Excerpt
Content
I. Introduction
II. Main body
1. Reasons in favour of golden parachutes
2. Reasons against golden parachutes
3. Problem-solving approach for the conflict of having “Golden parachutes” or not
III. Conclusion
IV. Bibliography
1. Literature
2. Graphics
I. Introduction
The aim of this essay is to assess the usefulness of business leaders having “golden parachutes” by applying microeconomic reasoning to critically evaluate a ban of the practice. A definition of golden parachutes will be given in this introduction, while in the main part the most important pros and cons of a ban of this practice will be critically evaluated. In addition, various solutions for resolving the conflict of interest will be shown and explained using German regulations as an example.
Adopted in the late 1970s and early 1980s (Bedchuk, Cohen and Wang, 2012), a golden parachute is a controversial management perquisite that allows protected managers to voluntarily resign and collect substantial remuneration – in some cases several million dollars – after a triggering event, usually a hostile takeover (Cochran, Wood and Jones, 2013). Mogavero and Toyne (2013) refer to golden parachutes as a form of compensation insurance in the event of termination of employment following a change of corporate control. However, this is a very broad definition of golden parachutes, with many authors referring to them as a bonus when a takeover occurs (Bedchuk, Cohen and Wang, 2012; Singh and Harianto, 2013; Machlin, Choe and Miles, 2013).
II. Main body
The magnitude of compensation for corporations’ chief executive officers (CEOs) has for some time spawned heated debate among academics and the public alike (Jensen and Murphy, 1990; Murphy, 1999), especially when golden parachutes reach figures of $30 million and more.
The top ten of golden parachutes are:
1) Lee Raymond (Exxon Mobil), $351,000,000
2) Hank McKinnell (Pfizer), $213,000,000
3) Robert Nardelli (Home Depot), $210,000,000
4) Richard Grasso (NYSE), $187,000,000
5) Bruce Karatz (KB Home), $175,000,000
6) Stanley ONeal (Merril Lynch), $160,000,000
7) Frank Newman (Bankers Trust), $100,000,000
8) Robert Eaton (Chrysler), $70,000,000
9) Wendelin Wiedeking (Porsche), $50,000,000
10) Klaus Esser (Mannesmann), $30,000,000
(Graphic 1: finanzen.net ranking, 2013)
The most frequent cause for the public to notice the effect of golden parachutes is on corporate acquisitions. In firms that have experienced and successfully fended off a previous takeover threat, it is expected that top managers will seek extended protection by golden parachute contracts. An independent board, on the other hand, will examine such golden parachute proposals from a cost-benefit perspective, assessing the expected economic value of golden parachutes to the shareholders (Singh and Harianto, 1989). An assessment of the value of golden parachutes must consider the probability of being taken over. However, although the considerations involved in this decision are clear, considerable ambiguity surrounds the estimation of the optimum golden parachute compensation, because it is contingent upon a hypothetical acquisition attempt by an unrevealed acquirer (Singh and Harianto, 1989).
1. Reasons in favour of golden parachutes
Proponents argue that the parachutes, which guarantee cash bonuses, stock options, or other benefits if upper-level managers lose their job in a merger or takeover, help attract and retain top talent (Bedchuk, Cohen and Wang, 2012). However, this is also an essential part of an employment contract if a company tries to recruit top managers from competitors.
Without such protection, executives could be motivated to stick with a “sinking ship” and refuse to accept reasonable offers (Bedchuk, Cohen and Wang, 2012). Furthermore, prior studies have shown that stockholders of target companies earn substantial profits when their firms are acquired (Jarrel, Brickley and Netter, 1988). Changes in corporate control, however, can cause hardships for terminated executives through loss of wages while they seek new employment, possible reductions in pay levels when new employment is found and loss of non-pecuniary benefits (Lambert and Larcker, 1984).
Another strong argument is that golden parachutes reduce conflicts of interest between executives and stockholders during a takeover, because the executives might support takeovers if they are good for the stockholder even if their own jobs will be terminated through this transaction.
Furthermore, Lambert and Larcker (1984) discovered that stock markets react positively, and statistically significantly, to the announcement that golden parachute arrangements have been adopted. Lambert and Larcker (1984) also discovered that stockholders thought that golden parachutes helped preserve stockholders’ interests during attempted takeovers. This positive effect is presumed, based on stock market evidence, to overweight the disincentives for potential suitors to bid for the firm due to higher cost-implicit golden parachute contracts (Singh and Harianto, 1989).
2. Reasons against golden parachutes
Opponents argue that golden parachutes reduce stock values by facilitating wealth transfers from stockholders to executives (i.e. wealth transfer hypothesis).
Manne (1965) in particular argues that takeovers provide a means of disciplining managers into acting in the shareholders’ best interests. The primary assumption invoked in this line of reasoning is that competing managers can profit by acquiring firms that are being run inefficiently, firing the current management, and running the firm more efficiently. The threat of losing their own job to a competing manager limits the manager’s incentive to run the business in a manner contrary to the shareholders’ best interests. However, if golden parachutes serve to insulate management from the takeover market, the discipline provided by the takeover market is reduced, and this increases the manager’s ability to transfer wealth from the shareholders to himself (Lambert and Larcker, 1984).
As Lambert and Larcker (1984) demonstrated in their study of golden parachutes, executive decision-making and shareholder wealth, though, the golden parachute is associated with a statistically significant and positive security market reaction.
Nevertheless, golden parachutes can reduce discipline on a firm’s management, and therefore adversely affect shareholder wealth in three ways (Lambert and Larcker, 1984).
1) First, the compensation provided by the golden parachute reduces the manager’s loss so that he views the threat of a takeover less seriously, and he is replaced (Lambert and Larcker, 1984). From a manager’s perspective, the threat of losing his own job is less dangerous because in the event of bad performance and a takeover a golden parachute will guarantee a large payment.
2) Furthermore, a golden parachute increases takeover costs in the event that management is dismissed. This reduces the takeover premium that the acquiring firm is willing to pay. However, the cost of golden parachutes is much smaller than the 30 per cent premium that is typically offered in takeovers (Mogavero and Toyne, 1995). This suggests that golden parachutes are not likely to be large enough in themselves to completely prevent a takeover (Mogavero and Toyne, 1995).
3) Finally, some firms define a change of control to include a change in the majority of the board of directors. This change of control feature means that the golden parachute would go into effect if a group of dissident shareholders succeeded in gaining control of the board. In these cases, the golden parachute also reduces the ability of the stockholders themselves to discipline and replace managers. Since golden parachutes have the potential to reduce the discipline on managers, the “Wealth Transfer Hypothesis” predicts that the adoption of golden parachutes should have an adverse impact on shareholder wealth. (Lambert and Larcker, 1984).
Additionally, investors may not be pleased by the relationship between golden parachutes and overall firm value. Bebchuk, Cohen and Wang (2012) discovered that, in the two years between publication of the Investor Responsibility Research Centre reports, the implementation of a golden parachute policy led to an average decrease of about 4.5 per cent in a company’s Tobin’s Q ratio. The Tobin’s Q ratio is the relationship between the market value and the replacement value of the same physical asset.
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(Graphic 2: Tobin’s Q Ratio, Investopedia, 2013)
Although investors may eventually benefit from a sale thanks to golden parachutes, they may find in the meantime that a company’s performance remains mired, in terms of firm valuation and stock returns, remains mired (Bebchuk, Cohen and Wang, 2012).
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