The interrelationship between top-management compensation and the design and mix of external claims issued by a firm is studied. The optimal managerial compensation structures depend on not only the agency relationship between shareholders and management, but also the conflicts of interests which arise in the other contracting relationships for which the firm serves as a nexus. We analyze in detail the optimal management compensation for the cases when the external claims are (1) equity and risky debt, and (2) equity and convertible debt. In addition to the role of aligning managerial incentives with shareholder interests, managerial compensation in a levered firm also serves as a precommitment device t o minimize the agency costs of debt. The optimal management compensation derived has low pay-performance sensitivity. With convertible debt, instead of straight debt, the corresponding optimal managerial compensation has high pay-to-performance sensitivity. A negutiue relationship between pay-performance sensitivity and leverage is derived. Our results provide a reconciliation of the puzzling evidence of Jensen and Murphy (1990) with agency theory. Other testable implications include (1) a relationship between the risk premium in corporate bond yields and top-management compensation structures, and (2) the announcement effect of adoption of executive stock option plans on bond prices. The model yields implications for management compensation in banks and Federal Deposit Insurance reform. Our results explain the dynamics of top-management compensation in firms going through financial distress and reorganization.

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The interrelationship between top-management compensation and the design and mix of external claims issued by a firm is studied. The optimal managerial compensation structures depend on not only the agency relationship between shareholders and management, but also the conflicts of interests which arise in the other contracting relationships for which the firm serves as a nexus. We analyze in detail the optimal management compensation for the cases when the external claims are (1) equity and risky debt, and (2) equity and convertible debt. In addition to the role of aligning managerial incentives with shareholder interests, managerial compensation in a levered firm also serves as a precommitment device to minimize the agency costs of debt. The optimal management compensation derived has low pay-performance sensitivity. With convertible debt, instead of straight debt, the corresponding optimal managerial compensation has high pay-to-performance sensitivity. A negative relationship between pay-performance sensitivity and leverage is derived. Our results provide a reconciliation of the puzzling evidence of Jensen and Murphy (1990) with agency theory. Other testable implications include (1) a relationship between the risk premium in corporate bond yields and top-management compensation structures, and (2) the announcement effect of adoption of executive stock option plans on bond prices. The model yields implications for management compensation in banks and Federal Deposit Insurance reform. Our results explain the dynamics of top-management compensation in firms going through financial distress and reorganization. INTERNAL INCENTIVE STRUCTURES DETERMINE how individuals behave in or-ganizations and their role is critical to developing a viable theory of the firm. Although the economic theories of agency and optimal contracts have provided some framework to think about the structure of management compensation, our understanding of compensation arrangements in large organi-* The authors are from the Stern School of Business, New York University. The paper has benefited from the comments of (Rutgers University). We are especially grateful to Rick Antle, Hayne Leland, Kevin Murphy, and an anonymous referee for extensive comments on an earlier draft. Financial support was provided by Stern School summer research grant (Teresa John) and a Bank and Financial Analysts Faculty Fellowship (Kose John). 950The Journal of Finance zations is still primitive. Many common features of organizational incentive systems such as pay systems with extremely low response to performance, the extensive use of promotion-based incentive systems, tenure, and up-or-out promotion systems all require more extensive study by economists.In this paper the design and characteristics of top-management compensation contracts are studied. In particular, we examine how the design and mix of external claims issued by the firm determine the optimal management compensation structure. The agency theory framework employed in most of the prior theoretical studies ...

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