It is a pleasure to be guest-blogging here at The Glom for the next two weeks. My name is Josephine Nelson, and I am an advisor for the Center for Entrepreneurial Studies at Stanford’s business school. Coming from a business school, I focus on practical applications at the intersection of corporate law and criminal law. I am interested in how legal rules affect ethical decisions within business organizations. Many thanks to Dave Zaring, Gordon Smith, and the other members of The Glom for allowing me to share some work that I have been doing. For easy reading, my posts will deliberately be short and cumulative.
In this blogpost, I raise the question of what is broken in our system of rules and enforcement that allows employees within business organizations to escape prosecution for ethical misconduct.
Public frustration with the ability of white-collar criminals to escape prosecution has been boiling over. Judge Rakoff of the S.D.N.Y. penned an unusual public op-ed in which he objected that “not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis.” Professor Garett’s new book documents that, between 2001 and 2012, the U.S. Department of Justice (DOJ) failed to charge any individuals at all for crimes in sixty-five percent of the 255 cases it prosecuted.
Meanwhile, the typical debate over why white-collar criminals are treated so differently than other criminal suspects misses an important dimension to this problem. Yes, the law should provide more support for whistle-blowers. Yes, we should put more resources towards regulation. But also, white-collar defense counsel makes an excellent point that there were no convictions of bankers in the financial crisis for good reason: Prosecutors have been under public pressure to bring cases against executives, but those executives must have individually committed crimes that rise to the level of a triable case.
And why don’t the actions of executives at Bank of America, Citigroup, and J.P. Morgan meet the definition of triable crimes? Let’s look at Alayne Fleischmann’s experience at J.P. Morgan. Fleischmann is the so-called “$9 Billion Witness,” the woman whose testimony was so incriminating that J.P. Morgan paid one of the largest fines in U.S. history to keep her from talking. Fleischmann, a former quality-control officer, describes a process of intimidation to approve poor-quality loans within the bank that included an “edict against e-mails, the sabotaging of the diligence process,… bullying, [and] written warnings that were ignored.” At one point, the pressure from superiors became so ridiculous that a diligence officer caved to a sales executive to approve a batch of loans while shaking his head “no” even while saying yes.
None of those actions in the workplace sounds good, but are they triable crimes??? The selling of mislabeled securities is a crime, but notice how many steps a single person would have to take to reach that standard. Could a prosecutor prove that a single manager had mislabeled those securities, bundled them together, and resold them? Management at the bank delegated onto other people elements of what would have to be proven for a crime to have taken place. So, although cumulatively a crime took place, it may be true that no single executive at the bank committed a triable crime.
How should the incentives have been different? My next blogpost will suggest the return of a traditional solution to penalizing coordinated crimes: conspiracy prosecutions for the financial crisis.
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I've enjoyed our short-but-sweet forum on executive compensation, and I hope you have to. You can find all of the posts collected here.
Just yesterday, Tony Jackson's FT column took the idea I had for this post, which was to praise my colleague Harwell Wells' wonderful paper "No Man Can Be Worth $1,000,000 a Year”: The Fight Over Executive Compensation in 1930s America. In The Fight, Harwell explores the deep roots of concerns about pay, and suggests that the social norms of previous generations might have permitted significantly more radical constraints than the modest gruel served up by Say On Pay.
Having been preempted from praising the use of history to study compensation, I suppose I'll have to question it.One thing you sometimes hear from historians of compensation is that the managerial power hypothesis lacks explanatory power when considered over time. Managers from the 40s-70s, despite having the same kind of power over boards to set their wages as they do today, didn't exercise it. Compensation was relatively stagnant. Because the law didn't much change, say historians, we must look to some other factor to explain the recent dramatic rise in managers' salaries. That other factor: the strength of the union movement. It's the decline of unionism and its coincident egalitarian norms that has permitted managers to extract ever-higher salaries from firms. Or so the story goes.
