Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management

Hart, Oliver, and John Moore, “Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management,” The American Economic Review, Vol 85, No 3 (1995), 567-585.

  • Assume that managers will always invest in every project (due to empire-building, prestige, resumé-building, etc.)
    • If managers have too much cash flow, they will invest in bad (negative NPV) projects along with good ones.
    • Debt can fix the agency problem by forcing managers to pay out cash flows before investing.
  • The debt overhang problem
    • If managers have too little cash, they will have to forgo investing in good projects.
    • If managers have too much debt, they will not risk losing their job and, again, will forgo investing in good but risky projects.
  • Long-term debt can outperform complicated contracts in solving agency problems.
    • Contracts that attempt to align manager compensation with shareholders’ interests can’t address every agency problem.
    • Long-term debt restricts managers from borrowing against future cash flows to invest in bad projects.