It used to be said that patriotism was the last refuge of scoundrels. Now that patriotism is being viewed with more irony than honor among a certain portion of Americans, I think the “last refuge” has become the bashing of “fat cats.” My evidence is a recent spate of articles on how President Obama, who is polling rather poorly these days, is once again going after Wall Street bonuses. There is no surer way to get heads nodding again when you speak.
I nod, too, but for a different reason. I continue to be astounded by the idea that banks had been managing the well-understood “trader’s option” problem for decades, then suddenly lost the ability to do so in the mid-2000s, and crash goes the financial system. This explanation simply doesn’t hold water. Neither does the idea that bankers suddenly became “greedy” in the mid-2000s, and crash went the financial system. No. If one wishes to develop a cogent theory about “what went wrong,” one must identify distinguishing characteristics, not common, long-imbedded ones.
I can (and have) provided many reasons why the “bonus culture” of banks has been unfairly blamed for the financial crisis. Fahlenbrach and Stulz (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1439859) provided the best empirical evidence that it didn’t.
Now, a new paper by legal scholars Whitehead and Sepe basically blames competition for talent as undermining proper incentives. I salute them for at least acknowledging the competition for talent in banking. Most critics of the banking system were feverishly trying to outdo each other in how firmly they would cap banker pay in arbitrary ways at arbitrary levels without regard to the competitive issues that such rules would create in order to “solve the problem” that they claimed was at the heart of the financial crisis. The ensuing exodus of talent at large, public U.S. banks has been unbelievable. (Literally–people outside of the industry don’t believe me when I tell them how bad it has been. The more polemical critics simply roll their eyes and smugly say, “Yeah, the talent to blow up the economy. Good riddance.”) Whitehead and Sepe acknowledge the competitiveness issue, but then go on to recommend arbitrary limits on how bankers may move from one firm to another.
If you believe that you have to compete for talent in financial services, including traders, and if you understand that different forms of pay offer different expected value to potential employees, then one can readily see that the only way to increase the risk and constraints of banker pay while acknowledging the need to compete for their talents would be to increase the expected value of that constrained, riskier pay package. Partnerships do this all the time. They create very risky, very constrained pay packages, and manage to lure incredible talent. Hedge funds didn’t contribute to the financial crisis, and didn’t need to get bailed out. And no one is suggesting that we need to limit how hedge fund employees move from one firm to another in order to moderate or contain risky behavior. What makes this work is that hedge funds don’t have to disclose how much their successful people earn.
How little President Obama and his staff know about these issues may or may not shock you. But he doesn’t have to know anything about the economics and dynamics of incentive compensation in the financial sector, or any sector. He just has to know the math: “Bashing Wall Street” = “Higher poll numbers.”
On Monday, Staples, Inc will try to win its “Say-on-Pay” vote with ISS recommending against approval the executive compensation plan. ISS made its recommendation based on its usual arbitrary, micro-managing concerns which are not the subject of this post. Here, I want to highlight the problem Staples created for itself, without anyone’s help, and unintentionally revealed in this pair of sentences:
The [Compensation] Committee … recognized the need to address retention of key talent and to continue to motivate associates in light of the fact that we did not pay any bonus under the Executive Officer Incentive Plan or Key Management Bonus Plan in 2013 and 2012.
As a result of the changes to the compensation program in 2013, an average of 84% of total target compensation (excluding the Reinvention Cash Award) for the NEOs was “at risk” based on performance results, and 100% of long term incentive compensation was contingent on results.
Anyone reading Staple’s proxy could be forgiven for thinking that these two sentences have nothing to do with each other, notwithstanding that they appear consecutively in this proxy. It’s clear that neither the authors of this disclosure nor the board that approved it saw the connection, either. But look carefully at what they are saying.
Read more of this article »
Whenever minimum wages are being debated, as they are once again, we can count on someone bringing up the old story about Ford’s $5-a-day gambit. It goes something like this:
Ford Motor founder Henry Ford revolutionized the industrial landscape when he doubled his employees’ wages to $5 per day in 1914. The pay increase allowed his workers to buy the Model T cars they assembled every day on the factory line.
Enabling workers to “buy their own product” supposedly enables the creation of a mass market, helping producers as well as consumers. But is that true? And is that how Ford benefited from his wage hike? Let’s look at the math.
