Efficiency wages, managerial discretion, and the fear of bankruptcy

JouRNALoF &@iniitiorI

of Economic Behavior & Organization Vol. 33 (1997) 41-59

ELSEVIER

Efficiency wages, managerial discretion, and the fear of bankruptcy Noel Gastona*b** a Department of Economics. University of Adelaide, Adelaide, South Australia 5005, Australia b Department of Economics, Tulane University, Tilton Hall, New Orleans, Louisiana 70118, USA Received 26 June 1995; received in revised form 22 January

19%

Abstract In the absence of complete contracts, a firm’s shareholders may be unable to credibly commit to honor performance-contingent rewards to workers. However, it is managers who usually administer compensation contracts and ensure that implicit commitments are fulfilled. The separation of ownership and control can increase the value of labor’s specific investments in the firm. Departing from previous work on delegation, I allow managers to transfer wealth from shareholders to workers. This creates a beneficial role for debt and a fear of bankruptcy that ensures managers take an ‘appropriate’ view of the effect that the payments they make to workers have on the financial health of the firm. JEL classification: G30; J30 Keywords:

Managerial

discretion;

Implicit contracts;

Efficiency

wages; Bankruptcy

1. Introduction The relationship between managers and shar$holders is commonly modeled as having no effects on the firm’s stakeholders or other parties to the firm’s ‘nexus of contracts’. Stakeholders such as labor, creditors, and other investors in the firm are often assumed to hold fixed, senior claims on the firm that are reliably enforced either by the courts and/or by completely efficacious reputational concerns. However, managerial discretion and

* Present address: Department of Economics, University Australia. E-mail: [email protected].

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0167-2681/97/$17.00 0 1997 Elsevier Science B.V. All rights reserved PII SO167-268 1(97)00020-6

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of Economic Behavior & Org. 33 (1997) 41659

corporate control characteristics can potentially affect the wealth of all stakeholders in the corporation. When contracts are incomplete in the sense that they contain elements which cannot be reliably enforced by third parties, either by the courts or, in the case of reputations, by future trading partners, then equity-holders are not full residual claimants. Consequently, the effects on shareholder wealth of actions taken by the firm’s decision-makers do not reflect all the external effects. A recognition that share prices do not necessarily provide perfect guidance in evaluating corporate decisions underpins recent theoretical models stressing the value of ‘delegation’. The basic insight is that it can often pay shareholders to allow decisions to be made by managers who are not solely interested in maximizing share values. In other words, managerial discretion can serve as a ‘bonding device’ which allows shareholders to commit ex ante to valuable promises on which they would otherwise be expected to renege upon. In the growing literature on delegation, the best-known result is that ‘managerial’ firms can credibly commit to aggressive output market strategies, that would simply not be credible for pure profit-maximizing firms (e.g. Vickers, 1985 ; Fershtman and Judd, 1987). In a similar vein, Brander and Poitevin (1992) and John and John (1993) have shown that delegating authority and decision rights to managers who are not strict value maximizers can attenuate the ex post divergence of interests of shareholders and bondholders. Shleifer and Summers (1988) argue more generally that corporations encourage workers, suppliers, and even local communities to make valuable specific investments by selecting and entrenching ‘trustworthy’ managers. Such managers are assumed honest and are trusted to fulfil implicit contracts. In these papers, it is implicitly assumed that managers never redistribute wealth from shareholders to the firm’s stakeholders. Shleifer and Summers (1988) present case studies in which wages and employment were drastically reduced following hostile takeovers. They argue that these actions are consistent with the view that managerial discretion enhances the value of implicit contracts, as takeovers plausibly represent a ‘reweighting’ of objectives toward shareholders and away from managers. Econometric studies by Lichtenberg and Siegel (1990), Rosett (1990), and Peterson (1992) present more mixed results. Williamson (1988) cautions that the Shleifer-Summers evidence is also consistent with the traditional agency cost view of ‘managerialism’. Specifically, managerial discretion could manifest itself by wealth transfers from shareholders to workers, far in excess of any implicit contractual promise. The wage and employment cuts resulting from takeovers, or any other shareholder intervention in the firm’s affairs, would simply be redressing this inefficient state of affairs. The existing labor literature generally finesses two important issues. First, the firm’s shareholders rarely administer the terms of implicit contracts themselves. Rather, this responsibility is delegated to the firm’s managers. Consequently, managers have considerable discretion over the terms and conditions of implicit contracts. Not only is the motivation of subordinates a primary role of management, but managers normally determine what constitutes satisfactory performance and the rewards or penalties due to workers (see Levine, 1993). The second point is that managers may misappropriate or obtain utility from overpaying their stakeholder constituency (Jensen and Meckling, 1976). Slichter (1950, p.88) noted the importance of ‘managerial policy’ for determining

