Showing posts with label executive pay. Show all posts
Showing posts with label executive pay. Show all posts

Sunday, March 3, 2013

In Defense of the CEO. By Ray Fisman and Tim Sullivan

In Defense of the CEO. By Ray Fisman and Tim Sullivan
The Wall Street Journal, January 12, 2013, on page C1
Chauffeur-driven limousines, millions in stock options, golden parachutes. It's no wonder bosses' pay and perks can rankle. Here's why the best ones are worth it.

A $90,000 area rug, a pair of guest chairs that cost almost as much, a $35,000 commode and a $1,400 trash can—these are just a few of the expenses from a remodeling of John Thain's office when he took over as Merrill Lynch's chief executive officer in December 2007. The total bill came to an astonishing $1.2 million—about the price of five average single-family homes.

Those same remodeling expenses contributed to Mr. Thain's resignation just over a year later, after Bank of America BAC bought Merrill, and helped to define the popular image of the CEO as someone who lives a life of extreme privilege: gold-plated faucets, country club memberships and chauffeur-driven limousines, all paid for through corporate largess. Mr. Thain's limo tab included $230,000 for his driver—$85,000 in salary, the rest in overtime and a bonus. This was on top of Mr. Thain's receiving a reported $78 million in compensation for 2007.

It's easy to get upset about perks and pay packages like Mr. Thain's. But even in the face of public and investor outrage, CEO salaries are still on the rise. Progress Energy's CEO Bill Johnson received a $44 million payout when he left the company after its merger with Duke Energy DUK last year, and Abercrombie CEO Michael Jeffries took home over $48 million in 2011—while the company's stock price tanked.

Excessive, decadent? That's a hard call to make without having some idea of what a CEO does. Many CEOs are overpaid or, even worse, paid for incompetence. Still, you can only appreciate the difference between pay-for-performance and pay-for-incompetence by first understanding the CEO's job.

Let's start with the basics: how chief executives spend their time. Among the first researchers to give us a glimpse into the day-to-day life of the CEO was management guru Henry Mintzberg, who followed a handful of business leaders for his Ph.D. thesis at the MIT Sloan School of Management over four decades ago. He discovered that, first and foremost, CEOs go to meetings. Lots of them—it is where his research subjects spent over 80% of their work hours.

The astonishing thing is that the percentage of time CEOs spend in meetings has hardly shifted in four decades, despite innovations like email. A study conducted last year by Oriana Bandiera of the London School of Economics, with Columbia's Andrea Prat and Harvard's Raffaella Sadun, assembled time diaries for hundreds of Indian CEOs. (With other collaborators, they have done similar research on smaller samples of Italian and American executives.)

Unlike Dr. Mintzberg—who did the legwork himself—this group of researchers asked the CEOs' executive assistants to record in 15-minute increments how their bosses allocated their time over the course of a week. Were they working alone or in a group? If in a meeting, how many were in attendance? Was the meeting with employees or with outsiders, via telephone or in person? Despite the vastly different geographies and eras—and differences in customers, products and size of organizations—the CEOs all spent their time in much the same way: in face-to-face interaction.

That time is often marked by interruption. In the five weeks of Dr. Mintzberg's study, he recorded extraordinarily few instances of a CEO alone and without disruption for more than 15 minutes straight. Half their activities lasted fewer than nine minutes—and this was in the pre-BlackBerry age—while only 10% went on for more than an hour. Those hourlong stretches were taken up primarily with hourlong meetings. The more recent studies have found a similar pace of interruption.

Yet saying that the job of someone like Jeff Bezos consists of going to lots of meetings is a bit like saying that Shakespeare wrote words. True, but pretty thin for explaining what made, say, Steve Jobs Steve Jobs.

Meetings remain the focus of the CEO's day because such personal interactions are critical to learning the information necessary to run a company effectively. After all, one of the most important jobs of managers is to decide what information gets passed up through the chain of command. If CEOs were to rely solely on written reports and data sheets from self-serving underlings, they almost would be guaranteed to make the wrong decisions. What manager wants to pass on bad news—so much easier to do in a report than when you're being questioned in detail by your boss? This very problem was at the root of Toyota's response to its problems in 2009 with sudden, unexpected acceleration in its vehicles: Managers were all too willing to paint a rosy picture for the CEO, which hampered his ability to direct the company to respond appropriately.

Harvard Business School professors Michael Porter and Nitin Nohria argue that the skill to extract from underlings the critical details that are needed to inform top-level decisions is part of what makes the best CEOs better than their peers. It works in reverse too. The information the CEO needs to convey is just as prone to being misrepresented and misinterpreted as it works its way through a corporation, across shareholders and among customers. So, in the vast majority of meetings, CEOs are not just uncovering information but also constantly refining their message.

Consider, for instance, founder Tony Hsieh's drumbeat in referring to Zappos as a "service company that just happens to sell shoes." Meetings give him the opportunity to let his stakeholders know exactly what he means. The company hit its billion-dollar sales goal two years before schedule, in 2008, and was acquired by in 2009 for a reported $1.2 billion.

The Porter-Nohria view is backed up by the data. In their time-use study of 354 Indian CEOs—still a work-in-progress—the researchers collected detailed information on the nature of CEOs' meetings, including who attended. Two dominant management styles emerged. "Style 1" leaders, in their taxonomy, spend most of their time meeting with employees; they also tend to hold larger meetings and to include people from a wider set of departments within the organization. "Style 2" CEOs are more apt to spend their time alone, in one-on-one interaction, and outside rather than inside the firm.

Though the researchers are still putting together their findings, they have observed that the first management style, which is inclusive and cross-functional, is typical of CEOs at companies that are more efficiently run and more profitable.

Why don't all CEOs adopt Style 1? It's likely that part of the story is ability: not everyone is up to the task of dealing with the complexities of a bigger conference room filled with disparate participants. It may also reflect a CEO's decision to devote less attention to the company than to cultivating his outside image. In a 2009 study, Ulrike Malmendier of the University of California, Berkeley, and UCLA's Geoff Tate found that companies performed poorly after their leaders were voted "CEO of the Year," because of the distractions that came with the fame, like writing a book and hobnobbing at Davos. A truly great CEO cannot be distracted; she must remain a great intelligence gatherer, a great communicator and ultimately a great decider, and meetings are one of her most important tools.

The existence of great CEOs does not mean, of course, that the average one deserves his millions—although CEOs, never known for their modesty, may think they do. When Dow Jones reporter Kaveri Niththyananthan questioned the CEO of U.K.-based EasyJet, Andy Harrison, about his 2009 compensation of nearly $4.5 million, Mr. Harrison smiled and replied, "I'm worth it." When a congressman suggested to Ford CEO Alan Mulally that he should take a salary of one dollar, given the near-bankrupt state of the U.S. auto industry, Mr. Mulally replied, "I think I am OK where I am"—this in a year when he took home nearly $17 million in compensation. (Mr. Mulally seems to know the value of meetings; he has listed "You learn from everybody" as one of the key attributes of great CEOs.)

What Messrs. Harrison and Mulally no doubt had in mind were their companies' profit numbers. Profits had fallen by 64% the year Mr. Harrison claimed to be worth his millions, but he could point to five straight years of profits as EasyJet CEO—a rare achievement in the airline business. Mr. Mulally's $17 million payday came on the heels of a billion-dollar turnaround that transformed a $970 million loss at Ford into profits of nearly $700 million just a year later.

But are CEOs really so much smarter (and better at running meetings) than the rest of us? Possibly, but that's not the right question to ask. To claim they're worth it, CEOs don't actually have to be all that much better than the runner-up for the job.

In "superstar economies," as in the market for CEOs, even a slight edge in ability can translate into enormous payoffs. That's why Major League Baseball pitchers earn so much more than triple-A players, despite throwing fastballs only a couple of miles an hour faster. When the stakes are in the billions, shareholders should be more than happy to sign off on a multimillion-dollar paycheck, even if the recipient is just slightly better than the next best option.

By the same token, if CEOs' decisions have such a disproportionate impact on corporate profits, you might be willing to pay a lot to motivate them to put in extra hours in the office. And this view helps to explain—if not always to justify—many of the privileges that come with a corner office: the corporate jet that gives CEOs more face time with employees in different locales; the chauffeured limo that frees up time during the morning commute.

As for another controversial perk, what could possibly be the point of paying CEOs for getting fired? The so-called golden parachute goes back to a perfectly reasonable attempt to get CEOs to create even more value for their companies. Introduced by TWA in 1961, the practice took off during the merger wave of the 1980s, when executives started pondering whether it was smarter to seek out merger opportunities to make money for shareholders or to hold on to their jobs. Mostly they opted for keeping their jobs, often to the detriment of the stock price.

As a result, shareholders gave CEOs an escape valve that, the reasoning went, would encourage them to work in the long-term interests of their companies. Even one of the fiercest critics of CEO compensation, Harvard Law School's Lucian Bebchuk, reports in recent research with Alma Cohen and Charles Wang that golden parachutes do motivate CEOs to find merger-and-acquisition opportunities and, as a result, to extract more takeover premiums for shareholders.

