Corporate Governance and Executive Compensation in Financial Firms: The Case for Convertible Equity-Based Pay


CORPORATE GOVERNANCE AND
EXECUTIVE COMPENSATION IN

FINANCIAL FIRMS: THE CASE FOR
CONVERTIBLE EQUITY-BASED PAY

Jeffrey N. Gordon*

Unlike the failure of a nonfinancial firm, the failure of a
systemically important financial firm will reduce the value of
a diversified shareholder portfolio because of economy-wide
reductions in expected returns and a consequent increase in
systematic risk. Thus, diversified shareholders of a financial
firm generally internalize systemic risk, whereas managerial
shareholders and blockholders do not. This means that the
governance model drawn from nonfinancial firms will not fit
financial firms. Regulations that limit risk-taking by
financial firms can thus provide a benefit, rather than
necessarily impose a cost, for the typical diversified public
shareholder. Managerial shareholding also gives rise to a
particular problem of the CEO who, despite the increasing
precariousness of the firm's position, may be reluctant to
pursue equity infusions or to sell the firm because of the
resulting dilution of his ownership stake. This might be
called the "Fuld problem." To mitigate excessive risk-taking
both in ordinary operations and as the firm approaches
financial distress, this paper proposes a new compensation
mechanism for senior managers: convertible equity-based
pay. Upon certain external triggers-for example, a
regulatory downgrade into a high-risk category, deterioration

* Richard Paul Richman Professor of Law, Columbia Law School.
Fellow, European Corporate Governance Institute. The author would like
to thank John Armour, Steve Bainbridge, Patrick Bolton, Ron Gilson, Rob
Jackson, Kate Judge, Mark Roe, Amir Rubin, and Holger Spamann for
comments and conversations on this paper. Correspondence should be
addressed to jgordon@law.columbia.edu.



No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PA Y 835

in a key financial ratio, or a significant stock price drop-
such stock-based compensation should convert into
subordinated debt, at a valuation discount. This will give
managers an incentive to curb excessive risk-taking and, in
particular, to steer the firm away from financial distress.

I. Introduction ........................ ...... 835
II. Corporate Governance and Executive

Compensation at Financial Firms.... .......... 838
A. Financial Firm Shareholders and Systemic

Risk ................................ 838
B. Corporate Governance in the Financial Firm.....841

III. A New Compensation Problem in the Financial
Firm .................... ............... 848

IV. A New Compensation Mechanism: Convertible
Equity-Based Pay ................... ............. 850
A. Proposal One: Eliminate Equity-Based Pay for

Senior Managers of Systemically Important
Financial Firms .. ................ ............... 850

B. Proposal Two: Tie Senior Management
Compensation to the Value of the Firm's Debt
and Equity ..................... ...... 851

C. An Alternative Proposal: Convertible Equity-
Based Compensation .............. ........... 853

V. Board of Directors Adoption of Convertible Equity-
Based Pay as Solving a Fiduciary Duty Problem.......860

VI. Conclusion ......................... ...... 863

I. INTRODUCTION

The financial crisis of 2007-09 raises the question of
whether the traditional tools of corporate governance are
adequate to address the potentially perverse effects of
executive compensation in financial firms. The argument for
regulatory intervention is that the usual focus of corporate
governance-to align the incentives of managers and
shareholders-does not work sufficiently to constrain
financial firm risk-taking. This is because shareholders are



said not to internalize the costs of systemic risk associated
with financial firm failure.' The problem is exacerbated by
the moral hazard concerns associated with "too big to fail."2

The prospect of government rescue lowers the cost of capital
for large financial firms, increases the resources they deploy,
and thus exacerbates the systemic harm of their failure.
This compounds the stakes in compensation design. We
have reasonably effective compensation models for aligning
managerial and shareholder incentives, but not for building
in an exception for "excessive" risk-taking that may arise
because of this purported failure of internalization peculiar
to financial firms.

This Article does four things. First, it offers a new
account of the weakness of corporate governance tools in
addressing executive compensation in financial firms. The
problem is not the failure in fact of systemic risk
internalization-diversified shareholders do indeed face this
risk-but rather the intellectual failure to appreciate the
gap between shareholder and managerial interests, which is
unusually wide for systemically significant financial firms.
Thus, there is a "business case" for corporate governance
activism by the diversified shareholders who are the
majoritarian owners to address compensation structures that
exacerbate systemic risk. Regulatory intervention is
necessary because of shareholder collective action problems,
agency problems within managerial capitalism, and the
diversity of shareholder interests both within and across

1 See Jeffrey N. Gordon, "Say on Pay": Cautionary Notes, 46 HARV. J.
ON LEGIs. 323, 365 (2009); Lucian A. Bebchuk & Holger Spamann,
Regulating Bankers'Pay, 98 GEO. L.J. 247, 248 (2010).

2 "Too big to fail" refers to financial firms that would be rescued by
the government rather than being allowed to fail, because the financial
claims on their balance sheet are so large relative to the financial sector
that failure would have large negative effects on other financial firms and
ultimately, large negative effects on the real economy. Ex ante, the
optimal policy is for government to pledge "toughness"-to permit failure
-to control excessive risk-taking; but ex post, in the face of the systemic
distress costs of the failure of a "too big to fail" financial firm, the
government should relent.

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No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

firms. But rather than imposing costs on shareholders in the
name of systemic stability, regulatory intervention can
provide a benefit to diversified shareholders.

Second, this essay identifies a new problem in executive
compensation in the financial firm, namely, the disincentives
of senior managers with substantial equity investments in
the firm to negotiate substantial new equity raises or a sale
of the firm that would substantially dilute their equity
positions. This might be called the "Fuld problem."
Contrary to some recent claims, a key systemic risk problem
was not that executives at Lehman and Bear Stearns had
insufficient stake in their firm's survival because they were
playing with "house money," having extracted large sums
through cash payments and stock sales in prior years.3

Rather, the critical point from the perspective of systemic
risk mitigation was that as their firms ran into financial
difficulty, these executives' large equity stakes created an
ever-widening gap between their interests and the interests
of non-managerial shareholders (as well as the social
interest). A CEO with a large equity stake would face a
much greater proportionate wealth loss than a diversified
shareholder from a dilutive capital raise or sale, while a
diversified shareholder would face a much greater
proportionate wealth loss from the systemic distress that
would follow the failure of a systemically important firm.

Third, this Article offers a new compensation mechanism,
"convertible equity-based compensation," that can at least
partially address some of the managerial incentive problems
in financial firms. The general idea is for management's
equity-based stakes to convert to subordinated debt upon
certain triggering events, for example, a downgrade into a
"high-risk" category by the financial regulator or a stock
price decline of a particular percentage. Such a mechanism
should constrain managerial risk-taking generally and
should particularly change managerial decision making as

3 See generally Lucian A. Bebehuk, Alma Cohen & Holger Spamann,
The Wages of Failure: Executive Compensation at Bear Stearns and
Lehman 2000-2008, 27 YALE J. ON REG. 257 (2010).

837



the firm's financial situation becomes more precarious. It
solves the "Fuld problem." Both of these changes in
managerial incentives should reduce systemic risk.