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the overall structure of wages in the economy, “. . . wages, within a considerable range, reflect managerial discretion, that where managements can easily pay high wages they tend to do so, and that where managements are barely breaking even, they tend to keep wages down.” In a similar vein, Monsen and Downs (1965) described management’s taste for a harmonious working environment. In particular, they noted that the problems associated with coordinating a widely dispersed group of shareholders and the regular, if not continuous, contact with workers and subordinates might lead management to cater more to the workers whose support they need. As a corollary, costs that arise from the unproductive lobbying activities of workers seeking preferential treatment from their superiors, or what Milgrom (1988) refers to as ‘influence costs’, may necessitate limits being placed on managerial discretion. In this paper, I consider implicit contracts that are managerially administered; in particular, deferred compensation contracts that are optimal when workers’ efforts are imperfectly observed or costly to monitor (see Carmichael, 1989). In the absence of complete contracts, the firm’s shareholders may find it difficult to credibly commit to honor any form of deferred payment to unsecured creditors, such as workers. Managerial entrenchment helps overcome this problem. Independent of any monitoring role they perform, professional managers also ensure that implicit commitments are fulfilled. Their presence increases the value of workers’ specific investments in the firm. In a departure from earlier work on delegation models, we allow managers to ‘misappropriate’ or to obtain utility by overpaying their subordinates. Concerns about managerial indiscretion are addressed in this paper by introducing a beneficial role for debt. The fear of bankruptcy and potential loss of firm-specific capital is a mechanism that ensures that managers take an ‘appropriate’ view of the effect that the compensation they award to workers has on the financial health of the firm. Managerial shareholding or tying managers’ fortunes to the value of the firm cannot alone achieve this, for it implies that workers will again be faced with the threat of opportunism, but now in the form of ‘managerial opportunism’. Once again, workers may choose to underinvest, or not to invest at all, in firm-specific assets. Section 2 lays out the basic model considered in this paper. It is shown that the presence of managers who derive utility from rewarding workers may help overcome the difficulty that the firm’s owners have in committing to pay deferred rewards to workers. In Section 3, the interaction between the firm’s capital structure, the managers, and the performance of its employees is considered. Section 4 discusses the empirical implications and evidence for the model and Section 5 briefly concludes.

2. The model The basic shirking or agency-cost model familiar in the labor and incentives literature (e.g. Becker and Stigler, 1974; Lazear, 1981) is adapted by introducing a role for a manager who administers the terms of implicit labor contracts by determining the reward to be paid for workers’ efforts. For simplicity, we consider a two-period employment relationship between a representative worker and a firm. Labor is essential to the production process. We also introduce a prominent role for debt in the model.

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At the outset, the firm’s founder chooses the capital and financial structure characteristics of the firm. The founder may also choose to sell a portion of their equity to other shareholders. The founder hires a manager and a worker. In period two, the worker produces output of value to the firm and the manager administers the worker’s contract and determines the reward payable, but only after the worker has worked. Two salient features of the model need to be emphasized. First, it is desirable to withhold some payment from the worker until after effort is provided due to moral hazard. Secondly, it is costly for the firm to credibly commit to uphold promises of deferred payments to hard-working employees. This paper focuses on the delegation of authority to a manager as a commitment device. 2.1. The worker The risk neutral worker is paid an upfront wage Wand a deferred payment or bonus B. W is paid before production (or any specific investment by the worker) takes place. The worker can either shirk or work. If the worker were paid entirely upfront, he would shirk. If the worker provides full effort, he produces output with value V to the firm and V - C, otherwise. Hence, shirking imposes costs C on the firm. The benefit to the worker of providing minimum verifiable levels of effort (or shirking) is 8. While the distribution of 0 is known by the worker and the firm at the time of contracting, we assume that its realized value becomes known to the worker, but not the firm, after the first period.’ For example, 19may be related to the level of job satisfaction that only becomes known to the worker after he has commenced employment at the firm (as in Carmichael, 1983). Prior beliefs about 0 across workers are represented by a c.d.f. G(&) = Prob(B < &) with density g(&) > 0, 0, E [e,@], @> 0 (and with G(B) = 0 and G(8) = 1). We assume that any worker caught shirking is not dismissed by the manager. In other words, shirking does not trigger a publicly observable signal that would lead to malfeasant workers being automatically terminated. This assumption serves to highlight the role of a manager who, for a given bankruptcy risk, would prefer paying and retaining his subordinates whether they shirk or not. It also forces us to focus on the avenues available to the founder of the firm that serve to ensure that a manager provides the ‘appropriate’ incentives to workers. Under the stated assumptions, a worker chooses to shirk whenever B, + 6 exceeds B,, where B, is the payment a worker receives should he decide to shirk and B, the payment should he decide to work. Letting 6 = B, - B,, the probability that the worker works is given by Prob (0 < 8) = G(6). Finally, the upfront wage is constrained to be at least the minimum wage, W 2 W,,, > 0. Hence, the worker may be unable to post employment bonds. The ‘This assumption simplifies the following analysis without affecting the nature of the results. If there were symmetric knowledge of 8, then compensation would depend on 0. For example, suppose that workers have value of marginal product equal to X and that their effort cost is X*/26’. The optimal effort level for a worker of type 0 equals 6. with an effort cost of 6/2. Hence, a deferred payment of at least O/2 would deter workers from shirking and high 0 workers receive higher bonuses. These bonuses are received after firm-specific investments or efforts are sunk; consequently, they are ‘exposed quasi-rents’ and the issue of how firms can credibiy commit them to make these payments still arises. See Garvey and Gaston (1991).

