Given CEOs’ substantial equity portfolios, much recent literature on CEO incentives regards cash-based bonus plans as largely irrelevant, begging the question of why nearly all CEO compensation plans include such bonuses. We develop a new measure of bonus plan incentives and show that performance sensitivities are much greater than prior estimates. We also test hypotheses regarding the role of bonuses in providing executives with individualized and team incentives. We find little evidence supporting the individualized incentives hypotheses but find consistent evidence that bonus plans appear to be used to encourage mutual monitoring and to facilitate coordination across the top management team as a whole.

Executive bonus plans often incorporate performance measures that exclude particular costs—a practice we refer to as “cost shielding.” We predict that boards use cost shielding to mitigate underinvestment and insulate new managers from the costs of prior executives’ decisions. We find evidence that boards use cost shielding to deter underinvestment in intangibles and encourage managers to take advantage of growth opportunities. We also find that cost shielding tends to be elevated for newly-hired executives, and decreases over tenure. Collectively, our results suggest that boards deliberately choose performance metrics that alleviate agency conflicts.

We study the extent to which creditors shape the executive bonus plans of their financially distressed borrowers. Financial distress can exacerbate agency conflicts between creditors and borrowers as concerns with underinvestment become more acute due to managerial myopia and debt overhang. Consequently, we expect creditors to exert their influence to ensure that these managers’ incentive-compensation plans encourage longer-term investments and directly reward outcomes that benefit creditors without exposing managers to unnecessary risk. We argue that bonus plans are an especially important way to provide these incentives because their flexibility allows creditors to more precisely target specific investment objectives. We find that borrowers’ bonus plans tend to have longer horizons and more convex payouts following covenant violations, especially when bonus plans can be a particularly effective way to address distress-related agency conflicts. Our evidence suggests that creditors protect their interests by exercising their control rights to shape their borrowers’ incentive-compensation plans.

ABSTRACT We investigate whether differences in the mix of financial covenants in debt contracts (i.e., covenant heterogeneity) reflect—and provide a way for lenders to elicit, or screen—borrowers’ pre-contractual private information about their future risk profile. Consistent with adverse selection theories, we predict and find that borrowers with higher future risk negotiate loans with covenants that are less sensitive to performance, compared to borrowers with lower future risk. We differentiate between screening and incentive explanations for this finding and provide evidence that screening accounts for a substantial portion of this overall relation. Our study highlights how, in addition to shaping borrowers’ incentives through monitoring, covenant heterogeneity reflects borrowers’ future risk profiles and can help lenders screen accordingly. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: G21; G32; G34.