So maybe we should be a bit more understanding of Gillette's board, which awarded a severance package worth well over $160 million to CEO James Kilts after the company was acquired by Procter & Gamble in 2005, in what Gillette shareholder Warren Buffett called a "dream deal." (And Merrill's Mr. Thain? He oversaw the company's acquisition by Bank of America at the height of the financial meltdown, a deal that remains shrouded in controversy, in part as a result of $4 billion in 11th-hour bonuses handed out in December 2008. By the time the dust cleared, Mr. Thain walked away with a seemingly modest $1.5 million severance package.)

Yet executives whose ineptitude or laziness makes their companies ripe for takeover also get rewarded sometimes. Indeed, Prof. Bebchuk's study finds that companies where executives are protected by golden parachutes generally trade at lower levels than those where CEOs don't have them. But how should we think about such pay-for-incompetence? Instead of shaking our heads at the injustice, we can consider it an unfortunate side effect of well-motivated incentives. Designing severance packages more carefully is a worthy idea, but simply eradicating them could do real damage.

Before joining the shareholder activists calling for CEOs to be held accountable and stripped of their more obvious excesses, it's worth pausing to think about why those perks exist in the first place. Sometimes it's the result of slick managers who have co-opted their boards, but sometimes it's simply that we can't easily distinguish good CEOs from bad ones before the employment contract is signed. Seeing CEOs make millions for being fired—and even for losing money—may be hard to stomach, but it is collateral damage in the economics of motivating them to run their companies well.

—Messrs. Fisman and Sullivan are the authors of "The Org: The Underlying Logic of the Office," published this month by Twelve.

Corrections & Amplifications

The remodeling of John Thain's office at Merrill Lynch in 2007 included a $35,000 commode (a piece of furniture). An earlier version of this article said the project included a $35,000 toilet.

Friday, May 4, 2012

Women, Welch Clash at Forum - "Great women get upset about getting into the victim's unit"

Women, Welch Clash at Forum. By John Bussey
Wall Street Journal, May 4, 2012, page B1

Is Jack Welch a timeless seer or an out-of-touch warhorse?

The former Master and Commander of General Electric still writes widely on business strategy. He's also influential on the speaking circuit.

On Wednesday, Mr. Welch and his wife and writing partner, Suzy Welch, told a gathering of women executives from a range of industries that, in matters of career track, it is results and performance that chart the way. Programs promoting diversity, mentorships and affinity groups may or may not be good, but they are not how women get ahead. "Over deliver," Mr. Welch advised. "Performance is it!"

Angry murmurs ran through the crowd. The speakers asked: Were there any questions?

"We're regaining our consciousness," one woman executive shot back.

Mr. Welch had walked into a spinning turbine fan blade.

"Of course women need to perform to advance," Alison Quirk, an executive vice president at the investment firm State Street Corp., said later. "But we can all do more to help people understand their unconscious biases."

"He showed no recognition that the culture shapes the performance metrics, and the culture is that of white men," another executive said.

Academy Award winning actor Geena Davis talks about the perception of women as seen in the media and about what has and has not changed in the past sixty years.

Dee Dee Myers, a former White House press secretary who is now with Glover Park Group, a communications firm, added: "While he seemed to acknowledge the value of a diverse workforce, he didn't seem to think it was necessary to develop strategies for getting there—and especially for taking a cold, hard look at some of the subtle barriers to women's advancement that still exist. If objective performance measures were enough, more than a handful of Fortune 500 senior executives would already be women. "

"This meritocracy fiction may be the single biggest obstacle to women's advancement," added Lisa Levey, a consultant who heard Mr. Welch speak.

Mr. Welch has sparked controversy in the past with his view of the workplace. In 2009, he told a group of human-resources managers: "There's no such thing as work-life balance." Instead, "there are work-life choices, and you make them, and they have consequences." Step out of the arena to raise kids, and don't be surprised if the promotion passes you by.

Of the Fortune 500 companies, only 3% have a female CEO today. Female board membership is similarly spare. A survey of 60 major companies by McKinsey shows women occupying 53% of entry-level positions, 40% of manager positions, and only 19% of C-suite jobs.

The reasons for this are complex and aren't always about child rearing. A separate McKinsey survey showed that among women who have already reached the status of successful executive, 59% don't aspire to one of the top jobs. The majority of these women have already had children.

"Their work ethic—these people are doing it all," said Dominic Barton of McKinsey. "They say, 'I'm the person turning off the lights'" at the end of the day.

Instead, Mr. Barton said, it's "the soft stuff, the culture" that's shaping their career decisions.

The group of women executives who wrestled with Mr. Welch were at a conference on Women in the Economy held by The Wall Street Journal this week. Among other things, they tackled the culture questions—devising strategies to get more high-performing women to the top, keep women on track during childbearing years, address bias, and make the goals of diversity motivating to employees. They also discussed the sexual harassment some women still experience in the workplace. (A report on the group's findings will be published in the Journal Monday.)

The realm of the "soft stuff" may not be Mr. Welch's favored zone. During his remarks, he referred to human resources as "the H.R. teams that are out there, most of them for birthdays and picnics." He mentioned a women's forum inside GE that he says attracted 500 participants. "The best of the women would come to me and say, 'I don't want to be in a special group. I'm not in the victim's unit. I'm a star. I want to be compared with the best of your best.'"

And then he addressed the audience: "Stop lying about it. It's true. Great women get upset about getting into the victim's unit."

Individual mentoring programs, meanwhile, are "one of the worst ideas that ever came along," he said. "You should see everyone as a mentor."

He had this advice for women who want to get ahead: Grab tough assignments to prove yourself, get line experience, and embrace serious performance reviews and the coaching inherent in them.

"Without a rigorous appraisal system, without you knowing where you stand...and how you can improve, none of these 'help' programs that were up there are going to be worth much to you," he said. Mr. Welch said later that the appraisal "is the best way to attack bias" because the facts go into the document, which both parties have to sign.

Mr. Welch championed the business philosophy of "Six Sigma" at GE, a strategy that seeks to expunge defects from production through constant review and improvement. It appears to work with machines and business processes.

But applying that clinical procedure to the human character, as Mr. Welch seems to want to do, is a stickier proposition.

"His advice was not tailored to how women can attain parity in today's male-dominated workplace," said one female board member of a Fortune 500 company. Indeed, a couple of women walked out in frustration during his presentation.

Saturday, January 23, 2010

Basel Committee publishes assessment methodology for compensation practices

Basel Committee publishes assessment methodology for compensation practices
BIS January 22, 2010

The Basel Committee on Banking Supervision today issued Compensation Principles and Standards Assessment Methodology. The Methodology seeks to foster supervisory approaches that are effective in promoting sound compensation practices at banks and help support a level playing field.

Mr Fernando Vargas, Chairman of the Basel Committee's Task Force on Remuneration and Associate Director General of Banking Supervision at Bank of Spain, explained that "the Methodology provides a comprehensive set of tools for supervisors to assess compensation practices in an effective and consistent manner."

The Methodology will help supervisors assess a firm's compliance with the Financial Stability Board's "Principles for Sound Compensation Practices" and related implementation standards. This will contribute to ongoing implementation of the Principles and Standards, including the FSB’s current thematic review of national and firm implementation. Consistent with the FSB "Principles for Sound Compensation Practices", the Methodology is structured based on the following themes:

1. Effective governance of compensation
2. Effective alignment of compensation with prudent risk taking, and
3. Effective supervisory oversight and engagement by stakeholders.

Mr Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank, stated that "use of the Methodology will promote appropriate compensation practices that create the right incentives for effective risk management and avoiding excessive risk-taking." He noted that "the Basel Committee's work on compensation issues is ongoing. It is likely that the Methodology will expand and change over time as more practical experience is gained."

Tuesday, January 12, 2010

Bashing Bankers Is a Political Duty

Bashing Bankers Is a Political Duty. By HOLMAN W. JENKINS, JR
But don't overlook the fact that taxpayers are making out on the bailout too.
WSJ, Jan 13, 2010

If you would know why bankers are enjoying a large and controversial deluge of annual bonuses, look no further than the monthly report of the New York State Comptroller's Office. The economy may be in the dumps, but Wall Street enjoyed record profits of $50 billion in the first nine months of last year—"nearly two and a half times the previous annual peak in 2000."

"Profitability," adds the state of New York, "has soared because revenues rose while the costs of doing business—particularly interest costs—declined" (in other words, thank you Federal Reserve).

That $50 billion may seem odd in relation to Wall Street's reported bonus pool of $90 billion, but compensation isn't paid out of profits, it's paid out of revenues. Goldman last year paid out about 44% of revenues as compensation, Citigoup about 30%. In contrast, an auto company pays out about 11% of revenues, but an auto company consumes a lot of other inputs—glass, steel, energy, advertising, aluminum—whereas Wall Street has only two inputs: smarts and money.

Bonuses are a dominant part of compensation because Wall Street firms pay a large chunk of compensation as variable comp, for which the word bonus has been used. Now some firms are paying larger fixed salaries just so the public won't hear the word bonus.

But look at it this way: The $90 billion that will be distributed to employees is but a sliver of the massive capital Wall Street is sitting on. One firm, Goldman, cares for $880 billion, Citi another $1.9 trillion, JP Morgan another $2 trillion. Much of the nation's paper wealth rebounded sharply last year from depressed values after (choose your reason) Americans overbet on housing or the federal government briefly fumbled public trust in its ability to protect the financial system.

Do bankers deserve it? Of course not. Do you deserve your good looks, good health or good luck in choice of parents and/or country you were born in?

