Maclean (Mac) Gaulin, Assistant Professor of Accounting at University of Utah’s David Eccles School of Business, has had a research paper conditionally accepted for publication at Contemporary Accounting Research (CAR), with an anticipated publishing in 2025. The paper, “CEO Short-Term Incentives and the Agency Cost of Debt,” was authored by Gaulin and professors Brian Akins (Rice University), Jonathan Bitting (Appalachian State University), and David De Angelis (University of Houston).

According to a summary provided by Gaulin, the paper investigates how a company’s debt influences the design of its CEO’s compensation package. Specifically, it shows that after violating a loan covenant (a condition in a loan agreement), companies tend to shift the CEO’s compensation towards shorter-term incentives. This means that CEOs are more likely to receive bonuses and stock options that vest quickly, rather than rewards tied to the company’s longer-term performance.

Here’s why this happens: When a company violates a loan covenant, it signals potential financial distress and gives more bargaining power to its lenders. To reassure these lenders and make renegotiation smoother, companies adjust CEO compensation to focus on short-term performance. This makes sense because lenders primarily care about the company’s ability to repay its debt in the near future.

The paper provides multiple pieces of evidence to support this argument. Using a large dataset of companies, the authors find a significant decrease in the time horizon of CEO pay following a technical covenant violation.

Furthermore, the paper explores how this relationship between debt and CEO pay varies under different circumstances. For instance, the effect is amplified when the remaining maturity of the loan is shorter. This is because lenders of loans that are near due are even more concerned about immediate repayment. Similarly, the effect is stronger when the company has lower cash reserves, as this indicates a higher risk of defaulting on its debt obligations.

Interestingly, the paper finds no evidence that shortening the CEO’s incentive horizon negatively impacts the company’s stock price. This suggests that investors understand the rationale behind this practice and don’t view it as detrimental to the company’s long-term health.

This research has important implications for understanding the dynamics between corporate finance and executive compensation. By demonstrating a clear link between debt covenants and CEO pay design, the paper offers valuable insights for various stakeholders:

• Investors can use this knowledge to better assess the risk profile of different companies. For instance, a company with a history of covenant violations and a CEO incentivized by short-term goals might be perceived as more focused on short-term debt management than long-term value creation.
• Boards of Directors can benefit from understanding the influence of debt on CEO compensation. By explicitly considering the company’s debt situation when structuring executive pay, boards can strike a balance between satisfying lenders and incentivizing CEOs to pursue long-term growth opportunities.
• Regulators can use these findings to inform policies related to corporate governance and financial stability. Understanding how debt covenants impact CEO behavior can help regulators design measures that promote responsible risk-taking and discourage excessive short-termism.

Professor Maclean’s background is in Electrical Engineering where he worked in the industry for four years before joining the Ph.D. program at Rice University. His research interests include corporate narrative disclosures, information demand and dissemination, and resultant economic outcomes.