In 1914, when Ford Motors instituted the $5-a-day wage, the company had about 14,000 workers making $2.25 a day, for a total wage cost of about $32 million. Ford was selling about 250,000 cars a year at about $500 per car. That’s about $125 million in total revenue. So, let’s say that ALL of the increase in wages–$2.75 per day per employee for all 14,000 employees–went toward the purchase of Ford cars. (Why that would have been impossible is a story for another time.) That would be sales of about 20,000 more cars (yes, more than one car per worker), yielding Ford about $10 million dollars more in revenue. So, the “buy-their-own-product” folks are asserting that Ford benefited by doubling his labor costs in order to increase his sales by less than 7 percent. For one year.
The buy-their-own-product rationale is as historically mistaken as it is economically ridiculous. Ford’s stated intent in dramatically raising wages was to reduce the huge turnover his new assembly line process had created, and the high costs of dealing with that turnover. In other words, it was a bold solution to a novel production problem.
Furthermore, far from expecting any major increase in sales (i.e., from his own workers), Ford counted on having his profits significantly reduced that year as a result of the wage increase. In fact, he was gleefully counting on it. Why would Ford want his profits hurt that year? Because he was in the middle of an outrageous gambit to squeeze out his fellow investors (and new car competitors) John and Horace Dodge, and a ding to the company’s profits that year would hurt them much more than it would Ford himself. Ford, in fact, expected to realize the benefits of lower turnover in later years once his volume was greatly expanded (which is what eventually happened).
The idea that increasing your employees’ wages to enable them to buy your product is one of those ditzy notions that requires math blinders to believe. Yet the “buy their own product” argument will continue to be made because belief is more powerful than math.
If I were a wheelwright, I would probably raise an eyebrow at stories like “Philadelphia man invents the wheel.” Since I create organizational incentives for a living, that was my initial reaction to this story, via the NYT:
In August, I wrote about the design and implementation of a profit-sharing plan for my business. I decided to try this because my company has a long history of producing poor (or no) profits…
The plan began with the second quarter of 2013, and here’s how it has worked out: We made a profit in three of the four quarters that followed.
It’s easy to joke about someone reinventing the wheel, but there is a difference between creating wheel, and creating a wheel that doesn’t come off when the road gets a little rough. A good incentive plan only gets that way after considering what, exactly, we want to motivate, and designing the plan to do that using the minimum number of moving parts needed to function effectively. I was impressed with the way this business owner went through that process, and what he ended up with:
If there is a profit, 30 percent of it goes into a profit pool. Half of that pool is split among all of the workers except me (because I keep the other 70 percent), and the other half is split just among the production employees (everyone except the two commissioned salesmen and the bookkeeper). The splits are all even, meaning lower paid and higher paid workers get the same share. If there is no profit in a quarter, there is no payout. A loss in one quarter gets subtracted from the subsequent quarter’s profits before any bonuses are paid out — but I don’t claw back previous bonus payments if there is a loss in a subsequent quarter.
Plans like this are becoming rarer, especially at larger or public companies. Of course, no plan is perfect. This plan was designed to encourage teamwork and a holistic focus on the business. I’m sure this owner will at some point get grief from his most productive people for pulling along the free riders. And he will be dealing with morale and retention issues when the market turns against his company for more than a couple of quarters. Whatever he does to ameliorate or prevent those problems will beget others. That’s life.
Nevertheless, his plan is impressive. This owner did not create sports car wheels for a motorbike, and he did not create the wheels within wheels that many compensation experts would consider “best practice.” He just thought about what he needed to get his business to the next level, and used his authority to do it right and keep it simple.
Private companies have a natural governance advantage over public companies - one that stems mainly from the presence on their boards of their largest owners. This governance advantage is reflected in the greater effectiveness of private company executive pay plans in balancing the goals of management retention and incentive alignment against cost.
Private company investor‐directors are more likely to make these tradeoffs efficiently because they have both a much stronger interest in outcomes than public company directors and more company‐specific knowledge than public company investors. Furthermore, private company boards do not have to contend with the external scrutiny of CEO pay and the growing number of constraints on compensation that are now faced by the directors of public companies.
