The Reasoning Behind Golden Parachutes

There's a reason that McCain and Obama brought up Golden Parachutes so much during the election -- it's a touchy subject and easy to despise (especially by those that are losing their homes). At first glance, paying large sums of money to failing executives seems like a bass-ackwards practice that rewards the rich for simply being rich. Many of us picture a clan of back-slapping, cigar smoking golfers sitting in a country club lounge, deceitfully scheming about how they'll bestow our retirement funds to each other. Though we must keep a watchful eye on those in power -- especially our politicians -- before you grab your torch and sword and storm the castle of Wall Street, know that there is a legitimate reason that executives are given wildly lavish compensation packages. Read on if you dare...

Executives have a fiduciary relationship to company shareholders. Basically that's a legal term that means that executives are legally responsible to act on behalf of the shareholders. So it's their job to see to it that shareholder's wealth is increased. It's up to them to save the company money wherever possible and increase sales. It's also up to them to encourage mergers that would benefit the shareholders. But unfortunately, sometimes mergers lead to eliminating redundant positions -- including executive positions. So even with the legal obligation to serve the shareholder, there is a clear conflict for an executive that's putting his own job on the line.

Let's say that the McDonalds and Burger King people decided to merge. For whatever reason, the CEOs honestly believed that it would be in the best interest of both sets of shareholders for the two restaurants to join forces. So with the paperwork filed and the stroke of a pen, every McDonalds and every Burger King became a McBurgles. The stock soared on day one, but soon after, it became time to start cleaning house. Though each restaurant was making both Big Macs and Whoppers, they only needed one kitchen. So some cooks got laid off. And each franchise didn't need two managers, so some of them got laid off, too. Next came the regional managers and the district managers. The chain of redundant position eliminations worked its way up, one job at a time, all the way to the executives at headquarters. The McDonalds and Burger King CEOs looked like two kids playing musical chairs, squeezing their butts into the only open red-leather seat in the top floor office of the McBurgles building. But it's not like they didn't see this coming.

When the CEOs of these companies started talking Merger, each of them knew that there was a good chance of getting laid off after the smoke cleared -- just like the cooks and managers. But they went through with it anyway. But wouldn't they have to be crazy? I mean, I like my job, but if I thought that there might be someone out there better than me at it, I doubt that I'd call my boss and say, "Hey, you should fire me because I think that Bill over here will do a better job than me." As they say, you've got to look out for Number One. So even though it might be better for the company to hire Bill and let me go (maybe because he doesn't blog during work hours -- just kidding :-) ), I'm not likely to speak up because I don't want to lose my job.

But what if you had an agreement with your boss ahead of time? He wants to make sure that the best person is doing your job; right now he thinks that is you. But should you ever find someone that might do it better than you, you should bring them in for an interview. Noting the inherent conflict of interest, your boss promises that as long as you're acting in the best interest of the company, you personally won't suffer financially. So if you're a carpenter and find someone that can swing a hammer harder than you, the company will pay you to give up your job to the stronger candidate.

Mergers happen all of the time in just about every major industry. Companies may merge to strategically increase shareholder wealth or to cuddle together in the same sleeping bag, living off each other's body heat to survive a frigid night. Those that oversee these complicated mergers are by far the companies' highest paid employees. And would these executives put their own family's livelihood on the line just because the decision would benefit the company? That's a tough question that many executives would answer differently. Essentially, golden parachutes exist to remove the conflicts of interest that are inherent to mergers. Unless some mechanism exists to ensure that executives have nothing to lose personally, it's likely that many mergers would never go through, even if they're in the best interest of everyone else.

Because executives are so highly paid (which is a different story altogether), golden parachutes exist in the form of many millions of dollars. Executives that lose their jobs are losing out on a very lucrative gig, and unless the severance package is big enough, the conflict of interest isn't truly eliminated.

It's easy to criticise those that are getting huge bonuses during a time of such national economic turmoil. But the distinction between reward and conflict resolution is critical. CEOs are often faced with business decisions that may positively affect the company and its shareholders but negatively affect their position. Golden parachutes take executives' personal risk out of the equation -- they're not meant to be a reward. So while it's fair to criticize performance bonuses given to those that don't, well, perform, it's important to know that certain bonuses are given to mitigate the effect of one's personal survival instinct on large-scale business transactions.

The first thing that I learned in my first day of collegiate economics is that people are smart and people are selfish. It's just human nature...