Compensation in our society is not set by Henry Waxman and a committee of Congress, but as a matter of legal and instrumental obligation under circumstances of market competition. A firm's management, with its own interests strongly in mind, ultimately decides how much of a firm's revenue to spend pleasing the highly mobile employees who do the work of pleasing the firm's highly mobile clients and investors.

But didn't taxpayers bail out the financial system, so don't taxpayers deserve the bonuses? No. Taxpayers (aka voters) were acting in their own interests in bailing out the system. They weren't doing anybody a favor. Furthermore, government already stands to collect about 50% of any Wall Street cash bonuses in the form of income tax (which explains why the subject is of interest to the New York state comptroller).

What's more, despite a casual imputation that taxpayers were the suckers at the table, taxpayers did not, as commonly alleged, "spend" money to bail out the banks. They traded one claim for another. Mostly, they traded claims they printed (dollars) for claims on real assets, such as housing, commercial property and industrial equipment.

Taxpayers effectively acquired these assets on a bet that taxpayers' own intervention would raise their value, which had previously been depressed at least partly by fears that taxpayers wouldn't intervene. That bet has proved a good one so far (as bets often do when you control the outcome). Even the most notorious of the exchanges that taxpayers engaged in—dollars for securities held by Goldman Sachs that had been guaranteed by AIG—are accruing profits on the balance sheet of the Federal Reserve.

In fact, yesterday the Fed, whose balance sheet is about the size of Citigroup's, reported whopping profits for 2009 of $52 billion—just a few billion shy of what Wall Street as a whole is likely to report for the year. (All this throws a mocking light on the Obama administration's claim yesterday that a new tax must be imposed on banks to "recoup" bailout costs.)

None of this means Americans don't have an ancient and abiding interest in subjecting bankers to scorn. A rough socialism is fundamental to civilization: The most beautiful virgin must be sacrificed to make the other virgins feel better—a service politicians are especially keen to provide when the alternative might be looking at their own role in the reckless risk-taking of banks and homebuyers.

Still, looking at Washington's own role would be a good idea, since taxpayers' success (so far) in catching the falling knife is certainly no reason to repeat the experiment.

Tuesday, December 15, 2009

The Backdating Molehill Revisited

The Backdating Molehill Revisited. By Holman W Jenkins, Jr
Why are the prosecutions going so badly? Maybe because there was no crime.
WSJ, Dec 16, 2009

It pains us, naturally, to see our forecasts and premonitions borne out in such exacting detail in the government's backdating prosecutions—why didn't we take our moment of searing foresight to the dog track instead?

Yesterday a judge threw out, with resort to unceremonious language, criminal charges against Broadcom co-founder Henry Nicholas III.

Mr. Nicholas, a physically large man, with an erratic personality, and accused of patronizing drug dealers and prostitutes, must have seemed a prosecutors' dream, since he gave them so much to talk about besides the details of backdating, which when examined closely invariably lead careful reasoners to wonder: Where's the crime here?

Mr. Nicholas did not benefit from any backdated stock options. He was Broadcom's largest shareholder, thus had no natural or unnatural interest in overpaying employees with backdated stock options. The company's outside auditor also appears to have blessed the essential no-no here, which amounts to reading into accounting rules a logic and coherence that didn't exist at the time.

The goal of backdating, it becomes clearer than ever, was to motivate employees at the lowest possible cost to shareholders. This was done by granting stock options that, at the date of issue, were "in the money"—because, it appears, Broadcom and hundreds of other Silicon Valley companies discovered in practice what a Nobel Prize in economics had discovered in theory: That people overvalue a seeming bird in the hand.

As far as we know, no court has gotten to the essential nullity of the backdating "wrong," but U.S. District Judge Cormac J. Carney seems to have gotten close. Less than a week earlier, he had thrown out the conviction of Broadcom co-founder Henry Samueli—who had pleaded guilty—saying he did not believe Mr. Samueli had committed a crime.

Yesterday he dismissed the remaining criminal charges against Mr. Nicholas and the company's former chief financial officer William J. Ruehle, saying the government's behavior had been "shameful," that it had made a "mockery" of a defendant's constitutional rights, and that prosecutors had "intimidated and improperly influenced" three crucial witnesses, including threatening one with prosecution if he repeated testimony already given to the SEC in a civil proceeding.

Now, call us cynical, but aren't threats often used against employees to turn them into friendly witnesses for the government? The judge complained that prosecutors had improperly leaked details of the investigation to the press—also unattractive behavior by government servants, but not exactly unusual.

Indeed, it's hard to escape the sense that such behavior was judged especially beyond the pale in this case because it was in the service of a prosecution that fundamentally never deserved to be brought.
OpinionJournal Related Articles:

To be sure, because of the incoherence of the applicable accounting rules, Broadcom had to take the biggest charge of any company to rectify its accounting for employee stock options: $2.2 billion. Investors would have understood, though, that this was not real cash, that indeed under then-regnant accounting rules Broadcom could have tried to give away the entire market cap of the company to employees without taking an accounting charge, had it simply issued "at the money" options instead of "in the money" options.

As we say, most backdating cases amount to companies trying to behave rationally amid irrational accounting rules, rather than the media's standard trope of businessmen a-lyin' and a-stealin'. Deep, rich and disappointing, then, is the irony of a recent decision by federal prosecutors to have a second go at another former Silicon Valley CEO, Gregory Reyes, of Brocade Communications

All that distinguished the Brocade case from hundreds of other instances of backdating was a prosecutor's allegation that, in order to effect backdating, Mr. Reyes had misled the company's own finance department.

This was laughable, since the SEC was simultaneously charging two former heads of Brocade's finance department with participating in and profiting from backdating. The prosecution's sole witness on the vital point recanted almost as soon as she got off the stand, and a federal appeals court eventually overturned Mr. Reyes's conviction on grounds of prosecutorial misconduct.

Why a U.S. attorney in San Francisco would want to try Mr. Reyes again is a mystery to us, but maybe it's time for an investigation of backdating investigations.

We can't close without mentioning the exemplary diligence and enterprise with which, way back when, certain reporters and editors uncovered the backdating phenomenon, and then the intellectual sluggishness with which they analyzed it.

They found an interesting story (one that fit well under the current interest in behavioral economics) and then got it fundamentally wrong by insisting on shoving it into a procrustean off-the-shelf narrative of executive "greed."

Indeed, for want of a single paragraph explaining why backdating could be (in the words of a recent academic paper) a case of optimum contracting between companies and employees, we might have avoided the waste and injustice of these misguided backdating prosecutions.

Wednesday, December 9, 2009

For Global Finance, Global Regulation

For Global Finance, Global Regulation. By Gordon Brown and Nick Sarkozy
Proposals that deserve consideration include taxes on financial transactions and 2009 bank bonuses.
WSJ, Nov 12, 2009

Europe led the way last year in facing down the global financial crisis, restructuring our banking system and strengthening the global financial system. The European Union was also at the forefront in calling for a new forum for economic cooperation of G-20 leaders. And from the outset of the crisis, it was Europe that promoted the fiscal stimulus—and sought to coordinate it globally—that has been a major factor in preventing recession becoming a world-wide depression.

Now we need to once again lead the way in forging a new global consensus.

Stable, open and competitive European financial markets are essential to global growth. We recognize the importance to Europe of ensuring that we have globally competitive financial services, and the importance of developing world-class financial centers such as London and Paris.

But the way global financial institutions have operated raises fundamental questions that we must—and can only—address globally.

We have found that a huge and opaque global trading network involving complex products, short-termism and too-often excessive rewards created risks that few people understood. We have also learned that when crises happen, taxpayers have to cover the costs. It is simply not acceptable for them to foot the bill for losses in a deep downturn, while institutions' shareholders and employees enjoy all the gains as the economy recovers.

Better regulation and supervision are the means by which the risk to the taxpayer can be reduced for the longer term.

In regard to regulation, the EU has adopted a comprehensive set of new rules for the financial sector to avoid the repetition of the crisis: control over credit rating agencies, stronger capital requirements on complex products such as securitization, and strengthened deposit guarantee schemes. We have set up strict rules to make sure that compensation systems avoid excessive risk taking. We will also implement stricter capital rules for banks.

We also have agreed on a more efficient system for supervision of the financial sector within Europe to better monitor systemic risks, to ensure that EU regulation is applied consistently, to settle disagreement between national supervisors, and to deal with crisis situations. Banks must now hold sufficient capital, ensure liquidity, and reward only genuine value creation and not short-term risk-taking.

This crisis has made us recognize that we are now in an economy which is no longer national but global, so financial standards must also be global. We must ensure that through proper regulation, the financial sector operates on a level playing field globally.

There is an urgent need for a new compact between global banks and the society they serve:

A compact that recognizes the risks to the taxpayer if banks fail and recognizes the imbalance between risks and rewards in the banking system.

A compact that ensures the benefits of good economic times flow not just to bankers but to the people they serve; that makes sure that the financial sector fosters economic growth.

A compact that ensures financial institutions cannot use offshore tax havens to negate the contribution they justly owe to the citizens of the country in which they operate—and so builds on the progress already made in ending tax and regulatory havens.

Therefore, we propose a long-term global compact that will encapsulate both the responsibilities of the banking system and the risk they pose to the economy as a whole. Various proposals have been put forward and deserve examination. They include resolution funds, insurance premiums, financial transaction levies and a tax on bonuses.