Finally, this Article explains why boards of directors
should adopt such a compensation mechanism. This is
because the board has distinct fiduciary duties as the
financial firm approaches the zone of insolvency. Precisely
because of the widening gap between the interests of
managers with large undiversified equity stakes and the
public shareholders who are presumptively diversified, the
board needs to intervene for similar reasons that call for
special board action in a management buyout. The board
can use an ex ante approach like convertible equity-based
pay, or it can assume direct responsibility for equity-raising
decisions or the sale of the firm.

II. CORPORATE GOVERNANCE AND EXECUTIVE
COMPENSATION AT FINANCIAL FIRMS

A. Financial Firm Shareholders and Systemic Risk

The claim that shareholders would a priori have
insufficient incentives to constrain "excessive" managerial
risk-taking in the financial firm rests on a model of
shareholder-manager interaction in the nonfinancial firm
that does not fit financial firms. The standard account
contemplates an incentive mismatch between risk-neutral
(because diversified) shareholder principals and risk-averse
managers. Thus the challenge for shareholders is to
encourage managers to take all positive net present value
investment opportunities despite the possibility that such
risk-taking may occasionally turn out very badly, leading to
insolvency or restructuring, and the consequent destruction
of the managers' firm-specific human capital investment.
The common solution to this problem is equity-based pay,

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which puts the managers in the shareholders' shoes.' But
this set-up rests on the critical assumption that the firm's
failure will not otherwise affect the diversified investor's
portfolio in any directional way. Competitors of the failed
firm may do better, suppliers to the failed firm may do
worse, but the consequences are "unbiased." In other words,
the effects of the failure will be "idiosyncratic," not
"systematic." Thus, if all firms are taking good bets, then on
average the diversified investor will be better off. This is not
the case when a systemically significant financial firm fails.
As demonstrated by the failure of Lehman Brothers in
September 2008, such a failure has powerful systematic
effects. The failure of one financial firm will damage its
competitors in the financial sector and, because of the
importance of the financial sector to the real economy, may
cause widespread damage to nonfinancial firms as well. In
short, the outbreak of systemic distress can depress values
throughout the diversified portfolio.

More technically, asset-pricing models generally specify
that shareholders are compensated for bearing systematic
risk (and perhaps other sorts of risk). The standard model
assumes that the level of systematic risk is not affected by
the failure of any particular firm. This is not the case for
systemically important financial firms. The failure of one
such firm will increase the likelihood that other financial
firms will fail due to contagion or commonality.' This will in

4 This is not necessarily optimal from the creditors' point of view,
since creditors internalize some of the risk of business failure. But the
standard model assumes that creditors will generally adjust via
compensatory interest rates or protective covenants. Note that this
account of stock-based compensation also implies an optimal level of
managerial diversification away from own-firm stock. A manager whose
entire net worth and human capital is linked to a single firm may be even
more risk-averse, which will undermine risk-taking incentives.

5 "Contagion" refers to how the failure of one financial firm could,
because of interfirm credit relationships, significantly increase the
solvency risk of other financial firms and trigger a cascading series of
runs. "Commonality" refers to how the information revealed from the
failure of one financial firm may increase the run risk at other firms

839



turn lower the expected profitability of many nonfinancial
firms via knock-on effects from contraction in the financial
sector. This contraction will reduce the availability of credit
and raise its cost. The failure of a systemically important
firm adds a new sort of risk to the economy. In short, the
failure of a systemically important financial firm can reset
systematic risk levels, increase the systematic risk-bearing
premium, and in turn generate value reductions across a
diversified portfolio.' Thus the systemic distress costs for
diversified investors are twofold: first, a reduction in
expected returns across the economy; second, an increase in
the systematic risk premium. Both will reduce the value of
a diversified portfolio.

This is a point with far-reaching implications. Managers
who have large equity positions in their firms are in a
substantially different position from diversified public
shareholders. Such managers do not internalize sufficiently
the consequences of systemic distress because their financial
and human capital investments may be undiversified.
Indeed, a major thrust of recent compensation reform has
been to increase managerial "skin in the game," and in
particular to increase sensitivity of managerial wealth to the
firm's performance. As the financial firm heads for trouble,
this opens a gap between managers, who do not internalize
the full consequences of the firm's failure, and diversified
shareholders, who do.'

following a similar asset and liability strategy. Uncertainty about the
extent to which particular firms are exposed to these sources of systemic
risk contributes to the run cascade. See Jeffrey N. Gordon & Christopher
Muller, Confronting Financial Crisis: Dodd-Frank's Dangers and the Case
for a Systemic Emergency Insurance Fund, 28 YALE J. ON REG. 151, 160
(2011).

6 A more formal way to make the point is to say that the level of
systematic risk is affected by the existence of systemically important firms
in the economy and the probability of their failure. By revealing
information about the probability distribution, the actual failure of any
such firm immediately increases the systematic risk discount.

7 Another way to frame the point is to say that economic losses of
diversified shareholders of a systemically important financial firm are not

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This analysis points to two areas of incentive
incompatibility: first, the general risk profile of financial
firms; second, decision making when the firm faces financial
distress. The "wedge" in the design of optimal compensation
is not between managers-and-shareholders and society, but
between managers and shareholders-and-society.

Now to reframe the point in governance terms: the
standard model of executive compensation drawn from
nonfinancial firms is that systematic risk levels are not
changed by terms of the shareholder-manager contract. This
follows from the observation above that systematic risk
levels are not affected by individual firm failure. Thus
assuming all actions are positive net present value bets,
"'excessive" managerial risk-taking is not a coherent idea for
the nonfinancial firm. But that conclusion does not follow for
a systemically significant financial firm, even from the
shareholder point of view. Thus a compensation mechanism
that reduces the probability of the failure of a systemically
important financial firm may redound to the diversified
shareholder's benefit, even if the consequence is to reduce
positive net present value risk-taking at a specific firm.

B. Corporate Governance in the Financial Firm

The argument thus far is that there is a distinct "business
case" for shareholder governance activism to shape the
management compensation contract so as to mitigate
systemic risk. Economically motivated shareholders as well
as socially responsible shareholders have a stake in the
outcome. Even though shareholders may not internalize all
of the costs of systemic distress (because there are losses

capped by limited liability when the firm fails, whereas undiversified
managerial shareholder losses are capped to a much greater extent. In
ordinary times, it might be thought that managers' large firm-specific
human and financial capital investments hold down excessive risk-taking,
but outside investments in cash and non-risky assets may provide "wealth
insurance." As the firm nears financial distress, the value of firm-specific
managerial investments declines, and as holders of near-the-money
options, managers' incentives shift accordingly.

841



beyond portfolio losses, for example, the human costs of
higher unemployment), their internalized losses are
sufficient to justify appropriate measures to control financial
firm risk-taking. Regulation is necessary to curb excessive
risk-taking by management in systemically important
financial firms because of the limits of collective shareholder
action, especially by diversified shareholders, not because
shareholder incentives are generally misguided.8 On this
view, the regulator provides the necessary coordination to
obtain shareholder objectives. Well-crafted regulatory
intervention in this realm is a benefit to diversified
shareholders, not a cost. The potential benefits of regulation
are two-sided. Regulation that reduces the failure risks of
systemically important firms not only protects against a

8 Another basis for government regulation is that shareholders will
not sufficiently internalize systemic risk because they expect government
intervention that will prevent the failure of any systemically important
firm; or a variant, government action that will permit the failure of a
single systemically important firm, but will then intervene to prevent the
follow-on failure of other systemically important firms. The emerging
financial regulation reform legislation aims to eliminate these variants of
"too big to fail." Whether this containment will be successful, or is even
wise, is a question some later crisis will demonstrate. However, the
diversified shareholder would benefit from risk-avoiding regulatory
restrictions on executive compensation that avoid a scenario testing the
credibility (and wisdom) of the "no bailouts" posture where the stakes are
a major outbreak of systemic distress.

