Legal Commentary

The Pay Czar and Compensation Issues--Posner's Comment

By Richard Posner

I agree with Professor Bebchuk of Harvard, and others, that there is a problem with the compensation of top executives at publicly held corporations (that is, corporations in which ownership is widely dispersed), so that control resides in the board of directors. The problem is that the individual directors do not have strong incentives to limit the pay of the CEO and other top executives. By limiting his and their pay, the board would narrow the field of selection, and if the company got into trouble they would be criticized for having been penny wise and pound foolish in resisting their "compensation consultant's" advice to pay top dollar. In addition, the directors often owe their lucrative directorships, and their continuation in them, to the CEO. The movement toward "independent" directors (as distinct from directors who are officers of the corporation) does not cure the incentive problems, but rather compounds them by making the board less knowledgeable about the corporation.

So there is a basis for concern with the compensation of top management in publicly held corporations, but it is not a momentous concern and costly measures to ally it would not be justifiable. Modest measures, such as making it easier for shareholders to replace directors than under the existing, Soviet-style system in which shareholders vote for or against the slate proposed by management, and requiring full disclosure and monetization of all forms of compensation paid CEOs and other top executives, may be sensible; but nothing more should be attempted.

The solving of the overcompensation problem would have little if any effect on risk taking by bankers and other financiers, so probably any efforts to solve it should be postponed until the economy recovers from its present sickness.

A distinct problem is that of compensation of executives of firms that are owned or controlled by the federal government, such as General Motors, American International Group, Fannie Mae, and Freddie Mac, and (or) that are recipients of federal bailouts. These are troubled firms, and the concern is that management may try to funnel the federal moneys that the firms have received into dividends and bonuses so that shareholders and executives will be protected should the company fail completely. The danger in other words is that when a firm is teetering on the edge of bankruptcy, management may stiff the firms' creditors by funneling some of the firm's remaining assets to managers and shareholders. The time to deal with this problem, however, is when the bailout is made; suitable conditions can be attached to it. To instead appoint a "pay czar" to deal with executive salaries of bailout recipients on an ad hoc basis creates all the problems that Becker discusses.

These problems are especially grave with regard to General Motors and Chrysler, as these are fast-failing firms that need to be able to offer high salaries to attract able executives. Between efforts by the "pay czar" to limit these companies' flexibility in compensation, and the efforts by Congress to limit the companies' ability to import vehicles and close plants and dealerships, the government is doing to best to minimize its chances of ever recovering its $60 billion investment in the two firms. This is called shooting oneself in the foot, or, alternatively, politics as usual.

Still another distinct problem is that of compensation practices of banks and other financial intermediaries. Here the problem is not the compensation of top management, but the compensation of traders and other investment officers at the operational level. The concern is that compensating them on the basis of the profitability of the individual deals that they make motivates them to take excessive risks. Suppose a deal has a positive expected value, but there is a 1 percent chance that it will fail in a way that imposes heavy costs on the corporation, and perhaps, because of the chain-reaction effect of the failure of a major bank (as we saw last September, when Lehman Brothers went broke), on the financial system as a whole. The trader who makes the deal may not worry much about that risk, because a 1 percent annual risk of disaster is very unlikely to materialize in the short run; the probability that an annual risk of 1 percent will materialize in 10 years is only 10 percent (actually a shade less).

Financial firms that worry as they should about such a catastrophic risk (since the firm makes many deals, which multiplies the risk of disaster), typically try to reduce it by employing "risk managers" who review proposed deals. Because this method of limiting risk failed to avert the financial collapse of last September, there are suggestions that it be supplemented or replaced by rules limiting the cash bonuses paid to traders, instead compensating them in restricted stock of the corporation, which they cannot sell for a number of years, or authorizing the corporation to "claw back" any bonus they receive should the risk involved in one or more of their deals later materialize and reduce or eliminate the profit that the corporation made on the deals.

It might seem that top management would have all the incentive it needed to prevent its subordinates from taking risks that would jeopardize the solvency of the company. But that is not true, because the private cost of bankruptcy is truncated by limited liability (the shareholders cannot be forced to pay the corporation's debts), but the social cost, as we have learned, can include a devastating global economic shock.

An external cost is a conventional justification for regulatory intervention--in principle. But the specific suggestions for curbing risk taking by traders are problematic. There are many influences on the value of a corporation's stock besides the outcome of a particular deal, and a claw-back possibility can greatly reduce the present value of a bonus, as well as complicating the recipient's tax and other financial planning. I conclude that it is premature to start regulating compensation practices in the banking industry; there are other ways of reducing financial risk that are less problematic.

Notice that this problem has nothing to do with boards of directors' inability under existing rules to control the compensation of top executives, because traders are not top executives. Management has no incentive to overpay its subordinates! Nor has this problem anything to do with government ownership or control, or a risk of insolvency that might induce top management to try to appropriate a firm's remaining assets.

Any monkeying by government with compensation practices, especially below the top level of management and especially in financial firms, will impair the ability of American firms to compete with foreign firms. The banking business is thoroughly international, and unless all countries act in lock step with the United States in regulating compensation practices, many of our ablest financiers will be lured to foreign banks.

One can only hope that the appointment of a "pay czar" is merely a sop to ignorant public and congressional opinion, and that Mr. Feinberg will be suitably restrained in the exercise of his powers. Secretary of the Treasury Geithner seems unenthusiastic about the government's imposing more than cosmetic changes on corporate compensation. practices. More power to him.

Full post as published by Becker-Posner Blog on June 14, 2009 (boomark / email).