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of Economic

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assumption is important and is weakened in Section 3. The worker’s reservation alternative is W, (where W, > W,). Hence, to ensure the worker’s participation, the firm must also set W, + b + E(B 10 > 8) > W,, where E(B 18 > 8) is the worker’s expected shirking rents and B is the worker’s expected bonus. b is based on the worker’s knowledge of the firm’s indebtedness and the manager’s objective function. When W, is sufficiently close to W, the worker receives a surplus, relative to the reservation alternative so that the payment scheme is of the ‘efficiency wage’ type (see Carmichael, 1990). Note that such payments reduce the owner’s share of the surplus. If it were assumed that the worker were able and willing to post employment bonds (in essence, W,,, < 0), then with perfectly reputable firms, the bonus could be set arbitrarily high and there would exist no surplus for the worker. In addition to the minimum wage, features such as the progressivity of income taxes, discounting, an imperfect capital market, or worker endowment constraints would serve to limit the size of B. More generally, whenever the reputations of firms are not completely effective (see Bull, 1987), once effort is sunk and since B reduces the owner’s share of the surplus, the temptation to renege on promised payments to workers is selfevident.2 Also, note that the very nature of deferred payments is that their precise value is only determined after efforts have been observed (as in the case of promotions or merit pay increases for well-performing assistant professors, for instance).3 Rewards and punishments can be announced before workers exert any effort or firm-specific investment, but though valuable, and in the absence of third-party enforcement, committing to pay such bonuses may not be credible. The relationship between the shareholders, manager, and worker and the ‘order of moves’ in the model we consider are summarized in Fig. 1. 2.2. The founder The founder of the firm can choose to finance the firm’s operations by issuing debt to creditors. I assume that the founder can raise Da dollars of debt capital by incurring a debt obligation D, the face value of debt. The firm’s realized revenues are affected by a random productivity shock, y. We assume that y N F(.), with c.d.f. f(.) and support [z,~]; further, all parties know F(.). Creditors have claims on the firm that are senior to %rmichael (1989, p.72) notes that firm reputations are likely to be important when workers are imperfectly informed about the characteristics of firms and thus cannot predict with certainty the incentive for any tirm to honor future commitments. The ease with which a firm can go out of business, move its operations, or break-up and reconstitute itself, the importance of a firm as a going concern and the salvage value of its assets in place, and the way in which information about firm characteristics are passed on from one generation of workers to another are all factors that may affect fum reputations. While not denying the importance of any of these factors, the focus in this paper is on the managerial administration of implicit contracts and how this may lower contractual commitment and enforcement costs. ‘There is certainly no presumption that deferred payment schemes are the only type of self-enforcing contract thai efficiently address the ‘shirking problem’. In general, there can be a multitude of such contracts (see MacLeod and Malcomson, 1989). The stylized deferred payment contract considered here is motivated by two assumptions. First, workers have finite lifetimes or enter contracts of fixed length with their employers, hence, they may cheat in the last period of a contract. This requires some form of ex post settling up (see Carmichael, 1989). Second, I do not assume that firms reputations are perfectly effective when it comes to upholding implicit contracts with workers (see Bull, 1987). The latter assumption enables me to focus on the role of managerial discretion as a way of enforcing implicit contracts.

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of Economic Behavior & Org. 33 (1997) 41-59

I

I Founder sets capital structure; hires n manager

I

Worker joins /irm

I

I

Worker chooses eflorl

B revealed to worker

I

Manager sets B

Revenues realized; cash jlows disbursed

Fig. 1. Timing of events.

those of shareholders

and become the firm’s residual claimants

whenever

V - B, + y if worker works, 1 V - C - B, + y otherwise,

D>

(11

where the subscripts on B represent the bonuses that are paid by the manager when the worker either works (w) or shirks (s), respectively. The worker’s claims on the firm’s revenues are more senior than those of debtholders and shareholders. Formally, the worker receives the first B dollars, debtholders receive the next D dollars, and shareholders receive the remainder, if it is positive.4 Let yzi(i = s, w) be the critical bankruptcy state, where for y < 72; the firm is bankrupt and the creditors become the residual claimants. In particular, we define yzW = D + B, - V and -yzS= D + B, - V + C.

(2)

Hence, F(yzi) = Prob(y < ~2~) represents the probability of bankruptcy. Note that once efforts are sunk, higher D, as well as higher B, increase the probability of insolvency by

f (72;). Define yii(i = s, w) as the critical state where creditors workers receive at least some part of their B, as Ylw =

B, - V and yiS = B, - Vt

Assume that debt is priced in an efficient, risk-neutral from debt of value D are equal to Do = G@)[D(l +(1 - G@))[D(l

-

F(72w))

F(72s))

+

+

receive

nothing,

C.

‘*w(V - B, ~ T(D) + y)dF(y)]

‘*‘(V - C-B, 715

(3)

bond market so that the proceeds

s YlW

J

although

(41

- T(D) + y)dF(y)].

Eq. (4) is the debtholders’ participation constraint. Debt is discounted for the probability of default and the probability that workers shirk. T(D) represents the costs incurred by creditors during bankruptcy proceedings (see Bronars and Deere, 1991).5

*his approximates actual bankruptcy practice and is called the ‘absolute priority rule’ (see White, 1989, p.139). See footnote 11. ?(D) is assumed convex and increasing, i.e. T(D) > 0 and T”(D) > 0 for D > 0. As the amount of debt increases, the number of creditors generally increases, hence bankruptcy proceedings involve more agents and competing claims. In the present context, these costs serve to impose some cost on workers and managers who would otherwise be indifferent about the firm’s bankruptcy. However, it is also assumed that these costs are not so high that creditors would be unwilling to lend to the firm in the first place.

N. Gaston/J. of Economic Behavior & Org. 33 (1997) 41-59

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Ex ante, the bond that the workers expect to receive is B = G@)[&,(l

+(l -

- F(yl,))

+ l”w(V

+

yPF(-/)l

(5)

G(B))[&(l- F(x)) + /‘“(V - c +y)d%)l. Y

To summarize, for y E [72i,y] the firm is solvent, the shareholders are paid the residual, the workers are paid B, and the creditors D; for y E [yti,yzi] shareholders receive zero, creditors receive some of their D, and workers are paid all of their bonus; for y E [y, - yii] shareholders and creditors receive zero, and workers receive any residual. 2.3. The manager The firm’s owner can alleviate the commitment problem, associated with making deferred payments, by hiring a manager whose job it is to administer implicit contracts with workers. To make these issues completely transparent, assume that the manager produces no output, but has discretion in the sense that they determine the worker’s bonus after observing the worker’s effort. The manager maximizes an objective function of the form U(Bi)

= M + Z(Bi)

- JF(yTi),

i = w, s,

(6)