Another ground for regulation is a belief that shareholders will be
myopic-that shareholders will not understand their long-term best
interests, especially with regard to outbreaks of systemic distress, which
are highly salient for a while and then recede. Regulators too will suffer
from myopia. But regulation can embed systemic risk-internalization
awareness; "lessons learned" become rules that may survive beyond the
myopic calculation of subsequent actors.

Finally, regulatory intervention is justified to provide systemic
stability against the inherent fragility of banks and functionally similar
non-banks arising from the liquidity mismatch between assets and
liabilities. Runs can occur even where risk-taking is not "excessive,"
meaning that a run can arise apart from the mismatch between private
gains and social losses. This fragility is mitigated by deposit insurance,
and safety and soundness regulation.

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No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

collapse in portfolio values, but also-as a result of
systematic risk reduction-may increase portfolio values.

The limits to effective shareholder action to control risk-
taking in financial firms are a mix of well-known limits to
shareholder power and some particular applications to
financial firms. First, dispersed shareholders are subject to
important collective action problems in facing management,
including but not limited to management's agenda control
and the regulatory barriers to shareholder coordination.
Some collective action problems have been mitigated by the
rise of institutional ownership, the liberalization of the proxy
rules, the role of proxy advisory services, and the activity of
trade associations like the Council on Institutional Investors.
New legislation now requires an advisory shareholder vote
on pay-setting ("Say on Pay");' this can be leveraged by the
threat of a "withhold vote" campaign against targeted
directors to provide a new route for shareholder initiative on
compensation practices.o The long-run impact of these
governance opportunities remains unclear.

9 See Dodd-Frank Wall Street Reform and Consumer Protection Act,
15 U.S.C. § 78n-1 (2012) [hereinafter Dodd-Frank Act] (adding Section
14A to the 1934 Securities Exchange Act); see also Shareholder Approval
of Executive Compensation and Golden Parachute Compensation,
Exchange Act Release No. 63,768, 100 SEC Docket 868 (Jan. 25, 2011)
(SEC implementation rules for Section 14A). The Act also eliminated
broker discretionary voting on executive compensation. See 15 U.S.C. §
78f(b) (2012) (amending Section 6(b) of the 1934 Securities Exchange Act).
This has now been implemented by SEC approval of amendments to NYSE
Rule 452 and NASDAQ Rule 2251, which deem executive compensation
matters to be "non-routine," meaning that brokers cannot vote shares
registered in "street name" without instructions from the beneficial owner.
See Order Approving NYSE Proposed Rule Change Relating to Broker
Discretionary Voting, Exchange Act Release No. 62,874, 99 SEC Docket
946 (Sept. 9, 2010); Order Approving NASDAQ Proposed Rule Change
Relating to Voting by Non-Beneficial Owners, Exchange Act Release No.
62,992, 99 SEC Docket 1528 (Sept. 24, 2010).

10 See David Katz, Focus in 2011 Will Remain on Executive
Compensation, HARv. L. SCH. F. ON CORP. Gov. & FIN. REG. (Jan. 16, 2011,
9:23 AM), http://blogs.law.harvard.edu/corpgov/2011/01/16/focus-in-2011-
will-remain-on-executive-compensation/#4b.

843



Second, of particular importance, institutional actors' use
of governance power in financial firms to protect diversified
shareholder interests will be constrained by what Ronald
Gilson and I have called the "agency costs of
agency capitalism."" Although the beneficial owners of
institutional claims are generally diversified, the self-
interest of the investment managers will limit the
institutions' firm-specific governance interventions on behalf
of diversified shareholder interests. The institutions'
investment managers are judged by whether they can deliver
"superior" performance, generally measured over a relatively
short time frame. This performance is typically measured
against a benchmark, so that the manager's focus is not the
market's performance but his or her portfolio's performance
relative to the benchmark. A manager overweight in a
financial firm's stock wants it to outperform, irrespective of
the fact that the greater risk-taking commonly associated
with such outperformance may have systemic implications.
Even if the manager foresees that such risk-taking by a firm
or group of firms may have systemic effects, the incentive
structure pushes the manager to assemble a portfolio that
will be less severely impacted by financial distress rather
than incur the uncompensated costs of a corrective
governance intervention. Managers who are underweight in
stocks particularly hard hit by systemic distress and
overweight in the relatively well-insulated stocks will
"outperform," even if their portfolios significantly decline.

Third, governance activism in financial firms is subject to
a special clash of shareholder interests that turns upside
down the standard models of the benefits of blockholders in
corporate governance. A large shareholder-a blockholder-
in a systemically important financial firm is probably under-
diversified.12  The deviation from diversification probably

11 See generally Ronald J. Gilson & Jeffrey N. Gordon, The Agency
Costs of Agency Capitalism: Activist Investors and the Revaluation of
Governance Rights, 113 COLUM. L. REV. (forthcoming May 2013).

12 Even one-percent ownership of a relatively small financial firm like
Lehman Brothers, worth $47 billion at its peak, would challenge the

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correlates with the increase in the percentage of ownership.
Such a shareholder will internalize a smaller share of
systemic risk distress cost relative to specific firm risk.13 A
blockholder may present very much the same problem as
management: willing to take "excessive" risk because it
internalizes the full upside but not much of the systemic
downside. Thus, for such a financial firm, the key divide is
not between shareholders with "short-term" versus "long-
term" horizons, but between diversified and undiversified
shareholders. The deep irony is that the blockholder with
enough clout to constrain managerial agency costs-the
objective of conventional corporate governance-also has
incentives to promote "excessive" risk-taking.

This clash reintroduces a particular sort of collective
action problem in which the interests of the "large
shareholder" (undiversified) minority can outweigh the
interests of the "small shareholder" (diversified) majority.
This is because the large shareholder has greater incentives
to invest resources in firm-specific governance activism that
is likely to influence managerial behavior. Put otherwise,
large shareholders, whether they are "patient" shareholders
or "short-termist" hedge funds, have disproportionate
influence because their highly salient activism may threaten
managerial reputation and careers. For nonfinancial firms
this is not a problem as long as managers are pushed to
pursue positive net present value projects." It can be a big

diversification strategy of all but the largest investors. This is not to say
that such an investor will have no other investments, but that such an
investor is likely to be significantly under-diversified.

13 Vehicles like total return swaps that substitute for direct stock
ownership can also increase firm-specific exposure, reduce diversification,
and thus increase the ratio of specific firm risk to systemic risk.

