Congress, Don’t Give up on Incentives

Editor’s Note: This post, which focuses on the executive pay restrictions imposed by the stimulus bill passed last Friday, is based on an op-ed piece by Lucian Bebchuk published in today’s Wall Street Journal. A related op-ed piece by Professor Bebchuk, published earlier this month in the Wall Street Journal and dealing with the pay guidelines proposed by the Obama administration, is available here. Memoranda providing a detailed review and analysis of the restrictions by Wachtell, Lipton, Rosen & Katz and Sullivan & Cromwell LLP are available here and here, respectively. A memorandum by Davis Polk & Wardwell highlighting important interpretive questions raised by the bill is available here.

In a last-minute addition to the stimulus bill passed Friday, Congress imposed tight restrictions on pay arrangements in all financial firms that have or will receive TARP funding.

While I have long been a critic of corporate compensation practices, these restrictions leave me concerned. They weaken executives’ incentives to deliver the long-term performance that is needed to benefit banks, the economy, and taxpayers who have injected vast amounts of capital into these institutions.

While the new restrictions seem to have been motivated by a desire to limit total pay, it is the pay structure that they tightly regulate. The Obama administration’s proposals focused on constraining pay unrelated to performance. The stimulus bill takes the opposite approach—constraining incentive compensation, limiting it to one third of total pay.

To be sure, incentive compensation in many public companies has been flawed. Some incentive compensation has been so in name only, and some of it has provided perverse incentives to focus on short-term results to the detriment of long-term performance.

But these problems require tightening the link between pay and long-term performance—not giving up on it altogether. Mandating that at least two-thirds of an executive’s total pay be decoupled from performance, as the stimulus bill does, is a step in the wrong direction.

Another wrong step is the bill’s categorical prohibition on using any form of incentive compensation other than restricted stock. In the first place, some executives covered by the bill (up to 25 in some firms) run limited parts of the company’s operations. Their incentive pay might be best tied to the performance of their unit’s particular results, not to that of the whole company.

But even for top executives, the banks’ special circumstances may make exclusive use of restricted stock contrary to taxpayer interests. In many banks, the shareholders’ equity, which is junior to the government’s investments in preferred shares and the claims of bondholders, now represents a small fraction of the bank’s capital. Indeed, the value of some banks’ common shares might largely represent an “out-of-the-money option,” expected to deliver value only if things considerably improve.

In such circumstances, restricted stock may provide incentives for executives to take excessive risks with the bank’s survival. Consider the case where an infusion of additional capital would greatly dilute the value of common shares but would be best for the bank, while failing to get that capital would put the bank’s future at risk. In such circumstances, compensation in restricted common shares would provide executives with an incentive to avoid raising capital (which would wipe out their shares’ value) and gamble on survival without additional capital.

The compensation restrictions have another adverse effect on incentives. Executives can sidestep them by returning TARP funds and avoiding them in the future. Some observers argue that such actions would be unlikely because they would be costly to the bank. This overlooks the divergence between the interests of the bank and its executives. The bill provides executives with counterproductive and unnecessary private incentives to terminate or avoid TARP funding, even when doing so would not be in the bank’s best interest.

The stimulus bill’s adverse incentives deserve special attention because of the government’s current approach to the banking sector. While infusing large amounts of capital into banks, the government has chosen to leave their management largely to the discretion of bank executives. This makes executive incentives of paramount importance.

Compensation structures with distorted incentives may have already imposed large losses on investors and the economy. Public officials should be wary of introducing new distortions and perverse incentives. With so much hanging in the balance, ensuring that those running the country’s banks have the right incentives is as important as ever.

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  1. Sabino (Rod) Rodriguez
    Posted Wednesday, February 18, 2009 at 10:06 am | Permalink

    While your points are well taken, I would not discount the value of a well-designed short-term incentive plan as part of a comprehensive package and I would not limit long term arrangements to restricted stock. Performance shares, RSUs and options can have a role.
    The problem with the Stimulus Package Act TARP compensation limitations is that the statute goes beyond appropriate Treasury-as-investor concerns with standards and accountablity, and attempts to micromanage (and does so poorly).
    (For an easy summary of the Stimulus Package’s exec comp limits, see the table at the end of our Alert at )

  2. Walt Gangl
    Posted Wednesday, February 18, 2009 at 10:18 am | Permalink

    Yes, we long-term investors (not “traders”) want long-term value creation. But you don’t get a management focused on long term value when they are whip-sawed by short-term traders, and the board is unable to reject takeovers driven by short-term profit strategies. If you want long term value creation, then long-term investors need to have a greater role in the control of the firm.
    One part of the answer is to give investors a greater voice based upon their holding period. Under that concept, for the Intel shares I’ve held for 10 years, I might have 2, 5 or 10 votes per share. (To do that you need to integrate the record & beneficial shareholder databases, but that should be done anyway to facilitate company-shareholder communications.)
    However it is implemented, it ought to be kept simple (i.e. keep the government out of it). It could start with a structure as simple as 2 votes/share for stock held over two years.
    You could exclude shares held by management.
    See how effective that is to drive focus on long-term innovation and true value and job creation versus serving the interests of short-sellers, hedge funds, arbs and the rest of the traders looking for a short-term “pop.”
    Again, to keep things simple, keep the SEC’s beneficial ownership disclosure rules tied to economic interest instead of voting power.