The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISFigure 4.2Improve incentives by lowering salaries and removing caps or jumpsNote:While Figure 4.1 has not completely solved the incentives and risk issues (becauseperformance below X 0 can still cause problems), we have greatly (and simply) reduced theirscope. Executives no longer profit from risk taking such that good years (when rewards arehigh) are followed by bad years (when penalties are capped at zero), provided thatperformance remains above X 0 ). To make executives accountable for performance below X 0 ,the schedule in Figure 4.1 can be improved further by imposing “negative bonuses” forespecially poor performance. Indeed, Figure 4.1 already illustrates how salary reductions caneffectively introduce negative bonuses for performance between X 0 and X 1 , since theexecutive in this range will receive compensation below his former base salary.Conceptually, negative bonuses can be implemented by asking the executive to write acheck back to the company in bad years, but this scheme is difficult to implement, especiallyafter the executive has paid taxes of the bonuses. A more palatable way of achieving negativebonuses is through deferred bonuses that are subject to partial forfeiture if performancedeteriorates. An example of this type of plan is the “bonus bank” pioneered by Stern Stewartand Co. and first implemented by Coca Cola and Briggs and Stratton in 1988 and 1989. 140Bonus banks are structured so that a positive bonus is not paid out entirely in cash eachperiod. Instead the bonus is deposited into the executive’s bonus bank account. The executivereceives a cash distribution equal to a fixed fraction of the account balance each year, while140 The Stern Stewart bonus banks are described in Stewart (1990) and Stewart (1991). Under the typical SternStewart plan annual bonuses are deposited into the bonus bank and the executive draws one third of the bankbalance each year.-107-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISthe remaining balance is “at risk” to fund negative bonuses in future years. To make thisapproach work, it helps if the formula produces positive bonuses over the first few years tobuild a healthy balance in the account. Alternatively, the executive could forgo some fractionof his base salary each year to pre-fund the bonus bank.For senior executives, negative bonuses can be introduced by paying bonuses partiallyin restricted stock or options. These plans penalize executives when performancedeteriorates, since the value of the stock or options will naturally fall. In addition, the boardcan retain the right to cancel vesting of restricted stock or exercisability of options.Negative bonuses are especially important in cases where the executive is paid “toomuch” in a prior year, due to revisions in performance data not apparent until after the bonuswas paid. Such revisions include, but are not limited to, formal restatements of accountingnumbers such as earnings or revenues due to mistakes, over-optimistic assumptions,“managed earnings,” outright fraud or short-term oriented decisions by management thatgenerated profits in an earlier period but lead to substantial long-run value destruction.Boards must always reserve the right to recover the ill-gained rewards in these situations.Provisions to allow such recovery have recently been labeled as “clawback arrangements”since the company is “clawing back” rewards that had already been paid. Such clawbackarrangements are typically not legally enforceable (and executives can often escaperepayments by resigning), thus clawback provisions are typically not as effective as bonusbanks or deferrals.4.4. Did Banking Bonuses Cause the Financial Crisis?The heavy reliance on bonuses has been a defining feature of Wall Street compensationfor decades, going back to the days when investment banks were privately held partnerships.Such firms kept fixed costs under control by keeping base salaries low and paying most ofthe compensation in the form of cash bonuses that varied with profitability. This basicstructure remained intact when the investment banks went public, but the cash bonuses werereplaced with a combination of cash, restricted stock, and stock options.The fact that (1) the financial meltdown involved banks, (2) banks rely heavily onbonuses, and (3) pay levels in banks are high, have led many in the political sector or popularpress to presume that banking bonuses much have caused the crisis and thus needs to bereformed. But, researchers have been (so far) unable to document a causal link between thestructure of compensation in banks and the crisis. For example, Fahlenbrach and Stulz (2010)-108-
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