Monthly ArchiveJune 2011
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The comment period for a multi-agency proposal on compensation at financial institutions ended yesterday, leaving a gaping hole in the rules proposal. http://www.sec.gov/rules/proposed/2011/34-64140.pdf
Although a large portion of CEO compensation is paid in stock or options, the impact of incentive pay which is paid in equity, rather than cash, is entirely missing in the proposal.
But research by Professors Rüdiger Fahlenbrach and René M. Stulz in 2010, following the crisis, demonstrated why equity as its own component should not be ignored. While the knee jerk reaction is that if equity is held by executives, it will create alignment with shareholders, the research didn’t demonstrate any such benefits.
According to the research, “banks where CEOs had better incentives in terms of the dollar value of their stake [in the company] performed significantly worse than banks where CEOs had poorer incentives.” “The top … equity positions at the end of fiscal year 2006 [were] held by James Cayne (Bear Stearns, $1,062 million), Richard Fuld (Lehman Brothers, $911.5 million), Stan O’Neal (Merrill Lynch, $349 million)[and] Angelo Mozilo (Countrywide Financial, $320.9 million).” All of those firms fared poorly in the crisis: sold in distress or in the case of Lehman, went bankrupt. http://www4.gsb.columbia.edu/rt/null?&exclusive=filemgr.download&file_id=7214553&rtcontentdisposition=filename%3DStultz_Bank%20CEO%20Incentives%20and%20the%20Credit%20Crisis%2020100508%20RMS.pdf
This finding indicates that the banks of CEOs with poorer equity ownership stakes did better — and that perhaps equity ownership exacerbates rather than ameliorates risk taking on the part of CEOs. Certainly, it is well recognized that high equity stakes would logically tend to dampen full negative disclosures.
A strong negative correlation between equity stakes and bank performance such as the research finds would seem to be a compensation mechanism that the regulators should be curious to understand in setting policy, given the apparent risk to bank performance and the huge consequences to stakeholders.
So why don’t the regulators examine the issue more closely or address it in their rules proposal?
This isn’t the first time I’ve written on the topic. Here’s what I wrote to the SEC on this in September 2009 http://www.sec.gov/comments/s7-13-09/s71309-107.pdf and to the Federal Reserve on this in November 2009 http://www.federalreserve.gov/SECRS/2009/December/20091214/OP-1374/OP-1374_112709_25335_596100224676_1.pdf.
And it’s not as if equity is a miniscule part of CEO pay. A quick review of the summary compensation tables in the latest proxies shows that the current CEOs of JP Morgan, Bank of America, Citigroup and Wells Fargo, through the crisis (over the last three years) received $127 million in equity and option awards, on average 80% of their total pay. It would appear the 80/20 rule would clearly apply warranting a look at the impact of equity.
To address compensation at financial institutions, regulators need to re-examine all the reasons equity may create these perverse effects including the fact that payments in equity may exacerbate the tendency to overpay (because of the false notion that equity and options are funny money and not real cash to the corporation). It may also encourage managers to take risks, increase the volatility of returns, extract potential windfall benefits from timed sales, and manipulate stock prices. And equity pay may do all this while diluting other shareholders and diminishing accountability to them and distracting managers from the real business of managing the business.
If regulators examine the issue carefully and reflect the impact in the rules proposal, maybe history won’t repeat itself. If they don’t, there is no reason to expect we won’t see the same movie once more.
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