Inside Debt

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday August 15, 2010 at 9:19 am
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Editor’s Note: The following post comes to us from Alex Edmans and Qi Liu, both of the Finance Department at the University of Pennsylvania.

In the paper, Inside Debt, which is forthcoming in the Review of Finance, we show that CEOs should be paid with debt in their own firm, to deter them from taking risky actions (e.g. sub-prime lending) that hurt bondholders, as was common in the recent financial crisis. Our theory justifies the substantial use of debt compensation documented by recent evidence, and underpins recent proposals to tie CEOs to the value of their debt to prevent future crises (as recently implemented at AIG).

Three decades of theoretical research on CEO pay have focused almost exclusively on justifying compensating CEOs with equity-like instruments alone, such as stock and options. This has likely been driven by the long-standing belief that, empirically, executives don’t hold debt. However, this belief arose not because CEOs actually don’t hold debt, but because disclosure of debt compensation was extremely limited and so researchers missed this component of compensation. New disclosures mandated by the SEC from March 2007 show that CEOs hold substantial debt in their own firms (known as “inside debt”) in the form of deferred compensation and defined benefit pensions. Indeed, in some cases, CEOs hold even more debt than they do equity. Since the use of debt sharply contrasts with existing theories which advocate only equity, some commentators have argued that it must be inefficient. By contrast, we show that inside debt can be optimal, and that it should be used in the types of firms in which they are indeed used in reality.

We start with a model in which the CEO chooses between a risky and a safe project. The risky project can sometimes create value (e.g. investing in R&D) but sometimes destroy value (e.g. diversification from one’s core business into derivatives trading, as with Enron and AIG). A CEO who holds only equity will take the risky project even when it destroys value because, if he gets lucky and it pays off, his equity will soar, but if it fails, it’s bondholders who suffer most of the losses (as in the recent crisis). Equityholders’ losses are capped by limited liability – thus, if the firm is already close to bankruptcy and equity is close to zero, things can’t get any worse and so the manager may “gamble for resurrection”, taking riskier and riskier projects to try to salvage the firm.

Prior research suggested that this problem might be solved by giving the CEO a bonus if his firm is solvent, or equivalently hitting him with a penalty if he goes bankrupt. Unfortunately, this doesn’t work because it only makes the CEO sensitive to the incidence of bankruptcy, but not the value of assets in bankruptcy. If the firm goes bankrupt, he loses his bonus regardless of whether creditors recover 80c in the dollar or 10c in the dollar. Thus, again, he’s induced to gamble for resurrection even if this means sacrificing recovery values. By contrast, deferred compensation and pensions stand in line with other unsecured creditors in bankruptcy, so if debtholders receive 80c per dollar, so does the manager. Thus, he’s aligned more closely with creditors. Bondholders will demand a lower return on their debt if they know that the manager is aligned with them and so won’t risk-shift. This in turn benefits shareholders – thus, even though it’s shareholders who set pay, they wish to take bondholders into account to reduce the firm’s cost of debt.

With a project selection decision alone, the manager should hold debt and equity in equal proportions – e.g. if he owns 2% of the firm’s shares, he should also own 2% of its bonds. When the CEO chooses effort as well, the problem becomes more intricate. If the CEO’s effort has a particularly high effect on the firm’s solvency value (e.g. they involve pursuing growth opportunities), the CEO should hold more equity than debt to induce effort. By contrast, if the CEO’s effort has a particularly high effect on the firm’s liquidation value (e.g. they involve scrapping non-core assets), the CEO should hold more debt than equity. Consistent with recent evidence, the model predicts that inside debt should be higher in more levered firms and lower in growing firms, and that CEOs with high inside debt manage their firms more conservatively.

The paper thus provides a theoretical framework underpinning some recent proposals to compensate CEOs not just according to equity value, but to debt value also. Indeed, AIG recently announced that, going forwards, 80% of their executives’ bonuses will depend on the price of their firm’s bonds and only the remaining 20% will depend on the price of their equity. We believe that this is a positive move which should hopefully prevent future financial crises and reduce conflicts between shareholders and bondholders.

The full paper is available for download here.

  1. How would this theoretical framework deal with accounting rule changes that impact a firms financial standing or firms that have privileged access to low cost financing or tax payer assisted funding?

    Comment by gold bullion — August 16, 2010 @ 8:30 am

  2. This sounds like its awful and pretty harsh for a a CEO but I think its a good way to ensure CEO’s are not spending irresponsibly.

    Comment by Melissa — August 16, 2010 @ 3:30 pm

  3. CEO need to be help more accountable for what goes on inside their company. Like parents of kids, they are responsible for the day to day activities.

    Comment by Adelard — September 22, 2010 @ 8:27 am

  4. [...] Paying directors on a board with debt: http://blogs.law.harvard.edu/corpgov/2010/08/15/inside-debt/ [...]

    Pingback by Project Cloud — October 18, 2010 @ 5:07 am

  5. CEO compensation has been growing wildly in the last 30 years since the reduction of the individual income tax from 70% to 28%. The value the CEO held is not commensurate with their actual compensation and their lack of buy in and risk is understated. The CEO has had little to no risk as stated in ‘Inside Debt.’ The maneuvering of the CEO back into a position of risk taker as a shareholder is, a “risk taker” only “shares the pain” if the CEO is remiss in his duties and obligations to his employees, shareholders and board.

    Comment by Kimberly — October 28, 2011 @ 1:04 am

 

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