The Company Lost Billions this Year But Where is My Bonus!

Over the last two weeks the gloom and doom economic reports seemed to have no end. Citi got another boost from the government, the auto companies pleaded for help, the entire "free market" as I knew it seemed to have dissolved. I was left wondering the why and how, and then I was given a bit of clarity. A large part of the problem may be a poor incentive structure that rewards executives for very risky, short term, decisions. I want to focus on two stories about two companies, Goldman Sachs and the audacity behind the executive request to forgo bonuses, and the severance checks for the executives of the fallen Wachovia. Both circumstances, although different, point out a unique nuance to our "free market" incentive structure, one that may be responsible for short sided decisions that can contribute to a cataclysmic demise of a multi-national goliath.  

 

It seemed oddly out of place the other day when I read that many Investment Banking Executives have decided not to take bonuses this year, sending letters to the board of directors requesting their usual bonuses not be offered.  What seemed so wrong about this story is the notion of Executives making a request. Over the years Goldman Sachs has posted some of the highest profits on Wall Street, and as a reward their top executives have seen healthy bonuses for leading this highly profitable company. Last year Lloyd Blankfein, CEO of Goldman, received a salary and bonus worth $68.5 million, almost all in bonuses (his salary was approximately $600,000). This very lucrative compensation is supposedly  awarded by the board of directors, representing happy stock holders and showing their power over the company’s leadership. The fact that the executives requested bonuses be withheld tells a much different story. An effective board would insist that the CEO who lost billions of dollars in stock value and nearly bankrupt the company would not receive a bonus. This effective board would never honor a request from executives to forego a bonus because it is not their decision to make. The Goldman Executive request shows the board does not really have the power of the purse, or any real control, it is all held with the corporate executive. This is a problem because the two groups represent different time horizons. The Executive view is short term, how can they make profits as high as possible year over year to justify a huge bonus at year end. In contract the board is supposed to represent longer view, ensuring company sustainability to ensure the company they own rises in value indefinitely. When the balance shifts completely to the executive view, because there is a powerless board, it results in short sided, quick profit decisions. In this case it meant diving head first into high risk sub-prime mortgages to get a $70 million pay day. The consequences are then left to the long term stock holders when the bets go wrong and the company is brought to its knees.

In yesterday’s Wall Street Journal, buried way back on page C5, was an article by Dan Fitzpatrick telling a story of the compensation received by executives in the wake of the Wachovia collapse. As a refresher Wachovia was one of the victims of the crisis, nearly collapsing under its exposure to sub-prime debt and eventually was acquired by Wells Fargo (Fargo won a fight for the company with Citi). In its wake was a devastated stock price, moving from about $50/share pre-crisis to today's value of about $5/share, and the prediction that most employees will be laid off as part of the acquisition. Today's WSJ article reports that the top 10 executives that controlled the helm of this company through its demise will be receiving a combined $98.1 million in severance for their fine work. I think a $100 million severance is a bit too high of a reward for destroying a company. Besides the obvious discomfort that comes with the fact that an executive is rewarded for bad work is the reality that this represents a backward incentive structure. In this case the severance is only accessible if the executive is let go. Similar to the Goldman situation they are now empowered to determine their salary. Looking at the fall of their stock options at some point a Wachovia executive would be better off letting the company fail and taking the severance rather than try to keep the company alive.

The stories of both companies point to an absurd incentive structure where executives may not be looking out for the best interest of their companies. By putting compensation decisions in the hands of those receiving compensation what is best for the company no longer persists, it turns into how someone can squeeze as much value out in a short period of time. In the Goldman case the CEO made very risky short term decisions to justify the enormous bonus he received, only to see the company approach collapse the next year. Then flexing his power, deemed it not necessary to receive a bonus for their own abysmal work. In the case of Wachovia one could assume at some point executives were inclined to cut and run from a failing company, a process that they put into motion. A publicly traded corporate structure means that at the end of the day shareholders have the ownership stake in a company, and therefore should be making the final decisions on the best path of a company. We toss around the phrase "a duty to the shareholder," but in these cases the phrase has little meaning. The above examples show real issues in the modern corporate structure because it does not hold Executives accountable over the long term. These are terrible market forces all working against long term sustainability and growth. 

Because I am never one to point out a problem without offering a solution, I will offer a simple and easy fix for this incentive structure: stock options only with a restriction on sale for 15 years.

For Wachovia a severance should only be offered as a certain number of stock shares and a restriction of sale for 15 years after the Executive leaves.  This assumes a severance is really necessary because of some belief that it is needed to attract talent. I really believe the best structure in this industry is no severance at all. Any highly paid executive has such a lucrative level of compensation that a comparable severance creates indifference for good work. (Go ahead and fire me I literally will make millions.) But if the market does somehow deem it necessary I think stock options instead of cash is a much better solution.

For the Goldman issue, the same solution. All executives of any company should only receive stock option bonuses, all with restrictions of sale of at least 15 years. By shifting from cash to stock with a long term outlook it would ensure decisions made in the short term are targeted at long term growth. If decisions made today go wrong these long term assets will be valueless.

This shift is not something that should be enforced by government but rather by shareholders through boards of directors. It is in the best interest of the stockholder to design a proper incentive structure; this change will do just that by making the executive reliant once again on the success of the company and the stockholder.