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The War on Executive Compensation--Skeel

As Congress rushes to enact the Treasury's $700 billion bailout plan this week, Obama, McCain, and politicians of both parties are insisting that the bailout include restrictions on executive pay at the firms whose mortgage backed securities will be bought by the government. Some of the executives' pay packages are indeed outrageous, but trying to impose pay limits is, it seems to me, one of the worst ideas yet proposed.

Hank Paulson has argued that firms might refuse to participate in the bailout if restrictions on pay were a condition of involvement. Perhaps this is true, although I suspect that shareholder pressure would force even the most reluctant firms to join the bailout party. But restrictions are likely to have two other effects, both of them bad. First, firms who wish to attract high quality executives will attempt to evade the restrictions. If the restrictions are onerous, these evasions may well be abetted by sympathetic courts. This is exactly what has happened after Congress imposed restrictions on executive compensation in bankruptcy in 2005.

The second possibility is that the restrictions will work, and that firms that participate in the bailout would be unable to attract top quality executives, who could earn far more in other, comparable positions. An effort by Ben & Jerry's to implement its social vision in the 1990s by limiting executive compensation to seven times the salary of its lowest paid employee is a sobering illustration of this problem. When the time came to replace Ben Cohen, Ben & Jerry's was unable to attract an acceptable executive, and it had to loosen the compensation restriction.

The urge to punish these executives is completely understandable. But discouraging high quality executives from entering the financial services industry at a time when they're sorely needed is an awfully high price to pay for the temporary illusion that justice is being done.

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Comments ( 7 )

I am not even a college graduate so maybe I'm ignorant. But this thought crossed my mind yesterday, too. If we hamstring companies with limitations on what they can pay a CEO then they won't be able to attract the best qualified person. But then the thought was immediatly followed by the greed factor. Those executives accepting the exorbitant "golden parachutes" are driven by greed. Does a greedy leader make the best leader? I think God wants "servant-leaders". A worker should earn an honest wage for an honest days work, but aren't we feeding the monster if we go beyond that. Compensation should be based on performance and if the company is failing the CEO did not perform.

The problem with your argument is how you define "high quality executives". I think that most of these firms thought they had exactly that. In fact they had the quality they desired, the ability to make enormously greedy decisions that enriched themselves and a select few. If these firms want to prove they have learned a lesson from their past mistakes, they will willingly embrace the financial conditions imposed on them so that they can help the financial system recover from their misguided decisions.

David, while I think you'd agree that blanket limitations on executive compensation in these financial firms is a bad idea (for precisely the reasons you cite, especially the failure to attract top talent), aren't there less problematic restrictions that could be put in place? Are there, for examples, forms of compensation peculiar to the financial services industry that could stand greater regulation?

I've come to maintain that the issue of executive compensation needs to be reconsidered for all industries in order to prevent precisely the talent drain to which you refer.

Just my $0.02

David,

A few months ago you were suggesting that McCain should tackle the issue of "runaway executive compensation" as a way to prove he is not beholden to his party. I pondered countering, though never did, with the suggestion that corporations were best situated to decide executive comp, rules would have little long term effect as they would encourage 'pay innovations' as they did in the 1990s and that corporations needed to attract talent from private companies that didn't operate with such restrictions. Now, here you are suggesting that the government should not hamstring executive comp at financial institutions so that they can attract top flight talent and I find myself thinking - no, they probably should limit it. Could you explain in greater detail why the circumstances have lead you in this direction?

It seems that the investment banks have continued to operate as they did when they were private in that they have paid their employees handsomely - Michael Lewis notest that "Last year Goldman paid its employees $20 billion, 44 percent of the firm's revenue." This looks like a huge agency problem. My primary argument for regulating exec comp in this circumstance would be that salaries and bonuses (particularly if they aren't in the form of options, which are now clearly underwater) are heavily predicated on accurate assumptions about future risk. When those risk assumptions have turned out to be dangerously wrong, it is the stockholders who end up bearing all of the loss and they have no way of clawing back that loss against their agents who paid themselves handsomely. But shouldn't they, perhaps (sincerely, I'm not intending any sarcasm or 'gotcha')?

Professor Skeel, this was a helpful article for me to read. Thanks! Keep on writing!

It seems to me that nobody frets that much about compensation until a crisis like this.

Perhaps the target should not be compensation (an incentive for success) but the "golden parachutes" that incentivize failure.

Do you think that this is legally feasible? Would it have the same unintended (negative) consequences as capping compensation?

In my view, there are important differences among strategies for addressing exec compensation. I have some sympathy for removing the tax deduction for pay that exceeds some ceiling (as I suggested in the earlier McCain post). This simply imposes a cost on corporations that exceed the amount, without purporting to outlaw higher pay. Most other kinds of limitations (such as a prohibition on pay that exceeds the amount the president makes, which was reportedly considered in connection with the bailout at one point) strike me as a major mistake, as argued in this post. The bailout ended up including both kinds of restrictions, a limit on deductability (though with a very low ceiling, $500,000) and restrictions on golden parachutes and other forms of compensation. I think the latter were a big mistake, and I have some doubts about former given how low the threshhold was and the fact that it would only be apply to a subset of firms (financial firms that receive gov't money). As far as letting shareholders clawback amounts that prove to have been awarded mistakenly, this is an interesting proposal. I suspect it would be awfully hard to implement in practice, though.