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Saturday, January 29, 2011

Limiting Executive Compensation is a Bad Idea (published in the Santa Barbara News Press in February of 2009)

Limiting executive compensation is a bad idea.  This week President Obama announced that a limit of $500,000 will be placed on executive compensation for any company that took government bailout money from the $700 billion TARP fund.  In his speech, Obama stated, "We all need to take responsibility.  And this includes executives at major financial firms who turned to the American people, hat in hand, when they were in trouble, even as they paid themselves their customary lavish bonuses. As I said last week, that's the height of irresponsibility. That's shameful."

There are some unfortunate consequences of this policy, which I believe will lead to competitive disadvantages for the major financial institutions and other companies that took money, even though I firmly agree that paying huge salaries and bonuses for losing billions of dollars is probably a bad idea. 

First, many of the current top executives running these companies were not there when the bad decisions were made that led to the financial crisis.  The people who made the mistakes, for the most part, were fired, and new executives were brought in to clean up the mess.  Now, with these restrictions, what we are saying is, come in and save the company, but oh by the way, we don’t want to pay you much for your efforts.  (I realize $500,000 is a lot of money, but to a top executive accustomed and able to make millions, it is a pittance.)

Second, the type of individual that rises to the level of top executive at a major public company is there for a reason, and that reason is to make money.  If you remove that incentive, and there is another company out there that is willing to pay them what they are worth, in many cases, they will leave for greener pastures.

Third, companies that really need money from the government will be far less likely to accept it, since the top executives responsible for deciding whether or not to take the money are the very individuals that will have their pay capped.  This conflict of interest could very likely result in some companies taking unnecessary risks that could ultimately lead to bankruptcies, or at a minimum, lingering poor performance.  While some may say good riddance; let them fail, the negative impact to the economy could be severe, and let’s not forget that when companies go bankrupt, employees who had nothing to do with making these bad decisions lose their jobs too.

Fourth, bonuses are a key component of total compensation on Wall Street and at banks, and they typically account for a large percentage of total compensation, especially for the best performing and most valuable employees of these firms.  While I understand and feel the outrage personally over firms paying bonuses after they have taken TARP money, keep in mind that most of the bonuses Obama is referring to, were paid in early 2008, before these companies took any money from the government. 

Merrill Lynch paid bonuses at the end of the year, and the combination of that decision, and his decision to spend $1.2 million redecorating his office led to John Thain’s dismissal (technically he resigned , but we all know he was fired).  These blatant, inexcusable actions have poisoned the public’s perception of Wall Street and the financial industry as a whole.  Granted, some of that perception is certainly warranted, but there are still a large number of honest, hard-working people—hundreds of thousands of them—that go to work every day, work hard, and deserve to be paid fairly.  Ask yourself: Should the person taking John Thain’s job suffer for Thain’s actions?

Another component of the plan Obama announced is that any compensation above the $500,000 annual cap can only come in the form of stock awards that cannot vest until after all money borrowed from the government is repaid.  Since we just don’t have any realistic visibility as to when (if ever) this money will be repaid, top executives will have little incentive to stick it out for the long-term, which is certainly what it will take to turn these companies around.  No quick fixes here. 

A fifth consequence could be that, if top executives leave, who will replace them?  Why would any qualified executive want to go to work for a struggling bank that is under intense scrutiny in this economy, with this much negative public sentiment against it, for $500,000 a year and some worthless stock options that won’t vest in this lifetime?  I don’t know about you, but if that job description was posted, I don’t think I would apply.

We need the best, most qualified people dealing with this problem, and we have some of them already at the helm of these troubled companies.  The last thing we want to do is to run them off by limiting their compensation, right at the time when we need them most.  There simply are not that many top executives with the level of knowledge and expertise sitting around twiddling their thumbs with nothing to do, hoping to get a job at a troubled financial institution, so we had better hang on to the ones we have.

One final consequence would be that foreign companies would gain a significant competitive advantage over their U.S. counterparts, as the brain drain that could occur due to low compensation may force these troubled companies to hire less-capable executives, resulting in more bad decisions, further losses, and poor overall financial performance.  Do we really want some of our largest banks to steadily decline until some Japanese, Chinese, or European financial institution buys them at a discount? 

We are witnessing first hand in the auto industry how poor decisions, weak management, and an exorbitant cost structure are killing these companies; allowing the Japanese automakers to gain market share and dominate the U.S. car market.  Do we really want the same for our banks? 

There is a better way.

What I suggest is tying top executive compensation to performance; not to performance of the stock, but to things like appropriate loan generation, management of troubled assets within the company’s portfolio, cost management, risk management, long-term profitability, etc.  Admittedly some of these concepts are hard to quantify, but it can and should be done so that top executives have well-defined incentives to turn these troubled companies around.  We need it for the economy in general, and we need it because hundreds of thousands of U.S. citizens’ jobs depend on the success of these executives.

I agree that we need executive accountability for performance, and no one should get paid when they perform poorly, or when they make terrible decisions or take-on undue risk, regardless of the results.  But this is the United States, and we have a capitalist system here, where people get paid for what they do, and they typically go to the highest bidder, with the best and brightest usually making the most money.  We are in a deep recession, and a lot of mistakes were made, but we are still the greatest country on earth for a reason, and that reason is capitalism. Let’s leave with who brought us to the party. 

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