Project Syndicate: Paid to fail - March 2010, By Lucian Bebchuk, Alma Cohen and Holger Spamann

http://www.marketobservation.com/blogs/index.php/2010/03/21/paid-to-fail?blog=3

By Lucian Bebchuk, Alma Cohen and Holger Spamann

In a report just filed with the
United States court that is overseeing the bankruptcy of Lehman Brothers, a court-appointed
examiner described how Lehman’s executives made deliberate decisions to pursue an aggressive
investment strategy, take on greater risks, and substantially increase leverage. Were these
decisions the result of hubris and errors in judgment or the product of flawed incentives?

After Bear Stearns and Lehman
Brothers melted down, ushering in a worldwide crisis, media reports largely assumed that the
wealth of these firms’ executives was wiped out, together with that of the firms they navigated
into disaster. This “standard narrative” led commentators to

downplay the role of flawed
compensation arrangements and the importance of reforming the structures of executive pay.

In our study, “The Wages of
Failure: Executive Compensation at Bear Stearns and Lehman Brothers 2000-2008,” we examine
this standard narrative and find it to be incorrect. We piece together the cash flows derived
by the firms’ top five executives using data from Securities and

Exchange Commission filings. We
find that, notwithstanding the 2008 collapse of the firms, the bottom lines of those executives
for the period 2000-2008 were positive and substantial.

Most importantly, the firms’ top
executives regularly unloaded shares and options, and thus were able to cash out a lot of their
equity before the stock price of their firm plummeted. Indeed, the top five executives unloaded more
shares during the years prior to their firms’ meltdown than they held when disaster came in 2008.
Altogether, during 2000-2008, the top executive teams at Bear Stearns and Lehman cashed out
about $1.1 billion and $850 million (in 2009 dollars), respectively.

These payoffs to top executives
were further increased by large bonus compensation. During 2000-2007, the top executives’
aggregate bonus compensation reached (in 2009 dollars) $300 million at Bear Stearns and $150
million at Lehman. Of course, the earnings that provided the basis for these bonuses
evaporated in 2008. But the firms’ pay arrangements did not contain any “claw-back” provisions that would
have enabled the firms to recoup the bonuses that had already been paid.

Combining the figures from equity
sales and bonuses, we find that, during 2000-2008, the top five executives at Bear Stearns and
Lehman pocketed about $1.4 billion and $1 billion, respectively, or roughly $250 million per
executive. These cash proceeds are substantially higher than the value of the holdings that the
executives held at the beginning of the period. Thus, while the long- term shareholders in their firms
were largely decimated, the executives’ performance-based compensation kept them in
positive territory.

The divergence between how top
executives and their companies’ shareholders fared raises a serious concern that the
aggressive risk-taking at Bear Stearns and Lehman – and other financial firms with similar pay
arrangements – could have been the product of flawed incentives. The concern is not that the top
executives expected their aggressive risk-taking to lead with certainty to their firms’ failure, but that
the executives’ pay arrangements – in particular, their ability to claim large amounts of compensation
based on short-term results – induced them to accept excessive levels of risk.

It is important for financial
firms – and firms in general – to reform compensation structures to ensure tighter alignment between
executive payoffs and long-term results. Executives should not be able to pocket and retain
large amounts of bonus compensation even when the performance

on which the bonuses are based is
subsequently sharply reversed. Similarly, equity incentives should be subject to substantial
limitations aimed at preventing executives from placing excessive weight on their firm’s short-term
stock price.

Had such compensation structures
been in place at Bear Stearns and Lehman, their top executives would not have been
able to derive such large amounts of performance-based compensation for managing the
firms in the years leading up to their collapse. This would have significantly reduced the executives’
incentives to engage in risk-taking.

Indeed, calls for comprehensive
and robust reform of pay structures should not be viewed as mere responses to populist anger.
Such reform could do a great deal to improve incentives and prevent the type of excessive
risk-taking that firms encouraged in the years preceding the financial crisis – thereby
enhancing the value of companies and the wealth of shareholders. Reforms that redress these
destructive incentives should stand as an important lesson and legacy of Bear Stearns, Lehman
Brothers, and the crisis they helped to fuel. 

Lucian Bebchuk, Alma Cohen, and
Holger Spamann are Professor of Law, Economics, and Finance, Visiting Professor of
Law and Economics, and Lecturer of Law, respectively, at Harvard Law School. 

 Copyright: Project
Syndicate, 2010. www.project-syndicate.org