The global nature of the economy today requires global financial standards, say French President Nicolas Sarkozy and Britain's Prime Minister Gordon Brown, seen above at the G20's London summit in April.

Among these proposals, we agree that a one-off tax in relation to bonuses should be considered a priority, due to the fact that bonuses for 2009 have arisen partly because of government support for the banking system.

However, it is clear the action that must be taken must be at a global level. No one territory can be expected to or be able to act on its own. And if we can find a solution, implemented consistently across the major economies, then we may find a way to ensure that taxpayers do not pay in a systemic crisis for the risks taken on by the banking sector. We might also be able to help the funding of our Millennium Development Goals and address climate change.

To achieve global coordination, we now propose a new process of deliberating and setting macroeconomic strategy, starting with the IMF report on global contributions and leading to a major discussion at the G-20 meetings chaired by South Korea next year. Through this process, we need to correct and prevent the build up of global imbalances. We need to enhance coordination at the global level so that foreign exchange volatility does not create a risk to the recovery. Each country should take its fair share of reducing global imbalances.

Stability and confidence requires us to bring financial markets into closer alignment with the values held by families and business owners: Rewarding hard work, responsibility, integrity and fairness.

People rightly want a post-crisis banking system which puts their needs first. To achieve that, nothing less than a global change is required.

Mr. Brown is prime minister of Great Britain. Mr. Sarkozy is the president of France.

Thursday, September 24, 2009

Bank Pay and the Financial Crisis: G-20 accounting rules, not bank bonuses, put the system at risk

Bank Pay and the Financial Crisis. By JEFFREY FRIEDMAN
G-20 accounting rules, not bank bonuses, put the system at risk.
The Wall Street Journal, page A21

The developed world's financial regulators and political leaders have, as one, decided what caused the financial crisis: the compensation systems used by banks to reward their employees. So the only question to be discussed at the G-20 summit that begins today in Pittsburgh is how draconian the restrictions on banker compensation should be.

The compensation theory is a familiar greed narrative: Bank employees, from CEOs to traders, knowingly risked the destruction of their companies because their pay rewarded them for short-term profits, regardless of long-term risks. It's conceivable this theory is true. But thus far there is no evidence for it—and much evidence against it.

For one thing, according to Rene Stulz of Ohio State, bank CEOs held about 10 times as much of their banks' stock as they were typically paid per year. Deliberately courting risk would have put their own fortunes at risk. Richard Fuld of Lehman Brothers reportedly lost almost $1 billion due to the decline in the value of his holdings, while Sanford Weill of Citigroup reportedly lost half that amount.

In the only scholarly study of the relationship between banker pay and the financial crisis, Mr. Stulz and his colleague RĂ¼diger Fahlenbrach show that banks whose CEOs held a lot of bank stock did worse than banks whose CEOs held less stock. (The study was published in July on Another study by compensation consultant Watson Wyatt Worldwide in July shows a negative correlation between firm Z scores—a measure of their risk of bankruptcy—and their use of such widely criticized practices as executive bonuses, variable pay and stock options. These studies suggest that bank executives were simply ignorant of the risks their institutions were taking—not that they were deliberately courting disaster because of their pay packages.

Ignorance of risk is also suggested in a study by Viral V. Acharya and Matthew Richardson of New York University (just published in the journal Critical Review). Their research shows that 81% of the time the mortgage-backed securities purchased by bank employees were rated AAA. AAA securities produced lower returns than the AA and lower-rated tranches that were available. Bankers greedy for high returns and oblivious to risk would have bought BBBs, not AAAs.

Even more relevant to the question of culpability in the financial system's crisis is why banks were buying mortgage-backed securities at all.

Commercial bank capital holdings are governed by the Basel regulations, which are set by the financial regulators of the G-20 nations. In 2001, U.S. regulators enacted the Recourse Rule, amending the Basel I accords of 1988. Under this rule, American banks needed to hold far more of a capital cushion against individual mortgages and commercial loans than against mortgage-backed securities rated AA or AAA. Similar regulations, contained in the Basel II accords, began to be implemented across the other G-20 countries in 2007. The effect of these regulations was to create immense profit opportunities for a bank that shifted its portfolio from mortgages and commercial loans to mortgage-backed securities.

Bankers were of course seeking profits by purchasing mortgage-backed securities, but the evidence is that they thought they were being prudent in doing so. They bought AAA instead of more lucrative AA tranches, and they bought credit-default-swap and other insurance against default. None of this can be explained unless, on balance, the banks' management and risk-control systems kept in check whatever incentives to ignore risk had been created by the banks' compensation systems.

Banks did not behave uniformly. Citigroup bought as many mortgage-backed securities as it could; banks such as J.P. Morgan Chase did not. Were incentives at work? Yes. But all bankers faced the same artificially created incentive to buy mortgage-backed securities. Most bankers seem to have agreed with the regulators that the profit opportunity created by the regulations outweighed any risk in these securities, especially when they were rated AAA. But some bankers, like Morgan's Jamie Dimon, disagreed.

That type of disagreement, otherwise known as "competition," is the beating heart of capitalism. Different enterprises compete with each other by pursuing different strategies. These strategies encompass everything an enterprise does—including how it manages and pays its employees.

At bottom, all the practices of an enterprise are tacit predictions about which procedures will bring the most reward and which ones will avoid excessive risk. Accurate predictions bring profits and survival; mistaken predictions bring losses and bankruptcy. But nobody can know in advance which predictions are right. By allowing different capitalists' fallible predictions to compete, capitalism spreads a society's bets among a variety of different ideas. That, not the pursuit of self-interest, is the secret of capitalism's achievements.

To be sure, capitalists' different ideas are all, in the end, about how to gain profit. That's why incentives matter. But what matters even more are diverse predictions about where profits—and losses—are likely to be found. For this reason, herd behavior is a danger to capitalism, if the herd bets wrong. But herd behavior is imposed on capitalists every time a regulation is enacted—and regulators, being as human as bankers, can be wrong.

Regulations homogenize. The Basel rules imposed on the whole banking system a single idea about what makes for prudent banking. Even when regulations take the form of inducements rather than prohibitions, they skew the risk/reward calculations of all capitalists subject to them. The whole point of regulation is to make those being regulated do what the regulators predict will be beneficial. If the regulators are mistaken, the whole system is at risk.

That was what happened with the G-20's own Basel rules. Now the G-20 has decided to blame the crisis on bank compensation systems, which it proposes to homogenize just as it had previously homogenized bank capital allocation. What has not been explained is why we should trust that the G-20's regulations won't be mistaken once again.

Mr. Friedman is a visiting scholar in the government department at the University of Texas, Austin, and the editor of the journal Critical Review, which has just published a special issue on the causes of the financial crisis.

Tuesday, April 7, 2009

Libertarian views: Resenting the Rich

Resenting the Rich, by Chris Edwards
This article appeared in the Economist on April 7, 2009

This is half of a larger debate between Chris Edwards and Professor Thomas Piketty.

Should the rich pay higher taxes? Definitely not. Governments do not need any more money, and they misallocate much of what they already take from us. Furthermore, taxation imposes large deadweight losses on the economy, which makes us all poorer.

More on those points later, but first let us examine how much tax the rich are currently paying. In the United States, Congressional Budget Office (CBO) data show average effective tax rates for five income groups or quintiles. The CBO data include federal income, payroll, and excise taxes (

The most recent data for 2005 show that effective rates (taxes divided by income) for the quintiles starting at the bottom were 4.3%, 9.9%, 14.2%, 17.4% and 25.5%. That is a steeply graduated tax system. I would prefer a flat or proportional system because I believe in the American ideal of equal justice under law. But it is amazing that some people want to increase taxes on the rich when the top quintile is already paying a rate five times higher than the rate at the bottom.

The Economist's proposition states: "Inequality has risen across the rich world since the 1970s" partly as a result of lower taxes on the rich. If income inequality has risen, the CBO data suggests that taxes are not the cause. The CBO data show that the effective tax rate on the top quintile has been fairly constant since 1979, hovering between 25% and 28%.

If there are disproportionately large tax cuts at the top end, it might lead to larger asset accumulations by the wealthy and greater pre-tax income inequality over time. But the CBO data show that is not what happened. The rich have been pummelled with an effective rate of 25% or more for decades, while effective rates on the other four quintiles have fallen modestly.

Statutory rates have been cut at the top end, but that has led to substantially higher reported income due to an increase in productive efforts and a reduction in tax avoidance. In a 2006 paper, Martin Feldstein at Harvard calculated that the elasticity of taxable income with respect to income tax rates is about 1, so that cutting the top rate from 40% to 30% would boost taxable income by about 16%. The result would be more work effort and less avoidance by entrepreneurs, doctors, scientists and others in the top quintile, which would greatly benefit the rest of us.

Unfortunately, President Obama wants to go in the other direction, raising the top two income tax rates, which would reduce production and increase avoidance by highly skilled people. Such economic damage from higher taxes is called deadweight loss. In the 2006 paper, Mr Feldstein argued that deadweight losses from a federal income tax rate increase would be $1.76 for every dollar of tax increase. That means that every new $1 billion spending programme in President Obama's budget will destroy about $1.76 billion of activities in the private sector.

