The neglected other side of politics-1

October 12, 2004

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Capital Structure and Executive Pay

Corporate governance (CG) is the "neglected other side of politics" because there are tens of thousands of web logs or newspaper columns covering political elections, but very view covering politics a little closer to the lives of most North Americans, Japanese, and Europeans: the politics of the corporations that employ us, design the products we consume, bombard us with advertising, and manage centuries worth of accumulated capital. In a way, this is understandable; businesses seek to maximize earnings and reduce uncertainty—two objectives that force the management to react to conditions. In contrast, those conditions traditionally have been determined by governments. That's far less likely to be true these days, in part because governments are now more directly and openly involved in the struggle to attract capital investment to their shores; partly because governments are faced with far stronger multinational corporations (MNCs), firms that are far less depend on the home market than in the past; and finally, because governments are far more sophisticated participants in the goods and currencies markets that they were just a couple of decades ago. Three recent papers published by the European Corporate Governance Institute (ECGI) broach the most urgent matters of how MNCs shape their policies in response to the climates in which they operate.

The first one, "Capital Structure is a sober analysis of the hot topic of executive compensation—a topic that was broached, as a matter of a fact, in Monday night's vice-presidential debates! The disconnect between what we pay the nation's top corporate managers and the performance of companies on their watch, has spawned both vitriol and exotic new theories. The matter is an urgent one in part because US-based MNCs have generally tended to compensate for their terrible management at the expense of the American taxpayer/worker and at the expense of the Third World.

Main Points in "Capital Structure"

1. The choice of which creditors to pay in the event of a firm going bankrupt is of urgent importance. Debt paid first is called "senior"; debt paid later, if a t all, is "junior." According to the laws of the UK and the US, first claims on the liquidated assets of a bankrupt company go to taxes, then to wages. However, in both countries bankrupt companies usually are run under management ("Chapter 11" in the USA), because this is expected to capture more money for creditors; and often the receiver elects to honor obligations to management (PDF-34; p.23).
2. In the USA, large firms enter Chapter 11 under the provision "debtor-in-possession," or self-administered penance for absolution. This is mentioned in the appendix twice, but it ties into the broader theme of managerial incentives: management is rewarded very handsomely and does not, contrary to the intent of the law, face a profound penalty for total failure.
3. Management of a financially distressed firm can often protect their gains by transferring profits to a subsidiary, or cashing out options. These and other methods introduce an element of moral hazard so large it has a macroeconomic effect on capital structure.
4. The seniority of debt incurred by a firm is part of its capital structure that, according to the authors, helps determine the incentive package that directors are likely to approve. If the debt is more junior, then pay-for-performance compensation—like stock options—is less, while base pay is more. If the capital structure is dominated by senior debt, then base pay will be lower, and performance sensitivity higher.
5. In order to test this, they used a constrained optimization function:

   We will consider a risk-neutral principal and a risk averse agent. If the manager accepts the contract at t = 1, she then chooses a non-verifiable effort level, e in an interval Λ = [0, e], that affects the probability distribution of the final cash flows. We assume for simplicity that, at t = 2, the firm can only produce a high cash-flow q₁ or a lower cash flow q₀8 without any earnings maturing at time one. For the moment, we assume that, once in place, the manager cannot change the pre-existing capital structure, which is given at the moment of the contract negotiation.
   [p.8]

   In fine, the principal (CEO, executive, what-have-you) seeks to minimize effort on her own part, while maximizing remuneration. The agent (the shareholders) presumably seeks to maximize return. This was used to configure empirical panel data regression.
6. The model examined the incentives to capital structure as well: whether or not the principal was motivated to alter the capital structure of the firm to favor seniority or juniority. One way of doing this would be to make the capital structure more junior by issuing more stock; more senior, by borrowing more or deferring taxes.
7. From the constrained optimization problem they derive the following empirically testable predictions—(a) The relative seniority of managerial remuneration and debt claims determines the managerial compensation schemes: when compensation is senior to debt in case of financial distress, higher leverage reduces the performance incentives, but increases the basic salary; and (b) If the relative priority of managerial compensation over debtholders’ claims is left unspecified, the cost of debt should be higher than in a situation in which such a priority is legally enforced ex-ante. [p.14] So, for example, Enron's top management managed to ensure that they got their compensation fast and secure, while the debt was left behind for the receivers to sort through. The authors established that this state of affairs tended to increase the base salary relative to performance bonuses. Prediction (b) implies that, if a future firm with Enron's financial and managerial configuration were to appear, and auditors were trying to establish the likelihood of it failing (and therefore, the appropriate cost of debt) then they would need to see if the seniority of CEO pay had been established. If the answer was "no," then the debt should be high.
8. The authors tested their propositions using 250 listed UK companies, randomly chosen from a notorious era in recent British business history [pp.14-17]. These results were, naturally, what I was trying to get at. One that confirmed my own pre-conceived notion was that, if the firm was closely held, manager pay was relatively low; this helps explain why major Japanese and Continental European firms tend to pay their top managers far less (traditionally, in Germany the prevailing ownership model is the Stiftung; in Italy, the IRI state holding company; in Japan, the keiretsu; in Korea, the chaebol.
9. The main results were that executive base salary was higher when leverage was lower, but performance incentives were lower in the same period. Also, bearing out the authors' predictions, base salary was lower when company leverage was higher, and performance incentives were higher.

That such a basic matter (as the firm's principals choosing to maximize long-run return-on-equity) should be contingent on bankruptcy laws, is stunning. I'll probably return to this in a little bit. SOURCES: Riccardo Calcagno and Luc Renneboog, "Capital structure and managerial compensation: the effects of remuneration seniority"