Executive Bonuses When the Bush

Executive Bonuses

When the Bush administration bailed out the banking industry in the fall of 2008, some of those banks, paid out substantial bonuses to their executives. The resulting uproar compelled the Obama administration to put caps on executive bonuses for banks that have received bailouts. The situation -- in particular the AIG debacle -- raised once again the issue of executive compensation (Quijano, 2009)). Since the bulk of compensation for most senior executives is in the form of various bonuses, it is the bonuses that are most at issue. It is my view, however, executive bonuses should not be subject to caps by anybody other than the shareholders in that company. Federal legislation capped or curtailing bonuses would be wrong-headed, and fail to address the core problems in executive compensation.

The History

The current model for executive compensation evolved in the 1990s as a means to align the interests of management with the interests of shareholders. Mehran (1995) showed that equity-based compensation was positively correlated with higher firm performance. A revolution in executive compensation was sparked. Stock options became the norm, because executives would need to drive a higher share price in order for the options to be in the money. It is also in the best interests of the shareholders that the share price be driven higher. The use of equity-based compensation was encouraged by the tax treatment of such compensation at the time.

Equity-based compensation was flawed, however, in that stock options have an expiry. Thus, the interests of management were aligned with the interests of the shareholders for the duration remaining on their options, but not beyond. This encouraged short-term risky behavior in order to increase the share price in advance of option expiry. Shareholders liked this, too, since for the most part they could sell when the stock ran up as well. Longer-term shareholders were more likely to bear the brunt of the risk taking since eventually the lack of long-term value building in the organization would result in a collapse of the share price.

Shareholders, however, were becoming increasingly oriented towards long-term growth, a function of increasing dominance of institutional investors. When the Financial Standards Accounting Board issued Statement No. 123(R), it removed the tax advantage that equity-based compensation had once enjoyed (Mullen & Guigliano, 2009), it signaled a shift in executive compensation. Plans emerged based around a variety of bonuses, as corporations attempted to maximize the tax-favorability of their executive compensation plans.

The Two Sides

There are many problems that the proponents of capping or curtailing executive compensation are trying to solve. Some of the most common views are that executives do not earn that level of pay; that they earn too much in proportion to the rank-and-file; and that such pay is not directly tied to the long-run stability of the firm.

The flip side of the argument is that such plans are necessary to attract and retain key talent, and that employees must be oriented towards maximizing shareholder wealth in some way. Furthermore, opponents of caps argue, companies are free to do as they please. If the shareholders did not like the bonus structure paid to their executives, they would simply replace the board and cut new deals with the executive team.

Indeed, many shareholders do precisely that. Warren Buffet does not award excessive bonuses to the CEOs of his companies because he does not view that as being an effective means of motivating executives in the right ways. Major institutional shareholders, such as CalPERS, also take an active interest in the executive compensation at the firms in which they are invested.

The Case Against Caps

The AIG situation was unique. The President demanded the caps in part because the American taxpayer was a de facto if not de jure shareholder in AIG. The President's move may have been motivated by optics as much as anything else, but yet it served as a clear example of proper shareholder diligence. When he, representing the de facto shareholders the American taxpayers, found the executive compensation plans were out of line with the objectives of said shareholders, he acted.

In the free market system, this is the only response. Shareholders have rights and duties as the owners of companies. The executive team acts as their agents. The shareholders have not only the right but the capability to fire boards of directors and by extension executives whose compensation does not match their performance. The public outcry with respect to excessive compensation typically occurs when shareholders neglect their duty. Yet, there are examples where the shareholders have upheld their duty. These firms -- the majority -- do not make headlines, giving the impression that executive compensation is a rampant problem in society. If a company dares to pay bonuses will laying off workers or reducing their wages, the outcry hits the front page. However, the system as a whole is working well.

Arguments based on the pay disparity between executives and rank-and-file are largely emotional in nature. However, they are not entirely without merit. Executive compensation has been to some extent driven higher than it should by the irrational quest for the charismatic leader. Too many firms view executive talent as a genuinely scarce resource, which causes them to overpay top executives (Lagace & Khurana, 2002). Even Mehran (1995) readily admitted that it was not the size of the paycheck that determined managerial performance, but rather its structure. Like all irrational bubbles, however, the bubble that leads to excessive executive compensation will burst. The factors are already in place. The tax incentives on equity-based compensation have been removed and shareholder rights legislation has been improved as well. The rise of the institutional shareholder only heightens the ability of owners to reign in executive salaries and bonuses. Smart owners like Buffett already do.