The Prime Directive

Much of the discussion in corporate law centers on executive compensation. While there is a debate over whether the current system is better described as mangers capturing directors so as to pad their pay packet or as the the result of a competitive market, all share the notion the goal of executive compensation is to align the incentives of the managers with the shareholders. Such an alignment may be important, but it is an odd place to start dicussions of corporate governance.

When we think of other organizations, we don't attribute their success to the compensation contracts that are in place. No one attributed the Chicago White Sox winning the World Series to the contracts that employed Ozzie Guillen and the players. When law faculties participate in a dean search, no one asks whether the administration is going to give the new dean a contract that will ensure that she is a faithful agent.

The key task (or as a paper that Douglas Baird and I are working on label it, "The Prime Directive") is to first hire the right person as CEO. After this, the second challenge is to ensure that the CEO is shown the door at the appropriate time. Picking the right leader is no trivial task. Sometimes the promise that the Board saw in the person selected as CEO does not materialize. Othertimes, the challenges that confront the business change. The person who was needed to push through the merger to change the corporate focus may not be well suited to overseeing the integation of the companies.

Leaving the hiring and firing decisions to the board itself may present problems. Human behavior suggests that the Board that reached consensus on the person to lead the company may be too slow in recognizing that a change needs to be made. Moroever, the CEO often can control to some extent the information that the Board receives.

In terms of the hiring decision, law plays at best a modest role. It can remind the directors that they should be looking for a leader who will maximize shareholder value, but it cannot identify which candidate would best accomplish this.

On the firing side, however, law can have a large impact. An underappreciated role of private debt is that it can lead to the dismissal of under-performing managers. Private debt contracts contain numerous covenants. Running afoul of a covenant will trigger a discussion with the lender. While the lender does not necessarily know how to run the business, it needs to have faith in the management team. The CEO who can convince the Board that hired her that things are in fact fine may have more difficulty making the case to the workout group at the bank.

In policing the bank-borrower relationship, law can influence the discussion. Doctrines such as lender liability, equitable subordination, and the tort of deepening insolvency, if pushed too far, can make lenders hestitate, thus prolonging the tenure of managers that need to go.

Comments

[ToddHenderson]

Welcome! Nice point. It relates to a paper I'm writing on the role of credit derivatives in corporate governance. Do you have any idea what the rise of new loan risk sharing mechanisms, like credit default swaps, has on this analysis? The credit derivative market has grown tremendously in recent years, allowing banks--who write these covenants that you rely on--to offload loan risk, and thus the reason for vigorously enforcing the covenants, onto others, such as insurance companies, hedge funds, and smaller banks. One can imagine a variety of market-style mechanisms that keep firms from obvious moral hazard problems when it comes to investment decisions (e.g., rating agencies rating loans, which they do now, reputation effects, etc.), but the case you mention might be one in which these mechanisms are less effective. Any thoughts?

[ToddHenderson]

How do you respond to the following baseball quote attributed to a variety of managers: "Give me 9 guys in the last year of their contract, and I'll win the pennant." This intuition is buttressed by some statistics, showing that production (along various metrics) for the average player increases dramatically in a player's contract year, that is, the year before they go on the market, and then falls steadily and significantly thereafter. This phenomenon doesn't happen as often for truly great players, but these are anomalies. Doesn't this suggest that incentive contracts really matter?

[BobRasmussen]

Todd raises a couple of nice points. The first has to do with the stability of the current system. In addition to credit default swaps which Todd brings up, there is also the secondary loan market. Most syndicated loans these days are traded on these markets. While it used to be the norm that the lead bank would take a big chunk of the loan and hold onto it, this norm may be changing. It is still unclear what the effect of these changes will be. Before, the lead bank would take primarily responsibility for monitoring and holders of the loan would generally go along with their recommendations. On the one hand, things like credit defaults and the ability to sell you interest may lessen the incentives for the lead bank. On the other hand, the folks that are buying loans in the secondary markets are not passive investors. They make their own decisions on whehter to go along with waivers and the like.

As to incentive contracts, sure they matter, and I would never contend otherwise. But the main point is that they are limited by the human capital of the CEO. Give me Kobe's contract, and I'm still a terrible basketball player. Also, it is unclear to me that it is as hard to induce effort from the type of person who wins the tournament to become CEO as it is to induce performance from a 20-something athlete.

[ToddHenderson]

Thanks for the response, Bob.

As to the point about Kobe's contract, I think the important thing to focus on is the marginal case. Sure, you won't be converted into a great hitter under the right incentive contract, but is the .250 hitter going to be a .300 hitter if he knows that it will make him millions? The data suggests that, again in the marginal case, the answer is "yes". The great players and the terrible players aren't impacted by this, but the average guy is. What might we take away from this:

First, does this finding also obtain for CEO contracts? If we looked at CEOs in the last year of their contracts, do we see them performing better? You could look at firm performance, say Total Return to Shareholders, in the final year of a CEO's multi-year contract (something they all have), to see how it compared with the prior several years and the followng several years. You'd have to adjust for all the other confounding variables, but it seems like an easy empirical test. If it looks like the baseball data, the performance (for the average guy) will ramp up to the final year (or be flat then peak in the final year), and then will fall off like a curve of radioactive decay. Stock option vesting rules and the like may complicate things, but it seems like you could correct for this.

Second, it is interesting that the incentives that work (at least in the baseball case) are not micro incentives but macro incentives: players are motivated not as much by individual contractual incentive clauses like "if you get 200 hits we'll give you $100,000" or "make the All-Star team and we'll give you a new truck" as by the total value of a new contract in free agency, that is, the implicit knowledge that if you play great in the last year of your contract, you'll strike it rich with your team or another. This might suggest that firms should rely less on narrowly tailored incentives (like meeting sales targets) and focusing more on the big picture, like the stock price. While this was the norm for years, there is some evidence that it is changing, with firms going more to the micro or itemized approach. The literature on incentives and the above intuition suggests this is a mistake.

Third, the fact that it is the marginal case where incentives work, suggests, perhaps counter-intuitively and counterfactually, that folks like Jack Welch and Michael Eisner don't need the incentive contracts; they'll do it anyway, for the love of the game. So why do they get such big incentives? Maybe their contracts send important signals to those marginal employees down in their organization. This seems related to your point about motivating CEOs versus 20-something athletes. I think that the right way to make this distinction is along a scale of greatness, not age.

[James]

I'm not sure I understand Professor Henderson's latest analysis. Why would it be the case that the best and worst CEO's aren't really affected by contractual incentives, but the middle ones are? One can imagine these variables (skill of CEO and responsiveness of CEO performance to incentives) being completely uncorrelated.

To put it another way, I don't read Rasmussen as saying that the Kobe's of the world disprove the importance of contractual incentives. Rather, Rasmussen is making a point about the relative importance of talent identification vs. optimal contracts. You're better off hiring Kobe and setting up a contract that extracts x% effort than you are hiring me and extracting 100% effort for just about any positive x. This is not to say that x doesn't matter, it's just a shift in emphasis to what seems to be the more important variable.

What's more, I suspect that Rasmussen would agree that at some point the board's marginal dollar is best spent figuring out a good contract instead of continuing the search for the next Kobe, or the next Jim Kilts:
http://www.theonion.com/content/node/33930
He is simply pointing out that the opposite seems to be the case for academia - the marginal hour is better spent understanding the selection process.

[Dirk van de Broek]

worst CEO's are always gettingthe long end of the stick