14 This observation is more rigorously stated in terms of the so-called
"unanimity theorem," in which under conditions of complete markets, all
shareholders should want the same thing: to maximize the share price.
See Jeffrey N. Gordon, Shareholder Initiative, 60 U. CIN. L. REV. 347, 368-
70 (1991); Jeffrey N. Gordon & Lewis A. Kornhauser, Efficient Markets,
Costly Information, and Securities Research, 60 NYU L. REV. 761, 833

845



problem in a systemically significant financial firm if
influential shareholders do not adequately internalize
systemic risk distress costs. In terms of the "wedge"
described above, the alignment should be restated as
managers and large (undiversified) shareholders versus
diversified shareholders and society. Thus, depending on its
source, corporate governance activism in financial firms
might well promote business strategies and associated
compensation arrangements that lead to excessive risk-
taking. This is borne out by post-financial crisis empirical
work that suggests that firms with a higher level of
institutional ownership,1 5 and in particular, firms with a
higher level of "short-termist" institutional ownership,
created executive compensation packages that produced such
risk-taking. 16

The peculiar political economy of corporate governance
means that the preferences of the diversified majority of
shareholders may lose out to the distinctly different
preferences of concentrated minority shareholders. That
divergence between the interests of an organized minority
and those of a relatively disorganized majority can produce a
welfare-reducing outcome is a well-understood result in the
political realm. The differential internalization of systemic
risk distress costs brings this problem directly into the
governance of the financial firm as well.1 7  This opens a

n.199 (1985); Mark A. Satterwaite, On the Scope of the Stockholder

Unanimity Theorems, 22 INT'L EcoN. REV. 119 (1981).
15 See David H. Erkens et al., Corporate Governance in the 2007-nO8

Financial Crisis: Evidence from Financial Institutions Worldwide, 18 J.
CORP. FIN. 389 (2012).

16 See Ing-Haw Cheng et al., Yesterday's Heroes: Compensation and
Creative Risk-Taking (Nat'1 Bureau of Econ. Research, Working Paper No.
16176, 2011), available at http://ssrn.com/abstract=1502762.

17 Conceivably, there is significant differential internalization of
systemic risk by diversified shareholders versus blockholders even for
nonfinancial firms. Imagine that blockholders push firms to follow a high-

leverage strategy or a particular operational strategy (e.g., disaggregated
supply chains) that successfully increases shareholder returns at some
firms, but if disseminated widely, will have systematic effects (e.g., greater

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space for regulation to defend the interests of diversified
shareholders (and the social interest) by constraining
excessive risk-taking that may be the result of-rather than
reflect a shortfall in-the influence of large, undiversified
shareholders. The case for regulation is strengthened by the
realization that many such blockholders are investment
intermediaries acting for diversified investors and thus
disserve the interests of their beneficial owners by promoting
excessive risk-taking by financial firms."

But regulation is necessary not only because of the
diversity of shareholders within firms, but also because of
shareholder diversity across firms. Blockholder- dominated
firms are likely to engage in greater risk-taking than other
firms. This increases the risk of own-firm failure, which
could impose systemic distress costs on diversified
shareholders (and others). But the higher (apparent)
returns from a higher-risk strategy will also put pressure on
all firms to engage in great risk-taking, even firms owned by
diversified shareholders without a dominant blockholder.
This pattern also increases the likelihood of systemic
distress.

The distinctive political economy of financial firm share-
ownership may affect not only financial firm governance but
also the regulatory intervention that could address the
consequences of this governance conflict. The same clash of
shareholder interests can also distort the regulatory process,
since large (undiversified) shareholders may be willing to
invest greater resources into shaping the regulatory
outcome, as noted above. One cautionary note for regulators:
watch carefully which shareholders you pay attention to.

exposure to the business and interest rate cycle), which diversified
shareholders will internalize but blockholders may not. Pension funds and
hedge funds make for uneasy partners in corporate governance, less on the
dimension of time frame than diversification.

18 See Gilson & Gordon, supra note 11.

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COLUMBIA BUSINESS LAW REVIEW

III. A NEW COMPENSATION PROBLEM IN THE
FINANCIAL FIRM

A distinct problem in the management of systemic risk in
the financial firm is the CEO's equity ownership. The prior
section discussed how management's stock ownership can
increase the gap in systemic distress risk-bearing with
diversified shareholders. But the impact of a large
management equity stake, especially a large CEO stake,
becomes particularly important as the firm faces the onset of
financial distress. This is a moment when systemic risk
considerations would argue for an immediate infusion of
equity capital to stabilize the firm, but the CEO's personal
wealth calculus argues against such dilution. This might be
called "the Fuld problem": a CEO, who is reluctant to
negotiate a large equity raise (or sell the firm) because the
terms would massively dilute his personal equity stake, may
instead calculate that holding out for a fortuitous turn in
markets or regulatory forbearance has a higher expected
payoff for him." When expected creditor losses are taken
into account, this is a negative net present value strategy
that replays the familiar debt-equity agency problem.20

When systemic distress costs are taken on board, the impact
of this incentive mismatch is highly consequential.

19 I merely speculate that Richard Fuld's decisions with respect to
possible equity suppliers, including Korean Development Bank, might
have been influenced by these incentives. The problem also could have
been labeled the "Cayne problem," since there are published claims that
Jimmy Cayne did not pursue opportunities to raise capital or sell Bear
Stearns. There is ample evidence that parties believe the CEO responds
to such incentives. The change-in-control provisions of golden parachutes,
which contemplate, among other things, the payment of three times
salary, and the acceleration of vested options are commonly explained as
incentive-alignment devices that induce managers to give up the private
benefits of control as well as their perhaps overly optimistic beliefs about
the firm's intrinsic value.

20 Michael C. Jensen & William H. Meckling, Theory of the Firm:
Managerial Behavior, Agency Costs and Ownership Structure, 3 J. FIN.
EcoN. 305, 334-43 (1976).

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The incentive mismatch is even more acute if the CEO
has private information indicating greater financial trouble
than is currently reflected in the market price. He would
calculate that this would be revealed in the negotiations (and
due diligence) over an equity raise or a sale. Not only would
this entail further dilution but such information would
become generally known, which could negatively affect the
firm's stock market price as well as counterparty
relationships, and generally restrict the CEO's capacity to
play for a fortuitous market turn or regulatory forbearance.

The CEO's reluctance may also stem from behavioral
effects exacerbated by his large ownership stake: over-
optimism bias about his ability to avoid the firm's failure
without a dilutive equity raise, availability bias ("this is like
the other crises I've steered the firm through"), or loss
aversion framed by the valuation high point of the CEO's
ownership stake. Regardless of whether the CEO is a cold
calculator or in the thrall of delusion, the reluctance to
accept dilution imposes default risks on creditors and
systemic risks on diversified shareholders.21

This analysis rejects the view that prior equity sales or
cash bonuses would make a CEO relatively indifferent to the
risks to his remaining, substantial equity position. If so, the
CEO would not fight so hard to avoid dilution. Rather, the
creditors of Lehman Brothers and the taxpayers (though not
necessarily the Lehman shareholders) would have been
better off had Fuld sold all his stock in the prior years. At

21 The analysis also assumes that the board will be unable to monitor
adequately the CEO's pursuit of (or rejection of) potential capital raises or
sales of the firm. This seems reasonable in light of the board's common
role of reviewing, rather than initiating, major transactions that have
been identified and negotiated by the management team. Moreover, the
board-which may own shares and be influenced by blockholders-may
share the CEO's sympathies. The analysis also assumes that the wealth
and power of a large equity position will overcome the CEO's reputational
concerns about risking the failure of the firm to avoid a serious dilution.
The point is not to assume a particular weighing of economic versus
reputational losses, but to observe a powerful temptation.