Apart from a management fee, M, there are two other forms of managerial consumption: Z(Bi) represents the utility derived from paying bonuses.6 For simplicity, we assume z to be a positive constant so that the manager’s benefit from paying Bi to workers provides constant marginal utility. The reason for including such a component in the utility function is that the manager receives a payoff from having ‘happier’ workers and a more harmonious working environment or may have reputational concerns of their own related to delivering bonuses to workers. This is consistent with the efficiency wage literature that suggests that managers may value worker morale, loyalty, and the perceived ‘fairness’ of the wage (e.g. Akerlof and Yellen, 1990) and a number of other studies that indicate that managers prefer harmonious relations with workers (e.g. Medoff and Abraham, 1980; Monsen and Downs, 1965). In particular, including Z(Bi) captures the spirit of delegation models in which it pays to entrench an agent with preferences different from the owners of the firm (see Jones, 1989). In this case the crucial difference is that managers are known, all else equal, to honor compensation promises to workers. The role of the manager is similar to the ‘budget-breaker’ who enforces penalties and pays rewards as suggested in Holmstrom (1982). The level of the worker’s bonus is determined entirely by a manager whose “. . primary role . . . is to administer incentive schemes that police agents in a credible way rather than to monitor agents as in Alchian and Demsetz’ story” (Holmstrom, 1982, p.328). Alternative specifications for managerial preferences (including the possibility of diminishing marginal utility) are considered in Appendix A.

‘If the manager derived utility from total compensation,

i.e. W + B, this would simply increase I/(.) by ZW.

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of Economic Behavior & Org. 33 (1997) 41-59

The interpretation given to J > 0 is that it represents the ex post ‘rents’ or firm-specific investments that would be lost by the manager if the firm were liquidated. An alternative interpretation is that J represents the personal transaction costs borne by the manager were the firm to go bankrupt. These costs may be associated with looking for a new job (see, e.g. Brander and Poitevin, 1992). Even simpler, is that J represents the weight given to debtholders’ claims, either implicitly (Garvey and Swan, 1992) or explicitly (Gilson and Vetsuypens, 1993).7 The manager can affect the probability of the loss of rents by the delegated authority to set B. Managers assess the contribution of the worker to reducing the likelihood that the firm will go bankrupt.8 Without this cost, the manager would be indifferent to the bankruptcy of the firm and simply pay high B to the workers. The first-order condition for the manager is U’(Bi) = Z - Jf(yzi) = 0,

i = W, S.

(7)

After having observed the worker’s output, the manager equates the marginal benefit of paying higher bonuses to the worker and the marginal impact of paying B on the likelihood of bankruptcy.’ The benefit of awarding higher bonuses is that they provide utility directly to the manager. The cost is the potential loss of on-the-job rents resulting from a higher probability of firm bankruptcy. Note that if 2 < 0, then Bf = 0 and the worker would shirk. Eq. (7) has a number of implications that are summarized in Proposition 1. Proposition I. (i) (a) If C > 3 , th e manager sets B, > B, + e, so the worker always works; (b) If C = 6 E [8, @I,the manager sets B, = & + 8, so that with probability G(8) the worker will work and with probability 1 - G(0) the worker will not work; (c) If C 5 e the manager sets B, < B, + & so the worker never works. (ii) The risk of bankruptcy is the same whether the worker works or shirks. (iii) The manager is better o& if the workers do not shirk. Proof. (i) From Eq. (7), z/J =f(D+ B, - V) if the worker works and z/J = f (D + B, - V + C) if not. Clearly, B; = B,* + C. Hence, C = s gives case (b). Cases (a) and (c) follow from f’ > 0. (ii) Part (i) implies yzw = yzs, so that ‘Another force operating to limit managerial indiscretion and excessive consumption of perquisites, which in this paper take the form of overpaying subordinates, is the managerial labor market. However, given the twoperiod structure of the game considered here, there can be no disciplining of the manager through subsequent wage revision (see Fama, 1980, p.304). On the other hand, J can be interpreted as a form of ex post settling-up, since the amount the manager transfers to workers affects the profitability of the firm and hence the probability of bankruptcy. Bankruptcy imposes significant costs on the manager (see Section 4). There is no guarantee, of course, that ex post settling-up would be complete with either a well-functioning labor market for managers (as Fama, 1980, p.306 notes) or with bankruptcy risk. sWe could also allow the manager to have some claim on the firm’s residual income, but this adds little. Higher managerial shareholding would lower the bonuses managers pay to workers, hence it is conceptually similar to investigating the effects of higher J. The Appendix considers a model with managerial shareholding and another model where J represents managerial job perquisites that reduce firm rents. ‘The second-order condition is: U”(Bi) = pJf’(yz,) < 0, i = w, s. Necessary for E* to maximize (Eq. (6)) isf’ > 0. If F(.) is symmetric and unimodal, this will be satisfied as long at the firm is solvent with probability greater than l/2. A sufficient condition is F”(.) > 0 (Convexity of the Distribution Function Property, see Grossman and Hart, 1983).

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of Economic Behavior & Org. 33 (1997) 41-59

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(iii) The manager’s utility is U(B,) = M + ZB, - JF(yzw) if the worker works and U(B,) = M +zB, - JF(72,) if the worker shirks. Hence, U(B,) - U(B,) = z > 0. !J F(T~~)

=

F(‘Y~~).

