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Executive Compensation When Agency Costs Are Low M University of Chicago Law School Chicago Unbound Coase-Sandor Working Paper Series in Law and Coase-Sandor Institute for Law and Economics Economics 2006 Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs Are Low M. Todd Henderson Follow this and additional works at: https://chicagounbound.uchicago.edu/law_and_economics Part of the Law Commons Recommended Citation M. Todd Henderson, "Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs Are Low" (John M. Olin Program in Law and Economics Working Paper No. 306, 2006). This Working Paper is brought to you for free and open access by the Coase-Sandor Institute for Law and Economics at Chicago Unbound. It has been accepted for inclusion in Coase-Sandor Working Paper Series in Law and Economics by an authorized administrator of Chicago Unbound. For more information, please contact [email protected]. CHICAGO JOHN M. OLIN LAW & ECONOMICS WORKING PAPER NO. 306 (2D SERIES) Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs Are Low M. Todd Henderson THE LAW SCHOOL THE UNIVERSITY OF CHICAGO September 2006 This paper can be downloaded without charge at: The Chicago Working Paper Series Index: http://www.law.uchicago.edu/Lawecon/index.html and at the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract_id=927081 Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs Are Low M. Todd Henderson† Conventional wisdom suggests that high agency costs explain the (excessive) amounts and (inefficient) forms of CEO compensation. This paper offers a simple empirical test of this claim and the reform proposals that follow from it, by looking at pay practices in firms under financial distress, where agency costs are dramatically reduced. When a firm files for Chapter 11 or privately works out its debt with lenders, sophisticated investors consolidate ownership interests into a few large positions replacing diffuse and disinterested shareholders. These investors, be they banks or vulture investors, effectively control the debtor during the reorganization process. In addition, all the other players in compensation decisions—boards, courts, and other stakeholders—play a much more active role than for healthy firms. In other words, agency costs are much lower in Chapter 11 firms. Accordingly, if pay practices look the same in bankruptcy as they do in healthy firms, we can conclude that either (1) the current practices are efficient, or (2) that proposals to change executive compensation by reducing agency costs are incomplete. The data support one of these hypotheses: amounts and forms of compensation remain largely unchanged as agency costs are reduced, and look similar to those of healthy firms. † Assistant Professor, University of Chicago Law School. J.D., University of Chicago Law School; B.S.E., Princeton University. DRAFT – 8/28/06 I. INTRODUCTION..............................................................................................................................................3 II. THE LANDSCAPE OF EXECUTIVE COMPENSATION...........................................................................6 A. COMPENSATION THEORY: “OPTIMAL CONTRACTING” VERSUS “MANAGERIAL POWER”....................................7 1. Optimal contracting....................................................................................................................................7 2. Managerial power ......................................................................................................................................8 B. REFORM PROPOSALS – INSTITUTIONAL INVESTORS AND POWERFUL BOARDS AS SAVIORS..............................10 1. Theoretical studies and proposals............................................................................................................10 2. Empirical studies......................................................................................................................................11 III. THE POWER OF CAPITAL PROVIDERS IN CHAPTER 11..............................................................12 A. MONITORING AND DISCIPLINE OUTSIDE CHAPTER 11.....................................................................................13 1. Costs of monitoring ..................................................................................................................................13 2. Benefits of monitoring ..............................................................................................................................15 B. MONITORING IN CHAPTER 11.........................................................................................................................16 1. Consolidating ownership interests reduces monitoring costs...................................................................17 2. The impact of financial distress on other monitoring costs......................................................................20 IV. BARGAINING FOR COMPENSATION IN THE SHADOW OF CHAPTER 11................................22 A. BARGAINING DYNAMICS................................................................................................................................22 1. Management power ..................................................................................................................................25 2. Creditor power .........................................................................................................................................27 B. MONITORING AND RECONTRACTING IN CHAPTER 11.....................................................................................29 1. Creditors as monitors ...............................................................................................................................29 2. Directors as monitors ...............................................................................................................................32 3. Judges as Monitors...................................................................................................................................36 4. Other Monitors .........................................................................................................................................39 V. AN EMPIRICAL LOOK AT COMPENSATION IN FINANCIALLY DISTRESSED FIRMS ..............40 A. THE DATA ......................................................................................................................................................40 TABLE 1.....................................................................................................................................................................41 B. CEO TURNOVER.............................................................................................................................................41 C. COMPENSATION TYPES AND METHODS ...........................................................................................................42 1. General contracts .....................................................................................................................................43 2. Example case study – New CEO of WorldCom ........................................................................................48 D. COMPENSATION LEVELS IN FINANCIALLY DISTRESSED FIRMS ........................................................................49 1. Cash compensation...................................................................................................................................49 2. Equity compensation.................................................................................................................................54 3. Total compensation ..................................................................................................................................57 VI. CONCLUSION............................................................................................................................................58 2 DRAFT – 8/28/06 I. INTRODUCTION The ongoing and increasingly vociferous debate about executive compensation boils down to a simple question of whether current compensation practices are a solution to the agency problem created by the separation of ownership and control in large public companies, or rather attempts by powerful managers to extract rents from under-incentivized owners—that is, evidence of the agency problem itself.1 Legions of academic articles in the law, finance, and economics literature have offered theoretical and empirical evidence in support of both sides of this debate without resolution. In fact, an entire issue of the Journal of Corporation Law was recently devoted to the book-length critique of executive compensation by Bebchuk and Fried.2 The book claims that managers abuse the power of their office to extract rents from the corporation, and that the solution is an increased monitoring role for boards and/or large, institutional shareholders. In other words, reducing agency costs will lead to lower and/or different forms of executive compensation. This paper offers a test of this critique and proposed reform by examining compensation practices in firms under financial distress, where agency costs are dramatically reduced as sophisticated investors consolidate ownership interests and assert significant control over firms in precisely the way critics propose will solve the pay problem for all firms. If compensation practices remain largely unchanged in these cases, one
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