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COLUMBIA BUSINESS LAW REVIEW

least his financial stake would not have been in opposition to
his reputational stake.

IV. A NEW COMPENSATION MECHANISM:
CONVERTIBLE EQUITY-BASED PAY

The Article thus far has identified two distinct moments
of excessive risk-taking associated with equity-based
executive compensation: in the general operation of the firm
and in the corporate finance decisions taken as the firm faces
financial distress. Part IV sketches and rejects two possible
reforms, including a recent proposal by Bebchuk and
Spamann, and offers a new compensation mechanism,
"convertible equity-based pay." Upon certain trigger points
associated with incipient financial distress, senior managers'
equity-based compensation would convert into subordinated
debt.

A. Proposal One: Eliminate Equity-Based Pay for
Senior Managers of Systemically Important
Financial Firms

One compensation reform that would reduce risk-taking
in systemically important financial firms is to pay senior
managers like bureaucrats.22 Practically speaking, this
would mean the elimination (or substantial cutback) of
equity-based compensation for the CEO and his or her senior
management team (and presumably an increase in fixed
salary). Stock ownership by senior managers, especially
large stakes, increases risk appetites in which the upside is
internalized and the downside systemic risk distress costs
are socialized. The shift into restricted stock (versus stock
options) or the requirement of long-term holding periods
affects this systemic risk mismatch only at the margin.

22 Cf. Brian J. Hall & Jeffrey B. Liebman, Are CEOs Really Paid Like
Bureaucrats?, 113 Q.J. EcoN. 653 (1998) (debunking the view that prior to
the 1990s deluge of stock-related compensation, CEOs were paid like
"bureaucrats"-receiving fixed compensation that was not responsive to
firm performance).

850 [Vol. 2012



No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

Ironically, longer holding periods may exacerbate the Fuld
problem.23

This is not a likely endpoint of compensation reform.
Among other things, in light of the range of financial firms
that may be systemically important-Bear Stearns was not
a particularly large firm-such a rule would dramatically
reduce financial incentives throughout the financial services
industry. It could invite regulatory arbitrage in which much
financial activity is shifted away from firms that regulators
designate as "systemically important" to other firms whose
systemic importance becomes apparent only too late.

B. Proposal Two: Tie Senior Management
Compensation to the Value of the Firm's Debt and
Equity

Bebchuk and Spamann have observed the mismatch
between systemic risk and firm-specific shareholder
objectives, and have proposed a compensation formula for
financial firms that would tie senior executive compensation
to the value of the firm's senior securities as well as its
equity.24 This would in effect ask managers to maximize the
enterprise value of the firm, not its equity value. Given
incentives to protect creditor claims, as well as to increase
shareholder value, managers will therefore be less likely to
engage in excessive risk-taking. This could operationalize a
compensation approach that mitigated the systemic risk
faced by diversified shareholders, so it might well fit a
corporate governance agenda (though undiversified
shareholders would oppose). Bebchuk and Spamann,

23 If the CEO were unable to take out any substantial wealth from the
firm, this could reduce risk-taking in ongoing operations and possibly at
the recapitalization moment. This would require that a CEO be unable to
diversify from own-firm risk and systemic distress risk through conversion
of stock to cash or other risk-free assets (that is, unable to purchase
"wealth insurance"). See id. at 657. Such a strategy would encourage sub-
optimally high CEO turnover, as presumably retirement would enable
unfettered access to own-firm stock.

24 See generally Bebchuk & Spamann, supra note 1.

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COLUMBIA BUSINESS LAW REVIEW

however, contemplate that regulatory implementation would
be necessary, and I agree.

Although interesting, the Bebchuk-Spamann approach
has serious flaws. First, it would place a burden on
regulators to define the elements of the firm's capital
structure that would be included in the compensation
formula. In turn, this would give managers an incentive to
vary the capital structure to maximize their compensation.
This balance sheet rearrangement might well be inefficient
and would not necessarily reduce systemic risk. Indeed, the
shareholders' governance power (especially as exercised by
blockholders) might well encourage management to engage
in this sort of regulatory arbitrage. Among other things, this
approach would provide an impetus for financial innovation
to create new instruments that would have particular weight
in the regulators' formula. The effort to specify what
"counts" in the managers' maxim sounds hauntingly similar
to the regulatory rules that encouraged firms to carry triple-
A rated structured finance products,2 5 or that permitted
lower capital charges for assets that were insured, or
guaranteed, by purportedly triple-A rated counterparties.26

Second, the valuation issues of "enterprise value" are
nontrivial. Many liabilities do not trade in thick markets.
In the case of bank finance, they may not trade at all.
Although credit default swaps may provide some useful
information, CDS trading markets are often thin and do not
necessarily cover the full range of bank liabilities. Thus, the
availability of reliable valuation information will vary across
firms and over time. There could well be pressure for firms
to standardize liability forms, to promote valuation
transparency, or to look to a particular subset of
standardized liabilities as a proxy for the firm's liabilities

25 Residential Mortgage-Backed Securities that were rated AAA
carried a 20% charge in the calculation of risk-weighted assets, whereas
residential mortgages held directly required a 50% charge ("qualifying") or
100% charge ("non-qualifying"). See MICHAEL CROUHY ET AL., THE
ESSENTIALS OF RISK MANAGEMENT (2006); 12 C.F.R. § 567.6 (2010).

26 See CROUHY ET AL., supra note 25; § 567.6(a)(1)(ii)(H)(1).

852 [Vol. 2012



No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

valuation. This creates incentives to distort capital structure
for a favorable valuation result. Such an approach also
increases the pressure on the "mark-to-market" debate over
financial firm balance sheets, which thus far has focused on
the asset side. If liability-side valuations affect managerial
compensation, elaborate accounting rules will follow.

Third, even a technically tractable, minimally game-able
compensation formula that includes credit claims rests on a
contestable assumption: that creditors would expect to bear
significant losses in the failure of a financial firm, and that
enterprise value would therefore be an effective instrument
to change managerial conduct. As an empirical matter, the
pre-Lehman risk of significant losses for creditors of large
financial firms was not high. Indeed, the government
actions to address the financial crisis are notable for the
losses not imposed on creditors.27 The current financial
regulation reform legislation tries to bring this "too big to
fail" problem under control with a new style of resolution
procedures for failing financial firms.2 8 In the wake of the
financial system freeze-up following the Lehman bankruptcy
filing, which did indeed result in significant creditor losses,
the credibility, even wisdom, of such a strategy is open for
debate.29

C. An Alternative Proposal: Convertible Equity-Based
Compensation

The value of the Bebchuk-Spamann analysis is to remind
us that the systemic risk associated with financial firm
failure requires us to think differently about executive
compensation in such firms. In particular we need to cabin
risk-taking by managers that may enhance shareholder

27 The exception was in the case of Washington Mutual. There, the
FDIC did not protect all non-insured creditors with its purchase and
assumption method of bank resolution.

