Compensation, Incentives, Corporate Governance, and Looting

Simon Johnson neatly characterizes the competing views of the behavior of top management at the largest banks:

One view of executives at our largest banks in the run-up to the crisis of 2008 is that they were hapless fools. Not aware of how financial innovation had created toxic products and made the system fundamentally unstable, they blithely piled on more debt and inadvertently took on greater risks.

The alternative view is that these people were more knaves than fools. They understood to a large degree what they and their firms were doing, and they kept at it up to the last minute – and in some cases beyond – because of the incentives they faced.

The emphasis is mine. He goes on to describe the conclusions of a recent paper in which the authors found support for the latter view rather than the former. In very terse summary over the period of 2000 to 2008 the CEOs of the top 14 financial institutions netted $650 million through sales of their own companies’ stock while the market caps of these stocks declined from $74 trillion to $47 trillion over the same period. That’s exclusive of wages. The authors found that:

CEOs are 30 times more likely to be involved in a sell trade compared to an open market buy trade. The ratio of the dollar value of their sells to buys is even more lop-sided. The dollar value of sales of stock by bank CEOs of their own bank’s stock is about 100 times the dollar value of open market buys of stock of their own bank’s stock.

Their proposal is that sales of stock by top management be prohibited until two years (or more) after the end of their tenure.

Over the period of the past 40 years there has been something of a cyclic trend for large companies to give their top management part of their compensation in the form of stock. When the stock is unrestricted as is generally the case, the incentive of the manager is like anybody else’s: buy low, sell high. Or in the case of banking stocks, sell high and don’t buy at all. The incentive is for short term gains potentially at the expense of the health of the company—a perverse one.

Why do stockholders put up with this? Over the same 40 years an increasing amount of stock ownership has been on the part of large institutional investors, particularly pension funds. These funds have maintained unrealistically high assumptions about the returns they can expect which are coming home to roost.

The key problem here is that these funds have much the same incentives for poor stewardship as the managers of the top 14 financial insitutions: take the money and run. The problem with being unconcerned about the long term fate of a company whether it’s a bank or an automobile manufacturer is that the long term eventually comes. Here, today, the future is now and our growth prospects don’t look nearly as rosy as they did just a few years ago.

IMO we need more managers whose motivation is to build and run companies than those who want to make a big pot of money and retire to Majorca. The incentives are aligned the wrong way. However, I don’t think that the prescription of the authors of the paper is practical, either. Perhaps we should be looking to dividends rather than stock prices and dividends should only be payable from profits of a growing concern.

17 comments… add one
  • steve Link

    I read the Bhagat and Bolton paper this morning (too long,ugh) and already posted my thoughts. I think that if you believe incentives matter, it is clear that finance execs had lots of incentive to maximize short term returns. It looks like that is what they did, rather than make a sustainable long term return for shareholders. It is interesting that this behavior is not seen so much with smaller banks.

    I have no idea what the answer is to this problem. It seems like more of a cultural problem with all of the upper level finance people, including their boards, believing that they are entitled to make as much as possible for themselves with shareholders as a secondary concern. I ma not sure how we legally penetrate that entitlement fog. Any attempt to do so by government agency will be decried as socialism, and I see no forthcoming movement to fix this within the industry. They still claim that Wall Street had nothing to do with the subprime crisis.

    Steve

  • PD Shaw Link

    I wonder whether it is really true that CEO security compensation is generally unrestricted. It is certainly true that it’s not restricted in the way being proposed, but my impression would be that they would be restricted either for a period of time, or by volume over a period of time, or the circumstances in which they can sell. CEOs may prefer them as a form of deferred compensation.

    I’m skeptical that monkeying with restrictions is going to align incentives significantly when you’re talking compensation at this level. And as a voluntary measure, Boards are going to fear that this particular restriction will promote high turnover and if used too much will dilute stock value.

  • IMO we need more managers whose motivation is to build and run companies than those who want to make a big pot of money and retire to Majorca. The incentives are aligned the wrong way. However, I don’t think that the prescription of the authors of the paper is practical, either. Perhaps we should be looking to dividends rather than stock prices and dividends should only be payable from profits of a growing concern.

    Dividends? Aren’t those paid to stock holders? Further, if the executives are dumping the stock as quickly as possible, or even if they hold onto it for a dividend payment then dump it I don’t see how this would help. You need a bit more explanation here I think.

    By the way, I don’t see the issue with the waiting to be able to sell stocks, it is similar to being fully vested in one’s pension plan/401k. It took me 5 years to become fully vested with the company’s matching contributions where I work. Each year up to that 5 year mark I was vested in 20% increments. Forcing an executive to hold payment via stocks for 2 years or even longer would at least reduce the incentive to focus only on short term profits and potentially at the risk of longer term health of the company. Why don’t you think it is practical?

  • sam Link

    Where were the boards of directors in all this? Acc to Steve Bainbridge, they’re the ones that really run the corporations (see, Director Primacy Theory).

  • Scott Link

    With all the finger pointing, it bugs me that the boards are often not blamed harshly enough. The boards hire the CEOs and determined their compensation. The boards help set corporate policy and strategy. Shareholders need to be more diligent in holding boards accountable. The boards are the last line of defense when the CEO’s are taking on way too risk. Only the boards can force the CEOs to change strategy or rein in risk taking. Just want to get that off my chest.

    Regarding incentives, I like Warren Buffett’s idea. Enact legislation that permits the clawback of prior compensation (and make it so executives and their spouses can’t shield personal family assets from a legal judgment via personal bankruptcy). If the company goes bankrupt, or requires a taxpayer bailout, the highest ranking executuves and their spouses go broke. Now that will ensure prudent behavior. Maybe then we’d create a new problem of exceptionally risk averse executives.

