The Magazine

Pay Day

Why it makes sense to worry about executive compensation.

Aug 31, 2009, Vol. 14, No. 46 • By IRWIN M. STELZER
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The rationale for government intervention on the widest possible scale is simple and, to some, persuasive. Compensation systems that encourage excessive risk-taking by firms that are too big to fail are not in the public interest--they contain the seeds of systemic collapse, as almost occurred at the start of the present crisis. So the government must have a say in the structure of bonuses of all banks to prevent excessive risk-taking.

Note that this argument applies to the risk-inducing nature of bonuses, hence the government's relaxed attitude towards bonuses in the form of restricted shares, which cannot be sold for several years, giving employees a stake in the long-term health and performance of their firms. Note, too, that the level of compensation is not supposed to affect whether the government approves any particular scheme, a distinction that might get lost in the hurly-burly of congressional hearings and White House press conferences.

Nor is the government certain to be deterred, in the end, by the presence of contracts setting compensation. After all, contracts that contravene public policy--think of agreements to fix prices, or a mob contract to "hit" a member no longer considered trustworthy--have long been held to be unenforceable. It is not a great stretch for the government to argue that contracts embodying compensation plans that encourage behavior so risky as to create systemic risk are null and void. After all, the government had no compunction about negating the contractual right of Chrysler's creditors to preferential treatment when it went bankrupt, in effect transferring such preference to vote-delivering trade unions. All in the public interest, of course.

The reasonableness of the government's claim for a seat at the compensation committee table doesn't mean that the government will do a good job of setting executive compensation. Populist and egalitarian pressures emanating from the Hill and the Oval Office will undoubtedly mount when Congress returns, and considers--if that is the right word--its reaction to the multimillion-dollar payouts planned not only by highly profitable firms such as Goldman Sachs, but by money-losers such as Citigroup, a bank that has received $45 billion in government aid in exchange for a 34 percent share in the company. Feinberg already has approved an $8.5 million pay packet, largely in the form of stock grants, to AIG's new president. He also is likely to approve plans such as those recently adopted by Wells Fargo--increase base pay and cut bonuses that might provide incentives to reckless lending and trading. And he must consider the impact of any decision on the ability of the firm involved to retain its top guns--although if his writ runs as widely as observers believe it will, unhappy bankers might have nowhere else to go--except perhaps to the new boutique advisory firms that are already wooing away bankers eager to find a niche below the government's radar.

Because Feinberg has refused to acknowledge that the provision protecting contracts signed before February 11 of this year puts them beyond his reach--the rules provide for a claw back of "any bonus based on materially inaccurate performance criteria"--he now has to deal with Citigroup's One Hundred Million Dollar Man.

Actually, Andrew Hall, the trader with Citigroup subsidiary Phibro, is entitled under his pre-February 11 contract only to $98 million, but a mere $2 million shouldn't be allowed to come between a fact and a good headline. Hall earned many times $100 million for Phibro and hence its parent, Citigroup, so his payout--Citigroup refers to it as a share of profits--is clearly performance-related, one of the stated goals of pay structure reformers. Absent Feinberg's ability to find some way around that contract, or a willingness by Hall to adjust his bonus (there is a rumor that he might be prepared to spread receipt over several years), Hall should whistle a happy tune en route to the bank while Treasury Secretary Tim Geithner hopes the congressional hearing at which he will be called upon to explain this provision of the law--something about constitutional protection against ex post facto legislation--does not last too long.

The sums involved aside, it is not unusual for loss-making banks such as Citi to feel it necessary to pay substantial bonuses to employees working in profitable divisions such as Phibro. None of this all-for-one-and-one-for-all stuff for traders, who seem to have learned their lesson from the town beggar in that great musical Fiddler on the Roof. When offered one kopek by the town butcher, the beggar demanded his usual two kopeks. On being advised by the butcher that he had a bad week, the beggar responded, "So you had a bad week--why should I suffer?"