Should executives be paid with debt? No! - CNN - 2 July 2010

By Eleanor Bloxham, contributorJuly 2, 2010: 4:06 AM ET

FORTUNE -- As
investigators comb through the wreckage of the financial meltdown, one
fact remains clear and startling: Credit default swaps and
collateralized debt obligations, as well as debt and equity from large
financial firms were useless as indicators of fiscal health. One of the
biggest revelations has been the utter failure of markets to capture the
relevant information required to set accurate prices on securities.

And
yet, despite the lessons learned that market pricing can be way off the
mark, tying executive pay to equity values has historically been
encouraged. Now the use of equity and other financial instruments in
compensation is slated to be set into law in Europe, and AIG (AIG,
Fortune
500) has just announced a plan to compensate executives partially
based on the performance of its debt. Can this possibly work?

According to the Financial Times, "Under legislation expected to
pass the European parliament next week," half of any undeferred bonus
"would have to be paid in shares or in other securities linked to the
bank's performance." Thus, the value of at least some portion of bonus
will be based on the value of equity securities or other securities
whose prices are set in the global capital markets and dependent on
their whims.

It is hard to see how this is a step in the right
direction. What once seemed like a sound way to ensure executives were
invested in the future health of the company has turned out to be little
more than an incentive for them to obscure risk and financial data in
order to maximize their own personal profits. The main draw for
corporations to tie their market performance to executive compensation
is that it sounds good, and in the case of debt based pay, it sounds
tough. But is it?

Equity based pay

Despite the
popularity of stock as a mechanism for compensating executives, it has
not worked well. The newspapers tell us that the prospect of higher
equity pay has led to greater risk-taking and financial scandals. Equity
prices also violate two tests for good compensation design: (1) can
managers control the outcome of the measure? (in this case stock price)
and (2) if they can control it, is it an outcome we really want managers
focused on? Manipulating stock prices is the last thing shareholders
want. Therefore, both empirically and theoretically, tying pay to equity
is not a good choice.

The new EU measure makes other options
available, however, when it says that rather than shares "other
securities linked to the bank's performance could be used". For
companies, two such securities come to mind: debt and credit default
swaps.

Debt based pay

This more novel compensation
technique received a vote of confidence in a May 28 filing with the SEC
by AIG. Under the revisions, some of their executives' bonuses will now
be tied to its debt, instead of its equity.

AIG will be basing 80%
of the value of its bonuses on its junior debt and 20% on AIG's stock.
As at most financial firms, bonus pay can make up a healthy percentage
of executives' overall compensation.

But is tying pay to debt,
even as a partial solution, really the answer? Harvard Law School
professor Lucian Bebchuk has argued in a series of papers
prepared for the Investor Research Responsibility Center Institute that
it is. On the face of it, debt based pay sounds exotic and almost
punitive towards executives. Yet the problems with the strategy are
remarkably similar to those experts warn about in regards to paying
executive with stock.

Take the managerial-control requirement
mentioned above. The price of debt responds to interest rates -- when
interest rates rise, the price of debt falls, and when interest rates
fall, the price of a debt instrument rises. But corporate executives
don't control interest-rate levels. Of course, if executives turned
their attention towards convincing the Federal Reserve to take actions
which would influence the movement of rates, their pay might go up. But
is this really what corporate executives should be thinking about?

That
brings us to the other useful test for payment mechanisms like this
one: Even if managers could control outcomes, are they outcomes they
should be striving for? For example, the price of debt also responds to
the perceived riskiness of a company, as represented by its credit
rating. Managers can control their firms' risk levels, but not credit
ratings. Should managers, in the wake of Lehman Brothers' Repo 105 accounting gimmick, be paid in a way that
creates incentives to mislead credit raters or bondholders as to the
riskiness of a company's debt?

Credit ratings of course have been
wildly off the mark, in cases such as Enron and the CDOs at the heart of
the financial crisis. And issuing more debt, just so executives can be
paid in it (a possibility created by this arrangement) seems misguided.

Credit
default swap based pay

Another alternative to equity and debt
is one advocated by Columbia Business School professor Patrick
Bolton: tying executive pay to the spread on CDS -- or, more precisely,
to deviations of a bank's CDS spread from the market average.

Bolton
claims that CDS spreads are pretty good predictors of default within a
year or so, but the use of CDS spreads also relies on the ability of the
market to perceive and properly price risk. As the financial crisis has
made painfully clear, especially in the case of opaque
financial-services firms such as AIG and more recently the squabble
between the firm and Goldman Sachs (GS,
Fortune
500) over CDS pricing at the FCIC hearing yesterday,
markets can be and are often quite bad at evaluating risk accurately.

Realizing
that equity isn't the answer for pay doesn't mean that debt or CDS
spreads are

Clearly, compensation should incentivize managers
to focus on good long term outcomes for the companies they run and
shareholders they report to. But inside information is always more
complete than the external information that markets are given to
process. In other words, pricing

http://bit.ly/aQ2lKn