The Importance of Compensation - 29 May 2009

In my opinion, one of
the biggest contributors to the crisis we know so well was compensation
schemes that gave individuals at financial institutions – from junior
traders all the way up to CEOs – the incentive to take massive bets.
Put people in a situation where the individually rational thing to do
is take lots of risk, and they will take lots of risk – especially if
they are generally ambitious, money-loving, and predisposed to think
that if the market is giving it to them, they must deserve it.

Alan Blinder does a good job explaining the problem in simple terms in the first half of his WSJ op-ed.  However, I’m not optimistic about his solution: 

It is tempting to conclude that the U.S. (and other)
governments should regulate compensation practices to eliminate, or at
least greatly reduce, go-for-broke incentives. But the prospects for
success in this domain are slim. (I was in the Clinton administration
in 1993 when we tried — and failed miserably.) The executives, lawyers
and accountants who design compensation systems are imaginative,
skilled and definitely not disinterested. Congress and government
bureaucrats won’t beat them at this game.

Rather, fixing compensation should be the responsibility of
corporate boards of directors and, in particular, of their compensation
committees. . . .  The unhappy (but common) combination of coziness and
drowsiness in corporate boardrooms must end. As one concrete
manifestation, boards should abolish go-for-broke incentives and change
compensation practices to align the interests of shareholders and
employees better. For example, top executives could be paid mainly in
restricted stock that vests at a later date, and traders could have
their winnings deposited into an account from which subsequent losses
would be deducted.

Why am I not optimistic? Disney.

In 1995, Disney Chairman and CEO Michael
Eisner hired his longtime friend Michael Ovitz to be president of the
company. Ovitz was the founder of one of Hollywood’s most powerful
agencies, but had no experience even working in a company like Disney,
let alone managing it. Eisner negotiated his friend’s employment
contract, which included a $1 million annual salary and 5 million
options, vesting in annual increments beginning in 1998. In addition,
if Ovitz were fired within his first five years (but not if he were
fired for “gross negligence,” and not if he resigned voluntarily), he
would be given – in addition to his salary for the remainder of the
contract – $1o million, $7.5 million per year remaining on the
contract, and his first 3 million options.

In 1996, one disappointing and controversial year after Ovitz
joined, “Eisner and Ovitz agreed to arrange for Ovitz to leave Disney
on the non-fault basis provided for in the 1995 Employment Agreement.” Brehm v. Eisner, 746 A.2d 244 (Del. Sup. Ct. 2000). As a result, Ovitz got about $40 million in cash and 3 million options.

Disney shareholders sued the board of directors, both for approving
a compensation agreement that gave Ovitz an incentive to try to

http://baselinescenario.com/2009/05/29/the-importance-of-compensation/