Hence, the dollar amount of the potential shirking cost imposed on firms is crucial for the compensation-setting behavior of the managers. Intuitively, if C is low then shirking does not place the firm at risk of bankruptcy and the manager has little to lose by allowing the worker to shirk. If C is high, the manager prefers subordinates to work. If C is ‘moderate’, the manager will allow some workers to shirk (those who draw high 0). Nothing in the model requires that C be large or small. On the other hand, small C implies that worker moral hazard is not economically important. In turn, this would tend to weigh against the use of compensation policies that involve deferring the worker’s compensation in the first place. In the following, I focus on the intermediate case (b) so that there will exist some shirking in equilibrium. From Eq. (7), the comparative statics are Bit = B:, = -B;” = -Jf(72i)/Jf(72i)

= -1,

(7a)

where i = w, s and Bix = dBi/dx. BLc = -1 indicates that when the cost of shirking increases that managers with an eye on the financial health of the firm reduce bonuses dollar-for-dollar. Note that this condition differs from that found in the standard bonding model (e.g. Lazear, 1981). In that model, B is set at the beginning of period one, or before the effort decision is made, with a view to deterring worker shirking, hence B increases in C. In the present context, B is set by the manager after the worker has performed and, thus, B adjusts to reflect worker efforts and shirking costs. From a commitment perspective, note that the more valuable are the worker’s efforts to the firm, then higher bonuses are paid by the manager, i.e. Biv = 1. That is, a manager will increase B if the worker produces more value. The worker knows this to be the case. The presence of the manager ensures that bonuses are paid to hard-working employees. This overcomes the time-inconsistent incentives of shareholders. However, the latter feature also provides the motivation for focusing attention on bankruptcy as the mechanism that disciplines the manager from ‘overpaying’ the workers. Eq. (7a) reveals that higher debt reduces B. That is, debt obligations limit the amount of the firm’s revenues the manager can pay their subordinates without the driving the firm to bankruptcy. We turn to this issue next.

3. The role of debt The founder of the firm chooses the optimal capital structure of the firm. The expected return to the founder is simply r lI(D) =D,--

W-M+ s 72

(V - D -B

+ y)dF(+r),

(8)

where B = B, = B, + C (Proposition l(i)) and 72 = 7zw = 7zS = D + B - V (Proposition l(ii)). The founder takes an initial dividend of Do - W - M which represents

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of Economic Behavior & Org. 33 (1997) 41-59

the payment for setting up the firm; providing plant and equipment, etc. The integral represents the expected residual after payments are made to labor and creditors. To encourage the worker and manager to participate they must receive at least W, and M, levels of reservation utility, respectively. That is,

G(8)U(B,) + (1 - G@))U(B,) 2 Ma, where fi is the worker’s expected bonus. Using Proposition B=B(l

-F(y,))+

J"

(V + y)dF(y)

(9b)

l(ii), we can write Eq. (5) as

- (1 - G(B”))C,

UOa)

_Y

where yr = yr,,, = yrs = B - V. The last term on the right-hand side indicates that B falls dollar-for-dollar if the worker shirks. Proposition l(iii) allows us to evaluate the manager’s expected utility as G@)U(B,)

+ (1 - G($)U(B,)

= M + Z(B) - JF(y2) - (1 - G@))))zC.

(1Ob)

Hence, worker shirking imposes a dead-weight loss on the manager. In the following, we assume that the market for managers is sufficiently competitive so that Eq. (9b) binds with equality. As mentioned in Section 2, whether the worker’s participation-constraint binds depends on whether workers receive any rents. In Eq. (9a), the upfront wage W could be negative (hence the terminology, ‘bonding’), so that workers do not earn any economic rents during their tenure with the firm. The worker will earn rents ifW=W,>O. In choosing D to maximize Eq. (8) there are two cases to consider. The first case is where competitive labor market conditions ensure that the worker’s expected utility is exactly W,. The second case is the efficiency wage case, i.e., where performance bonds cannot be posted; as for instance, due to rigidly enforced minimum wage legislation. Case I (No worker rents): The founder’s objective is described by Eq. (8) above, Substituting Eq. (4) and assuming that both constraints in (9 a and b) bind, Eq. (8) can be drastically simplified to yield

JJO@ -(I -G(6)= -

II(D) = V-

W, +

C)dG(B)-

(F(y2)

- F(T))W’)

where ET is the expected value of y. Kuhn-Tucker D@(D)

= -DI(F(y2)

- F(n))T’(D)

+f(n)T(D)+.!ffyd]

(11)

Ma +Z(B)-JF(y2)

first-order

+ ET,

conditions

are

= 0 and n’(D)

5 0, (12)

having simplified and using Eq. (7), and noting that & = 0. Clearly, D* = 0.Debt plays no role! In order to get the workers to work, managers are encouraged to fully pay out B

N. Gast0d.l.

51

of Economic Behavior & Org. 33 (1997) 41-59

to workers. The managerial consumption z is offset by ‘charging’ a fee to manage the firm, i.e., Z is part of the manager’s compensation, which reduces the upfront fee M payable to managers. And, of course, high B is ‘recovered’ from the worker by having them post large bonds (small W). As long as Eq. (11) is positive (i.e. II(O) > 0), this would be preferable to having no manager at all. Case II (Worker rents or eficiency wages): Without loss of generality, suppose that the worker’s participation constraint is

where ‘p E [0, I], with cp = 1 representing the ability of the worker to post performance bonds (as in case I), and cp = 0 being the case, where W, = W, and the worker’s bonus is all economic rent. By construction, worker participation is assured. (1 - cp) is simply the fraction of the worker’s expected wealth that is economic rent. Alternatively, cp may be interpreted as a bargaining power or rent-sharing parameter with cp 4 0(-t 1) representing an improvement in the worker’s (firm’s) relative bargaining position. The founder’s objective is now described by II(D)=V-w,-(l-cp)B+cp

_‘(0 - C)dG(B) - M, + Z(B) - JF(y2)

(14)

s -(l

- C@)PC

-

N-Y2)

”

~(~I~~W~

where B is given by Eq. (lOa). Substituting condition, assuming an interior D, is II’(D) = (1 - cp)(l - F(P))

- 2 -

(F(y2)

+

ET,

cp = 1 gives Eq. (11). The first-order

-

F(y,))T’(D)

-f(n)W)

=

0,

(15)

once again using Eq. (7).” It is clear from Eq. (15), that as cp --f 1, D* + 0. Hence, the existence of worker rents, in the efficiency-wage sense, requires more debt to limit the discretion of the manager.

