 361 0.086 0.074 0.000 0.001 Return volatility 806 0.29 0.18 225 0.34 0.23 379 0.26 0.18 0.03** 0.08*** Log(Total assets) ($mil) 808 7.60 7.42 225 7.56 7.40 381 7.36 7.09 0.25*** 0.20* Institutional block ownership 808 0.17 0.15 225 0.17 0.15 381 0.16 0.13 0.01* 0.02* Board size 668 9.68 9.00 174 9.51 9.00 302 9.58 9.00 0.09 -0.08 Board independence (in %) 668 68.41 71.43 174 67.72 70.00 302 63.93 66.67 4.49*** 3.79*** Full Compustat sample Distress risk 1,187 -6.41 -6.91 811 -6.65 -7.09 0.25* Takeover probability 1,600 0.075 0.071 1,086 0.070 0.068 0.005*** Return volatility 1,693 0.41 0.23 1,157 0.43 0.23 -0.02* Log(Total assets) ($mil) 1,745 6.42 6.39 1,207 5.71 5.73 0.71*** Institutional block ownership 1,745 0.14 0.11 1,207 0.12 0.08 0.02*** Table 4: Characteristics of firms that grant severance contracts

The table examines the determinants of the grant of severance pay contracts using various models. Marginal effects are reported for probit models (Columns 1, 2 and 6), while the regression coefficients are reported for all other models. “Existence of contract” is an indicator variable that takes the value of 1 if an executive has at least one explicit severance contracts with her firm and 0 otherwise. “New/revised contract against no contract” is an indicator that equals 1 if a severance contract is newly granted or materially revised from an existing contract in 2004 and 0 if no severance contract exists. Other variables are as defined in Table 3. While “New/revised contract against no contract” and “Log(New incentive grant)” are measured at the end of the year, all other variables are lagged by one year. In the hazard model, the dependent variable is an indicator that equals 1 if a severance contract is newly granted in 2004 and 0 if no severance contract exists. All regressions include 2-digit SIC industry fixed effects. T-statistics based on standard errors corrected for heteroskedasticity and firm clustering are reported in parentheses below the regression coefficients. *, ** and *** indicate statistical significance at the 10%, 5% and 1% levels, respectively.

Sample: CEOs All executives Log(New Existence New/revised contracts against no incentive New/revised contracts Dependent variable of contract contract grant) against no contract Model: Probit Probit Hazard Sim Eq. Sim Eq. Probit Hazard (1) (2) (3) (4) (5) (6) (7) Executive variables: Incentive residual -0.029 -0.050*** -0.532*** -0.012* -0.051 -0.010 -0.557*** (-1.49) (-2.74) (-3.79) (-1.73) (-1.35) (-1.57) (-4.44) Log(New incentive grant) 0.044*** 0.018* -0.154 -0.004 0.010* -0.168* (4.88) (1.83) (-1.52) (-0.68) (1.94) (-1.79) New/revised contract against -0.721 no contract (-0.51) Log(New incentive grant), 0.768*** lagged (34.14) Executive Age -0.010*** -0.008** -0.071** -0.003*** -0.012** -0.003*** -0.062*** (-3.61) (-2.56) (-2.23) (-2.83) (-2.05) (-2.81) (-2.65) CEO and Chairman indicator 0.058 0.070* -0.532 0.078*** 0.319** 0.024 -0.633* (1.45) (1.88) (-1.36) (4.00) (2.21) (0.88) (-1.66) CEO indicator 0.056** 1.040** (2.50) (2.40) Firm variables: Distress risk 0.023*** 0.025*** 0.022 0.007** 0.012** 0.066 (2.66) (2.96) (0.28) (2.16) (2.37) (1.42) Takeover Probability -0.266 -0.147 -20.586** -0.253 -0.325 -9.407 (-0.41) (-0.25) (-2.08) (-0.84) (-0.81) (-1.27) Year-on-year change in 3.028** 25.317** 1.005 1.165 18.822** takeover probability (2.41) (2.40) (1.40) (1.54) (2.01) Return volatility -0.009 0.194** -3.695** 0.136*** 0.135 0.078* -2.609** (-0.09) (2.12) (-2.00) (3.44) (0.47) (1.79) (-2.40) Log(Total assets) -0.018 0.013 0.727*** 0.019* 0.140*** 0.015 0.499*** (-0.86) (0.77) (3.00) (1.91) (3.32) (1.44) (2.71) Institutional Block Ownership 0.016 0.404** 2.290* 0.110 0.506 0.111 3.580*** (0.10) (2.28) (1.67) (1.57) (1.37) (1.41) (3.18) Board Size 0.001 0.002 0.001 -0.004 -0.003 (0.12) (0.27) (0.13) (-0.20) (-0.43) Board Independence 0.003** 0.002 0.000 0.003 -0.000 (2.12) (1.16) (0.14) (1.28) (-0.29) Number of Observations 934 239 1,607 239 239 901 3,140 Pseudo R2 0.098 0.385 0.285

