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Skin in the Game

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from First Quarter 2011
Corporate Board Member
by Julie Connelly

There is a fresh idea about paying CEOs to take less risk that is coming out of academic research. Studies emanating from New York University’s Stern School of Business, The Wharton School at the University of Pennsylvania, Boston University School of Law, and the Goizueta Business School at Emory University conclude that to the extent CEOs have more debt-like instruments in their pay mix, they will become more risk-averse and manage more cautiously. Today, when all boards are supersensitive about risk and want to create pay packages that motivate their chieftains to take prudent gambles but not to swing for the fences, increasing the CEO’s level of debt seems particularly fetching. Yet, the idea has not caught on among comp committees, likely because when academic theory meets the real world of setting pay, it begins to break down. “The major part of having skin in the game is still telling the CEO that he needs to have some multiple of pay in stock that he holds until retirement,” says David Gordon, a compensation consultant in the Los Angeles office of Frederic W. Cook & Co. “There is no trend in the direction of raising the inside debt at this stage.”

The debt-like instruments the academics are focusing on consist of SERPs (supplemental executive retirement plans) and deferred compensation accounts, which together are known as inside debt. These are, in effect, corporate IOUs and are not guaranteed obligations of the employers. Should a company go bankrupt, the CEO will have to line up with all the other unsecured creditors to get whatever he or she can. As New York University finance professors David Yermack and Rangarajan Sundaram observed in 2007 from studying CEO pay at 237 large companies: “When managers hold large inside debt positions, the expected probability of the firm defaulting on its external debt is reduced, consistent with a hypothesis that these managers operate the firm conservatively in order to protect debt values.”

The concept of inside debt is not new, but SERPs and deferred compensation accounts were never disclosed in any detail until the SEC changed its rules on compensation disclosure in 2006. What is new, says Christopher Young, national compensation practice leader in the New York office of Buck Consultants, “is thinking about the SERP and deferred comp as vehicles for motivating behavior.” Equity encourages risk taking; debt discourages it. Boston University law professor Frederick Tung and Goizueta Business School assistant accounting professor Xue Wang looked into the compensation of 82 bank CEOs in 2006 and then tracked the performance of their banks between July 2007 and year-end 2008. They found that: “In general, financial institutions with higher CEO inside debt/equity ratios before the crisis perform better, have lower risk exposure, and issue less risky loans during the crisis than those with lower CEO inside debt/equity ratios.”

Most companies are trying to grow and those boards don’t want risk-averse CEOs, but troubled companies may need them. That’s why, as of this writing, perhaps the only company that is trying to link CEO pay with debt to reduce risk is the imperiled AIG, which is operating under federal pay curbs. In May 2010, the big insurer yoked incentive pay for its top executives to the performance of its junior debt. Alex Edmans, an assistant finance professor at the Wharton School, notes that the real payoff from inside debt comes when a firm is teetering toward bankruptcy because such a scenario motivates CEOs— unsecured creditors, remember—to focus on liquidation value. They won’t try to “gamble for resurrection,” as Edmans puts it, hoping to salvage their worthless equity, because failure will destroy the value of their SERPs and deferred comp as well. Tung discovered that his bankers held substantially less inside debt relative to their equity than did CEOs at nonfinancial firms. With the view of hindsight, the results were predictable—the bankers took too many risks and wiped out creditors as well as shareholders.

How much inside debt is enough to affect risk taking? David Yermack, who wrote the first paper in 2007 that kicked off this line of research, believes the right level for the CEO is the same as the corporation’s debt/equity ratio. If the firm is leveraged one-third debt to two-thirds equity, the managers should be also. Where the leverage is modest, he thinks inside debt should also be modest, but all CEOs, he says, should have at least 10% of their compensation in debt as an insurance policy.

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