4. Empirical

implications

and discussion

The preceding sections examine a setting in which it is costly for firms to commit to pay performance bonuses to workers. In Section 2, it was shown that the separation of ownership and control or the presence of managers who prefer, all else equal, to pay performance rewards to workers may lower these commitment costs. In addition, under certain circumstances debt can be used to encourage managers to act in the best interests of the firm. In Section 3, it was shown that the absence of performance bonding enhances the beneficial role for debt. Specifically, debt is most important when workers earn

‘%or D’ to be a global maximum we require n”(D) = (1 - p)j(yl) - (F(yz) - F(yl))T’(D) - 2f(n) T’(D) +f’(rl)T(D) < 0. Hence, 3D*/a~ = (1 - F(y,))/n”(D) < 0. Since ‘p is inversely related to the existence of worker rents then debt is higher when workers earn efficiency wages.

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Behavior

& Org. 33 (1997) 41-59

economic rents or ‘efficiency wages’. In this section, we consider some evidence that bears on these findings. There are three inter-related features of the model developed in this paper. First, managers with discretion gain utility from rewarding their subordinates and prefer to honor implicit compensation promises. Second, managers are disciplined by debt. Finally, leverage is higher when the share of firm rents that workers receive is greater, ceteris paribus. As for the first feature, are managers likely to honor implicit contractual promises and generally be ‘nice’ to workers? Management compensation, broadly defined, and the compensation of subordinate workers are positively related. The economics literature has long had stories about management’s desire for a ‘quiet life’ and harmonious working relationships with their subordinates (e.g. Hicks, 1935; Monsen and Downs, 1965) and, as mentioned in Section 1, Slichter (1950) attributed the high wage-low wage structure across industries to managerial generosity toward workers. There has also been an empirical literature that generally finds evidence of the ‘expense-preference’ behavior of managers. For example, Hannan and Mavinga (1980) find that manager-controlled banks operating in noncompetitive markets spend more on inputs likely to be preferred by managers, including the wages and salaries of employees, compared to owner-controlled banks. More recently, Levine (1993) provides evidence about the importance of ‘fairness’ and equity for compensation managers. In particular, he finds that managers are likely to maintain equity and constant wage differentials within broad occupational or career groups, even when external labor market conditions would seem to dictate otherwise. That is, managers tend to preserve the career incentives of their subordinates. Why managers act like this, when they are not impelled to do so, is moot, of course. However, there do exist instances where the reason is transparent. For example, some firms have recently adopted compensation policies that limit the monetary rewards for their top executives to some pre-determined multiple of the average compensation levels of their subordinates (see Mitchell, 1992). More indirect evidence is provided by Shleifer and Vishny (1989) who interpret the large positive stock price effect on the sudden death of an entrenched manager (see Johnson et al., 1985) as evidence that the firm’s employees and other suppliers were attached to him and that he administered and negotiated many of their implicit (not explicit) contracts. When an executive dies, the firm inherits many of the implicit contracts. On the other hand, if the board fires the executive, he would take the contracts with him and the value of the firm falls. Hence, there is a value to managerial entrenchment. In fact, Shleifer and Vishny go on to suggest that the very reason that implicit, rather than explicit, contracts are negotiated by managers is their desire to entrench themselves. This enables the managers to extract higher wages (and also explains the positive stock price reaction). The ability of managers to transfer rents to workers hinges on their entrenchment. If they are not entrenched, the firm’s owners cannot commit to hire a manager and not to dismiss him or her when it suits them. Carter and Stover (1991) examine the effect of changes in management ownership on the total compensation costs for employees of savings and loan associations. They find a negative relationship between management

N. Gaston/J. of Economic Behavior & Org. 33 (1997) 41-59

53

ownership and total compensation for both high and low ranges of ownership and a positive relationship in the intermediate range. At moderate levels of shareholding, managers are effectively entrenched (see Merck et al., 1988). At low levels of managerial ownership, the cost to shareholders of removing managers is relatively low and at sufficiently high levels of ownership, the managers have motives indistinguishable from those of the firm’s other shareholders (see Appendix A). As for evidence on the relationship between deferred rewards and managerial share ownership, Garvey and Gaston (1991) find that deferred compensation is greater when the separation of ownership and control is more complete, for a sample of middle managers at large Australian firms. They interpret their findings as being consistent with the view that delegated authority can encourage the formation of valuable implicit contracts. An implication of the model in this paper is that managerial compensation may exhibit a low sensitivity to firm performance in order to encourage work efforts by subordinates. In the recent literature, the focus has been on the benefit of performance-insensitive compensation for CEOs that lowers the agency costs of equity finance (e.g. Brander and Poitevin, 1992; John and John, 1993). The empirical implication of both research perspectives is that debt will be higher in ‘pure’ managerial firms. Recent research provides evidence consistent with this implication. Friend and Lang (1988) find that the top manager’s pay sensitivity to company performance is lower in leveraged firms. That is, debt-equity ratios are generally higher in firms run by ‘pure’ managers. In the present setting, the role played by debt relates to the incentives of managers to over-reward workers. This is very much in keeping with the literature where debt is used to reduce the agency costs of ‘free cash flow’, i.e. quasi-rents or profits (Jensen, 1986). More generally, by committing cash flows to bondholders, the use of debt can limit the discretion of managers in their administration of implicit contracts. While managers perform the role of ‘budget-breaker’ by rewarding hard-working workers, debt ensures that managers weigh the effect of bonuses paid to workers on the financial health of the firm. While a surplus may be necessary to encourage workers to invest in the firm, limits must be placed on managerial discretion to prevent ‘over’ payments to subordinates. Another important feature of debt in the model of the previous sections is that bankruptcy would be costly for the firm’s managers. Gilson and Vetsuypens (1993) provide evidence that the costs of bankruptcy for managers are potentially great. For firms that are financially distressed or file for bankruptcy they find that about one-third of CEOs are replaced and that those keeping their jobs experience large salary and bonus reductions. In addition, newly-appointed CEOs with ties to previous management are typically paid about 35% less than the CEOs they replace; while those without such ties are paid 36% more. The final major implication of the model developed in this paper is that debt is most useful when workers earn economic rents or a greater share of firm rents. Ippolito (1985) and Bronars and Deere (1991) describe a beneficial role for debt with a similar function to that which it plays in this paper. Debt may aid in avoiding the potential appropriation of firm-specific quasi-rents by unions threatening to organize and to increase wages above competitive levels in particular firms. Bronars and Deere show that the cost of higher debt or an increased probability of bankruptcy can be offset by the benefits of expected wage savings. In their model, creditors hold senior claims on the firm’s assets,