In a way, this explanation fits well with the left's dominant theory explaining the strikingly different fates of employment (awful) and corporate profits (terrific) in our jobless recovery. Here's David Leonhardt in the Times:
"Relative to the situation in most other countries — or in this country for most of the last century — American employers operate with few restraints. Unions have withered, at least in the private sector, and courts have grown friendlier to business. Many companies can now come much closer to setting the terms of their relationship with employees, letting them go when they become a drag on profits and relying on remaining workers or temporary ones when business picks up."
The idea, then, is that a culture (societal or firm-specific) that is unionized is one where the managers pays a social penalty for having a salary that is vastly different from the line workers. It's a bit of a variant on Robert Frank's theory about how the top earners in a firm must implicitly give up part of their salary to compensate the lowest earners for taking a status hit. This idea about pay's structure is intuitively compelling, but it has a hole. As Megan McArdle put it, "the decline of the labor movement is not an uncaused cause." She attributes the decline of unions - and the loss of a employment stability during recessions - to the rise of more economically competitive firms:
"[When firms lost their "cosy oligopolies"] it made it much harder for labor unions to bargain: whatever arrangements they struck suddenly had to take customers, competitors, and shareholders into account, rather than simply arguing with management over their share of a relatively fixed pie. This made unions much less valuable to workers; it also, independently, put pressure on companies to fire workers during downturns."
I am wondering how business associations and corporations teachers approach executive compensation. After teaching now at two law schools, I’m still surprised how this hot-button issue does NOT provoke one of the more interesting class discussions of the semester. I wonder if it is because I look at executive compensation in discrete units – first in fiduciary duties and later in discussing the proxy system. Does it pay to revisit executive compensation again as a stand-alone issue?
Two things I do think are worth imparting about compensation. First, is a question about what causes high levels of compensation for executives. The law school environment tends to promote a sense that legal rules or failures of legal rules are the key drivers to all sorts of problems. The business associations world tends to use agency costs as its prime prism. But older economic scholarship on “superstars” suggests other potential causes to extreme disparities in salary, in particular when the market for high level employees expands to national or even global levels. The Times had a nice feature on this scholarship a few weeks ago that provides for an interesting link between the compensation of star athletes and executives.
Second, I aim to spend at least one class at the end of the semester talking about corporate reform – including but not limited to corporate social responsibility. One point in the lesson plan is to beware of unintended consequences for any reform you tout. Executive compensation and “pay for performance” is Exhibit B. Now questioned for lining the pockets of wealthy executives at the expense of shareholders, the movement began as a reform effort to address concerns about entrenched management.
Ideas on teaching executive compensation are more than welcome in the comments.
You know a corporate law issue is hot if it is hotly debated around our Holiday table. Try as I could, I found it hard to mount a successful defense of current levels of executive compensation. (The only person who bought my arguments was my 19 year old cousin who wants a summer job at Goldman Sachs). But is it just the obscene level of compensation and income disparity that bothers us? One relative – let’s call her “mom” – said that executive compensation caused the financial crisis. Yet the precise link between executive compensation and the financial crisis is not easy to articulate. Raghuram Rajan has been rightly lauded for sounding a warning for the crisis with his 2005 article Has Financial Development Made the World Riskier? In that article, Rajan focused on the skewed incentives that investment managers had to take risky bets by enjoying the upside but not the downside of investments. His analysis is still compelling.
Yet re-reading Rajan also leads me to believe that some of the broader strokes of Dodd-Frank dealing with executive compensation, such as say on pay, may be too broad. If we are justifying regulating compensation because of the crisis, it seems odd to sweep in non-financial firms. What, after all, does the pay of executives at Intel, Google, Boeing, or Exxon Mobil have to do with the financial crisis? Say-on-pay and other Dodd-Frank reforms that apply to a broad swath of non-financial firms need to be justified on their own merits and not with an invocation of crisis spirits.
