Personal Debt of CEOs as Pre-commitment

I’m interested in the topic of very high executive pay, which I’ve written about several times on this blog. The short version of my take: the expected payoff for getting the very best person, as compared to the second or third-best person, can be worth millions or even billions of dollars. So it’s worth shelling out for top talent. Also, once you snag this person, it’s worth coming up with some kind of incentive scheme to actually motivate them. A relatively low base-salary with generous bonuses for performance is probably better than a flat multi-million dollar base salary.

Another problem might be the following: Once you snag the best person, how do you ensure they stay snagged? If someone paid me a $5 million salary, I’d be very tempted to work for one year and then retire. A tiny fraction of the pay that a high-powered corporate executive makes over the course of their career would make a substantial nest egg for any mere mortal. Warren Buffet’s austerity aside, many CEOs have reputations for lavish spending and luxurious homes.

I’m curious if lavish spending can be a sort of commitment strategy for highly-paid executives. In The Smartest Guys in the Room, a book about the Enron crisis, there is a brief discussion of Ken Lay’s personal finances at the end of his tenure. Enron was basically trying to oust him, but he wouldn’t go quietly. It seems he’d racked up $20 million or so in personal debt, some no doubt from his own consumption, some from supporting various benefits and charities. He made sure to negotiate a nice severance for himself, because he had backed himself into a tough spot. (This is from memory, from a book I read in 2011. If any of the details don’t match the actual story, I’m sorry. In that case, please take this example as a hypothetical.)

In that particular case, the pre-commitment strategy backfired. Lay’s debt made it harder for Enron to get rid of him when they wanted to. But in normal times and for normal companies, it’s probably a good thing for a firm if their CEO is sweating a little about their personal finances. It means they’ll stick around. It solves the “What’s keeping this guy from working for a single year then leaving?” problem.

There are other solutions to this problem. “Debt as a pre-commitment” is surely a small piece of the answer. There’s always the good old contract. Just have a clause saying the new CEO will stay on for at least 5 years or something. This isn’t perfect. You might get two great years and then three lack-luster years as the CEO loses interest in the company and starts salivating over his early retirement. Contract or no contract, it’s impossible to make someone show up to work and perform to the peak of their ability if they just don’t wanna. Reputation has to be part of the answer, too. People have personal reputations for things like ambition, honesty, and so on. The board will consider these traits when they appoint their next CEO, looking for some assurance that the person will stick around. Maybe for the kind of person who is likely to climb to the top of a corporation, the “work one year, then retire early” option isn’t even appealing. Maybe the vetting/promotion process selects for people with a lot of raw ambition.

There is a broad literature on this topic of incentivizing executive performance. In the actuarial exam syllabus, there is a discussion of whether or not investors should let companies hedge their risks, and why or why not. The investors can hedge their own risks by investing broadly, so they don’t want the individual companies to blow a lot of money on expensive insurance policies or hedging strategies. But one reason to allow hedging has to do with incentivizing the executives. You want the executive to make a substantial investment in the company, the thinking goes, so they have skin in the game. But it hurts to lose skin, so CEOs will hesitate to invest more than they absolutely have to. Allow the CEO to hedge and protect their investment, and they’ll be prone to invest more of their own private wealth in the company. With more skin in the game, they’re on the hook for bad decisions, they’re more likely to take a long term view, and so on. This is another way to solve the problem described above. It will be hard for a CEO to leave and sell off their investment in their employer without losing a substantial chunk of their investment. A CEO’s surprise retirement is likely to make a company’s stock take a dive. Similar with a major shareholder selling off large quantities of stock. This is a good way for a CEO to tie himself to the mast.

Interestingly, Jeff Skilling, who succeeded Lay at Enron, seems to have tried some version of “work a single year then leave” strategy. Except he didn't quite make it a full year: 

On February 12, 2001, Skilling was named CEO of Enron, receiving $132 million during a single year….Skilling unexpectedly resigned on August 14 of that year, citing personal reasons, and he soon sold large amounts of his shares in the corporation.

Oops! Apparently it’s important to worry about this problem. The Smartest Guys In the Room fills in the details of his short tenure and unexpected resignation.