Should We Pay CEOs With Debt?

This problem of “risk-shifting” has long been known, but is difficult to solve. One remedy is for bondholders to impose covenants that cap a firm’s investment. But covenants can only restrict the level of investment – they cannot distinguish between good and bad investment. Thus, covenants may unduly prevent good investment. A second remedy is to cap executives’ equity ownership – but this has the side-effect of reducing their incentives to engage in productive effort.

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