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The Radical Experiment in Pay Regulation under TARP

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Mark Hodak, my friend and colleague, who worked on the original Shareowner Alignment Index that sparked our idea of measuring and investing in companies whose management team was most closely aligned with shareowners.

This is an excerpt from the second in a two-part series on executive compensation and financial service regulation. Marc’s part one article examines the short history of executive compensation and how it is influencing today’s policy debate over regulation reform.

6a0105367c6ad9970b01157040cb63970b-320wiMost people in and out of the financial industry believe that perverse incentives were at least partly responsible for the crisis prompting the TARP program, initiated in the Emergency Economic Stabilization Act (EESA). Stronger alignment of managers and shareholders would likely have prevented much of the damage we are now facing, and it’s sensible that financial services reforms address those incentives. (my emphasis; this stronger alignment also eliminates shenanigans and poor performance at non-financial companies as well) EESA includes a provision that calls on the elimination of compensation that creates “unnecessary and excessive risks,” a provision reiterated in the American Recovery and Reinvestment Act (ARRA).

Unfortunately, EESA and AARA depend on the Treasury Secretary to make distinctions about what incentives do or do not contribute to excessive and unnecessary risk. This is not an easy call. Even the most seasoned corporate boards, with considerable experience in managing or overseeing financial services firms, have a very difficult time distinguishing compensation-induced risk, even without the political considerations that might drive directors to conflate governance risk and business risk.

6a0105367c6ad9970b01156f4a7bd5970c-320wiFor instance, most people equate compensation plans with steep pay-for-performance lines as “riskier” than plans with weaker incentives. Critics argue that stronger incentives induce reckless behavior. In fact, shareholders have been placed in far more danger when the incentive leverage is zero than when it’s steep. The area below targets or goals where there is no longer any more pay-for-performance is where the trader finds his or her greatest temptation to double down in the hope of getting back into the green. This phenomenon is well known in banking circles as the “trader’s option.” The fundamental problem is not the steepness of the plan when the participants are on the incentive line, but the discontinuous incentive leverage across the spectrum of performance. This problem is reinforced by discontinuities across time, characteristic of bonus plans with specific end dates, like the November 30 fiscal year-end for many banks, which means to a manager that anything that happens after that date is of no consequence to my bonus this year. These discontinuities create asymmetry between the risk preferences of the employee versus the shareholders.

Marc Hodak is Managing Director of Hodak Value Advisors, a firm specializing in the finance and compensation issues of corporate governance. Marc teaches corporate governance at New York University’s Leonard N. Stern School of Business. He can be reached at mhodak@hodakvalue.com.