Creditor Control Rights and Executive Bonus Plans

We study whether and how creditors exercise their control rights to shape their borrowers’ executive compensation plans. Highly levered borrowers often face incentives to underinvest due to agency conflicts driven by differences in time horizon and risk-taking preferences between managers and creditors. Thus, we expect that creditors exert their control to ensure that their borrowers’ executive compensation plans encourage investments with longer-term payoffs and provide more direct rewards for profitable outcomes. We also argue that executives’ bonus plans become relatively more important in these instances because their flexibility (e.g., potentially non-linear and non-monotonic payoffs) allows creditors to target specific investment objectives. We find that borrowers’ bonus plans tend to have longer horizons and more convex payouts when their creditors acquire more control following covenant violations. Our evidence suggests that creditors exercise their influence to shape their borrowers’ executive compensation plans in ways that protect their interests.