Tar Heel Business

This is an article written back in April that was released in print, but never posted on the website.  Since executive compensation is still such a hot-button issue, I think it would be good to post it.

When AIG came out and announced that it was going to pay $218 million in bonuses to the employees of its financial services division, there was quite an uproar from the public and policymakers alike.  This is the same division that has contributed to the systemic collapse of the world economy, and has managed to build up a $170 billion tab with the American taxpayer.  Without question, there is something wrong with this scenario, and in order to find an efficient solution, regulators and the public must avoid making snap judgments and decisions which result in unintended consequences.

When the Federal Government decided that AIG presented a systemic risk to the economy, it decided that the company was too big to fail.  In doing so, the government made sure that AIG was able to uphold its contractual obligations of paying off credit-default swaps.  The problem occurred when the stimulus bill passed in February didn’t earmark the money sent to AIG.  As such, AIG received a blank check to decide where and what to spend the bailout money on.  Part of their contractual obligations was the payment of bonuses to many of its employees.  Thus two questions are raised: Why wasn’t this caught in Congress and why are the bonuses written into employee contracts?

The answer is that Congress was only given a day to review the thousands of pages long stimulus bill before it was voted on.  It is impossible for the government to provide efficient regulation and transparent usage of taxpayer dollars if officials continue to strong arm legislation through without proper and thorough consideration.  It would be very surprising to find out that there wasn’t any other problems created by forcing the nearly $800 billion stimulus package through Congress.

The problems and outrages over contractual bonuses are more complex.  These contractual bonuses were ‘invented’ after the income tax was changed such that all income earned above $357,700 was taxed at 35%.  Thus, companies found a loophole whereby an employee’s base salary would be paid for up to this highest tax bracket, and the rest of their compensation would be paid through contractually binding bonuses which are taxed at a lower rate.  In effect, these bonuses are supposed to be built into their base salary anyway, and stand as a reflection of how much the employee is worth to the company.  If these bonuses were taken away through a 90% punitive tax, the ‘talent’ at AIG or other bailout receiving institutions would have a strong incentive to jump ship, thereby hurting the companies and the recovery effort.  As such, the debate over the payment of these bonuses has been misinterpreted, and instead should be looked at as a debate over who should control executive compensation and how best to minimize the principle-agent problem.

With the ousting of General Moter’s CEO, Rick Wagoner by the President, and the executive order to cap executive income at TARP receiving companies at $500,000, it is clear that the government is taking a more active role in the management of America’s private sector.  Also, there has been Washington chatter of somehow extending these limits to all private companies and corporations.  Surely this is just populist grandstanding, but it is important to recognize a popular sentiment.  More reasonably, many politicians have been arguing for increased rules and regulations of compensation.

The most interesting ideas for minimizing this principle-agent problem and for increased regulation have recently come from Goldman Sachs’ CEO Lloyd C. Blankfein.  He suggests that “all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.”  Furthermore, the percentage of equity received should increase with income, and senior employees should be required to retain the majority of their equity until they retire.  These regulations would theoretically decrease the problems of excessive risk-taking in the short term by executives, and help to align the goals of executives with those of the owners.

Unfortunately, in asking for the government to provide a framework or regulation for executive compensation, Blankfein is inviting the government into other workings of his business.  One problem is that government regulations are sticky and can take a long time to remove if the results are undesirable.  Also, not all businesses are homogeneous (a lot of people make the majority of their money based on commission, or the number of hours they bill to the client), so it doesn’t make sense to have a standard of rules and regulations that apply to all companies.  Moreover, there is no evidence that owners cannot institute the rules that Blankfein suggested without government involvement.

Excessive risk-taking caused by the principle-agent problem was one of the main catalysts for leading the world into depression.  In order to avoid repeating our mistakes, owners and regulators must work together without political or financial motivation to find the most efficient solution.  It is a good sign that we have moved beyond death threats and screaming on television to a more productive debate.

-Graham Lovin