Inside Debt and the Design of Corporate Contract

The following post comes to us from Divya Anantharaman of the Accounting Department at Rutgers University, Vivian Fang of the Accounting Department at Rutgers University, and Guojin Gong of the Accounting Department at Pennsylvania State University.

In the paper, Inside Debt and the Design of Corporate Contract, which was recently made publicly available on SSRN, we investigate whether debtholders recognize the incentive effects of executive debt-like compensation when contracting with the firm. Top executives in the United States are commonly compensated with both equity and debt. While prior research has examined the incentive effects of equity-based compensation extensively, most academic work has ignored the incentive effects of debt-like compensation. The greater the ratio of CEO debt-to-equity compensation to corporate leverage, the more aligned the CEO’s interests should be with debtholders vis-à-vis stockholders. If debtholders recognize these implications, we expect firms with higher CEO relative leverage to have lower cost of debt and fewer covenants restricting managers’ activities after debt issuance.

Using a sample of 1,462 new private loan facilities issued during 2006-2008, we find that as CEO relative leverage increases, lenders charge a lower cost of debt financing and reduce the usage of covenants in loan contracts, especially in firms with high default risk. These results are consistent with CEO debt-like compensation reducing stockholder-debtholder conflicts, and with debtholders recognizing this alignment.

We find that the negative relationship between CEO relative leverage and the cost of debt also holds with a sample of new public bond issues. However, CEO relative leverage does not seem to affect covenant usage in bond contracts, probably due to covenants being less valuable as a monitoring tool in public bond issues, compared to private loans.

Our study confirms that debt-like compensation is an important tool in the resolution of agency conflicts between stockholders and debtholders, and that debtholders incorporate such incentive alignment effects into debt contracting. Future research may explore the relative effectiveness of various institutional features of debt-like compensation (e.g. pensions, other deferred compensation schemes) in mitigating stockholder-debtholder agency conflicts.

The full paper is available for download here.

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