28 Dodd-Frank Wall Street Reform and Consumer Protection Act, 12
U.S.C. §§ 5381-94 (2010) (comprising Title II, Orderly Liquidation
Authority of the Dodd-Frank Act).

29 See generally Gordon & Muller, supra note 5.

853



value only if systemic distress costs are not considered. The
design problem is how to make managers "see" those costs
yet not erase the traditional managerial obligation to
shareholders; that is, to encourage "optimal" risk-taking, not
"excessive" risk-taking. The goal is a compensation
mechanism that cuts off the part of the risk-incentivizing
distribution in which customary incentives may have
significant social costs, because of the potential for systemic
distress should the risks turn out badly.30

Here is a different approach to that problem: convertible
equity-based pay. Specifically, senior executives at financial
firms should receive a significant portion of stock-related
compensation in the form of equity that will convert into
subordinated debt upon certain external triggering events,
such as a downgrade by the regulators to a "high-risk
category," a specific deterioration in the firm's book-to-equity
ratio (or some other critical ratio), or perhaps a stock price
drop of a specified percentage over a limited time period.
The equity will convert into subordinated debt based on the
value of the converted equity as of a period prior to the
conversion moment, less a significant haircut. This
mechanism both imposes losses on senior management for
deterioration in the firm's financial condition, while also
giving it a significant stake in avoiding further deterioration.
The recent financial crisis provides a useful time series of
stock price changes that could be mapped against other
measures of financial distress at both the firm level and the
financial sector level so as to provide the appropriate trigger
points, which should be set well in advance of financial firm
insolvency. The recent period has also provided data to
calibrate an appropriate conversion algorithm. 31 The goal is

30 See generally Sudhakar Balachandran, Bruce Kogut & Hitesh
Harnal, The Probability of Default, Excessive Risk, and Executive
Compensation: A Study of Financial Services Firms from 1995 to 2008
(Columbia Bus. Sch. Research Paper, 2010), available at http://ssrn.com/
abstract=1914542.

31 Convertible equity-based pay bears a family resemblance to
"contingent convertible bonds" that have been proposed as a new element

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No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

to avoid the need to use resolution authority, which could
accelerate financial sector distress.3 2

This approach has four particular advantages. First, it
will give senior managers incentives to avoid risky
strategies. The financial crisis demonstrated that stock
prices of financial firms respond to shareholders' perceptions
of financial distress, not just because of the risk of the firm's
insolvency, but because of the more common dilution risk
from additional equity issuances to stabilize the firm.
Requiring managers to register an equity conversion plus
haircut because of a stock price decline (or a regulator's
downgrade) will create a manager-specific dilution risk that

in financial firms' capital structure. Among other features, so-called "co-
co's" promote shareholder monitoring of managerial risk-taking by
providing a credible threat of dilution in the event of financial distress,
because of the automatic conversion of a significant amount of debt into
equity. Assuming that anti-dilution protection is scrubbed out of
managerial compensation contracts, the dilution threat from co-co's should
also directly affect management behavior. However, because co-co's are
addressed to the entire equity base, the extent of dilution, and thus the
effect on managers, will be less than for convertible equity-based pay. As
a practical matter, it may be easier to adopt an approach that is targeted
at only managerial conduct rather than an approach that is a new
mandatory feature of the financial firm balance sheet that also aims to
provide a guaranteed source of new equity to cover prior capital losses.
Also, co-co's do not address the perverse incentives of CEOs to resist
equity raises, known as the "Fuld problem."

32 See Gordon & Muller, supra note 5, at 180. The design problem is
similar to the challenge in fashioning an effective contingent capital
instrument, which contemplates conversion of debt to equity at critical
points in the evolution of financial distress so as to avert the failure of a
systemically important financial firm. One such proposal seeks to provide
"strong incentives for the prompt recapitalization of banks after significant
losses of equity but before the bank has run out of options to access the
equity market." Richard J. Herring & Charles W. Calomiris, Why and
How to Design a Contingent Convertible Debt Requirement 1 (Apr. 19,
2011) (unpublished manuscript), available at wwwl.gsb.columbia.edul
mygsb/faculty/researchlpubfiles/5631/contingent_convertible debt.pdf.
Convertible equity-based pay is in the spirit of such proposals. The
compensation conversion mechanism is designed to produce incentives for
a recapitalization before the onset of severe financial distress, operating
directly through the managerial incentives channel.

855



COLUMBIA BUSINESS LAW REVIEW

will change managerial behavior. Rather than alter the
general managerial charge to act on behalf of shareholders or
attempt to refigure a new maxim and enterprise value, this
mechanism is tailored to give managers special incentives to
avoid financial distress. In other words, the mechanism will
curb "excessive" risk-taking from the social perspective but
leave in place incentives for risk-taking that are closer to
optimal.33

Second, convertible equity-based pay avoids the Fuld
problem. At the point at which the firm should be
negotiating for new capital, indeed, may even come under
regulatory pressure to raise new capital, the CEO's
incentives switch dramatically from protecting the
shareholder option to protecting the creditors. By extension,
this will include avoiding a firm failure that could trigger
systemic distress. Because the equity converts into
subordinated debt, the senior management wealth tied up in
the firm becomes a debt claim that is senior to shareholder
claims. In other words, at this important moment in the
evolution of firm-specific financial distress, management now
has incentives to find additional capital to buoy the firm.
This of course will protect the creditors and dilute the
shareholders, but it fits with the program of minimizing
systemic distress. 34

33 This is not to say that convertible equity-based pay is a complete
solution-even from a compensation perspective-for the problem of
excessive risk-taking in a financial firm, which can manifest itself in a
range, and among employees (like traders) who are not senior managers,
before conversion becomes a serious threat. A variant of the proposal
could possibly be employed for non-senior managers.

34 As proposed, this convertible equity-based pay calls for a
managerial haircut at the time of conversion to avoid the anomaly of
rewarding managers for decision making that threatens the firm with an
economic claim superior to shareholders'. Yet the haircut should be
relatively small to avoid incentive effects for extra risk-taking as the firm
nears the conversion trigger point. Otherwise, it would undermine the
objective of minimizing the risk of firm failure. Similarly, while it may be
desirable to provide a reconversion option-from subordinated debt to
stock-based instruments-as the firm moves beyond financial distress, the
terms and timing of any such reconversion must be measured to avoid

856 [Vol. 2012



No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

Convertible equity-based pay solves a shareholder
commitment issue in addressing the Fuld problem. Ex ante,
shareholders may agree about the importance of avoiding
systemic distress. Nevertheless, the shareholders of
Lehman-particularly the large, undiversified ones-may be
rooting, ex post, for Fuld to play tough in negotiating for new
capital or a sale. They may press Fuld to promote immediate
shareholder interests, to enhance the value of their near-the-
money (or out-of-the-money) option. The convertible equity
approach solves this problem by locking in a reversal of
managerial incentives for a financial firm nearing financial
distress, to give Fuld a tangible reason to push back against
such shareholders.

Third, another advantage is that convertible equity-based
pay could be promoted and adopted as part of a corporate
governance reform agenda. Even though shareholders-
particularly large, undiversified shareholders-may not, ex
post, favor conversion, they might well favor, ex ante, a
strategy that provides managerial incentives to avoid
financial distress. There are two sorts of reasons, firm-
specific and systemic.