. Table 5: Relation between severance pay and CEO portfolio vega The table examines how the CEO’s portfolio vega relates to the grant of severance pay contracts. Marginal effects are reported for a probit model where the dependent variable is an indicator that equals 1 if a severance contract is newly granted or materially revised from an existing contract in 2004 and 0 if no severance contract exists. Vega is defined as the change in the value of the CEO’s option portfolio for a 0.01 change in the annualized standard deviation of the firm’s stock returns. Other variables are as defined in Table 3. All independent variables are lagged by one year. “Low return” signifies lagged excess stock return in the lowest quartile and “High return” signified lagged excess return in the highest quartile over the prior year. Regressions 1 and 4 include 2-digit SIC industry fixed effects and all other regressions include 1-digit SIC industry fixed effects. T-statistics based on standard errors corrected for heteroskedasticity and firm clustering are reported in parentheses below the regression coefficients. *, ** and *** indicate statistical significance at the 10%, 5% and 1% levels, respectively. Low High Low High Sample All Return Return All Return Return (1) (2) (3) (4) (5) (6) Executive variables: Log(portfolio vega), lagged -0.013 -0.106** 0.058* 0.000 -0.090* 0.046 (-0.68) (-2.10) (1.92) (0.00) (-1.78) (1.30) Incentive residual -0.056*** -0.064* -0.045 (-2.80) (-1.84) (-1.19) Executive age -0.008*** -0.007 -0.012** -0.009*** -0.012** -0.005 (-2.76) (-1.33) (-2.50) (-2.78) (-1.98) (-1.52) CEO and Chairman indicator 0.062 -0.101 0.126* 0.082** -0.020 0.041* (1.62) (-1.19) (1.87) (2.10) (-0.22) (1.74) Firm variables: Distress risk 0.027*** 0.024 -0.024 0.024*** 0.009 -0.007 (2.80) (0.84) (-1.03) (2.61) (0.29) (-0.86) Takeover probability 0.322 1.545 -6.657 0.013 0.767 -4.002 (0.44) (0.98) (-1.52) (0.02) (0.45) (-1.45) Year-on-year change in takeover 2.899** 3.730 -4.946 2.921** 3.686 -1.784 probability (2.12) (1.29) (-0.94) (2.36) (1.17) (-0.95) Return volatility 0.175* -0.138 0.572** 0.224** -0.021 0.251 (1.67) (-0.80) (2.06) (2.08) (-0.11) (1.43) Log(Total assets) 0.017 0.000 0.006 0.015 -0.002 -0.019 (0.82) (0.00) (0.10) (0.85) (-0.03) (-0.84) Institutional block ownership 0.510*** 0.873** 0.096 0.428** 0.875** -0.006 (2.83) (2.18) (0.34) (2.23) (2.00) (-0.07) Board size 0.015 0.017 0.049** 0.008 0.024 0.012 (1.52) (0.59) (2.06) (0.87) (0.85) (1.15) Board independence 0.002 0.002 0.002 0.002 0.001 0.001 (1.32) (0.83) (0.71) (1.50) (0.32) (1.26) Number of Observations 262 96 78 239 93 75 Pseudo R2 0.314 0.291 0.353 0.371 0.323 0.461 Table 6: Characteristics of firms that grant or revise severance contracts against universe of firms with no contract, new versus incumbent CEOs This table examines characteristics of firms that grant or revise severance contracts against universe of firms with no contract, separately for new and incumbent CEOs. Marginal effects from probit regressions are reported. The dependent variable is an indicator that equals 1 if a severance contract is newly granted or materially revised from an existing contract in 2004 and 0 if no severance contract exists. New CEOs are CEOs that come to office during the fiscal year 2004 and incumbent CEOs are CEOs that come to office before 2004. “New CEO hired externally” is an indicator for new CEOs that are hired from outside the firm. Other variables are defined in Table 3. Regressions 2 and 4 include 2- digit SIC industry fixed effects. T-statistics based on standard errors corrected for heteroskedasticity and firm clustering are reported in parentheses below the regression coefficients. *, ** and *** indicate statistical significance at the 10%, 5% and 1% levels, respectively.

