Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs Are Low

I. INTRODUCTION The ongoing and increasingly vociferous debate about executive compensation boils down to a simple question: whether current compensation practices are a solution to the agency problem created by the separation of ownership and control in large public companies, or, alternatively, attempts by powerful managers to extract rents from underincentivized owners-that is, evidence of the agency problem itself.1 Legions of academic articles in law, finance, and economics literature have offered theoretical and empirical evidence in support of both sides of this debate. An entire issue of the Journal of Corporation Law was recently devoted to the book-length critique of executive compensation by Lucian Bebchuk and Jesse Fried.2 Bebchuk and Fried claim 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, large institutional shareholders, or both. In other words, reducing agency costs will lead to executive compensation that is lower or takes a different form. This Article 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 might conclude that existing practices are by and large efficient or, at the very least, that proposed reforms to increase the role of boards or institutional investors in order to reduce managerial rent seeking are misplaced or incomplete. The data supports this hypothesis. We see that employment contracts for managers of firms in bankruptcy written by sophisticated investors with controlling stakes in the debtor look nearly identical in form and amount to those written in higher agency cost environments. In other words, this Article argues that reducing agency costs does not cause material changes in the fundamental nature of compensation bargains. There are two competing schools in the current executive compensation debate. The so-called optimal contracting school views typical compensation packages as fair and efficient bargains struck between principals (various "owners") and agents (management). According to this school, employment contracts are designed to align incentives among corporate participants with different risk profiles and investments in the firm, and various market forces (for labor, for products, for control) constrain managerial rent seeking. These forces create a negotiation dynamic that approximates arm's-length bargaining between managers and owners. Critics-the so-called managerial power school-believe that CEOs are often overpaid and inefficiently paid, and that pay practices represent a taking advantage of, rather than a solution to, the agency problems in large public firms.3 According to this theory, managers are able to extract significant rents because distant, diffuse, and disinterested shareholders are unable or unwilling to discipline managers, and because the board is captured and manipulated by the CEO. A CEO accomplishes this by selecting sympathetic board members and by using a variety of monetary rewards and psychological pressures to make the board a mere instrumentality of her will, especially when it comes to compensation decisions. The obvious solution that follows is to weaken the power of CEOs by partially or completely reuniting "ownership" and "control." The mechanism proposed for achieving this reunification is empowering either large shareholders (typically so-called institutional investors) or directors to play a more active role in the management of the firm as a counterpoise to management. In both cases, the core idea is to increase the power of shareholders vis-a-vis managers. …