Are Ex-Ante CEO Severance Pay Contracts Consistent with Efficient Contracting?

Efficient contracting predicts that ex ante severance pay contracts are offered to chief executive officers (CEOs) as protection against downside risk and to encourage investment in risky projects with a positive net present value (NPV). Consistent with this prediction, we find that ex ante contracted severance pay is positively associated with proxies for a CEO's risk of dismissal and costs the CEO would incur from dismissal. Additionally, we show that the contracted severance payment amount is positively associated with CEO risk taking and the extent to which a CEO invests in projects that have a positive NPV. Overall, our findings imply that ex ante severance pay contracts are consistent with efficient contracting.