Capital Structure and Managerial Compensation: The Effects of Remuneration Seniority
CentER Working Paper No. 2000-101
34 Pages Posted: 16 Sep 2004 Last revised: 19 Oct 2018
We show that the relative seniority of debt and managerial compensation has important implications on the design of remuneration contracts. Whereas the traditional literature assumes that debt is senior to remuneration, we show that this is frequently not the case according to bankruptcy regulation and as observed in practice. We theoretically show that including risky debt changes the incentive to provide the manager with stronger performance-related incentives ("contract substitution" effect). If managerial compensation has priority over the debt claims, higher leverage produces lower power-incentive schemes (lower bonuses) and a higher base salary. With junior compensation, we expect more emphasis on pay-for-performance incentives. The empirical findings are in line with the regime of remuneration seniority as the base salary is significantly higher and the performance bonus is lower in financially distressed firms.
Keywords: seniority of claims, remuneration contracts, financial distress, insolvency, leverage
JEL Classification: G32, G33, G34, K12
Suggested Citation: Suggested Citation