Such constraints focus almost entirely on one dimension of compensation governance - cost - in the belief that such constraints are required to limit the ability of directors to overpay their CEOs. In practice, any element of compensation can serve to improve retention or alignment, as well as being potentially costly to shareholders. Furthermore, any proscribed compensation element can be “worked around” by plan designers, provided the company is willing to deal with the complexity. For this reason, rules intended to deter excessive CEO pay are now effectively forcing even well‐intentioned public company boards to adopt suboptimal or overly complex compensation plans, while doing little to prevent “captured” boards from overpaying CEOs.
As a result, it is increasingly difficult for public companies to put in place the kinds of simple, powerful, and efficient incentive plans that are typically seen at private companies - plans that often feature bonuses funded by an uncapped share of profit growth, or upfront “mega‐grants” of stock options with service‐based vesting.
All of this is detailed in my newest article published in the Journal of Applied Corporate Finance.
Transparency has its benefits. It enables shareholders to see into the company they own, and thereby judge whether it’s worth owning. The main mechanism for transparency in the corporate world is company disclosures. Does that mean that more disclosure is better? This article suggests otherwise:
In a coming paper in the Journal of Finance, Messrs. Loughran and McDonald suggest that size may be what really matters. They studied 66,707 10-Ks filed for the years 1994 through 2011. Controlling for factors including size and industry—bigger or highly regulated companies naturally file longer 10-Ks—they looked at how well the stock market appeared to read the performance of companies with lengthy filings.
Answer: Not so well. In the weeks after filing, shares of those with longer reports tended to be more volatile than those favoring brevity.
Somewhere along the line, disclosure became synonymous with transparency. Particularly in eyes of many governance mavens. Perhaps that’s because, since 1933 at least, the ability to compel disclosure has been the main tool in the federal regulatory tool chest. When you have a hammer…
I often introduce the Enron case with its 10-K from the year before the firm’s implosion. It’s difficult to go through that tome, including the volume of data on its infamous Special Purpose Entities, and claim that insufficient disclosure was the culprit. Their management accurately, if literally, conveyed the complexity of its operations.
This new study begins to explain how disclosure is not the same thing as transparency, and why the “more is better” instinct may be leading us astray.
Paradox: a statement that is seemingly contradictory or opposed to common sense and yet is perhaps true
The media in Europe are starting to call skyrocketing banker salaries across Europe the “bonus paradox.”
The EU limit on bonuses to 100 percent of salary (or 200% with shareholder approval) is ushering a paradoxical parade of unintended consequences. But just because consequences are unintended doesn’t mean they are unpredictable.
The economic ignoranti fully expected overall banker pay to be clipped by the EU measure. José Manuel Barroso, president of the European Commission said, “This is a question of fairness.” So, there it is.
Except that banks are not going to lose their most mobile workers for insufficient pay. Bankers, you may not be surprised, are good with money; they know what they are worth, and they are confident about it. They would actually prefer to be paid for performance, and are unhappy about the higher mix of fixed-to-variable compensation that effectively caps their upside, even if it leaves them more-or-less whole in expected value terms. But they will not accept less than what the guy down the street, or in New York or Hong Kong, will pay them.
The more sophisticated proponents of this law would say that it wasn’t the level of pay they were actually after, but the structure of pay in the form of bonuses that encouraged undue risk taking. They’re OK with the new compensation mix, and feel it will reduce financial risk. They are wrong, too. Yes, it is theoretically possible that perverse incentives can lead to undue risk-taking, and there was certainly some of that going on in the lead-up to the financial crisis. But there is zero evidence that bonus structures that have been around for decades, and whose incentive effect have been understood and refined and overseen for decades, would all of a sudden in the middle of the aughts suddenly be the cause of a global catastrophe. If you want to properly diagnose a cause, look at what has changed, not at what was always there. If that logic doesn’t persuade, then perhaps empirical evidence would, and the evidence denies the hypothesis. If logic and empiricism don’t sway you…then you are fully qualified to run for the legislature.
Unfortunately we are not done with paradoxes and unintended consequences. Read more of this article »
I am excited to announce a new online resource for corporate professionals interested in ethics, governance, and related business issues: EthicalSystems.org. The idea behind Ethical Systems is to provide academic rigor to work on improving the ethical behavior of organizations.
