The Problem with Bonuses

This week, Nortel Networks restated its 2003 earnings for a second time and told the public what most people in business already know: salary bonuses can make business people do funny things. In this case, officers pumped up earnings with cookie-jar reserves to make the balance sheet look good on the date it needed to for their bonuses to be at the optimum level. Then, of course, everything unraveled. If you only need to look good on a certain day, anyone can look good. If you don't believe that, then just look at my family's Christmas card picture from last year.

I tell my classes in Corporate Finance that most salary structures intended to align the incentives of employees and the entity that employs them have problems. We hear mostly about the problems with giving executives and other officers stock options, but bonus plans have the same internal problems. In my area of practice, we often saw officers of corporations hurrying to do a deal on December 31 that shouldn't have been done or should have been negotiated harder, even if that meant pushing the closing back. However, these officers were quite willing to give away the farm if that meant closing by December 31 for bonus purposes. I also had clients that gave huge, six-figure bonuses at the close of certain deals as incentives to get the deal done. Of course, then you saw business people pushing to close deals that shouldn't have been closed. When you dangle in front of someone a "retire in Aspen" bonus, then you have created some final-period problems where that person is tempted to cheat. (In the words of Professor Gilson.)