That is the economics of tax hikes, but what about the politics? The Economist proposition suggests that "resentment over inequality is growing ever more vocal … is taxing the rich more heavily necessary to buy social peace?" Consider that 43% of American households do not pay any federal income tax, according to data from the Joint Committee on Taxation. That large group is doing little to support the huge burden of the welfare state, so it is laughable that they might be angry at the wealthy who do bear the burden. The CBO data show that the top one-fifth of households pay 69% of the entire costs of the federal government. Frankly, the rest of Americans are free-riders on the top quintile's enormous financial support of government.

In America, it is not rich and productive people that create resentment. Instead, it is corrupt politicians handing out special favours, it is the bungling bureaucrats we saw after Hurricane Katrina, and it is cabinet nominees who cheat on their taxes. Americans are not upset at wealthy Steve Jobs and his amazing innovations, but they are upset when they hear that global warming advocate Al Gore lives in a mansion that consumes 15 times more electricity than the average US home. It is hypocrisy, fraud and corruption that people do not like, not hard work and high incomes.

The main reason that we should not increase taxes on the rich is that most governments are far above their optimal size. Vito Tanzi, a former top economist at the International Monetary Fund, noted in a 2004 study: "All the theoretical reasons advanced by economists to justify the role of the state in the economy, including the need to assist the poor, could be satisfied with a much smaller share of spending of GDP than is now found in most industrial countries." Mr Tanzi found that bigger governments were not correlated with better human development indicators such as education achievement, infant mortality or life expectancy.

There are fundamental reasons why big governments do not work very well. As taxes rise, resources are shifted from more efficient private activities to less efficient government activities. The private sector is not more efficient than government because it does not make mistakes, but because it has mechanisms to purge mistakes and move resources to higher-valued uses. Government policymakers do the opposite: they retain failed programmes year after year, and resources get stuck in low-value uses.

Even if politicians did focus on moving resources to higher-value uses, they would be unable to because government activities do not generate the price and profit signals needed to allocate capital and labour efficiently. A final problem is that government programmes are often horribly managed. To take one example, President Obama wants to expand subsidies for energy research, but past US energy subsidies have led to boondoggle after boondoggle, as I have documented at Perhaps governments in other countries work better than in the United States, but I doubt it.

Some economists in America think that it is inevitable that taxes will rise in coming years. But Canada's recent experience shows a different path. Since the early 1990s, Canada has cut individual and corporate tax rates, shrunk the overall size of government from 53% of GDP to 40%, and has consistently balanced its federal budget. In Canada, tax cuts, spending cuts and debt reduction have not led to less social peace, nor should it anywhere else.

Chris Edwards is tax policy director at the Cato Institute and co-author of Global Tax Revolution.

Saturday, April 4, 2009

Obama administration to avoid Congressional limits on executive pay

Administration Seeks an Out On Bailout Rules for Firms. By Amit R. Paley and David Cho
Officials Worry Constraints Set by Congress Deter Participation
Washington Post, Saturday, April 4, 2009; A01

The Obama administration is engineering its new bailout initiatives in a way that it believes will allow firms benefiting from the programs to avoid restrictions imposed by Congress, including limits on lavish executive pay, according to government officials.

Administration officials have concluded that this approach is vital for persuading firms to participate in programs funded by the $700 billion financial rescue package.

The administration believes it can sidestep the rules because, in many cases, it has decided not to provide federal aid directly to financial companies, the sources said. Instead, the government has set up special entities that act as middlemen, channeling the bailout funds to the firms and, via this two-step process, stripping away the requirement that the restrictions be imposed, according to officials.

Although some experts are questioning the legality of this strategy, the officials said it gives them latitude to determine whether firms should be subject to the congressional restrictions, which would require recipients to turn over ownership stakes to the government, as well as curb executive pay.

The administration has decided that the conditions should not apply in at least three of the five initiatives funded by the rescue package.

This strategy has so far attracted little scrutiny on Capitol Hill, and even some senior congressional aides dealing with the financial crisis said they were unaware of the administration's efforts. Just two weeks ago, Congress erupted in outrage over bonuses being paid at American International Group, with some lawmakers faulting the administration for failing to do more to safeguard taxpayers' interests.

Rep. Edolphus Towns (D-N.Y.), chairman of the House Oversight and Government Reform Committee, said the congressional conditions should apply to any firm benefiting from bailout funds. He said he planned to review the administration's decisions and might seek to undo them. "We have to make certain that if they are using government money in any sort of way, there should be restrictions," he said.

A Treasury spokesman defended the approach. "These programs are designed to both comply with the law and ensure taxpayers' funds are used most effectively to bring about economic recovery," spokesman Andrew Williams said.

In one program, designed to restart small-business lending, President Obama's officials are planning to set up a middleman called a special-purpose vehicle -- a term made notorious during the Enron scandal -- or another type of entity to evade the congressional mandates, sources familiar with the matter said.

In another program, which seeks to restart consumer lending, a special entity was created largely for the separate purpose of getting around legal limits on the Federal Reserve, which is helping fund this initiative. The Fed does not ordinarily provide support for the markets that finance credit cards, auto loans and student loans but could channel the funds through a middleman.

At first, when the initiative was being developed last year, the Bush administration decided to apply executive-pay limits to firms participating in this program. But Obama officials reversed that decision days before it was unveiled on March 3 and lifted the curbs, according to sources who spoke on condition of anonymity because the discussions were private.

Obama's team is also planning to exempt financial firms that participate in a program designed to find private investors to buy the distressed assets on the books of banks. But Treasury officials are still examining the legal basis for doing so. Congress has exempted the Treasury from applying the restrictions in a fourth program, which aids lenders who modify mortgages for struggling homeowners.

Congress drafted the restrictions amid its highly contentious consideration of the $700 billion rescue legislation last fall. At the time, lawmakers were aiming to reform the lavish pay practices on Wall Street. Congress also wanted the government to gain the right to buy stock in companies so that taxpayers would benefit if the firms recovered.

The requirements were honored in an initial program injecting public money directly into banks. That effort was developed by the Bush administration and continued by Obama's team. The initiative is on track to account for the bulk of the money spent from the rescue package. All the major banks already submit to executive-compensation provisions and have surrendered ownership stakes as part of this program.

Yet as the Treasury has readied other programs, it has increasingly turned to creating the special entities. Legal experts said the Treasury's plan to bypass the restrictions may be unlawful.

"They are basically trying to launder the money to avoid complying with the plain language of the law," said David Zaring, a former Justice Department attorney who defended the government from lawsuits involving related legal issues. "They are trying to create a loophole to ignore Congress, and I think the courts will think that it's ridiculous."

The federal watchdog agency overseeing the bailout is looking into the matter, trying to determine whether the Treasury's actions are legal.

Of the two major restrictions imposed by Congress in the bailout legislation, the limit on executive pay has been the most politically explosive issue.

Obama himself has called for these limits. "We've got to make certain that taxpayer funds are not subsidizing excessive compensation packages on Wall Street," he said earlier this year.

But officials at the Treasury and the Fed said they worry harsh pay limits will undermine critical bailout programs by discouraging financial firms from participating. Although many of these companies could survive without government help, they might lack money to ramp up lending, which officials consider critical to turning the economy around.

In private meetings with officials in both the Bush and Obama administrations, firms' leaders have pushed back against pay limits.

A major test of whether the Treasury would apply the congressional restrictions was a $1 trillion program developed last fall to revive consumer lending. The initiative, known as the Term Asset-Backed Securities Loan Facility, or TALF, will be seeded with up to $100 billion from the financial rescue package, with the rest coming from the Fed.

The program set up a special entity providing low-cost loans to hedge funds and other private investors so they can buy securities that finance consumer debt from banks and other lenders. This would free these companies to make more loans.

When the Bush administration announced the program in November, officials directed the Fed to apply the pay limits to the lenders because they stood to benefit the most from the program. "There was a public hunger for executive-compensation restrictions, and we knew we couldn't be tone-deaf to the politics there," a former Bush administration official said.

In February, Obama administration officials at the White House and the Treasury began reviewing that decision. Treasury officials consulted with Department of Justice attorneys, who said they could legally avoid the pay restrictions, according to a government official. The requirements were removed just before the initiative was launched.

The concerns persisted as the administration crafted other initiatives. Some private investors said, for instance, that they would not help the government buy toxic assets from banks if the congressional restrictions were applied to them. And every major provider of small-business loans has said that it will not participate in the government's program if it has to surrender ownership stakes to the government or submit to executive-pay limits.

Thursday, March 5, 2009

The Right Way to Determine Executive Pay

The Right Way to Determine Executive Pay. By Richard R Floersch
Compensation is about more than just recruitment and retention.
WSJ, Mar 05, 2009

It's that time again -- proxy season -- when compensation committees, independent advisers and HR executives are making final decisions about executive compensation in public companies for 2009 and beyond. Meanwhile, public anger about big paychecks is at a fever pitch.

In this climate, those responsible for setting the parameters in the private sector need to start asking the right questions and taking actions, even if the results aren't popular among executives. If they don't, Congress will likely seek to change the way compensation is provided.

This would be unfortunate, because aside from disclosure, past attempts to regulate the amount and form of executive compensation have backfired. The $1 million limitation on deductibility of senior executive compensation, which became law in 1993, resulted in many companies increasing CEO salaries to $1 million. Earlier limitations on exit packages had the same effect -- the ceiling became a floor.

