M & A Law Prof Blog

Editor: Brian JM Quinn
Boston College Law School

Monday, April 16, 2012

Inside debt

My colleague, Brian Galle, and his co-author Kelli Alces have just posted a paper, Is Inside Debt Efficient?.  During the post-financial crisis there has been a lot of thought about executive compensation and the role that it might have played in encouraging excessive risk taking and what to do about it. One common suggestion is the use of inside debt to incentivize executives.   Galle and Alces are less sanguine about the efficacy of inside debt to postively influence managers' behavior.  Instead, inside debt may unnecessarily complicate manager incentives.

 Abstract: The average publicly-traded firm pays its CEO millions of dollars in deferred compensation and defined-benefit pension commitments. Scholars debate whether firms use these payments to efficiently align managerial interests with those of creditors, or whether instead they represent “hidden” forms of rent extraction. Yet others recommend these forms of debt-like incentive compensation, sometimes called “inside debt,” as a way of controlling risk-taking in systemically important financial institutions. 

We argue instead that inside debt is unlikely to be efficient in either setting. Inside debt is costlier and more complex than other tools for managing risk, such as covenants or simply cutting back on option pay, and gives managers opportunities to hedge their equity positions without revealing that fact to investors. Drawing on the behavioral literature, we also show that increasing pay complexity is likely to reduce the efficacy of all forms of manager incentives. 

To test these hypotheses, we conduct a series of panel regressions utilizing matched CEO and firm data covering over 1300 firms during the period 2007 to 2009. Under most specifications, we find little evidence that current borrowing needs correspond with executive pay structures. We do find, however, significant relations between the use of pensions and markers of managerial power, markers of board risk aversion, and lagged firm debt levels.



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