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A good friend of mine raised this very question, and I have to admit it gave me pause. Sure, we're all aware of certain limitations placed on executive compensation within the Economic Stabilization Act of 2008. The rules are specifically geared towards towards institutions that take advantage of the Troubled Asset Relief Program [TARP]. But when you look at these rules they really lack teeth; you will still have bailed out executives making seven-figure sums. And when you juxtapose this against a backdrop of economic weakness, rising unemployment, and a population that is growing less fond of the bailout by the day, it could make for a toxic cocktail of disbelief, hostility and rage. TARP has created an odd situation where those doing the bailing out (the US taxpayer) may well be funding compensation 10x, 20x, 50x greater than their own, with an average employee at a bailed out firm making, say, 4-8x more than their ostensible sugar daddies. This math just doesn't seem to add up.

Remember how irked both media and the general public got when it came to light that AIG was funding a party for its top producers? And this totaled around $400,000. How about TARP-benefiting firms with bonus payments - in the billions! How are people going to feel then? Uh, I shudder to think. The backlash could be harsh and swift, encouraging Congress to attempt to show that they're on the case by imposing some ill-fated dictum with unintended consequences. Just what we need. Not.

The whole issue of executive compensation - both on and off Wall Street - needs a redo. I have a hard time with the concept of large single-year cash payouts. Senior executives should be paid for value creation over time. Just like hedge fund managers. If you want to be assessed on creating long-term value, which should be every Board's goal, than executive compensation needs to fit this mold. Same with hedge fund managers. With performance comes payout, and if performance is long-term then payout should be long-term as well. With hedge funds implementation would be easy; only pay management fees currently and pay performance fees either based upon P&L realization (as opposed to P&L realized and unrealized that is the model for most) or over a time horizon that approximately matches holding period (which could be 3-5 years for certain long-term value managers with concentrated positions).

WIth corporations it is somewhat harder, as the concepts of realization and holding period are difficult to apply. That said, long-term stock options with long-dated cliff vesting comes pretty close to achieving this objective. I like the idea of senior executives holding 10 year options with 5 year cliff vesting (meaning that they fully vest only after 5 years; if they resign or get fired before 5 years they leave it all behind). This, I believe, closely aligns senior management with stockholders, and specifically avoids quarterly maniupulation that is the hallmark of large option grants that vest on a short-dated schedule. But this only works if almost all of executive compensation is in these options, such that the cash portion isn't so large as to incentivize bad behavior and the quarterly earnings manipulation mentioned above.

For instance, consider a guy like Dick Fuld. In my scheme Dick would have been holding a portfolio of these 10 year maturity/5 year cliff-vesting options, meaning that he has 5 years of stock compensation cumulatively tied up in the company at all times. Now consider if this total compensation was weighted, say, 80-90% in these options, such that he got enough cash to live very, very well, but that almost all of his net worth was tied up in the stock. Tied up for 5 years. All the time. It is very hard to keep a fraud going for 5 years, to fool the market for 5 years. So Dick, in my example, would have lost almost everything when Lehman went down. Which is as it should be.

Highly compensated traders should be paid the same way, specifically to avoid the kind of "swing for the fences" attitudes that permeated Wall Street and amplified risk to reckless levels. All in the name of current year compensation. This has been and will continue to be a recipe for disaster unless a wholesale revamping of executive and highly-compensated employee compensation is undertaken.

This then leaves us with hedge funds. Now is the time for LPs to push back on current pay for future value. Because most managers aren't going to volunteer a pay cut in order to better align their interests with those of their LPs. Few are masochists, and even fewer are pure enough such that they would choose intellectual honesty over cash. For the system to be truly revamped reform needs to cut across Wall Street, hedge funds and corporations alike. And Government regulation isn't the way to do it. But it may be well imposed if those in the positions of power and responsibility don't act with their brains.  Boards need to discharge their fiduciary responsibiltiies and wake up. LPs need to discharge their fiduciary responsibiltiies and wake up. Compensation is broken, and it is far beyond a PR issue. It is a value creation issue, an issue that will plague our economy until something is done about it. Now.

Source: Bailed-Out Banker Compensation: A PR Disaster in the Making?