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Executive Compensation and Corporate Governance in Financial Firms: The Case for Convertible Equity-Based Pay

Jeffrey N. Gordon

Columbia Law School; European Corporate Governance Institute (ECGI)

July 9, 2010

Columbia Law and Economics Working Paper No. 373

Unlike the failure of a non-financial firm, the failure of a systemically important financial firm will reduce the value of a diversified shareholder portfolio because of an increased level of systemic risk. Thus diversified shareholders of a financial firm generally internalize systemic risk whereas managerial shareholders and blockholders do not. This means that the governance model drawn from non-financial firms will not fit financial firms. Regulation that limits risk taking by financial firms can thus provide a benefit, rather than necessarily impose a cost, for the typical diversified public shareholder. Managerial shareholding also gives rise to particular problem of the CEO who, despite the increasing precariousness of the firm’s position, may be reluctant to pursue equity infusions or to sell the firm because of the consequent dilution of his ownership stake. This might be called the “Fuld problem.” To mitigate excessive risk-taking both in ordinary operations and as the firm approaches financial distress, the paper proposes a new compensation mechanism for senior managers, convertible equity-based pay. Upon certain external triggers, such as a downgrade into a high risk category by regulators or a stock price decline of a particular percentage, such stock-based compensation should convert into subordinated debt, at a valuation discount. This will give managers an incentive to curb excessive risk-taking and in particular to steer the firm away from financial distress.

Number of Pages in PDF File: 18

JEL Classification: E61, G28, G32, J33, K22, M52

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Date posted: July 4, 2010 ; Last revised: February 28, 2014

Suggested Citation

Gordon, Jeffrey N., Executive Compensation and Corporate Governance in Financial Firms: The Case for Convertible Equity-Based Pay (July 9, 2010). Columbia Law and Economics Working Paper No. 373. Available at SSRN: https://ssrn.com/abstract=1633906 or http://dx.doi.org/10.2139/ssrn.1633906

Contact Information

Jeffrey N. Gordon (Contact Author)
Columbia Law School ( email )
435 West 116th Street
Ctr. for Law and Economic Studies
New York, NY 10027
United States
212-854-2316 (Phone)
212-854-7946 (Fax)

European Corporate Governance Institute (ECGI)
B-1050 Brussels
HOME PAGE: http://www.ecgi.org
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