The Importance of Compensation

In my opinion, one of the biggest contributors to the crisis we know so well was compensation schemes that gave individuals at financial institutions – from junior traders all the way up to CEOs – the incentive to take massive bets. Put people in a situation where the individually rational thing to do is take lots of risk, and they will take lots of risk – especially if they are generally ambitious, money-loving, and predisposed to think that if the market is giving it to them, they must deserve it.

Alan Blinder does a good job explaining the problem in simple terms in the first half of his WSJ op-ed.  However, I’m not optimistic about his solution:

It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.

Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. . . .  The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

Why am I not optimistic? Disney.

In 1995, Disney Chairman and CEO Michael Eisner hired his longtime friend Michael Ovitz to be president of the company. Ovitz was the founder of one of Hollywood’s most powerful agencies, but had no experience even working in a company like Disney, let alone managing it. Eisner negotiated his friend’s employment contract, which included a $1 million annual salary and 5 million options, vesting in annual increments beginning in 1998. In addition, if Ovitz were fired within his first five years (but not if he were fired for “gross negligence,” and not if he resigned voluntarily), he would be given – in addition to his salary for the remainder of the contract – $1o million, $7.5 million per year remaining on the contract, and his first 3 million options.

In 1996, one disappointing and controversial year after Ovitz joined, “Eisner and Ovitz agreed to arrange for Ovitz to leave Disney on the non-fault basis provided for in the 1995 Employment Agreement.” Brehm v. Eisner, 746 A.2d 244 (Del. Sup. Ct. 2000). As a result, Ovitz got about $40 million in cash and 3 million options.

Disney shareholders sued the board of directors, both for approving a compensation agreement that gave Ovitz an incentive to try to get fired in the first five years, and for allowing him to leave on a “non-fault basis” rather than firing him for cause (gross negligence). On both counts, the courts, in both Brehm v. Eisner and In re Walt Disney Co. Derivative Litigation (Del. Ch. 2005), held that the board was not liable because of the “business judgment rule.” The business judgment rule says, in essence, that as long as a board of directors does not have a conflict of interest, informs itself adequately, and makes a decision, it cannot be held liable for that decision, no matter how obviously stupid it is or how catastrophic it turns out to be.

The business judgment rule is not a crazy rule; it is designed to allow directors and managers to take risks that may turn out badly without worrying that they may be held personally liable. But one of its effects is to shield boards of directors from any accountability for executive compensation decisions. It’s nice to say that boards “should” implement compensation practices that align managers’ incentives with those of shareholders, but it’s hard to see why this should happen.

Board behavior is determined by two things: power and incentives. The problem is that even though things have improved a little since Enron and WorldCom, directors are often de facto appointed by the CEO and serve at his pleasure; serving as a director is cushy enough that directors want to keep their jobs; and directors are dependent on the CEO and other managers for information. Although directors nominally represent the interests of shareholders, they can become a kind of insider, captured by the perks of the job and management’s control over the flow of information. From an individual director’s perspective, the high-percentage play is to approve generous compensation packages for the CEO and his lieutenants; that maximizes his chance of holding onto his board seat, and he has no personal accountability for his vote. Blinder describes “executives, lawyers and accountants” running rings around government regulations and regulators; today’s board of directors is an even easier mark for them.

Blinder says regulation of compensation practices is likely to fail. Having lived through it, he would know better than I. But I don’t think that waiting for better corporate governance is the answer. We will still be waiting when the next crisis hits.

If anything, I find myself more sympathetic to the views of Goldman CEO Lloyd Blankfein:

We should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.

For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Blankfein’s comments about regulation were not specifically addressed to executive compensation, but the references to “basic standards” in the first sentence and “elevating standards” in the last imply that he would not see compensation as off limits for regulation.

About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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