Incumbent CEOs or new Incumbent New CEOs CEOs promoted Subsample New CEOs CEOs hired externally internally (1) (2) (3) (4) Executive variables: Incentive residual -0.041 -0.052** (-1.48) (-1.99) Executive Age -0.008 -0.010** -0.037*** -0.011*** (-0.59) (-2.45) (-2.63) (-2.69) CEO and Chairman indicator -0.034 0.098** -0.027 0.101** (-0.17) (2.23) (-0.16) (2.25) New CEO hired externally 0.420** (2.38) Firm variables: Distress risk -0.072 0.037*** -0.057 0.034*** (-1.64) (2.74) (-1.63) (2.78) Takeover Probability -6.849*** 0.176 -5.108** -0.072 (-2.73) (0.22) (-2.53) (-0.09) Year-on-year change in takeover -0.180 3.687* -1.214 4.616** probability (-0.05) (1.79) (-0.35) (2.29) Return volatility 0.581* 0.200 0.402 0.275** (1.92) (1.56) (1.40) (2.28) Log(Total assets) 0.150* -0.002 0.151** 0.010 (1.66) (-0.07) (2.00) (0.45) Institutional Block Ownership -0.320 0.419 0.449 0.422* (-0.50) (1.59) (0.67) (1.82) Board Size -0.040 0.012 0.008 0.015 (-0.99) (1.04) (0.21) (1.30) Board Independence -0.002 0.003* 0.005 0.003 (-0.30) (1.82) (1.13) (1.60) Number of Observations 60 170 43 203 Pseudo R2 0.216 0.332 0.297 0.354 Table 7: Correlations between the magnitude of severance contracts and other components of CEO compensation

For golden handshake severance contracts, Log(expected severance pay) equals the natural logarithm of the dollar amount of cash severance pay times the ex-ante probability of CEO dismissal. For golden parachute severance contracts, log(expected severance pay) equals the natural logarithm of the dollar amount of cash severance pay times the ex-ante probability of takeover. Expected severance pay multiple is the minimum number of years of severance pay times the ex-ante probability of CEO dismissal or the ex-ante probability of takeover, whichever applies. Both variables take the value of 0 for CEOs without severance contracts. Defined over all CEOs with severance contracts, above-median expected severance pay indicator is 1 for severance contracts with expected severance pay exceeding the sample median and 0 otherwise. * indicates statistical significance at the 5% level.

Above- median Expected expected Log(expected severance severance Stock severance pay pay Log(Total Salary/Total Bonus/Total grant/Total pay) multiple indicator compensation) compensation compensation compensation Expected severance pay multiple 0.7923* Above-median expected severance pay indicator 0.6909* 0.4563* Log(Total compensation) 0.2745* 0.2054* 0.4330* Salary/Total compensation -0.1742* -0.1424* -0.2829* -0.7975* Bonus/Total compensation 0.0605* 0.0039 0.1919* 0.0314 -0.0846* Stock grant/Total compensation 0.0853* 0.0480 0.1150* 0.3018* -0.2909* -0.1609* Option grant/Total compensation 0.0727* 0.0941* -0.0246 0.3762* -0.5124* -0.4007* -0.2382* Table 8: Determinants of the magnitude of severance contracts