Firm-specific. Because convertible equity-based pay will
reduce the risk of the firm's failure, it should lower the cost
of debt generally, which will redound to equity's benefit.
Overcoming the Fuld problem will have particular benefits.
Creditors who are entitled to make collateral calls to cover
shortfalls from the possible decline in asset values or who
can simply refuse to rollover their debt are more likely to
forebear at crucial moments if they know that the CEO will
not have the incentive to risk the firm's franchise value on a
low-probability turnaround bet. After the conversion trigger,
the CEO will be working for the creditors (or at least not
against them), which will reduce the run risk from short-
term creditors. Ex ante, equity holders will share in the
value of these benefits. Even undiversified shareholders

incentives for premature risk-taking after the injection of new equity, and
to assure that the level of the capital raise will meaningfully reduce the
riskiness of the firm.

857



gain from these firm-specific effects of convertible equity-
based pay.

Systemic. As explained above, the standard incentive
alignment story contemplates risk-neutral shareholder
principals (as a result of diversification) and naturally risk-
averse managers who are compensated with stock-based
compensation to change their risk preferences. It also rests
on the assumption that systematic risk levels are not
changed by the shareholder-manager contract. But the
failure of a significant financial firm imposes costs on
diversified shareholders because a breakout of systemic
distress will likely reduce overall portfolio values, that is,
will have a systematic effect. Asset-pricing models generally
specify compensation for bearing systematic risk. Thus, a
compensation mechanism that can reduce the risk of
systemic distress will inure to the diversified shareholder's
benefit.

Conceivably, convertible equity-based pay could be
adopted via debt covenants, since creditors would also
benefit from avoidance of the Fuld problem. New covenant
requirements seem unlikely, however. In general,
management is eager to obtain "covenant lite" financing.
Secured creditors of financial firms seem to focus more on
collateral quality and priority. Thus, governance reform
seems a more promising private-ordering route.

Recent compensation changes promoted by governance
activists have reflected concerns that certain managerial
incentives are too high-powered and may distort
management decisions toward excessive risk-taking. This
has led to moves away from stock options, for example, in
favor of restricted stock. The Council of Institutional
Investors, which offers guidance to public pension funds and
other institutional investors, warns against pay practices
that leave managers "emboldened to take excessive risks to
pump up short-term gains at the expense of long-term value

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No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

creation."3 5 Indeed, a focus on "long-term equity" is reflected
in the RiskMetrics Compensation "GRId," which bases a
third of the company's score on the proper design of long-
term incentive plans.3 6  Convertible equity-based pay fits
with this agenda.

New federal legislation offers a ready avenue for a
governance campaign to adopt convertible equity-based pay
for financial firms. As noted above, the Dodd-Frank
financial regulatory reform legislation contains a "Say on
Pay" provision for all public firms, including, of course,
financial firms. 3 7 It would be easy to promote convertible
equity-based pay as part of the annual compensation review.

Fourth, a final advantage is that convertible equity-based
pay would be a suitable measure for the Federal Reserve and
other financial regulators to promote or even mandate as
part of the ongoing "guidance" of large financial firm
compensation practices.3 8 This approach addresses the effect

35 COUNCIL OF INSTITUTIONAL INVESTORS, ToP 10 RED FLAGS TO WATCH
FOR WHEN CASTING AN ADVISORY VOTE ON EXECUTIVE PAY 2 (2010),
available at www.cii.org/UserFiles/file/resource%20center/publications/
March%202010%20-%20Say%20on%2OPay%2OChecklist.pdf; see also
Lucian A. Bebchuk & Jesse Fried, Paying for Long-Term Performance, 158
U. PA. L. REV. 1915 (2010) (surveying recent calls for a long-term focus in
financial firm compensation).

36 Adam 0. Emmerich, Understanding Risk Metrics Compensation
"GRId", HARv. L. SCH. F. ON CORP. Gov. & FIN. REG. (June 1, 2010, 9:31
AM), http://blogs.law.harvard.edulcorpgov/2010/06/01/understanding-risk
metrics-compensation-grid.

37 See supra text accompanying note 9.
38 Section 956(b) of the Dodd-Frank Act requires financial regulators

to promulgate regulations that prohibit compensation practices by covered
financial institutions (those with at least $1 billion in assets) that provide
officers or employees "with excessive compensation, fees, or benefits" or
"could lead to material financial loss to the covered financial institution."
12 U.S.C. § 5641 (2012). Financial regulators have proposed an
implementing rule. See Incentive-Based Compensation Arrangements, 76
Fed. Reg. 21,170 (proposed Apr. 14, 2011). The proposed rule would
incorporate the Guidance on Sound Incentive Compensation Policies,
previously adopted by the federal banking agencies, the Office of the
Comptroller of the Currency, the Board of Governors of the Federal
Reserve, the Federal Deposit Insurance Corporation, and the Office of

859



of compensation structures on risk-taking by financial firms,
rather than trying to set compensation ceilings. Such a
structural approach falls more readily in the Fed's
regulatory remit. Moreover, this particular mechanism does
not require the Fed to devise a new objective function for the
financial firm, or to produce an elaborate regulatory guide
for implementation of a new balance of interests between
shareholder and creditor interests in the financial firm.
Convertible equity-based pay is also consistent with
regulatory strategies like "living wills" that force firms to
devise mechanism of coping with the onset of financial
distress. Of particular importance, a regulatory mandate
would provide a benefit, not a cost, for a diversified
shareholder. This result may not be achievable through
private ordering because of the organizational advantages of
potential blocking coalitions made up of management and
large shareholders as opposed to diversified shareholders.

V. BOARD OF DIRECTORS ADOPTION OF
CONVERTIBLE EQUITY-BASED PAY AS SOLVING

A FIDUCIARY DUTY PROBLEM

The decisions of a systemically important financial firm
on the edge of financial distress present distinct fiduciary
duty challenges for the board of directors. In addition to the
likely clash of interests between shareholders and creditors,
there is a novel conflict between the interests of managerial
shareholders and most public shareholders, who
disproportionately face systemic risk. Convertible equity-
based pay is an ex ante approach to resolving these issues.

Thrift Supervision. See 75 Fed. Reg. 36,395-02 (June 25, 2010). The
proposed rule or its successors could include a requirement for convertible
equity-based pay. Id. Another basis for regulatory intervention is Section
166 of the Dodd-Frank Act mandating that the Federal Reserve require
measures for "early remediation" of financial distress of systemically
important financial institutions. 12 U.S.C. § 5366 (2012). A compensation
feature that assures appropriate managerial incentives in a firm facing
financial distress would be a useful, additional component.

