Tuesday, August 17, 2010

CEOs and Debt

We have all become rather accustomed to the fact that executives of a company are often compensated for their services in part by equity in the corporation -- or, in the alternative, by options to buy equity.

Not only does this seem normal, there is a superficially plausible case to be made that it aligns incentives properly. A CEO with stock in the company has "skin in the game," as the saying goes.

There are two sides to that, though. As Roger Lowenstein wrote in ORIGINS OF THE CRASH (2004), "For an incentive to functiom properly, there must be a prospect of pain as well as gain" and the the 1990s dotcom bubble with which Lowenstein was concerned in that book, the very possibility of CEO pain was "trivialized."

Another common complaint about reimbursement through equity is that if executives see themselves as equity holders, they have an incentive to shift wealth away from debt holders, toward themselves and their fellow stockholders. How might they do this? By over-paying dividends, most obviously. If a company is in trouble (in the "zone of insolvency" as lawyers sometimes say, although not across that line yet) and it pays its shareholders a generous dividend anyway, then the company is essentially making sure the shareholders get cash while the 'gettin' is good.' That cash will never be available to pay off the bondholders should the company default and either voluntarily file bankruptcy or be pushed in that direction by debtor action.

So: if executives are compensated in stock, they may have a commonality of interests with their fellow shareholders, but this may express itself not in productive dcisions, but in beggaring other stakeholder groups.

What, then, about compensation in bonds? Perhaps a CEO who really wants to show us that he has skin in the game will load up on debt instruments issued by his company. Here is the recent discussion of that point that has gotten me thinking.

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