This table reports coefficients from Tobit regressions on the magnitude of severance pay. Variables are defined in Tables 1, 3 and 7. All regressions include 1-digit SIC industry fixed effects. T-statistics based on standard errors corrected for heteroskedasticity and firm clustering are reported in parentheses below the regression coefficients. *, ** and *** indicate statistical significance at the 10%, 5% and 1% levels, respectively. Dependent variable: Log(expected severance pay) Expected severance pay multiple New Incumbent New Incumbent Sample: All CEOs CEOs CEOs All CEOs CEOs CEOs (1) (2) (3) (4) (5) (6) Executive variables: Incentive residual -0.390** -0.337** -0.021*** -0.017** (-2.49) (-2.01) (-2.64) (-2.02) Log(Total compensation) 1.219*** 1.300*** 0.042*** 0.045*** (7.29) (7.41) (5.44) (5.57) Executive Age -0.093*** -0.063 -0.100*** -0.005*** -0.005** -0.005*** (-4.80) (-1.22) (-4.91) (-5.07) (-2.10) (-4.93) CEO and Chairman indicator 0.504* -0.608 0.574* 0.031** -0.010 0.032** (1.71) (-0.77) (1.83) (2.23) (-0.30) (2.20) Outside CEO -0.479 -0.052* (-0.73) (-1.87) Firm variables: Distress risk 0.174*** -0.184 0.189*** 0.010*** -0.001 0.010*** (2.88) (-1.00) (3.04) (3.31) (-0.07) (3.47) Takeover Probability 0.758 -24.965* 1.014 0.814*** -0.188 0.847*** (0.17) (-1.90) (0.22) (2.97) (-0.30) (2.99) Return volatility -0.330 1.143 -0.288 -0.015 0.008 -0.013 (-0.53) (0.88) (-0.45) (-0.51) (0.13) (-0.44) Log(Total assets) -0.252 0.978** -0.286* -0.017** 0.016 -0.018** (-1.63) (2.50) (-1.71) (-2.21) (0.82) (-2.22) Institutional Block Ownership 0.674 -2.481 0.257 0.038 0.000 0.015 (0.56) (-0.85) (0.20) (0.64) (0.00) (0.24) Board Size 0.021 -0.091 0.011 0.001 0.002 0.001 (0.28) (-0.50) (0.14) (0.39) (0.23) (0.15) Board Independence 0.020** -0.050 0.023** 0.001* -0.002 0.001** (2.19) (-1.66) (2.33) (1.84) (-1.27) (2.05) Number of Observations 920 88 863 938 93 881 Pseudo R2 0.035 0.057 0.038 0.496 -0.296 0.472 Table 9: Characteristics of firms that grant new severance contracts or materially revise contracts, golden handshakes versus golden parachutes This table examines characteristics of firms that grant new severance contracts or materially revise contracts in place in 2004 by the type of severance contracts. Multinomial Logit regression models are used where the dependent variable is a categorical variable of which the base category is the universe of firms with no severance contracts, the second category is golden handshake severance contracts that are newly granted or materially revised from an existing contract in 2004, and the third category is new or revised golden parachute severance contracts. Other variables are defined in Tables 1 and 3. Both regressions include 2-digit SIC industry fixed effects. T-statistics based on standard errors corrected for heteroskedasticity and firm clustering are reported in parentheses below the regression coefficients. *, ** and *** indicate statistical significance at the 10%, 5% and 1% levels, respectively.

