The media has been abuzz the past two days over US pay czar, Kenneth Feinberg’s decision to cut executive pay at seven federally aided companies.
There are many arguments both in support and in opposition to this decision. Some may feel that tax payers shouldn’t have to pay for large executive bonuses, especially due to poor risk management.
However, others feel that restricting executive pay may cause a “brain drain”, where talent will leave these companies in search for better pay elsewhere.
While the amount of executive pay is a topic of much debate, there is an issue concerning executive pay that is much more pressing: the timing of executive pay.
Golden Parachutes–severance pay and cash bonuses paid out to executives upon their dismissal is an extremely pressing concern, especially in this economy. These payouts create an enormous conflict of interest for top executives and rewards them for the wrong behavior.
Severance pay packages offer payouts to executives up to five times their salaries and bonuses in the event that they are ousted. This large and immediate payout in essence gives an incentive to executives to get fired.
Executives are charged with one overarching goal: to maximize shareholder wealth. While their bonuses are determined by their ability to meet this goal, an executive’s largest payout would be in the event of being ousted: either through dismissal or a takeover.
One might say it would be shortsighted of the executive to seek one giant severance payout instead of a constant, salary and bonus every year. However, constant pay for a top executive is not as likely as it seems.
Future cash flows are valued less due to perceived risk–and a CEO, being under constant scrutiny, has a very risky job. So risky, in fact, that it seems unlikely that a CEO will receive a steady paycheck from the same company over a long period of time.
Because of this, it only seems logical that a CEO would prefer a severance pay sooner rather than later, since he or she knows their days are numbered from the word go.
Poison Pills are no different. Poison Pills are a type of Golden Parachute paid to executives specifically in the event of a merger or acquisition, where they would be replaced by new management. They are designed to repel takeover attempts, since companies would prefer not to suffer large payouts if they can be avoided.
Mergers and Acquisitions are generally bad for shareholders–they rarely result in good synergy for the newly combined company, and generally causes a reduction of stock value.
So why do M&A’s happen so frequently? One reason is due to executive pay and Poison Pills.
Pretend Company A is purchasing Company B. The executives at Company A will push for the acquisition since executives typically get paid more for managing a larger company. The executives at Company B, on the other hand, know they will receive a large payout in the event of the acquisition, since they are being replaced.
This results in both groups of executives, who have a fiduciary responsibility to the the shareholders, to instead put their own interests first at the shareholder’s expense. And Poison Pills, the very thing meant to dissuade takeover attempts actually incent executives to pursue them.
Is there a solution to this problem? Golden Parachutes are offered to executives across the globe, so even if one country were to outlaw them, that could create a similar “brain drain” where executives will simply flock to companies in other countries that do offer them.
The only real (and unlikely solution) is that the practice of offering Golden Parachutes is ended everywhere.
Disagree with the risk of Golden Parachutes and Poison Pills? Comment below!