Debt-Based Pay May Give Much-Needed Balance

When business takes a bad turn, managers whose compensation only ever contains equity-like instruments, such as stock and options, are often tempted to take bigger risks in a last-ditch attempt to salvage their firms. But even if their firms go down in flames, these managers usually emerge with fewer scars than those unfortunate bondholders saddled with the resulting debt. The litany of corporate failures in the United States and elsewhere remains fresh in everyone’s memory. This article is based on a paper originally written with Qi Liu of Wharton, forthcoming in the Review of Finance, which has attracted considerable attention for being the first to show that debt compensation can be an optimal element in executive compensation, particularly when a company faces financial difficulties. Instead of the typical practice of paying top managers heavily with stock, the author suggests giving them debt-like securities, such as bonds, pensions or deferred compensation, or linking their bonuses to the price of debt or to a firm’s credit rating or credit default spread. He suggests what proportion of a manager’s compensation should be issued in debt: equal proportions of debt/equity if the manager only ever takes project-selection decisions; less so in situations when a CEO has to take decisions in which “effort” is a key variable, depending on whether effort has a greater effect on the firm’s solvency value or liquidation value. With new evidence emerging that an estimated 13 percent of CEOs hold a greater percentage of debt than equity in their firms, along with recent moves by A.I.G. and others in a similar direction, the author feels that this compensation model is an idea whose time has come.