The softer side of severance pay

Severance encourages execs to take risks that shareholders want, and to confront bad news quicker

Lori Johnston | Nov. 13, 2018

Takeaways

  • Severance pay for executives is good for shareholders.
  • Career concerns encourage executives to withhold bad news in the hopes that subsequent events will turn in their favor. 
  • If executives are promised a meaningful severance in the event of dismissal, they no longer delay the disclosure of bad news.

Corporate executives are likely to withhold bad news from their shareholders, especially when their jobs could be on the line. But companies that provide generous severance packages to their executives give them confidence to share failures as readily as successes, according to Terry College of Business accounting professor John Campbell.

“Managers delay telling their shareholders bad information for as long as they can, in the hope that something good will come along and turn it around,” said Campbell, an Severanceassociate professor and EY Faculty Fellow in the J.M. Tull School of Accounting. “If you get that person a compensation package that gives them some benefit if they get fired, they are more likely to tell you the bad news more quickly.”

Severance in general gets a bad reputation because people ask, “Why pay someone so much money when they've failed?” But Campbell said that perspective misses the point because people only observe the payments after a very bad outcome.

“If you contract with the manager up front, it encourages them to take risks that shareholders want, and to be more honest about those risks,” he said.

The severance pay has to be “meaningful,” which is about three to four times the individual’s annual compensation, according to the research findings.

What might be bad news, however, could prepare shareholders for the firm’s financial challenges ahead. Bad news could serve as a signal that shareholders might want to engage more with managers on how they plan to get through those challenges, Campbell said.

Shareholders usually want to know bad news as soon as they can get it because the accounting rules are predicated on recording losses as soon as they are probable, but deferring gains until they actually occur. In general, bad news comes at the end of the quarter, according to the research, while good news is released throughout the period. Severance pay corrects for that tendency.

“Shareholders want the good and the bad to be disclosed simultaneously,” he said.

The study, published in The Accounting Review, looked at S&P 1,500 firms that represent about 90 percent of stock market value, but Campbell said the same findings would likely translate to smaller companies as well.

The researchers hand-collected information from firms’ proxy statements about the total severance, as well as the breakdown of the severance among cash payments, stock options, and other perks. Then they separated managers into those with high levels of severance and those with low levels of severance and observed whether their behaviors differed in disclosing bad news during the quarter.

The study follows up on Campbell’s previous research, which found that executives with severance pay are more likely to take risks that benefit shareholders and the risks tend to improve the firm’s value.

Severance pay has a greater effect when the executive is younger and has more years until retirement, as these CEOs have a greater tendency to want to withhold bad news.

“They younger they are, the more worried they are,” Campbell said. “They don’t have established reputations. Severance pay helps to correct that concern.”

The paper, “Do Career Concerns Affect the Delay of Bad News Disclosure?” was published in The Accounting Reviewin 2018. It was co-authored by Campbell and Stephen P. Baginski of the University of Georgia, Lisa A. Hinson of the University of Florida and David S. Koo of the University of Illinois at Urbana-Champaign.

 


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