Often lost in public debate is a critical point: Compensation is, or should be, an integral part of a business strategy, devised to incentivize executives to accomplish that strategy.

Pay isn't just about recruitment and retention. It's also a form of communication about a company's culture and values, which can impact a company's relationship with its employees, its brand reputation, and ultimately its share value. The boards and executives at leading companies have created a culture of leadership that reinforces a true pay-for-results orientation -- pay goes up with positive results and down when the company does poorly.

Perhaps the best way all companies can demonstrate this orientation is to ask the following questions:

Does your company have incentive measures that address both company performance and its sustainability? A focus on revenue growth means little if the results will have negative long-term effects or result in massive write-downs.

Are the potential payouts under your annual incentive capped at a reasonable level to minimize "swinging for the fences" at the expense of long-term company viability? Does your compensation committee have discretion to adjust payouts that, while reflective of actual performance, do not appear fair in the broader context? Finally, does your compensation committee place a higher priority on doing what's right for the company in the long term ahead of merely copying what competitors and other companies are doing?

Other questions: Are your company's stock ownership and/or retention policies sufficiently rigorous to require executives to own substantial company stock over their careers, and hold it for long periods of time to align pay with shareholder interests? Does your company have a meaningful clawback (recoupment) policy? More than 64% of the Fortune 100 companies have clawback policies. If a company doesn't perform as well as originally believed, then why pay executives as if it did?

The good news is that setting aside the unique Wall Street pay model, which was focused on short-term results and annual bonuses, many large companies already have executive compensation structures that are predominantly focused on compensation for long-term performance. According to Equilar Inc., a leading compensation data and analysis firm, roughly 70% of total compensation for S&P 500 CEOs was in the form of long-term incentives, typically earned over three years or more and predominantly tied to shareholder return.

The debate over executive pay will no doubt persist. Policy makers should abjure knee-jerk reforms and carefully consider the actual impact of proposed changes on pay. And boards and corporate leaders need to earn policy makers' trust by demonstrating that we understand that pay communicates a broader message, and are willing to be part of the solution.

Mr. Floersch is executive vice president of McDonald's Corp. and chairman of the Center on Executive Compensation, which represents the senior HR executives at some of the largest U.S. corporations.

Thursday, February 26, 2009

Are Executives Paid Too Much?

Are Executives Paid Too Much? By Judith F. Samuelson and Lynn A. Stout
Congress asks the wrong question and comes up with the wrong answer.

A last-minute provision added to the stimulus bill President Barack Obama signed into law on Feb. 17 restricts companies that accept federal bailout funds from paying performance bonuses that exceed one-third of an executive's total annual compensation. This punitive measure may be understandable as a reflection of populist fury over bonuses being paid to heads of failing companies that received billions in taxpayer money. But it utterly fails to fix the real problem with executive compensation: short-termism.

Our economy didn't get into this mess because executives were paid too much. Rather, they were paid too much for doing the wrong things.

There have been nearly as many reasons proposed for the current crisis as there are experts to propose them. But if we had to pick one overarching cause, it would be business leaders taking on excessive risk in the quest to increase next quarter's profits. This short-term thinking, in turn, was driven by two trends in the business world: shareholders' increasingly clamorous demands for higher earnings, and compensation plans that paid managers handsomely for taking on risks today that would only be realized later.

In the summer of 2006, well before most economists had any inkling of the calamity that was about to unfold, the Aspen Institute brought together a diverse mix of high-level business leaders, investment bankers, governance experts, pension fund managers, and union representatives. When you put successful people with such disparate and conflicting backgrounds and loyalties together in the same room, the result can be a shouting match. But the members of the newly formed Aspen Corporate Values Strategy Group found they shared an unprecedented consensus: Short-term thinking had become endemic in business and investment, and it posed a grave threat to the U.S. economy.

People in all walks of life need months or years to master a significant new project, whether it be getting a graduate degree or perfecting a 75 mph minor-league pitch into a 90 mph major-league fastball. Large corporations operate on a time scale that can be even longer. They pursue complex, uncertain projects that take years or decades to reach fruition: developing brand names, building specialized manufacturing facilities, exploring and drilling for oil and gas fields, or developing new drugs, products and technologies.

Yet over the past decade, corporations in general -- and banks and finance companies in particular -- have become increasingly focused on a single, short-term goal: raising share price. Rather than focusing on producing quality products and services, they have become consumed with earnings management, "financial engineering," and moving risks off their balance sheets.
This collective myopia had many causes. One cause, the Aspen Group concluded, was the demands of the very shareholders who are now suffering most from the stock market's collapse. It is extremely difficult for an outside investor to gauge whether a company is making sound, long-term investments by training employees, improving customer service, or developing promising new products. By comparison, it's easy to see whether the stock price went up today. As a result, institutional and individual investors alike became preoccupied with quarterly earnings forecasts and short-term share price changes, and were quick to challenge the management of any bank or corporation that failed to "maximize shareholder value."

Meanwhile, inside the firm, executives were being encouraged to adopt a similarly short-term focus through the widespread use of stock options. The value of a stock option depends entirely on the market price of the company's stock on the date the option is exercised. As a result, managers were incentivized to focus their efforts not on planning for the long term, but instead on making sure that share price was as high as possible on their option exercise date (usually only a year or two in the future), through whatever means possible.

Executives eager to maximize the value of stock options began adopting massive stock-buyback programs that drained much-needed capital out of firms; jumping into risky "proprietary trading" strategies with credit default swaps and other derivatives; cutting payroll and research-and-development budgets; and even resorting to outright accounting fraud, as Enron's options-fueled and stock-price obsessed executives did.

The system was perfectly designed to produce the results we have now. To get different results, we need a different system.

Simply cutting executive pay is not going to get either executives or investors to pay more attention to companies' long-term health. To get business back on track, the Aspen Group concluded, it is essential to focus on not just one but three strategies: designing new corporate performance metrics, changing the nature of investor communications, and reforming compensation structures.

Starting with metrics, we need new ways to measure long-run corporate performance, rather than simply relying on stock price. In terms of investor communications, companies need to ensure corporate officers and directors communicate with shareholders not about next quarter's expected profits, but about next year's and even next decade's.

Finally, and perhaps most importantly, companies must change the ways they reward not only CEOs and midlevel executives, but also institutional portfolio managers at hedge funds, mutual funds, and pension funds. Executives and managers should be rewarded for the actions and decisions within their control, not general market movements. Incentive-based pay should be based on long-term metrics, not one year's profits. Top executives who receive equity-based compensation should be prohibited from using derivatives and other hedging techniques to offload the risk that goes along with equity compensation, and instead be required to continue holding a significant portion of their equity for a period beyond their tenure.

It's always tempting in the midst of a crisis to look for a quick fix. But that's the kind of short-term focus that got the business world into trouble in the first place. So long as our metrics, disclosures and compensation systems encourage executives and institutional fund managers to look only a year or two ahead, we have to expect that that is what they'll continue to do. It's time for a long-term investment in promoting long-term business thinking.

Ms. Samuelson is the founder and executive director of the Aspen Institute Business and Society Program. Ms. Stout is professor of corporate and securities law at the UCLA School of Law and director of the UCLA-Sloan Research Program on Business Organizations.

Tuesday, February 17, 2009

Congress Gets Punitive on Executive Pay

Congress Gets Punitive on Executive Pay. By Lucian Bebchuk
We want compensation tied to performance.
WSJ, Feb 17, 2009

In a last-minute addition to the stimulus bill passed Friday, Congress imposed tight restrictions on pay arrangements in all financial firms that have or will receive funds from the federal government's Troubled Asset Relief Program (TARP).

While I have long been a critic of corporate compensation practices, these restrictions leave me concerned. They weaken executives' incentives to deliver the long-term performance that is needed to benefit banks, the economy, and taxpayers who have injected vast amounts of capital into these institutions.

While the new restrictions seem to have been motivated by a desire to limit total pay, it is the pay structure that they tightly regulate. The Obama administration's proposals focused on constraining pay unrelated to performance. The stimulus bill takes the opposite approach -- constraining incentive compensation, limiting it to one-third of total pay.

To be sure, incentive compensation in many public companies has been flawed. Some incentive compensation has been so in name only, and some of it has provided perverse incentives to focus on short-term results to the detriment of long-term performance.

But these problems require tightening the link between pay and long-term performance -- not giving up on it altogether. Mandating that at least two-thirds of an executive's total pay be decoupled from performance, as the stimulus bill does, is a step in the wrong direction.

Another wrong step is the bill's categorical prohibition on using any form of incentive compensation other than restricted stock. In the first place, some executives covered by the bill (up to 25 in some firms) run limited parts of the company's operations. Their incentive pay might be best tied to the performance of their unit's particular results, not to that of the whole company.

But even for top executives, the banks' special circumstances may make exclusive use of restricted stock contrary to taxpayer interests. In many banks, the shareholders' equity, which is junior to the government's investments in preferred shares and the claims of bondholders, now represents a small fraction of the bank's capital. Indeed, the value of some banks' common shares might largely represent an "out-of-the-money option," expected to deliver value only if things considerably improve.

In such circumstances, restricted stock may provide incentives for executives to take excessive risks with the bank's survival. Consider the case where an infusion of additional capital would greatly dilute the value of common shares but would be best for the bank, while failing to get that capital would put the bank's future at risk. In such circumstances, compensation in restricted common shares would provide executives with an incentive to avoid raising capital (which would wipe out their shares' value) and gamble on survival without additional capital.

