The trader supervisor’s option

Posted by Marc Hodak on March 8, 2009 under Executive compensation, Unintended consequences | Read the First Comment

So, is it an “irregularity” or a “misunderstanding?”  Those were the terms offered by the BofA and a currency trader, respectively, to describe that trader’s suspected $400M trading loss that had been previously reported as a $120M gain when this operation was still part of an independent Merrill.

Recall that shortly before BofA closed their acquisition of Merrill at the end of ’08,  Merrill had paid significant bonuses to certain of its senior executives.  One of its $10M men was David Gu, who headed up Merrill’s rates and currency operations.  If this report turns out to be more than a misunderstanding, or even an irregularity, this $520M turnaround in the paper fortunes of Mr. Gu’s operations will significantly cut into the profits for which Mr. Gu was rewarded.

Such a turn would bring up the question of clawbacks.  How much of a bonus would Mr. Gu have gotten if this unit’s profits were lower by $520M?  Will Mr. Gu be on the hook for any of that difference?

A more fundamental question is what Mr. Gu’s complicity might have been in the bogus profit number.  I doubt that Gu would have actively participated in fraud on his employer, or even tolerated fraud if he knew about it.  But the numbers coming up from his unit are ultimately his responsibility, as are the systems and accounting controls that guarantee the integrity of his reporting.  Is it possible that Mr. Gu had less reason to scrutinize the excellent numbers coming from his London currency trading desk than from, say, some poorly performing desks in other areas?

Everyone knows that the incentive to perform is indistinguishable from the incentive to cheat.  That’s why the quality of measures are important, and why the people doing the measuring are as different as possible from the people doing the performing.  But a key person in the measurement chain is the performer’s boss.  He or she has to be among the front line filters of suspicious activity.  What if he or she has a leveraged bonus opportunity that literally pays them to ignore or downplay warning signs of bloated performance?

I have no insight into what happened in this particular case, or if it really isn’t a “misunderstanding” (though I would bet against this trader on that one).  But a crude clawback mechanism, such as now exists at BofA as well as most other companies, is a clumsy, improvident way of addressing this problem.  A much better mechanism would be a multi-year reward system that included performance-based clawbacks (or something equivalent, such as what we are currently developing for clients).  Our mechanism would actually increase the incentive of supervisors to insure the integrity of their business’s reporting, as well as the incentive to appropriately balance short-term and long-term performance.  Unfortunately, we will need to overcome considerable institutional inertia to make such mechanisms more widely available.