Paying executives in debt

By Felix Salmon
July 13, 2010
Alex Edmans makes a very good point today: it makes a great deal of sense, especially in leveraged companies, to pay CEOs in debt rather than equity. What's more, such compensation is already quite widespread: if a company has promised an executive a defined-benefit pension upon retirement, that's essentially unsecured debt of the company, and can be substa

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Alex Edmans makes a very good point today: it makes a great deal of sense, especially in leveraged companies, to pay CEOs in debt rather than equity. What’s more, such compensation is already quite widespread: if a company has promised an executive a defined-benefit pension upon retirement, that’s essentially unsecured debt of the company, and can be substantial.

Edmans is right that there’s the germ of something possibly quite powerful here. If companies started institutionalizing payment-with-debt, rather than having it simply be a necessary byproduct of making promises to pay out money in the future, that could go a good way towards reducing incentives for executives to take on excessive amounts of risk:

The risky project can sometimes create value (e.g. investing in R&D) but sometimes destroy value (e.g. subprime lending). A CEO who holds exclusively equity will take the risky project even when it destroys value (a behaviour known as “risk shifting” or “asset substitution”) because, if he gets lucky and it pays off, his equity will shoot up in value, but if the project is unsuccessful, it is bondholders who suffer the bulk of the losses – as has been clear in the recent global crisis. Equity holders’ 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.

The problem, of course, is getting companies to sign up to such a scheme. Compensation committees are created by the board of directors, which is elected by shareholders, not bondholders. So it’s only natural that those compensation committees will structure things in the benefit of shareholders, with bondholders bearing the brunt.

But in extraordinary circumstances, it can be done. AIG executives’ compensation is in 80% debt and 20% equity, for two unusual reasons. Firstly, the equity is worthless, and the executives know that the equity is worthless. And secondly, the debt is paying an attractive coupon.

Expanding this model from AIG to other leveraged companies will be hard. But increasingly institutional investors place their money across the whole capital structure of a company, rather than just in equity or in debt. If a firm’s big shareholders are also big bondholders, they might be able to persuade the board to do the right thing.

13 comments

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I guess executives should be payed with exactly the same mix of debt and equity as the current capital structure of the firm.

Posted by josefsen | Report as abusive

Don’t executives have a fiduciary duty to shareholders not bondholders? If I’m a partial owner of a firm, I want my agents to be maximizing the expected value of equity (on a risk-adjusted basis), even if that means leveraging up and increasing the risk of bankruptcy.

This proposal only makes sense for a systematically important financial firm, where the American taxpayers are short a credit default swap and receive no premium. It is therefore important that executives are incentivized to consider taxpayer interests as well.

Posted by Stevensaysyes | Report as abusive

How about payment in the form of contingent convertible debt? This would give the owners continued interest in maintaining the economic fortunes of their companies as well as act to automatically de-lever the company in case of a financial crisis. Perhaps with an option to convert at a higher strike price at the owner’s election in order to better align their interest with the shareholders.

Posted by JohnOmeara | Report as abusive

Felix, I suggest reading the following paper from the NY Fed:
http://www.newyorkfed.org/research/staff _reports/sr456.html

Executive Compensation and Risk Taking
June 2010 Number 456
JEL classification: G21, G34

Authors: Patrick Bolton, Hamid Mehran, and Joel Shapiro

Abstract
This paper studies the connection between risk taking and executive compensation in financial institutions. A theoretical model of shareholders, debtholders, depositors, and an executive suggests that 1) in principle, excessive risk taking (in the form of risk shifting) may be addressed by basing compensation on both stock price and the price of debt (proxied by the credit default swap spread), but 2) shareholders may be unable to commit to designing compensation contracts in this way and indeed may not want to because of distortions introduced by either deposit insurance or naive debtholders. The paper then provides an empirical analysis that suggests that debt-like compensation for executives is believed by the market to reduce risk for financial institutions.

Posted by ExaminerCarter | Report as abusive

Steven,

I’m a bankruptcy attorney. While the law varies from state to state, there is generally some sort of fiduciary duty to creditors when the company is or is nearly insolvent.

In some jurisdictions, this doesn’t give any creditors new rights – its just a gloss on the well-established creditors’ rights to bring suit to avoid fraudulent or preferential transfers.