On the other hand, financial firms are fundamentally different beasts. We cannot stop with the standard analysis of agency costs that applies to the compensation arrangements at generic companies. The capacity of financial firms to externalize the costs of their risk-taking on the credit markets and the economy as a whole argues for additional scrutiny. The principal Federal bank regulators made this point in June 2010 guidance on compensation policies at banks. They wrote, “Aligning the interests of shareholders and employees, however, is not always sufficient to protect the safety and soundness of a banking organization.” The regulators argued that the presence of a federal safety net meant that shareholders may not care enough about whether a bank’s compensation policies encourage excessive risk. This argument could be taken a step further as the failure of firms, like Lehman, that did not receive a federal lifeline still caused massive economic damage. Financial firms need to be treated differently. Moreover, the agency cost rubric for looking at compensation that applies to most firms – does compensation align management and shareholder interests – may produce perverse results if applied to financial firms. Leo Strine of the Delaware Court of Chancery makes a case that further aligning manager interests with those of shareholders might further encourage short-termism – including high-reward-today-high-risk-tomorrow investments. This argument becomes stronger when applied to financial institutions.
If much of Dodd-Frank’s compensation focus is thus too broad, much of it is also too narrow. The compensation of non-executives – from traders at a Bear Stearns trading desk to mortgage brokers earning six figure incomes at Countrywide – may explain more of the perverse risk-taking in the crisis than the pay of ceos at those firms. Indeed, many of the most prominent ceos pilloried after the crisis – Cayne, Mozilo, Fuld – actually lost a significant chunk of their personal fortunes as their firms foundered. (See Fahlenbrach & Stulz for a more rigorous analysis).
If compensation – executive and non-executive -- at financial institutions is more directly connected to the crisis, then banking regulation offers a better toolbox for addressing skewed incentives for taking excessive risk produced by bad compensation arrangements. But which tool in that toolbox is worth applying? The June 2010 Guidance from the Federal Reserve/OCC/OTS/FDIC mentioned above offers one approach, namely making compensation arrangements a key part of the examination of the safety and soundness of federally regulated financial institutions.
Even so, a great deal of skepticism is in order over whether this guidance for bank examiners will have a meaningful effect. Two concerns stand out. First, this guidance just adds to the already voluminous standards that examiners must consider in evaluating safety and soundness. Voluminous is a severe understatement; as part of my research into risk models I downloaded Federal Reserve and FDIC examination manuals. The material took over three flash drives. There is no way even Hercules (the Ronald Dworkin version) could read, let alone actually apply all of those standards. Will compensation just get lost in the weeds?
Second, what is the both intellectual and regulatory framework for identifying and promoting good compensation arrangements? The June 2010 Guidance gets the conceptual issues with executive compensation right – albeit on a very high level of abstraction: making sure that all bank employees, not just executives, have balanced incentives for risk-taking. This would include ensuring that employees feel the downside pain and not just the upside gain of credit and investment decisions. But what does this mean in practice? And what standard would apply to banks? Here, the regulators, with a mix of wisdom and cowardice, resort to a principles-based approach and eschew setting concrete standards.
There are obvious benefits to remaining general but big drawbacks as well. Where is the certainty for banks and their counsel? Will this standard just be yet another blurry aspirational standard that just hides the naughty bits of banks and regulators?
So the jury is out on whether bank regulators “get” compensation and whether it will translate into flexible, but durable regulation. The issue is worth studying and monitoring closely, because looking at compensation offers one of the most cogent ways of addressing financial institution risk-taking. I am a proponent of simpler regulatory approaches that address overall incentives of actors as opposed to micromanaging processes. Ensuring appropriate compensation structures for financial institution employees means we don’t have to get lost in the weeds of determining how much risk is too much. As a case in point, I spent a good part of Wednesday reading through proposed Federal rules on capital requirements for market risk. Asked to comment on the rules, I found myself at a loss to say whether the agencies’ technocratic fixes to regulating bank risk models made any sense at all. Who knows if the regulators are requiring adequate adjustments to VaR for correlation trading positions? I had the sinking feeling that agencies may not see the risk they face of again getting inextricably tangled in the technocratic underbrush.
