Debt Dynamics in Executive Compensation

The prevailing agency theory framework in executive compensation studies highlights the conflict of interest between managers and shareholders. Our study extends the literature by examining the incorporation of debt-related performance metrics (DPMs), such as credit ratings and debt-to-EBITDA ratios, into executive compensation contracts. Using a manually collected dataset, we find that approximately 19% of US publicly traded firms incorporated DPMs in their compensation contracts between 2007 and 2020. The likelihood of including DPMs increases after creditors’ monitoring incentives increase due to credit quality deterioration or debt maturity pressure. To allow causal inferences, we use the exogenous default of lenders' other clients and observe that focal companies are more likely to include DPMs in compensation contracts when lenders perceive an increased likelihood of future default. We demonstrate shareholders incorporate more non-debt metrics in their incentive programs in response to DPM inclusion. Our results indicate that firms with DPMs in compensation contracts reduce future R&D intensity and SG&A expenses. Our study highlights the importance of debt-related factors in executive compensation and contribute to understanding the agency costs of debt