Entrenchment and Severance Pay in Optimal Governance Structures

Authors

  • Andres Almazan,

  • Javier Suarez

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    • Almazan is from the McCombs School of Business, University of Texas at Austin, and Suarez is from CEMFI, Madrid. We are grateful to Ty Callahan, Murray Carlson, Marco Cel-entani, Thomas Gehrig, Rick Green, Maria Gutierrez, Gordon Hanka, David Hirshleifer, John Moore, Jorge Padilla, Bob Parrino, Ramesh Rao, Clara Raposo, David Scharfstein, and especially Sheridan Titman and two anonymous referees for their useful comments and suggestions. Any remaining errors are our sole responsibility.

ABSTRACT

This paper explores how motivating an incumbent CEO to undertake actions that improve the effectiveness of his management interacts with the firm's policy on CEO replacement. Such policy depends on the presence and the size of severance pay in the CEO's compensation package and on the CEO's influence on the board of directors regarding his own replacement (i.e., entrenchment). We explain when and why the combination of some degree of entrenchment and a sizeable severance package is desirable. The analysis offers predictions about the correlation between entrenchment, severance pay, and incentive compensation.

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