The compensation restrictions have another adverse effect on incentives. Executives can sidestep them by returning TARP funds and avoiding them in the future. Some observers argue that such actions would be unlikely because they would be costly to the bank. This overlooks the divergence between the interests of the bank and its executives. The bill provides executives with counterproductive and unnecessary private incentives to terminate or avoid TARP funding, even when doing so would not be in the bank's best interest.

The stimulus bill's adverse incentives deserve special attention because of the government's current approach to the banking sector. While infusing large amounts of capital into banks, the government has chosen to leave their management largely to the discretion of bank executives. This makes executive incentives of paramount importance.

Compensation structures with distorted incentives may have already imposed large losses on investors and the economy. Public officials should be wary of introducing new distortions and perverse incentives. With so much hanging in the balance, ensuring that those running the country's banks have the right incentives is as important as ever.

Mr. Bebchuk, director of the Harvard Law School program on corporate governance, is co-author of "Pay without Performance: The Unfulfilled Promise of Executive Compensation" (Harvard University Press, 2004).

Sunday, February 8, 2009

Bonuses are getting a bad rap, but they're an important and useful part of the financial services industry

Greed Is Good, by Roy C Smith
Wall Street bonuses are getting a bad rap, but they're an important and useful part of the financial services industry. Taking them away could hamper the economic comeback.
WSJ, Feb 07, 2009

Wall Street bonuses are getting a bad rap, but they're an important and useful part of the financial services industry. Taking them away could hamper the economic comeback.
1973 was a terrible year on Wall Street. An unexpected crisis in the Middle East led to a quadrupling of oil prices and a serious global economic recession. The president was in serious trouble with Watergate. The S&P 500 index dropped 50% (after 23 years of rising markets), and much of Wall Street fell deeply into the red. There were no profits, and therefore no bonuses.

I was a 35-year-old, nonpartner investment banker then and was horrified to learn that my annual take-home pay would be limited to my small salary, which accounted for about a quarter of my previous year's income. Fortunately the partners decided to pay a small bonus out of their capital that year to help employees like me get by. The next year was no better. Several colleagues with good prospects left the firm and the industry for good. We learned that strong pay-for-performance compensation incentives could cut both ways.

Many wondered if that was still the case last week, when New York State Comptroller Thomas DiNapoli released an estimate that the "securities industry" paid its New York City employees bonuses of $18 billion in 2008, leading to a public outcry. Lost in the denunciations were the powerful benefits of the bonus system, which helped make the U.S. the global leader in financial services for decades. Bonuses are an important and necessary part of the fast-moving, high-pressure industry, and its employees flourish with strong performance incentives.

There is also a fundamental misunderstanding of how bonuses are paid that is further inflaming public opinion. The system has become more complex than most people know, and involves forms of bonuses that are not entirely discretionary.

The anger at Wall Street only grew at the news that Merrill Lynch, after reporting $15 billion of losses, had rushed to pay $4 billion in bonuses on the eve of its merger with Bank of America. Because Merrill Lynch and Bank of America were receiving substantial government funds to keep them afloat, the subject became part of the public business. The idea that the banks had paid out taxpayers' funds in undeserved bonuses to employees, together with a leaked report of John Thain's spending $1 million to redecorate his office, understandably provoked a blast of public outrage against Wall Street. The issue was so hot that President Barack Obama interrupted his duties to call the bonuses "shameful" and the "height of irresponsibility." Then, on Wednesday, he announced a new set of rules for those seeking "exceptional" assistance from the Troubled Asset Relief Program in the future that would limit cash compensation to $500,000 and restrict severance pay and frills, perks and boondoggles.

In the excitement some of the facts got mixed up. Mr. DiNapoli's estimate included many firms that were not involved with the bailout, and only a few that were. Merrill's actions were approved by its board early in December and consented to by Bank of America. But the basic point is that, despite the dreadful year that Wall Street experienced in 2008, some questionable bonuses were paid to already well-off employees, and that set off the outrage.

Many Americans believe that any bonuses for top executives paid by rescued banks would constitute "excess compensation," a phrase used by Mr. Obama. But no Wall Street CEO taking federal money received a bonus in 2008, and the same was true for most of their senior colleagues. Not only did those responsible receive no bonuses, the value of the stock in their companies paid to them as part of prior-year bonuses dropped by 70% or more, leaving them, collectively, with billions of dollars of unrealized losses.

That's pay for performance, isn't it?

"Wall Street" has always been the quintessential, if ill-defined, symbol of American capitalism. In reality, Wall Street today includes many large banks, investment groups and other institutions, some not even located in the U.S. It has become a euphemism for the global capital markets industry -- one in which the combined market value of all stocks and bonds outstanding in the world topped $140 trillion at the end of 2007. Well less than half of the value of this combined market value is represented by American securities, but American banks lead the world in its origination and distribution. Wall Street is one of America's great export industries.

The market thrives on locating new opportunities, providing innovation and a willingness to take risks. It is also, regrettably, subject to what the economist John Maynard Keynes called "animal spirits," the psychological factors that make markets irrational when going up or down. For example, America has enjoyed a bonus it didn't deserve in its free-wheeling participation in the housing market, before it became a bubble. Despite great efforts by regulators to manage systemic risk, there have been market failures. The causes of the current market failure, which is the real object of the public anger, go well beyond the Wall Street compensation system -- but compensation has been one of them.

The capital-markets industry operates in a very sophisticated and competitive environment, one that responds best to strong performance incentives. People who flourish in this environment are those who want to be paid and advanced based on their individual and their team's performance, and are willing to take the risk that they might be displaced by someone better or that mistakes or downturns may cause them to be laid off or their firms to fail. Indeed, since 1970, 28 major banks or investment banks have failed or been taken up into mergers, and thousands have come and gone into the industry without making much money. Those that have survived the changing fortunes of the industry have done very well -- so well, in fact, that they appear to have become symbolic of greedy and reckless behavior.

The Wall Street compensation system has evolved from the 1970s, when most of the firms were private partnerships, owned by partners who paid out a designated share of the firm's profits to nonpartner employees while dividing up the rest for themselves. The nonpartners had to earn their keep every year, but the partners' percentage ownerships in the firms were also reset every year or two. On the whole, everyone's performance was continuously evaluated and rewarded or penalized. The system provided great incentives to create profits, but also, because the partners' own money was involved, to avoid great risk.

The industry became much more competitive when commercial banks were allowed into it. The competition tended to commoditize the basic fee businesses, and drove firms more deeply into trading. As improving technologies created great arrays of new instruments to be traded, the partnerships went public to gain access to larger funding sources, and to spread out the risks of the business. As they did so, each firm tried to maintain its partnership "culture" and compensation system as best it could, but it was difficult to do so.

In time there was significant erosion of the simple principles of the partnership days. Compensation for top managers followed the trend into excess set by other public companies. Competition for talent made recruitment and retention more difficult and thus tilted negotiating power further in favor of stars. Henry Paulson, when he was CEO of Goldman Sachs, once remarked that Wall Street was like other businesses, where 80% of the profits were provided by 20% of the people, but the 20% changed a lot from year to year and market to market. You had to pay everyone well because you never knew what next year would bring, and because there was always someone trying to poach your best trained people, whom you didn't want to lose even if they were not superstars. Consequently, bonuses in general became more automatic and less tied to superior performance. Compensation became the industry's largest expense, accounting for about 50% of net revenues. Warren Buffett, when he was an investor in Salomon Brothers in the late 1980s, once noted that he wasn't sure why anyone wanted to be an investor in a business where management took out half the revenues before shareholders got anything. But he recently invested $5 billion in Goldman Sachs, so he must have gotten over the problem.

As firms became part of large, conglomerate financial institutions, the sense of being a part of a special cohort of similarly acculturated colleagues was lost, and the performance of shares and options in giant multi-line holding companies rarely correlated with an individual's idea of his own performance over time. Nevertheless, the system as a whole worked reasonably well for years in providing rewards for success and penalties for failures, and still works even in difficult markets such as this one.

At junior levels, bonuses tend to be based on how well the individual is seen to be developing. As employees progress, their compensation is based less on individual performance and more on their role as a manager or team leader. For all professional employees the annual bonus represents a very large amount of the person's take-home pay. At the middle levels, bonuses are set after firm-wide, interdepartmental negotiation sessions that attempt to allocate the firm's compensation pool based on a combination of performance and potential.

Roy C. Smith, a professor of finance at New York University's Stern School of Business, is a former partner of Goldman Sachs.

Saturday, February 7, 2009

Barney Frank: TARP's compensation curbs could be extended to all businesses

Barney Frank: TARP's comp curbs could be extended to all businesses. By Neil Roland
Would be part of broader bill limiting hedge funds, credit-raters, and mortgage securitizers; 'deeply rooted anger'
Financial Week, February 3, 2009 3:01 PM ET

Congress will consider legislation to extend some of the curbs on executive pay that now apply only to those banks receiving federal assistance, House Financial Services Committee Chairman Barney Frank said.

“There’s deeply rooted anger on the part of the average American,” the Massachusetts Democrat said at a Washington news conference today.

He said the compensation restrictions would apply to all financial institutions and might be extended to include all U.S. companies.

