Managerial Opportunism and Hybrid Financial Instruments

Simone M. Sepe, LUISS University / Yale Law School

Abstract

In the context of a public corporation, investors are faced with a fundamental tradeoff between giving managers the freedom to maximize expected returns and constraining managers from behaving opportunistically. Managers who are not constrained have the opportunity and the incentive to pursue their own interests, at the expense of investors. However, constraining managers’ freedom in order to limit their ability to act opportunistically may mean interfering with their ability to make profit maximizing decisions for the business.

This paper will argue that corporate law cannot optimally solve the freedom-constraint tradeoff underlying manager-investor relationships and neither can the traditional contracts that investors write with firms: simple equity and debt contracts. The paper’s novel contribution is to show that hybrid financial instruments (HFIs) which are often issued by firms are better suited to solving this problem. By making it costly for managers to behave opportunistically, conversion and/or redemption options granted by HFIs can reduce managers’ incentives to deviate from the set of actions agreed to in the investors’ contract with the firm. This constraint scheme has the advantage of not preventing managers from pursuing alternative projects when these projects’ expected surplus is higher than the cost HFI options impose on their undertaking. For any given capital structure, it is possible to design HFIs so that only value-increasing decisions satisfy this incentive compatibility constraint. Hence, these instruments allow investors to write contracts in which the gains from giving managers freedom are not offset by increased agency costs.

This paper derives two policy consequences from this use of HFIs. First, it suggests that the imposition by law of a standardized HFI disclosure format would help reducing these instruments’ complexity and therefore promote their use by investors. Second, it shows that the use of HFI contracts can prevent the distortion of managerial incentives the shareholder primacy rule (SPR) occasionally induces, making this rule an optimal proxy for corporate value maximization. However, to avoid that uncertainty over the ex-post content of the SPR might jeopardize this property of HFI contracts, this rule should be strictly interpreted by courts. Further, under such a regime the SPR should be made a default norm to enable investors who cannot use HFIs to contract around the rule so as to mitigate its potential externalities.