This site is the brainchild of Jonathan Haidt, the brilliant NYU researcher and author of the bestselling “The Righteous Mind.” Jonathan was grappling with the fact that ethical behavior has, thus far, been profoundly resistant to improvement via formal training. So he corralled some world-class researchers* to develop individual pages devoted to specific topics such as Cheating, Corruption, Leadership, and (of course) Corporate Governance.
Take a look at it, and feel free to send comments or ideas to the researchers managing the pages. This is intended to be a collaborative effort not just among academics, but between academia and the businesses this initiative is intended to serve.
* As the person maintaining the Corporate Governance page, I am definitely the least distinguished of this group
About a year ago, I wrote about the new restrictions the EU imposed on banker bonuses, i.e., limited to two times their salaries. I predicted that bankers, being better versed than legislators on how money works, would likely nominally raise salaries, then claw back a portion of that nominal salary based on performance. One year later, it appears that is pretty much what Goldman Sachs and Barclays (at least) are doing:
Starting this year, certain Goldman employees will earn a salary, a bonus and some “role-based pay.” It may be paid monthly or divided, with some paid monthly and some accruing to be handed out at the end of the year. The new type of pay will not be used when tallying pension contributions. The bank may be able to claw some of it back, and it can change from year to year. But it will have the effect of driving up base salaries.
Yes, to some extent base salaries are going up, but the deferred portion subject to claw-back serves exactly the same function as a target bonus that is realized (or not) based on performance. And this bumped up “salary” provides enough headroom to provide double the amount again for bonuses.
For an example, here is how the numbers worked for Goldman. Last year, average salary for Goldman employees covered by the new law was about $750,000, and their average total pay was about $4.5 million. This year, Goldman bumped up these folks salaries by about $1.5 million, for a total “salary” of $2.25 million. Half of that “salary” increase (hence the quotes), i.e., $750,000, is subject to a performance-based clawback. If, instead, the employee performed well, they would get their total “salary” of $2.25 million. If they performed very well, they could get another $2.25 million, for a total pay of about $4.5 million. In other words, they could end up exactly where they were before, but via a more complicated path to be in compliance with the letter of the law.
If you can’t follow these numbers, that’s OK, you could still become a legislator. If one were serious about containing bankers’ pay, they would be pursuing a very different, more finance-literate path of regulation. I’m not holding my breath.
* That’s a longer headline than “Dog bites man,” but I must be cognizant of what search engines will pick up.
Aubrey McClendon, former CEO of Chesapeake Energy Corp. (which, as far as I know had nothing to do with the bay near where I grew up), is pulling in billions in new capital via his American Energy Capital Partners LP. The partnership will have some unusual governance features:
American Energy Capital also disclosed a range of potential conflicts of interest. The sponsors can favor their own interests over those of investors. In addition, the partnership may invest in oil and gas properties where Mr. McClendon’s firm has interests. Mr. McClendon’s management group won’t owe a fiduciary duty to the partnership, according to its registration statement.
Now, would I buy into a partnership with such conflicts? Probably not.
Would I prohibit anyone else from buying into such conflicts? Definitely not.
This partnership may or may not prove to be as good a deal for its investors as Chesapeake was for theirs. I would leave it to others to discern the bet they are making. But I would not prevent them from making their bet. And once they buy into this partnership, I would not favor the government forcing a change to the rules they bought into for the sake of “good governance.”
If all this makes sense to you, and I know it won’t to everyone, then you should be disturbed when public companies are forced to reform their governance through a federalization of corporate rules that supersede their charters. We can’t know that such “reform” will enhance the returns of outside shareholders; no governance regulation adopted by Congress over the last couple of decades had any empirical support that it would actually help shareholders, either before it was adopted or after it was implemented. But we do know that the reforms will cost every company in three ways:
(1) The Compliance CAFE (Corporate Advisers Full Employment)
(2) The occasional cost of sub-optimal decisions because of decision-making constraints created by the rules, i.e., unintended consequences
(3) The costs of lawsuits alleging a breach of the rules, regardless of their actual breach, because it is often less expensive to settle these suits than to fight them and win, i.e., the Plaintiff Lawyer’s Tax
This is not to say that we shouldn’t have any rules with regards to corporate governance. But I would suggest that the rules agreed upon by the original parties to the transaction should be given much more of the benefit of the doubt than those dreamed up by a meddling Congress. Even bad bets contribute to our progress.