CEOs only All executives (1) (2) Golden Golden Golden Golden Type of contracts handshakes parachutes handshakes parachutes Executive variables: Incentive residual -1.348** -0.737*** -0.265 -0.162 (-2.57) (-2.58) (-1.33) (-0.99) Executive Age -0.124** -0.115** -0.069** -0.062** (-2.32) (-2.38) (-2.51) (-2.48) CEO and Chairman indicator 2.596** 0.587 0.718 0.295 (2.50) (0.84) (1.16) (0.58) CEO indicator 0.769 1.256*** (1.42) (2.92) Firm variables: Distress risk 0.460** 0.270 0.333*** 0.176* (2.19) (1.64) (2.96) (1.69) Takeover Probability 10.838 -7.234 -5.932 -4.419 (0.83) (-0.52) (-0.61) (-0.45) Year-on-year change in takeover 57.383 29.583 35.447** 21.785 probability (1.56) (1.07) (2.02) (1.20) Return volatility 2.095 3.448*** 0.952 2.366*** (1.26) (2.64) (1.07) (2.90) Log(Total assets) -0.063 0.309 0.486* 0.290 (-0.15) (0.95) (1.92) (1.35) Institutional Block Ownership 10.686** 3.017 2.464 2.146 (2.58) (1.06) (1.34) (1.25) Board Size -0.017 0.215 -0.193 0.132 (-0.09) (1.32) (-1.49) (1.23) Board Independence 0.036 0.032 -0.010 0.008 (1.29) (1.40) (-0.64) (0.59) Number of Observations 371 1,163 Pseudo R2 0.471 0.367 Table 10: Analysis of different types of golden parachute contracts Panel A reports details on the benefits specified in the golden parachute contracts offered. Panel B compares the terms of contracts between double-trigger and single-trigger golden parachutes. Panel C reports marginal effects from the probit regression model. The dependent variable is the above-median expected severance pay indicator. Double-trigger golden parachutes are contingent golden parachute severance contracts where severance payment is contingent upon termination for good reason or without cause. Single-trigger golden parachutes are golden parachute severance contracts where severance payment is due regardless of whether the executive’s contract is terminated. Variables are defined in Tables 1, 3 and 7. All regressions include 1-digit SIC industry fixed effects. T statistics based on standard errors corrected for heteroskedasticity and firm clustering are reported in parentheses below the regression coefficients. *, ** and *** indicate statistical significance at the 10%, 5% and 1% levels, respectively.

Panel A. Terms of golden parachute contracts

Number of Standard 5th 95th Variable contracts Mean Median deviation percentilepercentile A. Cash-related compensation benefits Minimum # of years 2,218 2.4 3.0 1.1 0.5 3 Maximum # of years 2,202 2.7 3.0 1.5 1 4 Minimum bonus 2,189 2.1 3.0 1.3 0 3 Maximum bonus 2,180 2.3 3.0 1.4 0 3 Long term compensation (Years) 335 0.5 0.0 1.1 0 3 Vested restricted stock 2,303 0.40 0.00 0.49 0 1 Vested restricted options 2,303 0.53 1.00 0.50 0 1 B. Insurance and retirement benefits Minimum defined benefit 280 37 36 28.8 12 36 Maximum defined benefit 281 39 36 29.1 18 60 Insurance (general) 2,303 0.64 1 0.48 0 1 Life (months) 994 32 36 34.9 12 36 Medical (months) 1,270 33 36 40.8 12 36 Dental (months) 770 34 36 51.7 12 36 Accident (months) 455 29 24 33.0 12 36 Disability (months) 550 30 30 30.4 12 36 C. Other benefits Other perks indicator 2,303 0.11 0.00 0.32 0 1 Excise tax gross-up indicator 2,303 0.58 1.00 0.49 0 1 Legal fees indicator 2,303 0.16 0.00 0.37 0 1 Outplacement indicator 2,303 0.15 0.00 0.35 0 1

Panel B. Terms of double- versus single-trigger golden parachute contracts

Double-trigger minus single- Contract type: Double-trigger Single-trigger trigger