In other states, directors’ loyalties are flipped to the creditors as the company approaches insolvency (the assets are treated as being held in trust for the creditors).

In yet a third group, the directors have a duty to maximize corporate value, not shareholder value, and so the court will judge whether the levering up was for the benefit of the corporation or just the shareholders.

Posted by AnonymousChef | Report as abusive

To Stephensaysyes,
We have a fundamental problem in the governance of financial institutions. Research on typical non-financial companies suggests that managers will take less risk than shareholders desire as they seek to exact rents. But there are certain countervailing incentives at financial institutions that cause managers to increase the risk they are willing to take (the moral hazard of deposit insurance and TBTF status). In addition, the high leverage of a financial institution makes equity based compensation more akin to options. So incenting managers to maximize the value of equity incents them to 1) maximize moral hazard risk, and 2) maximize leverage. Not socially productive things from a systemic POV.

Posted by ExaminerCarter | Report as abusive

Anonymouschef,
I imagine that these may be distinctions without difference, as financial firms will perceive they are solvent right up until the moment that they are not.

Posted by ExaminerCarter | Report as abusive

The last thing I’d want as a shareholder is for my CEO to be paid in debt. I want his interests aligned as closely as possible with my own. The debt owners never hesitate to destroy the shareholders. Governance would be awful.

-James Altucher

Posted by jaltucher | Report as abusive

AnonymousChef, that’s a good point. Firms on the brink of bankruptcy should clearly be managed with bondholders in mind.

ExaminerCarter, I agree that TBTF financial institutions are a special case where incentivizing managers to maximize equity value is dangerous.

Felix didn’t specify that debt compensation is a good idea primarily for financial firms or firms near insolvency. More generally, I don’t think that executives should be incetivized to protect naive bondholders at the expense of shareholders.

Posted by Stevensaysyes | Report as abusive

As long as US corporations run their accounting the way Bank of America does, you’ll never know how close they are to insolvency. And they won’t either.

It’s not just debatable accuracy in the numbers – it’s what you mean by “debt” in an age of shifting sands, which might boil down to anything a major corporation can’t get the taxpayer to pay for. Which by recent experience values equates to: “not a whole lot, really”.

The epitome of an American CEO in plausible denial these days seems to be not knowing your assets from a hole in the ground, but getting paid anyway.

Posted by HBC | Report as abusive

I wonder whether this could usefully be done in terms of bond covenants. In theory, that would reduce borrowing costs, and so the shareholders would be compensated in some proportion to what they might be giving up in terms of favor by the directors (equal to that cost in a Modigliani-Miller world).

Posted by dWj | Report as abusive

ExaminerCarter, that is because in alot of cases the financial firms ARE solvent until one day they are not.

HBC, you may have accidently said something intelligent, although I strongly suspect it is not what you actually meant. There is an artificial distinction between “debt” on one hand and “equity” on the other. Both are claims on the cash flows of the company, the standard distinction being that debt carries a fixed return and has priority on cash claims but these days there are many many hybrid products which are one thing to one regulator and another to another regulator.

Posted by Danny_Black | Report as abusive

Felix, think this guy is a little bit confused. He is confusing people who bought ABSes and the bondholders in the firms. Bond holders most certainly did NOT get screwed in the current environment – with the politically sensitive exceptions of the automakers where the current regime decided to screw bondholders to payoff the people who had caused the automakers to crash in the first place, organised labour.

With the notable exceptions of WaMu and LEH most holders in debt of financial orgs were made whole and it was equity holders who got shafted. Look at Fannie, Freddie, AIG, BSC, C etc. This bondholders got bailed out because they were politically sensitive, such as the chinese and Russians who stood to get killed if the GSEs defaulted or pension funds who invested in “safe debt”.

Also debt is usually considered LESS risky than equity. You are senior in the capital structure and like equity the most you can lose is your principal and you have a contractual arrangement to receive coupon payments unless you are a zero. The only thing that he says that sort of makes sense is that in a near insolvent company a bondholder has more incentive to force a bankruptcy than shareholders because of this seniority

Needless to say if your assumptions are wrong that casts doubt on your conclusions.

Posted by Danny_Black | Report as abusive