Friday, February 6, 2009

"Wage ceilings" for executives!

The ongoing financial crisis has seen some of the hallowed principles of free-market capitalism taking a beating and being put aside and government interventionist policies being embraced. First came the acknowledgement that markets are not always efficient in both allocating resources efficiently and discovering prices, as the sub-prime bubble built up and then burst in spectacular fashion. Then came the more distressing conclusion (or a re-affirmation) that markets are not self-correcting and require massive government interventions through monetary, credit and fiscal policy support. This has been followed by the more dramatic measures like creeping nationalization through liquidity injections to ailing banks, protectionism, and the latest being the modern day equivalent of rent controls and minimum wages - ceiling on executive compensation!

The Obama administration has finally bowed to populist pressure and taken the plunge by placing limits on executive compensation for Wall Street firms (both those bailed out in exceptional circumstances and those receiving general bailout money) taking the bailout assistance. The objective is "to ensure that the compensation of top executives in the financial community is closely aligned not only with the interests of shareholders and financial institutions, but with the taxpayers providing assistance to those companies".

The Plan limits the total executive compensation to no more than 500,000, including bonuses and except for restricted stock awards or other long term awards, that vests till the government has been repaid with interest, thereby aligning their incentives with both the long-term interests of shareholders as well as minimizing the costs to taxpayers. It also contains more pro-active disclosure and certification requirements by the company boards on executive compensation. There are provisions to clawback bonuses for top executives engaging in deceptive practices, after the wrong-doings come to light. Other highlights include - restrictions on severance payouts (golden parachutes) to less than one year; restrictions on luxury expenditures which would include adoption of a company policy on such expenditures and require certification by the CEOs etc.

It also offers a few suggestions for long term restructuring of executive pay regulations - greater disclosure and more proactive explanations for higher payouts; restrictions on stocks cash-out, so as to encourage long-term perspective; and shareholder inputs on these payments. It will apply only to those now seeking assistance from the government, and not to the 350 odd financial institutions who have already sought government assistance. There are also certain flexibilities - there is no restriction on the amount of long term bonuses/stocks that can be awarded; companies that seek aid but do not need exceptional government assistance can waive the $500,000 pay cap, as long as they submit their executive pay policies to a nonbinding shareholder vote etc.

The $500,000 cap has to be seen in light of the spectacular increases in executive compensation over the past few years. In 2007, the latest year that figures are available, the largest participants in the bailout program paid their chief executives an average compensation of $11 million, including salary, bonus and benefits. Of that amount, only about $844,000 was cash salary, about $2.5 million was in a cash bonus, with the bulk — $7.4 million — in stock awards, and the remainder in benefits and perks. New York based financial institutions, most of whom received bailout money, paid out $18.5 bn as bonuses in 2008, even as these institutions tottered on the edge of precipice.

Politically, it had become almost impossible for the Obama administration to stave off the demands to impose restrictions on executive compensation, following news reports of excesses in many firms receiving tax-payer bailout money. There are a few issues that are likely to get debated here. Lawrence Katz and Claudia Godin studied the career choices of Harvard undergraduates since the 1960s, and found that the share entering banking and finance rose from less than 4% to 23% or so in recent years, and those who chose careers in finance made three times the pay of their peers, adjusting for grade-point averages and test scores.

Will the pay caps drive away the most talented people from the sector, just as they attracted these people during the boom years of the past two decades? Will these restrictions discourage institutions away from seeking bailout assistance? This in turn could have two contrasting effects - it could incentivize the firms to seek out the best possible deals from the market to salvage their companies, thereby promoting most efficient allocation of scarce tax payer money, or it could lead to executives delaying seeking government assistance till they face the inevitable, when the costs of any bailout will naturally be much larger. On an even more distortionary note, will the pay caps drive these talented people to those relatively less regulated areas of the financial markets, like private equity and hedge funds in the shadow banking system?

Update 1
Two articles by Uwe Reinhart and Robert H Frank, has some interesting points. Economists refer to two issues in support for higher supply-demand driven executive compensation - some executives are truly endowed with exceptional qualities that deserve a high enough premium (this in turn is a derivation from the premise that individuals can have disproportionately large influence on the fates of companies), and that the supply of such individuals is limited thereby magnifying the premium. Now both these assumptions have been questioned in numerous studies, thereby leaving these fundamental assumptions in doubt.

Update 2
Lucien Bebchuk feels that the Obama administration's execitive compnesation cap is too modest and liberal, in so far as it leaves companies, including those receiving exceptional assistance, free to increase performance-based compensation to make up for any salary reduction. Reed Hastings calls for a 50% tax on executive compensation, instead of pay caps.

Update 3
NYT has this account of the deal when Merrill was taken over by Bank of America, which conveys a tale of greed and deception.

Update 4
NYT has this article which discusses the disclosure by New York Attorney General that Merrill Lynch doled out $3.6 bn in bonuses in 2008, an year it lost $27 bn and then disappeared into the stables of Bank of America in December. About 696 out of the 39,000 employees received $1 million plus bonuses, while 149 of them received more than $3 million, amounting to $858 mn. Payments were made just before the takeover by BoA.

Update 5
Uwe Reinhardt marshals impressive statistics to prove that Jack Welch may after all not be the Lone Ranger CEO he is made out to be.

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