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In my earlier post on bailed-out banker pay, I argued that we need a simplified compensation regime that more closely aligns corporate managements with their shareholders:

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.

The hallmarks of my plan are transparency, simplicity, fairness and alignment of motives. Successful executives get extremely well-paid, as they should. But they don't gain material wealth for simply showing up. They've got to perform. And the way to cement alignment of motives is by tying their prospects to long-term, not short-term stock-based performance, and to have this comprise the vast majority of their total compensation (say 80-90% of total comp). But this only solves part of the problem.

The recent revelation concerning the magnitude of deferred compensation liabilities faced by the largest Wall Street firms raises two important questions:

  1. Why do we have these deferred compensation plans in the first place?
  2. Why are the U.S. taxpayers injecting money into institutions and effectively protecting these unsecured liabilities?

Deferred compensation plans exist as yet just another perk of being a member of senior management, not just of banks and Wall Street firms but of many corporations as well. I earn my money, I get my bonus, but because I don't need all that wealth to live right now I can defer it and pay taxes in future value dollars instead of present value dollars. Not all deferred compensation is in company stock: executives can defer cash bonus portions as well, and often have the ability to invest those sums in third-party mutual funds, firm-sponsored private equity and venture capital funds and other alternative assets.

The trick to make these plans work, however, is that the accounts are technically not guaranteed, e.g., they are unsecured liabilities of a separate corporate holding company that administers the plan. So, in the case of Lehman, all that deferred compensation is gone, both cash and stock, because of the bankruptcy and the magnitude of senior claims on liquidated assets. But in the case of Bear Stearns, JP Morgan (NYSE:JPM) in its role as acquirer is standing behind the deferred compensation obligations.

But what about all those banks and Wall Street firms that have received massive capital injections under TARP, firms that may or may not have survived without Government (read: U.S. taxpayer) assistance? A good chunk of TARP funds are effectively backstopping these liabilities. Is this right and fair? I'd say not. Prior to TARP injection of $25 billion, what do you think Citigroup's (NYSE:C) deferred compensation plans would have traded at, as cents on the dollar? I'm not sure, but I know they would have traded at a steep discount, a far steeper discount than after the Treasury showered it with capital. Was this transfer of value from the U.S. taxpayer to Citigroup senior management intended? I certainly hope not. Which is one of the fundamental problems I have with TARP in the first place. It is, at least temporarily, bailing out the senior executives and shareholders of sick firms. This should not have been the intention of Paulson, Bernanke et al. Regardless, this is one of those unintended consequences that is both wrong for long-term shareholder value and as a matter of fairness to those U.S. taxpayer. And I'm really not happy about it.

There is no reason to have these plans. Just pay executives what they are worth, structure their compensation to be aligned with shareholders and get on with it. Forget complex deferred compensation provisions that chew up tax revenues and are, frankly, neither fair nor necessary. Let's get rid of those excessive golden parachutes; they're not needed, either. Let's focus on optimizing executive pay, narrowly defined (cash plus long-term stock awards) and eliminating all the perks and benefits that have long been opaque and, frankly, costly and unfair to shareholders and other employees. And especially at a time when the U.S. taxpayer is propping up much of the U.S. financial sector, these plans should not be subsidized by their dollars. It is ethically wrong, morally bankrupt and is yet another scar on a program that is burdening our country for generations. That is a topic for another post.

Source: In Defense of the U.S. Taxpayer: End Deferred Compensation and Its Tax Subsidy