  • There are lots of problems with boards of directors and I’ve criticized them pretty harshly around here from time to time. For one thing there are conflict of interests issues. Directors are frequently CEOs of other companies (or have been) and there’s a “I’ll vote for your compensation package if you’ll vote for mine” quid pro quo.

    There’s an article I read this morning on entrepeneurialism that I may link to. IMO too many big company execs are lacking in entrepeneurial spirit.

    Steve, the issue with sale of stock is that CEOs have fiduciary responsibilities that you don’t.

  • steve Link

    “By the way, I don’t see the issue with the waiting to be able to sell stocks, it is similar to being fully vested in one’s pension plan/401k.”

    I have wondered about that also. I think it would need to be a policy set by corporate boards. Does Congress have the authority to dictate exec pay structure? I also think that if we are to align risk correctly, there needs to be a possibility of real loss, not just an inability to make huge gains.

    Steve

  • steve:

    I think that Congress has pretty broad authority over issues of corporate governance in publicly held companies (which are the ones we should be most concerned about). And we’re about to see whether Congress’s powers to regulate commerce are limited in any way whatever.

  • After Raich and depending on how the PPACA case goes there might not be much of anything Congress wont have the ability to regulate…right down to how much broccoli your eat or grow in your garden. So Dave is right if Congress wants to set executive pay to $0.01/year they could.

  • Regarding incentives, I like Warren Buffett’s idea. Enact legislation that permits the clawback of prior compensation (and make it so executives and their spouses can’t shield personal family assets from a legal judgment via personal bankruptcy). If the company goes bankrupt, or requires a taxpayer bailout, the highest ranking executuves and their spouses go broke. Now that will ensure prudent behavior. Maybe then we’d create a new problem of exceptionally risk averse executives.

    Yeah, and also punish executives who did everything right, but the business still failed. Yeah, not exactly the best idea, IMO.

  • PD Shaw Link

    The feds already require certain restrictions on securities under the Securities Act of 1933 (or at least SEC and judicial interpretations of it), but that’s largely about protecting the investor against fraud and close-dealing, not really corporate governance.

    The linked proposal does not propose government mandates, but suggests that it would be a good business practice for Boards to adapt voluntarily. Compensation is about hiring someone to do a job, I think Boards would be better off with performance bonuses for achieving set goals. The thing about looking at compensation versus performance is that it may require higher compensation to take the helm of a floundering, flailing ship. Why would you want to handicap the Board from hiring a guy that doesn’t want to risk personal insolvency to help fix someone else’s problem?

    Consider last year’s total compensation (salary, bonuses, restricted stock and options) for two CEO’s:

    Steve Jobs, Apple: $0
    Kenneth Lewis, Bank of America $0

    What does that tell us about structuring compensation? Not much, I’m afraid.

  • When you write a will you have the option of granting a lifetime residency to your home before it can be sold and the proceeds distributed to the designated beneficiaries.

    The “option culture” can be changed to create a long-term incentive which more neatly aligns principal and agent objectives by distributing a class of stock which cannot be sold on the open market but which the is transferable into common shares upon the death of the recipient. Secondly, the class transfer can also occur to pay tax obligations and during a bankruptcy proceeding in order to turn an illiquid asset into a liquid asset.

    This class of stock focuses on long term growth and away from short term gains. The stock grant isn’t fully theirs to do with as they please but they get the use of the capital and dividends.

  • stuhlmann Link

    I read somewhere recently that on average, stocks are held for less than a year. Perhaps fund managers justify their fees by trading frequently. The point is that people, who do not plan on owning a stock for the long haul, have little reason to keep a close watch on the CEO.

  • john personna Link

    I suspect something could be done with the top marginal tax rate and the capital gains rules to realign incentives.

    For one thing, no one should be able to shelter what are essentially wages as lightly taxed capital gains.

    If it was me, I might tax income based on a 3-5 year moving average, to separate windfall people from long-term high earners. Put a high tax rate on people who make $1M+ every year, year after year. And then, I might charge a pretty good rate on 0-5 years capital gains, less on 5-10, and then nothing on instruments or properties held 10 years or longer. YMMV.

  • john personna Link

    BTW, while we’re talking smack about what we’d do if we could, I’d also kill IRA/401K and just give everyone their money back.

    I’ve decided it is just a back door fix to a way too low interest/dividend exemption. Make dividend and interest tax free up to median US income, and you encourage savers incrementally, easily, without the necessity of a whack 401K “industry” quietly siphoning everyone’s management fees.

  • Drew Link

    One of the luxuries of being in the Private equity business is that you can set things up that really work.

    We strongly encourage equity ownership in our businesses because it aligns managment and capital providers interests, and is an amazing motivator. Here’s the catch: Vesting schemes are based on a) achievement of performance hurdles and b) sale of the company, which by definition means managers are taking 3-8 year investment horizons into consideration. It works.

    A mistake commonly made on forums such as these, or in general public discourse, is to equate “business” with large corporations. I generally share many of the criticisms of large corporate practices expressed here and elsewhere, although I’m not sure I’ve got any solutions at the ready.

    One view which is short sighted and fails to understand well worn practices is the notion of eliminating the (lower) capital gains rate. This distinction has been in effect for quite some time in recognition of the value of long term value creation/capital formation/business building. Better to do a better job of setting up the incentive systems than screw around with that provision of the tax code.

  • john personna Link

    Drew, I hear about hedge fund managers taking their compensation as (through some trick) low-rate capital gains. If you can figure out how to separate that from the guy who spends 20 years building an auto dealership, grand.

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