by Julie Connelly for Boardmember, April 2011.
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.” (continue reading… )