The Case for Golden Parachutes

The Case for Golden Parachutes

By Ray Fisman and Tim Sullivan

Ray Fisman is the Lambert Family Professor of Social Enterprise and co-director of the Social Enterprise Program at Columbia Business School. Tim Sullivan is the editorial director of Harvard Business Review Press. From The Org: The Underlying Logic of the Office (Twelve). ©2013

The public’s collective sense of outrage toward high-paid executives is never greater than when those executives get fired and walk away under the shelter of enormous golden parachutes. Stan O’Neal stepped down as Merrill Lynch CEO in 2007, amid accusations of creating a culture of reckless risk-taking and pushing Merrill to build its business of repackaging and reselling subprime loans. He left with a package worth over $160 million. Bob Nardelli’s golden handshake is one for the record book—a $210 million gift for leaving Home Depot in 2007 after six bad years of leadership that left the company with its lowest profits in a decade. Why should the pink slips of O’Neal, Nardelli, and other failed leaders be accompanied by tens or hundreds of millions in severance pay?

This seemingly absurd system of compensating CEOs for getting fired goes back to a perfectly reasonable attempt to get CEOs to create even more value for their companies. The golden parachute was written into the employment contract of, appropriately enough, the CEO of an airline company, TWA, in 1961. But the practice never really took off until the merger wave of the 1980s was in full swing, when execs started pondering whether it was smarter to seek out merger opportunities to make money for shareholders, or hold on to their jobs instead. Mostly, they opted for the latter (keeping their jobs) by discouraging the advances of corporate suitors, often to the detriment of stock price.

Creating incentives to motivate CEOs to seek out merger opportunities turned out to matter a lot, since one of the best ways for corporate leaders to create value is to make the company a target for merger or acquisition. When larger orgs gobble up smaller ones, it’s usually at a premium to what the smaller orgs are worth on their own, so shareholders (the owners of the org) get to cash out at a big profit. But the combined firm needs only one boss, so odds are one of the two CEOs in the merger is out of a job. Ironically, one of the most value-enhancing ways a CEO can spend his time (shopping his company around for acquisition) also results in his getting fired. No CEO is going to pursue those options unless there’s a financial upside to do so.

Shareholders responded by providing CEOs with the escape valve that, the reasoning went, would encourage them to work in the long-term best interests of their companies. Looking back on the decade in 1988, Harvard Business School economist Michael Jensen wrote that, while there have been abuses of executive escape chutes—he notes, in particular, one company that packed golden parachutes for more than two hundred managers, thereby making it impossibly expensive for any buyer to take over the company—in general they create a lot of value for investors, who welcome the takeover-motivating effects. Jensen also argued that what is good for CEOs’ retirement accounts is also good for society in general, since it encourages CEOs to open the door to corporate raiders, who strip their purchases of waste and other inefficiencies to produce more valuable companies.

By this line of reasoning, golden parachutes make the world a better place by making companies more efficient. That can be hard to swallow.

Why don’t regular employees get paid to get fired? CEOs are doing their jobs right only if once in a while it gets them fired, which isn’t the case for lower-level employees. This reminds us of another peculiarity of the trade-offs in getting incentives right. If the contract says you get a big bonus check if you lose your job when the company is taken over, that works to align CEO incentives with those of shareholders, but it also means that executives whose ineptitude also makes their companies ripe for takeover will be rewarded for their incompetence. And, of course, when we see pay-for-incompetence, we shake our heads at the corruption and injustice of corporate America, rather than thinking of it as an unfortunate side effect of generally well-designed incentives.

The Conference Board Review is the quarterly magazine of The Conference Board, the world's preeminent business membership and research organization. Founded in 1976, TCB Review is a magazine of ideas and opinion that raises tough questions about leading-edge issues at the intersection of business and society.