The provision will be part of a broader package that would likely give the Federal Reserve the authority to monitor systemic risk in the economy and to shut down financial institutions that face too much exposure, Mr. Frank said.

Also included in the legislation: registration requirements for hedge funds and proposals aimed at curbing conflicts of interest at credit-rating agencies such as Standard & Poor’s.

The bill, which the committee is working on in consultation with the Obama administration, also will require financial institutions that bundle mortgages into securities to share in potential losses. This would give banks and mortgage-specialists an incentive not to make bad loans, he said. Institutions that securitize loans improperly will incur tougher penalties.

“There have been too few constraints on major financial institutions incurring far more liability than they could handle,” Mr. Frank said.

The committee hopes to have a general outline of the legislation by early April, he said. It will be the panel’s first priority in its effort to restructure financial regulation in the wake of the worst economic crisis since the Great Depression.

Mr. Frank has summoned the CEOs of Citigroup, J.P. Morgan Chase and the seven other U.S. financial firms that got $125 billion from TARP to testify at a Feb. 11 committee hearing.

Mr. Frank seems to be in synch with the Obama administration in his plans for executive compensation.

Treasury Secretary Timothy Geithner said last month that he might try to extend to all U.S. companies a restriction that prohibits bailout banks from taking a tax deduction of more than $500,000 in pay for each executive.

The Troubled Assets Relief Program legislation enacted in October seeks to give companies receiving aid under the $700 billion bailout a number of incentives to curb what it calls excessive executive pay.

Mr. Geithner said he would consider “extending at least some of the TARP provisions and features of the $500,000 cap to U.S. companies generally.”

Under the legislation, banks receiving bailout money must limit golden parachute payments to senior executives to no more than three times the executives’ base pay. The companies also must subject any bonuses or incentives to clawbacks if the payouts are based on bank’s misleading financial statements.

In addition, bailout recipients can’t offer top managers incentives that “encourage unnecessary excessive risks that threaten the value of the financial institution.”

These limits apply to the chief executive officer, chief financial officer and the next three most highly compensated executives in a bank receiving rescue funds.

Mr. Frank said provisions on golden parachute payments and bonus clawbacks would probably be in the legislation, though he declined to provide more detail because “we’re early in the process.”

A congressional oversight panel headed by Harvard Law professor Elizabeth Warren also recommended last week that Treasury consider revoking executive bonuses at failed institutions getting federal aid.

Currently, these institutions must subject bonuses to clawbacks only if the payouts are based on banks’ misleading financial statements.

The top Republican on the committee, Spencer Bachus of Alabama, said last month he has reservations about giving the Fed new powers, such as the authority to monitor systemic risk.

Mr. Frank said today that after lawmakers address issues on systemic risk, they will consider how to bolster investor protection via changes at the Securities and Exchange Commission. The committee also will review proposals to assist struggling homeowners and expand the housing supply, and to strengthen international financial institutions such as the World Bank, he said.

Friday, February 6, 2009

Andrew Napolitano's Imaginary Constitution

Andrew Napolitano's Imaginary Constitution, by Matthew J. Franck
Bench Memos/NRO, Friday, February 06, 2009

Today's Wall Street Journal features an exchange on whether the government should cap executive compensation in companies receiving federal assistance. Harvard law professor Lucian Bebchuk is for 'em—he thinks, indeed, that they should be more stringent than the administration proposes—and former New Jersey judge Andrew Napolitano is agin 'em. Napolitano would have the better argument if he would stick to what's really wrong with compensation caps—that they're economically counterproductive, politically unwise, and morally objectionable as a species of envy-driven vindictiveness.

But Napolitano can't leave well enough alone. He adds the argument that compensation caps are unconstitutional. Why? "[B]ecause freedom of contract is protected by the Constitution." Oh, really? Where? For about 40 years, from the 1890s to the 1930s, the Court protected (inconsistently, to be sure) something it called "freedom of contract," but it was based on an illegitimate reading of the due process clauses that was cut from the same "substantive due process" cloth that gave us the protection of slavery in the Dred Scott case and of abortion in Roe v. Wade. You don't have to be a fan of the New Deal to recognize how right the Supreme Court got this one when it gave up on this line of reasoning in 1937, with Chief Justice Hughes saying, "What is this freedom? The Constitution does not speak of freedom of contract."

Napolitano doesn't even attempt to defend his remark about "freedom of contract," but instead moves immediately to saying that compensation caps "also constitute a taking" prohibited by the Fifth Amendment. It has been a hardy perennial in the imaginary constitutional garden of the libertarians to say that all manner of taxes and regulations are "takings" without "just compensation" ever since Richard Epstein of the University of Chicago published his book Takings in the 1980s. But this reading of the Constitution is as insupportable as "freedom of contract" under "substantive" due process, and invites rampant judicial activism—only substituting conservative activism for the liberal variety. All sorts of government regulations of the economy favor some behaviors over others, impinge on people's earning power, and thus in some extremely remote sense "take" resources people would otherwise acquire or keep. The Epstein-Napolitano version of the Constitution would sweep like a scythe through good regulations and bad ones, blatant ones and subtler ones, and without any basis in the original understanding of the document.

The idea of executive compensation caps is a very bad one on all sorts of policy grounds. It is also unjust. But injustice and unconstitutionality are not the same thing, try as Napolitano may to equate them.

Napolitano on executive pay caps: They Violate Good Sense and the Constitution

. . . They Violate Good Sense and the Constitution. By Andrew P Napolitano
The government cannot condition benefits on the nonassertion of rights.
WSJ, Feb 06, 2009

The executive compensation caps that President Barack Obama and Treasury Secretary Tim Geithner summarily announced this week violate both the Constitution and Economics 101.

I have argued on this page that the Troubled Asset Relief Program for the banks is itself inherently and profoundly unconstitutional for several reasons. It promotes only short-term private benefit, rather than the general welfare as the Constitution commands of all federal spending. It evades the constitutional requirement of equal protection by saving some businesses and letting others that are similarly situated simply expire. And it delegates to the secretary of the Treasury the power to spend taxpayer dollars as he sees fit, in violation of the express constitutional grant of the nondelegable spending power to the Congress.

Now the federal government wants to interfere with private employment contracts already entered into -- and regulate those not yet signed -- in order to satisfy the perceived populist instincts of the electorate. To do so, it demands salary caps as a condition to the receipt of public assistance.

Salary caps are unconstitutional because they violate the well-grounded doctrine against unconstitutional conditions. Simply stated, the government may not condition the acceptance of a governmental benefit on the non-assertion of a constitutional liberty. The government cannot say to individual welfare recipients that they may not criticize the Congress or their welfare checks will be cut off, because the right to criticize the government is a constitutionally protected liberty. It similarly may not condition corporate welfare on the prohibition of contracts with employees above an arbitrary salary amount, because freedom of contract is protected by the Constitution as well.

The salary caps also constitute a taking. High ranking executives are corporate assets with experience and knowledge unique to their employers' businesses. By arbitrarily reducing their salaries to serve the government's political needs, deflating their worth to their employers, incentivizing them to work less, or chasing them away, the government has stripped these individuals of their personal value and of their value to employers without just compensation. Such a taking is prohibited by the Fifth Amendment.

Moreover, government-mandated salary caps will impede economic progress. We can presume that the senior executives of the banks that have received TARP funds who are paid more than $500,000 annually are worth at least that much to their employers. Otherwise the employers would be violating their fiduciary duties to their shareholders by paying those salaries. These employers are banks which the government has "rewarded for failure," to use the president's phrase, by investing money from taxpayers who would not voluntarily invest their own money there.

So, not only are these banks in distress, not only do they seek federal dollars in order to stay afloat, but under these salary caps they cannot go out and get the best talent to run them. The government that is trying to save them, the government that has forced taxpayer dollars into them, has denied them the freedom of contract necessary to assure their salvation. Why would underpaid executives stay with a bailed out bank when their true worth will be compensated elsewhere?

The government can't run a business. Just look at the Post Office, which loses $6 billion a year and has salary caps. Is this what's coming to the banks? If the government can evade the Constitution and violate the basic laws of economics what will it do to free enterprise next?

Mr. Napolitano, who was on the bench of the Superior Court of New Jersey between 1987 and 1995, is the senior judicial analyst at the Fox News Channel. His latest book is "A Nation of Sheep" (Nelson, 2007).

Attempt to establish non-market prices: The Athenian Grain Merchants, 386 B.C.

Cold Case Files: The Athenian Grain Merchants, 386 B.C. By Wayne R. Dunham
Cato Journal, Vol. 28, No. 3 (Fall 2008). Feb 2009

Food price increases have always been politically sensitive. Price spikes like those that have occurred recently create the demand for action on the part of government to alleviate the problem. Yet, government intervention can often do more harm than good. This article examines one such example of a counterproductive response that occurred in 388 B.C. in Athens, Greece. In response to a negative supply shock to the grain market, regulators encouraged grain importers to form a buyers' cartel (monopsony), hoping that it would reduce retail prices by first lowering wholesale grain prices. In reality, the decrease in wholesale prices resulted in a decrease in the willingness of producers in other regions to supply grain to Athens, and retail grain prices increased substantially. Grain importers soon found themselves on trial for their lives in what is probably the earliest recorded antitrust trial. This article uses the information presented at that trial and other contemporary sources to evaluate the grain merchants. actions. More generally, it analyses the impact of a buyer's cartel or monopsony on prices and consumption.