Standard Standard p-value Variable N Mean Median deviation N Mean Median deviation Mean (T Test) A. Cash-related compensation benefits Minimum # of years 1,147 2.6 3.0 1.1 1,071 2.2 2.0 1.1 0.4 0.00 Maximum # of years 1,143 2.8 3.0 1.7 1,059 2.5 3.0 1.2 0.3 0.00 Minimum bonus 1,127 2.3 3.0 1.3 1,062 1.9 2.0 1.3 0.5 0.00 Maximum bonus 1,126 2.5 3.0 1.3 1,054 2.1 2.0 1.4 0.4 0.00 Long term compensation (Years) 312 0.5 0.0 1.1 23 1.2 1.0 1.0 -0.7 0.00 Vested restricted stock 1,183 0.4 0.0 0.5 1,120 0.4 0.0 0.5 0.0 0.01 Vested restricted options 1,183 0.5 1.0 0.5 1,120 0.5 1.0 0.5 0.0 0.38 Minimum defined benefit 237 33.6 36.0 8.2 43 58.2 36.0 67.8 -24.6 0.01 Maximum defined benefit 238 34.3 36.0 8.3 43 62.9 36.0 67.4 -28.6 0.00 B. Insurance and retirement benefits Insurance (general) 1,183 0.7 1.0 0.4 1,120 0.6 1.0 0.5 0.2 0.00 Life (months) 568 32.9 36.0 35.2 426 31.0 30.0 34.4 1.9 0.19 Medical (months) 722 33.1 36.0 36.0 548 31.9 24.0 46.4 1.2 0.31 Dental (months) 460 33.8 36.0 44.5 310 34.0 24.0 60.9 -0.2 0.48 Accident (months) 269 27.8 36.0 9.8 186 30.0 24.0 50.3 -2.2 0.28 Disability (months) 327 28.5 36.0 9.8 223 30.9 24.0 46.3 -2.4 0.23 C. Other benefits Other perks indicator 1,183 0.2 0.0 0.4 1,120 0.1 0.0 0.2 0.1 0.00 Excise tax gross-up indicator 1,183 0.7 1.0 0.5 1,120 0.5 0.0 0.5 0.2 0.00 Legal fees indicator 1,183 0.3 0.0 0.4 1,120 0.1 0.0 0.2 0.2 0.00 Outplacement indicator 1,183 0.2 0.0 0.4 1,120 0.1 0.0 0.3 0.1 0.00

Panel C. Determinants of expected severance pay in double-trigger and single-trigger golden parachutes

Sample: All Golden Golden parachutes contracts handshakes Both Double-trigger Single-trigger (1) (2) (3) (4) (5) Executive variables: Incentive residual -0.057** 0.002 -0.040* -0.114** -0.009 (-2.23) (0.05) (-1.69) (-2.07) (-0.44) Log(Total compensation) 0.169*** 0.128*** 0.116*** 0.243*** 0.056* (5.60) (3.93) (3.68) (3.64) (1.69) Executive Age -0.005 -0.013*** 0.002 0.004 0.002 (-1.51) (-2.92) (0.62) (0.64) (0.70) CEO and Chairman indicator 0.106** 0.105** 0.013 0.051 -0.014 (2.21) (2.29) (0.31) (0.54) (-0.42) Firm variables: Distress risk 0.019* 0.055*** 0.007 0.022 -0.001 (1.83) (3.88) (0.67) (1.11) (-0.12) Takeover Probability 0.279 1.124 3.396*** 2.756 2.718*** (0.42) (1.60) (2.98) (1.15) (3.03) Return volatility -0.292*** -0.056 -0.284*** -0.505** -0.155** (-2.68) (-0.43) (-3.16) (-2.30) (-2.10) Log(Total assets) 0.016 -0.041 0.057** -0.005 0.058** (0.56) (-1.32) (2.10) (-0.09) (2.31) Institutional Block Ownership 0.060 -0.079 0.002 -0.311 0.063 (0.31) (-0.38) (0.01) (-0.90) (0.45) Board Size 0.020* 0.020* 0.011 0.016 0.005 (1.76) (1.72) (0.94) (0.63) (0.54) Board Independence 0.000 0.001 -0.001 -0.004 0.000 (0.31) (0.78) (-0.47) (-1.28) (0.27) Number of Observations 600 221 363 154 204 Pseudo R2 0.141 0.325 0.341 0.337 0.398

