No issue in recent American politics has stirred more passion than that of excessive executive pay, especially in poorly performing firms. In March 2009, when media outlets reported that high-level managers of the insurance firm AIG would receive bonuses—though the company had needed billions in government bailout money just to stay afloat—President Obama called the payouts outrageous and promised that he would work to block them. Politicians across the spectrum echoed the president’s anger and derided the bonuses as an affront to common sense. But work by Andrea Eisfeldt, an associate professor of Finance at the Kellogg School of Management, and Adriano Rampini, an associate professor at Duke University, suggests that there is an economic logic behind giving bonuses to badly performing executives. Though politically toxic, such bonuses serve a purpose.

The research focuses on the influence that managers have on the timing of the revelation of bad news, which can be used to downsize and restructure poorly performing firms. More broadly, high-level managers have a major impact on the potential for economy-wide capital reallocation and restructuring. In theory, there should be a high level of capital reallocation during an economic downturn, with assets being shifted from bad managers to good managers. This is because the differences between well and poorly performing firms are larger in recessions. Also in theory, there are strong incentives for corporate takeovers during bad economic times, since stronger firms can buy the assets of weaker firms at a lower cost. Yet these theoretical likelihoods do not hold true. Capital reallocation across firms slows during bad times and, as Eisfeldt and Rampini have shown in previous work, trade between firms diminishes. “There’s something inhibiting reallocation in recessions,” Eisfeldt says. “There’s more sand in the wheels of the economy.” But why?

Managers play an important role in the answer because they have private knowledge about their suitability for the job and about the firm’s overall performance. They know how well their company is likely to be doing some time down the road, based on information that is available only to them. This is good news because the information can help the firm correct its course and improve its performance, but bad news because the managers may keep the information to themselves.

Incentives for Honesty
And this is where the bonuses come into play. The popular anger they have stirred is based on the belief that they reward poor past performance. But Eisfeldt and Rampini’s research suggests that their function is less about the past than the future. Bonuses provide managers with an incentive to be honest about their own performance and about the firm’s prospects earlier rather than later, when shifting capital to more productive managers and more productive uses can have the greatest impact.

“If you want your managers to reveal early when there’s bad news, you have to give them an incentive,” Eisfeldt notes. “You know that the managers are going to have a lot of control over information about what’s going on with the firm. One year ahead, one quarter ahead, they will have an idea about whether things are going well or going poorly. And if you want them to report when things are going poorly, you don’t want them to take a big hit in their compensation. In fact, you may want to reward them. If you’re going to fire them with nothing, they’re going to try to hide that fact.”

The effects of the incentive to conceal bad news extend far beyond the fate of individual firms. They help to account for the sluggish pace of capital reallocation and low rates of economic productivity in the overall economy. And there is a certain irony in this equation, because it means that bonuses could have a significant positive impact during an economic downturn—yet this is precisely when they seem most nonsensical. The irony is heightened by the fact that managers require bigger bonuses to be truthful during bad economic times, since they have fewer outside options.

Exit Strategies
“If I’m a bad manager, I will always require a bonus to tell you that,” Eisfeldt explains. “But in good times, I know that I’m going to get a decent job after you fire me. I’m not that worried about telling you. In bad times, I know that if you fire me, I’m in a bad position. So I become desperate to hold onto what I have. You would need to pay me more to let go of what I have in bad times, and you may decide not to incentivize me to do that. So that’s exactly what would stop capital reallocation from happening in bad times.”

The authors’ focus on the leverage that managers possess even in bad times—and the impact of their behavior on the broader economy—is innovative and has been well -received: in June 2009 their work was awarded second place in the annual Jensen Prize competition, established by The Journal of Financial Economics to honor the best articles appearing in its pages the previous year.

“People usually think that the board will just fire the managers,” Eisfeldt says. “But in practice managers have private information. They have to reveal that they should be separated. They play an active role in the decision.” The upshot is that, strange as it may seem, bonuses paid to poorly performing executives can be a good investment for the health of individual firms and the nation’s economy as well.

“People are getting all up in arms about these big bonuses, but there are reasons you have to pay them,” Eisfeldt maintains. “There is restructuring that needs to happen, and these are top-level managers. You want them to participate. Restructuring is going to be bad for them, so you have to give them some upside. It’s like with crime and punishment—if you do a hit-and-run, there’s a much worse punishment than if you hit someone and stick around and deal with it. You need to give people the incentive to help the firm do the right thing, even when it’s not the best thing for the manager.”