A surefire way for a company to garner bad press and anger investors is to reward an outgoing, terminated CEO with a hefty payout despite poor firm performance. A recent study detailed in the September/October issue of The Accounting Review, a publication of the American Accounting Association journal, puts a contrarian spin on those controversies and suggests these agreements are often beneficial for a company and counter the pressure on managers to deliver short-term performance at the expense of long-term goals and investments.
The academic paper, “CEO Contractual Protection and Managerial Short-Termism,” makes the case that CEOs with contracts that protect them from being terminated without cause, or that grant them generous severance packages if they are, make them “less likely to engage in myopic behavior compared to those without contractual protection.” Contrary to what critics argue, contractual protection “can address the agency problem of short-termism," specifically the knee-jerk reaction to cut long-term investments, such as research and development, to meet or beat short-term performance targets. The study calculates that an agreement of this sort lowers by nearly 25 percent the probability of cuts in investments that would be essential to future company growth.
“The fundamental driver of managerial short-termism is the pressure on managers to deliver short-term performance. CEO employment contracts can ease such pressure by protecting CEOs from short-term performance swings and downside risk,” the authors—Xia Chen and Qiang Cheng of Singapore Management University, Alvis Lo of Boston College, and Xin Wang of the University of Hong Kong —wrote.
"Even though contractual protection of chief executives may anger shareholders and on occasion may encourage CEO entrenchment or complacency, its effect on short-termism represents a benefit for investors that should not be underestimated,” says Lo, an assistant professor in Boston College’s accounting department. “Short-termism, after all, is widely regarded as one of the most serious shortcomings of present-day corporate governance.”
The paper's findings derive from an analysis of financial and governance data from companies in the S&P 500 from 1995 through 2008. In total, the data comprised 2,027 firm-years, about 70 percent of which involved companies where the CEO had a comprehensive fixed-term employment contract or stand-alone severance pay agreement and 30 percent of which involved firms where the CEO had neither.
Concerns over short-termism, Lo says, were the basis of an intriguing recommendation by the law firm Wachtell, Lipton, Rosen & Katz that the Securities and Exchange Commission no longer require public companies to issue quarterly financial reports. Also, one of Europe's largest institutional asset-management firms, Legal & General Investment Management, sent a letter to the boards of the 350 largest companies on the London Stock Exchange proposing much the same.
Lo asks: “Which would most investors prefer as a way of combating short-termism, the professor wonders, job protections for CEOs or doing away with corporate quarterly reports?”