My wish is that one year I’ll be sitting around a Gerding family table in November and December and will be able to share the raucous good news that bank regulators are doing a good job with compensation. It may not satisfy mom, but it if keeps my Wall-Street-bound cousin from crashing the economy that would do just fine.
We chose today as the date for our forum because it marks the inauguration of say-on-pay: effective today, you get a vote on the compensation of the CEOs of the companies you own. So far, there's been more whimper than bang associated with this new shareholder right. There's been discussion about how often shareholders should exercise it: every year? every three years? But I can't find much else on Google News.
I'm not sure whether the deafening silence is because no one is sure what will come of all this, or everyone knows nothing will come of it. I tend to think the latter: say on pay will be another annoyance in an already overloaded proxy. Most shareholders won't vote and there'll be very little utility to the information we gain from the votes.
Bah. Much ado about nothing. Or am I wrong?
Only rarely does history supply a direct answer to current questions but it furnishes many perspectives through which to view the present. I'm grateful to the organizers of The Conglomerate for inviting me to blog, on this occasion about executive compensation. My current thoughts reflect two books I read over the holidays, both well-written but each a window into its own era. Toward the end of The Big Short (2010), Michael Lewis observes that "What are the odds that people will make smart decisions about money if they can get rich making dumb decisions?" Put differently, what worries Lewis is the risk that the incentives that channel greed aren't necessarily calibrated to encourage smart decisions. And, in the book's saga of derivatives transactions and traders, although abundant rewards came to those who perceived the wisdom of finding a way to short subprime mortgage bonds, those on the wrong side of the transactions did not walk away poor even when their firms collapsed.
Pressing a bit further, decisions that are dumb may have negative effects for particular firms and their constituents, including shareholders. But, as we know, the adverse consequences of some dumb decisions extend more broadly. Some reforms to executive compensation practices - say-on-pay, more disclosure, greater focus on the composition and independence of boards' compensation committees - may help but also seem at best indirect responses to managerial decisions that create major systemic risks.
Much more of my vacation reading time was occupied by TJ Stiles's biography of Cornelius (a/k/a "Commodore") Vanderbilt, The First Tycoon (2009). When the Commodore died in 1877, the $100 million value of his estate's assets if then liquidated for cash would have taken out of circulation one out of every twenty dollars then in circulation (including demand deposits) in the United States. The Commodore's wealth stemmed from a long career of dominance of leading modes of transportation - first steamboats, then railroads. To his biographer, the Commodore is a sympathetic but ruthless figure who built his wealth as an owner and manager of the business firms he controlled. The Commodore's compensation came through dividends on stock; he managed his businesses as his own property. Stiles contrasts the Commodore with his competitors, top executives of the Pennsylvania Railroad, who were professional executives who rose through the compay, owned little stock in it, and demanded kickbacks from outside contractors who did business with the railroad.
The Commodore's business adventures did not all succeed - the failed Atlantic-Pacific transit route through Nicaragua, for example- but perhaps most interestingly for our times, he emerged unscathed through the Panic of 1837. The Panic followed an asset bubble - much debt incurred on the basis of high expectations for cotton prices, all to collapse when the Bank of England restricted credit. Although many of the Commodore's debtors defaulted, he never lent on the security of cotton consignments, instead demanding prime real estate as collateral. The market value of shares he held declined, but he invested to secure operational control or longer-term gains, and he held plenty of cash. "Cold, hard cash" according to Stiles - silver shillings and gold coins paid for fares. And the steamboat business remained in demand.
To be sure, the Commodore's saga also amply illustrates anticompetitive and manipulative business tactics later to be prohibited or regulated. The larger picture is of incentives that encourage making smart decisions.
Welcome to our Masters forum on executive compensation. Readers of the Glom know that executive comp is a topic of perennial topic, and was a topic of heated debate during the financial crisis. Last week Bob Diamond, CEO of Barclays, defended bankers' bonuses and said "There was a period of remorse and apology; that period needs to be over." So I ask the Masters: what have we learned from the crisis and its denouement? Is the executive compensation furor over? Or have we not yet begun to fight?