Executive Bonuses and the Case Against Federal Caps

Introduction

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 had 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, that executive bonuses should not be subject to caps by anyone other than the shareholders of the company in question. Federal legislation capping or curtailing bonuses would be misguided and would fail to address the core problems in executive compensation.

The History of Executive Compensation

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, and a revolution in executive compensation followed. 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" — which also served the best interests of shareholders seeking a higher share price. The use of equity-based compensation was further encouraged by favorable tax treatment at the time.

Equity-based compensation was flawed, however, in that stock options carry an expiry date. As a result, the interests of management were aligned with those of shareholders only for the duration remaining on their options, not beyond. This encouraged short-term, risky behavior aimed at increasing the share price before option expiry. Shareholders often welcomed this as well, since they could sell when the stock ran up. Longer-term shareholders were more likely to bear the brunt of such risk taking, since the eventual lack of long-term value building would result in a collapse in the share price.

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

The Two Sides of the Debate

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

The opposing view holds that such pay plans are necessary to attract and retain key talent, and that executives must be oriented toward maximizing shareholder wealth in some measurable way. Opponents of caps also argue that companies should be free to set their own terms. If shareholders disliked the bonus structure paid to their executives, they could simply replace the board and negotiate new deals with the executive team.

Indeed, many shareholders do precisely that. Warren Buffett, for example, does not award excessive bonuses to the CEOs of his companies because he does not view that as an effective means of motivating executives appropriately. Major institutional shareholders, such as CalPERS, also take an active interest in the executive compensation practices of the firms in which they invest.

Conclusion

The debate over executive bonuses intensified in the aftermath of the 2008 financial crisis, but the evidence suggests that federal intervention is neither necessary nor desirable. The historical evolution of executive pay — from equity-based stock options through modern bonus structures — reflects ongoing market adaptation. Shareholders, particularly institutional investors, already possess the tools and incentives to discipline excessive pay. Research confirms that compensation structure matters more than compensation size, and market forces are already correcting the distortions introduced by past tax policies and investor irrationality. Imposing federal caps would constitute an additional distortion rather than a cure. The market, guided by engaged and rational shareholders, remains the most reliable and least disruptive mechanism for setting appropriate executive compensation.

Works Cited

Quijano, E. (2009). Obama tries to stop AIG bonuses. CNN. Retrieved December 3, 2009, from http://edition.cnn.com/2009/POLITICS/03/16/AIG.bonuses/index.html

Mehran, H. (1995). Executive compensation structure, ownership and firm performance. Journal of Financial Economics, 38(2), 163–184.

Mullen, E., & Guigliano, G. (2009). Recoverability of equity-based compensation deferred tax assets. Journal of Accountancy. Retrieved December 3, 2009, from

Lagace, M., & Khurana, R. (2002). The irrational quest for charismatic CEOs. Harvard Business School. Retrieved December 3, 2009, from http://hbswk.hbs.edu/item/3095.html

Sesil, J., Yu, P., & Director, S. (2005). Stock option adoption and irrational exuberance: The impact on profitability. Working Paper Series in Human Resources Management, Rutgers University. Retrieved December 3, 2009, from http://www.chrs.rutgers.edu/pub_documents/SOProfit010306%5B3%5DF.pdf