Table 11: Determinants of ex post dollar value of severance pay This table examines the determinants of ex post severance pay. In Panel A, the dependent variable is the logarithm of the ex post severance pay amount, defined as the total cash compensation to executives when she leaves her current employer. In Panel B, the dependent variable is the excess ex post severance pay (in $millions), defined as the difference between the ex post severance pay and the severance pay by ex ante contract. Contracted severance pay is based on the severance agreement in effect at the time of termination. Real GDP Growth is GDP growth in real terms from the Bureau of Economic Analysis. Industry Growth is the industry median market-to-book ratio. Industry Stock Return is the industry median annual stock return. All firm characteristics are measured at the time of termination. If board independence and board size are not available for the termination year, their values from the most recent year with available data are used. Industry fixed effects are at the 2-digit SIC level and year fixed effects are by the termination year. Other variables are as defined in Tables 1 and 3. The standard errors are robust standard errors, clustered by firm. T-statistics are provided in the parentheses below the regression coefficients. *, ** and *** indicate statistical significance at the 10%, 5% and 1% levels, respectively. Panel A: Determinants of ex-post log(dollar value of severance pay) (1) (2) (3) (4) (5) Executive variables: Log(dollar value of contracted 0.677*** 0.636*** 0.719*** 0.665*** 0.569** severance pay) (3.86) (3.79) (3.55) (2.85) (2.06) Log(Total compensation) -0.068 0.139 0.184 (-0.28) (0.54) (1.03) Executive Age 0.014 0.022 0.010 (0.55) (0.73) (0.38) CEO and Chairman indicator -0.482 -0.555 -0.558* (-1.35) (-1.44) (-1.69) Firm variables: ROA -2.661 -1.896 (-1.47) (-0.64) Return volatility -1.622* 0.762 (-1.68) (0.40) Takeover Probability -4.367 4.478 (-0.93) (0.79) Log(Total assets) -0.107 (-0.50) Institutional Block Ownership 1.195 (0.91) Board Size 0.060 (0.61) Board Independence -0.040*** (-3.90) Industry and year fixed effects No Yes Yes Yes Yes Number of Observations 99 99 98 92 77 Adjusted R2 0.267 0.254 0.245 0.263 0.450 Panel B: Determinants of excess ex-post severance pay (in $millions) (1) (2) (3) (4) Executive variables: Log(Total compensation) 0.793 0.688 0.619 0.295 (0.88) (0.86) (0.55) (0.28) Executive Age 0.167 0.195 0.037 0.007 (1.22) (1.43) (0.41) (0.08) CEO and Chairman indicator -1.456 -0.948 0.675 0.890 (-0.97) (-0.69) (0.69) (0.93) Firm variables: ROA -8.403 -12.849 -2.880 -3.302 (-0.55) (-0.89) (-0.37) (-0.42) Stock Return -1.381 -1.778 -3.472* -2.285 (-0.74) (-1.06) (-1.90) (-1.34) Return volatility 7.745 1.886 6.059* 7.711** (0.72) (0.22) (1.68) (2.03) Takeover Probability 26.747 34.005 29.026 25.198 (0.76) (0.99) (1.00) (0.93) Log(Total assets) -0.298 -0.677 -0.054 0.098 (-0.35) (-1.13) (-0.10) (0.19) Institutional Block Ownership -4.204 -3.513 -9.167 -9.153* (-0.46) (-0.44) (-1.65) (-1.71) Board Size -0.430 -0.386 -0.402* -0.434* (-1.10) (-1.02) (-1.67) (-1.89) Board Independence -0.128*** -0.122*** -0.080** -0.100** (-2.93) (-2.93) (-2.07) (-2.37) Macroeconomic and Industry variables: Real GDP Growth -1.670 -2.588** -2.696** (-1.21) (-2.18) (-2.24) Industry Growth -3.043** -3.127*** (-2.58) (-2.72) Industry Stock Return -6.610** (-2.22) Fixed effects Industry & Year Industry None None Number of Observations 77 77 77 77 Adjusted R2 0.246 0.273 0.194 0.240