Golden parachutes and moral hazard: parachutes can be important in resolving potential conflicts, but can also magnify potential problems.

AuthorWalkling, Ralph W.
PositionEVIDENCE AND PERSPECTIVES

IN DESIGNING executive compensation we are always striving to align owner-manager interests. Readers of Directors and Boards know that this is a formidable task, fraught with tradeoffs and pitfalls.

In particular, compensation contracts must seek to avoid what economists call moral hazard. Moral hazard exists when someone has the opportunity to influence the outcome of actions that benefit themselves, generally at the expense of other parties. Quite simply, incentives are misaligned. Moral hazard is the reason we can't insure our homes for twice their value: Such policies might cause us to be less than prudent in safeguarding our homes.

Acquisitions create a natural owner-manager conflict: the best interest of the shareholders (perhaps selling the company) may be in conflict with the interests of the CEO (keeping their jobs). Golden parachutes can help neutralize these conflicts, providing a payoff to executives after a change in control. In addition, golden parachutes provide assurance that there will be at least some compensation if implicit contracts are canceled. (Implicit contracts are of the form "if things go well, we'll take care of you"; such promises can be forgotten after a change in control.)

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Nevertheless, when it comes to compensation, golden parachutes are fraught with the potential for moral hazard. Typically, these contracts are triggered by a change in control regardless of the final acquisition terms. This creates a natural moral hazard. A parachute too small could produce unyielding resistance to a bid. A parachute too generous could produce a rush to sale. Neither situation is likely to benefit shareholders.

To examine the impact of golden parachutes, two colleagues and I analyzed a sample of 851 acquisition bids from 1999-2007, giving particular emphasis to variables designed to signify the potential for moral hazard. [See "On the Importance of Golden Parachutes" by Eliezer M. Fich, Anh L. Tran and Ralph A. Walkling, December 7, 2010, presented at the CELS 2009 4th Annual Conference on Empirical Legal Studies; the paper may be downloaded at the Social Science Research Network website http://ssrn.com/abstract=1425211.]

We sought to measure the total wealth impact to a CEO from a change in control. Some components of the exit package (e.g., stock and options owned by the CEO) increase directly with the bid premium of the deal. Other components (e.g., the loss of future compensation and golden...

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