Inside Debt and the Design of Corporate Debt Contracts

Theory posits that managerial holdings of debt ("inside debt") align managers' incentives with those of outside debtholders. Executive pensions, consisting of rank-and-file (RAF) plans and supplemental executive retirement plans (SERPs), and other deferred compensation (ODC) have debt-like payoffs, and could therefore function as inside debt. However, whereas SERPs are often unfunded and unsecured, RAF plans are funded and secured to some extent, and ODC may be invested in equity and withdrawn flexibly before retirement. Special arrangements in executive debt-like compensation could hence weaken or even nullify any incentive-alignment effect. We find that higher CEO debt-like compensation leads to lower promised yield and fewer covenants in a sample of loans originated in 2006-2008. This effect is driven entirely by benefits accrued under SERPs, consistent with SERPs more closely resembling risky corporate debt; balances accrued under RAF and ODC plans do not provide similar effects. Furthermore, promised yields are lower when debt-like compensation claims can be withdrawn only after outside debt claims are expected to settle. Our findings persist after accounting for endogeneity using state personal income tax rates as an instrument for CEOs' willingness to defer compensation. Overall, the evidence suggests that executive debt-like compensation is only effective at resolving stockholder-debtholder conflicts when its payoffs are truly debt-like and that lenders' perceptions are affected not only by the magnitude of debt-like compensation but also by its seniority.