54

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in turn, this reduces the temptation to rent-seeking unions.’ ’ Debt serves the role of committing the firm’s net revenues to third parties. Bronars and Deere also present empirical evidence indicating that industry debt-equity ratios are positively related to industry unionism rates. They conclude by suggesting that higher leverage provides an effective shield against the potential losses from union organization. Since unionization and wages are highly positively correlated, their evidence is also consistent with an important implication of the model in this paper. That is, debt is higher when workers receive a greater share of the firm’s rents. This paper suggests an even more general relationship between capital structure and industry rents. Higher debt limits the amount of compensation that workers receive over and above their reservation alternative, regardless of whether this surplus is gained by union bargaining strength or by managerial discretion or expense-preference behavior.

5. Conclusion Shareholders rarely play a central role in the administration of implicit contracts with workers - managers do. When implicit contracts are important and when reputation effects are not completely effective, professional managers, with interests sufficiently distanced from those of the firm’s shareholders, may provide the agency benefit of providing a credible commitment that promises of deferred compensation to hardworking employees will be honored. This paper showed that the separation of ownership and control may therefore increase the value of the firm’s implicit contracts with workers. This paper also contributed to the literature on delegation models by introducing a beneficial role for debt. Debt provides a mechanism that ensured that managers, while still interested in fulfilling the implicit promises made to workers, will not transfer the entire value of the firm to the firm’s stakeholders. However, the argument for the beneficial role of debt was shown to only apply when workers received payments in excess of competitive wage levels.

Acknowledgements The author is grateful to Gerald Garvey, Robert anonymous referees for their constructive comments.

Hutchens,

Jay Stewart,

and two

“Since only verifiable worker claims would be covered by bankruptcy law, it could be argued that promised bonuses would not receive priority over debt claims in a bankruptcy settlement. However, the seniority of claims is not central to the findings of this paper. For instance, if we redefine the problem so that workers receive zero and creditors get all or some part of the residual in the event of bankruptcy, i.e. yIW = D - V and ?I~ = D - V + C, then in lieu of Eq. (1l), the founder’s objective is II(D) = V - W, +

‘(0 ~ C)dG(B) - A4, + Z(B) - JF(yz) - (1 - G(8))% J’H

-(G(@(r~w) It is straightforward

+ (1 ~ G(~)F(w))T(D)

+ ET.

to show that the key results from Section 3 still hold.

55

N. Gasron/J. of Economic Behavior & Org. 33 (1997) 41-59

Appendix A Alternative A.

specifications

1. Management

of the manager’s

utility

shareholdings

In lieu of Eq. (6), suppose the manager maximizes U(Bi) = M + Z(Bi) - JF(T&) + X where X E (0,l) condition is

and

all other

terms

U’(B,) = Z - Jf(rzi) The second-order

condition

i = w, s,

‘(V - D - B + y)dF(y), s ^12, are as previously

defined. i =

+ X( I - F(yF&)) = 0,

W,

The

(Al)

first-order

S.

C-42)

is

U”(Bi) = -Jf’(yzi)

+ Xf(yzi) < 0,

i =

W,

(A31

S.

Eq. (A3) requires f’ > 0 as well as X to be ‘small’ relative to J. This means that the manager must have a greater concern for firm survival and downside ‘risk’ than the upside opportunities embedded in the option characteristic of common equity (see Garvey and Swan, 1992, p.363). Comparative statics, for i = w, s, are Bix = (1 - F(y*i))/U”(Bi)

< 0;

BiJ =f(Tz;))/U”(Bi)

BiD = -Biy- = (Jf’(‘~z~) - xf(Tzi))/U”(Bi)

= 1;

< 0;

(A41

and B:, = -1.

Satisfaction of Eq. (A2) requires B:, = B$ + C. As in Section 2, this leads to Proposition 1. The return to the founder is r II(D)=DO-W-M+(l-X) Further, as long as the manager’s Section 3 is unaltered. A.2. Diminishing

(V - D - B + y)dF(y). J’Y2 participation

in

maximizes U(B,) = M +

W, S,

Eq. (9b) binds, the analysis

marginal utility

Suppose the manager

for i = condition

constraint

(A5)

where

Z’(Bi) > 0 and

Z(Bi)

-

(‘46)

JF(Y2i),

Z”(Bi) < 0, with

Z(0) = 0. The

first-order

is U’(Bi) = Z’(Bi) - Jf(yzi),

The second-order

condition

i=

(A71

is

U”(Bi) = Z”(Bi) - Jf’(yzi) < 0, Since Z”(Bi) < 0, sufficient

W, S.

for B* to maximize

i =

W, S

Eq. (A6) isf’ > 0. Comparative

(A@

statics,

56

N. Gaston/J.

of Economic Behavior & Org. 33 (1997) 41-59

for i = w, s, are Bio = Jf’(Tzi)/U”(Bi) Biv = -Jf’(yzi)/U”(B;)

B> =f(TZi)/U”(Bi)

< 0;

< 0;

andB& = .I”‘(~~~)/U”(B,)

> 0;

649) < 0.

