The Problematic Case for Incentive Compensation in Bankruptcy

This article is a response to Professor Yair Listokin's article: Paying for Performance in Bankruptcy: Why CEOs Should be Compensated with Debt. In this response, I argue that the Professor Listokin's proposal is for empowering creditors' committees to bind all unsecured creditors to compensate managers with a vertical strip of unsecured pre-petition debt is, at best, duplicative of existing corporate governance mechanisms and, at worst, detrimental to good governance. As a general matter, the case for incentive compensation of kind in bankruptcy is weak. Bankruptcy has many more corporate governance safeguards than normal business operations, so it has less need for incentive compensation. Firms operate in bankruptcy under supervision of creditors, the United States Trustee, and the court, so management is much more constrained in its actions, and agency problems are less than in normal business operations. Moreover, the dynamics of the turnaround industry provide market discipline on managers of bankrupt firms. Professor Listokin's proposal would also impose considerable systemic costs. Giving creditors' committees binding authority of any sort has significant, if not prohibitive systemic costs on the bankruptcy process. It would require substantive consolidation of the different debtor entities in a firm as well as revision of the process of selecting and governing creditors' committees. Finally, Professor Listokin's proposal is based on assumptions about valuation, capital structure, and residual ownership that run contrary to empirical data and observation. A problem that bedevils all corporate governance reforms in bankruptcy is the difficulty in identifying the residual owner(s) ex-ante given the uncertainties of valuation and variations in capital structure. If the proposal's assumptions are relaxed to account for real world uncertainty, the incentive pay structure he proposes could exacerbate agency costs. Management compensation in bankruptcy is an important and understudied issue, but Professor Listokin's unsecured debt proposal is unlikely to be adopted by the market