The relation between earnings-based measures in firm debt contracts and CEO pay sensitivity to earnings

Abstract

I investigate how implicit incentives provided by earnings-based debt covenants affect the structure of CEO compensation contracts. This provides a new and unique view of how the CEO[U+05F3]s incentives are shaped by not only his compensation contract but also debt contracts. I find when debt contracts contain an earnings-based covenant, the CEO[U+05F3]s pay sensitivity to earnings is muted. Additionally, I find some evidence that pay sensitivity to earnings varies with earnings-based covenant slack. This study provides evidence consistent with shareholders rebalancing the CEO[U+05F3]s earnings incentives in the presence of earnings-based covenants, thereby tilting incentives away from earnings performance.