In fact, BID E (-I, 0), with B!o + 0 as Z” 4 -cc and Bio + -1 as Z” + 0. A dollar of additional debt leads managers to reduce B by less than a dollar. Further, Biv E (0, I), with B:o + I as Z” --f 0. That is, a dollar of additional value produced by the worker increases the bonus payment to workers by less than a dollar. Proposition AI. (Diminishing

marginal utility). The manager sets (i) B, > B, but (ii) (iii) the probability that the worker works is lower; (iv) the risk of

B, > B, + C; bankruptcy

is higher if the worker shirks.

Proof.

(i)

Z’(B,)/J

=f(D

Follows

B:,

from

< 0

and

Eq. (A6);

(ii)

+ B, - V) if the worker works and Z’(B,)/J

From

=f(D

Eq. (A7),

+ B, - V + C) if

not. Bk < Bz + C since C > 0 and Z’ is decreasing in Bi, for i = w, s; (iii) Since 8 = B, - B, then 8 < C, hence, Prob(B < 8) = G(8) < G(C); (iv) From (ii), yzW < yzs,

q

so that F(-Y~~) < F(y4. Proposition A2. diminishes, Proof

As the manager

i.e., as Z” +

-m

becomes

more risk-averse,

the bene@cial role of debt

then D” + 0.

The founder’s objective

is T

II(D) = Do - W -M

(1 - G(8)) ./I(V >I Substituting

J’

+ G(6)

(V - D - B, + y)@(y) 7%.

(AlO)

- C - D - B, + y)dF(y).

Eq. (9b) and Eq. (13) rewrite Eq. (AlO) as

s

II(D)=V+Ey-W,-(1

.I’

-cp)B+cp

(6’ - C)dG(B) - M,

hr

+G@)(Z&)

-

WjW(y2d

-

JF(y2,))

+

F(TI~))T(D)

(1 -

G@))(Z(B,)

(1 -

-

G(@)(%2,)

(Al 1)

WYZ,)) -

F(yd),

where B is given by Eq. (5). As 2” + --co, B& ---f 0. Hence, in the limit, the first-order condition becomes n’(D)

= -G(&!WY~~)

- (1 -

-(@)[%2w)

Since H’(D) < 0, D* = 0.

-

G(@)Jf(xs) - (G(@(mv) - (1 - G(@)f(yzs))T(D) (A121

F(nw)]

0

+

(1 -

G@))[%z.,)

-

F(y,,)])T’(D).

N. Gaston/J.

of Economic Behavior & Org. 33 (1997) 41-59

A.3. Effect of job perks Let the manager’s rents J reduce the firm’s revenues directly. For example, J may be on-the-job perquisites or fringe benefits that would be lost if the firm were to go bankrupt. The founder’s objective is now r (V - D - B, - J + y)&‘(y) s YZW

II(D) = Da - W - A4 + G(6)

(Al3)

(1 -G(t?))J’I(V-C-D-B,-J++%(y), s where 72W = V - D - B, - J and yzS = V - C - D - B, - J. Higher J increases the risk of bankruptcy. Clearly, the manager’s marginal incentives are unchanged, and Proposition 1 follows. The return to the founder is R

II(D) = V - W, - (1 - cp)B + cp -(I

-

G@))ZC

-

.I e

(0 - C)dG(B) - M, + Z(B) - J

(F(+Y~)

with B given by Eq. (10a). The first-order

-

F(yl

condition,

=‘cD)= (1- cP)(l- F(‘Yt)) + z - (F(y2) -

)V-(D)

assuming F(y,))T’(D)

t.414)

+ ET,

an interior D, is -f(r,)T(D)

= 0,

using Eq. (7). This increases the optimal D’ for all ‘p. However, the principal finding remains, i.e. debt decreases in ‘p and increases with the payment of efficiency wages. References Akerlof, George A. and Janet L. Yellen, 1990, The fair wage-effort hypothesis and unemployment, Quarterly Journal of Economics, 105, 231-254. Becker, Gary S. and George J. Stigler, 1974, Law enforcement, malfeasance, and compensation of enforcers, Journal of Legal Studies, 3, I-18. Brander, James A. and Michel Poitevin, 1992, Managerial compensation and the agency costs of debt finance, Managerial and Decision Economics, 13, 55-64. Bronars, Stephen G. and Donald R. Deere, 1991, The threat of unionization, the use of debt, and the preservation of shareholder wealth, Quarterly Journal of Economics, 56, 23 l-254. Bull, Clive, 1987, The existence of self-enforcing implicit contracts, Quarterly Journal of Economics, 102, 147159. Carmichael, H. Lome, 1983, Firm-specific human capital and promotion ladders, Bell Journal of Economics, 14, 251-258. Carmichael, H. Lome, 1989, Self-enforcing contracts, shirking, and life-cycle incentives, Journal of Economic Perspectives, 3, 65-83. Carmichael, H. Lome, 1990, Efftciency wage models of unemployment - one view, Economic Inquiry, 28,269295. Carter, Richard B. and Roger D. Stover, 1991, Management ownership and firm compensation policy: Evidence from converting savings and loan associations, Financial Management, 20, SC-90. Fama, Eugene F., 1980, Agency problems and the theory of the firm, Journal of Political Economy, 88,288-307. Fershtman, Chaim and Kenneth L. Judd, 1987, Equilibrium incentives in oligopoly, American Economic Review, 77, 927-940.

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Slichter, Sumner H., 1950, Notes on the structure of wages, Review of Economics and Statistics, 32, 80-91. Vickers, John S., 1985, Delegation and the theory of the firm, Economic Journal, 95, 138-147. White, Michelle J., 1989, The corporate bankruptcy decision, Journal of Economic Perspectives, 3, 129-I 5 I. Williamson, Oliver E., 1988, Comment, in: Alan J. Auerbach, Ed., Corporate Takeovers: Causes and Consequences, (University of Chicago Press, Chicago, Illinois) pp. 61-67..