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No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

Ever since Chancellor Allen's famous footnote in the
Credit Lyonnais case,3 9 the Delaware courts and boards of
firms incorporated in Delaware have struggled with the
question of the board's fiduciary duties to creditors as the
firm approaches the "vicinity" or "zone" of insolvency.
Should the board's customary duty to shareholders shift so
as to require at least some concern for creditors, or should
shareholder interests remain the priority in the event of a
conflict? The concern is particularly acute when pursuit of
shareholder interests may result in negative net present
value bets in which the upside goes to shareholders while
most, if not all, of the downside, hits creditors. After some
initial doctrinal uncertainty, Delaware corporate law
attempted to mitigate this problem by permitting, but not
obligating, the board of a firm that is in the "zone of
insolvency" to consider creditor interests, not just
shareholder interests. 4 0  Nevertheless, the creditors can
bring a derivative claim for detrimental actions taken after
the corporation becomes insolvent, such as the negative net

39 Credit Lyonnais Bank Nederland, N.V. v. Pathe Commc'ns Corp.,
Civ. A. No. 12150, 1991 WL 277613, at *1155 n.55 (Del. Ch. Dec. 30, 1991).
The footnote provided a hypothetical in which a highly levered firm faced a
choice between (i) accepting a litigation settlement offer that would fully
cover creditor claims, but leave only a small amount for shareholders, or
(ii) defending on appeal a highly favorable verdict that if sustained would
provide shareholders with a substantial recovery, but if reversed could
lead to the firm's insolvency. Given the odds on appeal, rejecting the
settlement in favor of the appeal would be a good bet for shareholders
(since the creditors bore most of the downside risk) but a poor bet for
creditors, and a negative net present value bet when both equity and debt
claims were aggregated. Id.; see also Bo Becker & Per Stromberg, Equity-
Debtholder Conflicts and Capital Structure (Harv. Bus. Sch., Nat'1 Bureau
of Econ. Research, Working Paper No. 10-070, 2010), available at
http://ssrn.com/abstract=1555660 (describing the capital structure effects
of Credit Lyonnais).

40 Prod. Res. Grp., LLC v. NCT Grp., Inc., 863 A.2d 772, 788-89 (Del.
Ch. 2004) (providing "shield" against shareholder objection, not a "sword"
for creditor imperative); N. Am. Catholic Edue. Programming Found., Inc.
v. Gheewalla, 930 A.2d 92, 100 (Del. 2007).

861



862 COLUMBIA B USINESS LAW RE VIE W [Vol. 2012

present value bet that favors the shareholders over the
interests of the corporation.4 1

A systemically important financial firm in the zone of
insolvency presents, however, an additional kind of fiduciary
duty challenge for the board due to the conflict between
managerial shareholders and the typical public
shareholders. In a capital raise or sale, a CEO's large equity
ownership position can produce a conflict of interest with
public shareholders akin to that in a management buy-out.
Preservation of the CEO's upside may entail a high risk of
systemic distress losses that are disproportionately borne by
public shareholders. While public shareholders of course
want to preserve their value in the firm, they have a much
greater tolerance for dilution than the undiversified CEO.4 2

Convertible equity-based pay offers the board an ex ante
approach to dealing with difficult fiduciary issues arising
from both the shareholder-creditor conflict and the
management-shareholder conflict. Presumably the trigger
for conversion of senior management's equity-based pay will
be a deterioration of the firm's financial condition. At that
moment, the firm is presumably in the "region of insolvency"
if not necessarily the "zone." The conversion of equity into
subordinated debt eliminates management's incentives to
pursue negative net present value bets. It consequently

41 See Prod. Res. Grp., 863 A.2d at 792; Gheewalla, 930 A.2d at 101-
02; see also Dianne F. Coffino & Charles H. Jeanfreau, Delaware Hits the
Brakes: The Effect of Gheewalla and Trenwick on Creditor Claims, 17
NORTON J. BANKR. L. & PRAC. 63 (2008). See generally Henry T.C. Hu &
Jay L. Westbrook, Abolition of the Corporate Duty to Creditors, 107
COLUM. L. REV. 1321 (2007) (providing a critical perspective on this
doctrinal development).

42 This conflict would be important even for those who would
minimize the significance of the shareholder/director conflict in the
vicinity of insolvency. The same is true for those who decry the doctrine as
unhelpfully collapsing the state law corporate governance regime-aimed
at protecting shareholder interests-into the federal bankruptcy regime,
triggered by a concrete legal event that results in judicial oversight of a
mechanism for creditor protection. See generally Stephen M. Bainbridge,
Much Ado About Little? Directors' Fiduciary Duty in the Vicinity of
Insolvency, 1 J. Bus. & TECH. L. 335 (2007).



No. 3:834] THE CASE FOR CONVERTIBLE EQUITY-BASED PAY

reduces the risk of creditor losses and of the failure of the
firm that could produce systemic losses for shareholders. A
board could find this ex ante approach particularly attractive
because the alternative approach to navigating the
management-shareholder conflict is to take over decision
making about capital raises and the sale of the firm as the
firm runs into financial difficulty.43

VI. CONCLUSION

This essay has proposed a novel compensation
mechanism for financial firms: convertible equity-based pay.
The goal is to reduce managerial incentives for excessive
risk-taking-that is, risk-taking that is disproportionate to

43 One potential objection is that the board's shareholder focus is
generally limited to interests with respect to the particular firm, not
"systematic" interests that arise because of share ownership in other
firms. One answer, of course, is that the governance of systemically
important financial firms is different, and concern for the "Fuld problem"
is one example. In the typical firm, nonshareholder interests can be
reasonably well protected through contract and tort; this is not so for the
systemically important firm. Moreover, the usual reason for the board's
own-firm focus is that shareholder interests outside the firm are so diverse
that the only point of shareholder agreement is to maximize share value of
the particular firm. This is not the case for diversified shareholders of a
systemically important firm, all of whom face systemic distress costs if the
firm fails. Moreover, the issue can be framed more narrowly: the conflict
is between managerial shareholders and other non-managerial
shareholders, a classic trigger for board concern.

A narrower reason for the board's concern about the "Fuld problem" is
that a board needs to attend to a conflict of interest between the CEO and
other shareholders, whatever the source. For example, in the case of
Smith v. Van Gorkom, the Court regarded the CEO's upcoming mandatory
retirement as undermining the board's entitlement to rely on his judgment
about a cash offer for the firm. 488 A.2d 858, 865-66 (Del. 1985). Both
the CEO and the other shareholders wanted to "maximize shareholder
value," but the CEO's desire for a near-term exit strategy presented a
clear conflict with the interests of other shareholders who lacked pressing
short-term objectives. Van Gorkom, 488 A.2d at 865-66. This conflict
required the board to intervene on their behalf. The "Fuld problem"
presents another instance of a clear conflict requiring board intervention
to protect non-managerial shareholders.

863



the social risk of systemic distress. It does this by forcing a
mandatory conversion of senior managers' equity into
subordinated debt on a valuation basis that imposes an
immediate loss but that also preserves incentives to prevent
further deterioration of the firm. In particular, this
mechanism avoids the "Fuld problem" of a CEO whose large
equity stake might deter him or her from pursuing a dilutive
capital infusion or sale that would reduce the chance of the
firm's failure. From the perspective of diversified
shareholders in a financial firm, this compensation
mechanism will improve their overall wealth because it
reduces the risk of systemic distress, which would damage
values across their portfolios and would increase the
systematic risk premium. Because of the improvement in
diversified shareholder welfare, convertible equity-based pay
could be pursued by private corporate governance activism.
It would also be a useful approach for the Fed's regulation of
executive compensation in systemically important financial
firms.

COL UMIA B USINESS LA W RE VIE W [Vol. 2012864