Costs of Performance-Based Compensation - Assignment Example

Costs of Performance-Based Compensation Discuss pros and cons, benefits and costs of performance-based Compensation and analyze issues related to executive compensation structures at Bear Stearns and Lehman. Explain performance based compensation using principal-agent theory and identify factors and environments where it works well. Introduction While looking at the core of the several factors, which affected the global financial crisis of 2008, it seems surprising at the indebtedness of the most refined banks of the world and their dependencies on mortgage supported securities and debt obligations. As high-risk loans were increasingly being documented the risk of default increased on behalf of the borrowers. In fact analysts and the common people were surprised at the high risk undertaken by such big companies as Lehman Brothers Holdings Inc. In fact Bear Stearns Cos. was acquired by JP Morgan Chase & Co despite being the for the largest investment bank at one point of time. Experts have long criticized such lack of foresight in risk taking. However one important factor which are not often brought up in the analyses of this problem is the compensation of executives especially those which are incentive based. As analyzed by the experts, years before this crisis took place, the executives undertook the long-term economic stability as a gamble to play with and focused more on short-term financial gains. (Keller & Stocker, 2008) Understanding this issue might prevent future dangers and thus address the problem of bankruptcy by designing better compensation arrangements. The problem of compensation can be analyzed with the help of illustrating the case of Lehman Brothers and Bear Stearns as depicted in the work “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008” by Lucian A. Bebchuk, Alma Cohen and Holger Spamann in 2010. Performance-base compensation – Bear Stearns and Lehman A panel of business and policy experts resented this lack of focus on long term worth and steadiness and the stress on short-term benefits. The National Association of Corporate Directors (NACD) suggested that the focus should lie on performance-oriented compensation rather than measuring the performance of the firm based upon stock prices. However the gap between such compensation and the value added to the American companies began to increase. In 2007 even when the mortgage crisis progressed further, the bonuses of Wall Street was at $33.2 billion, merely 2 percent below the high levels of 2006. The fall of Bear Stearns shows the problems brought about by the inclination towards short-term success. (Keller & Stocker, 2008) The study brings out the huge financial gains in terms of performance based compensation during the period 2000-2008 accruing to the top five executives of the firms – “we estimate that the top executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1 billion respectively from cash bonuses and equity sales during 2000-2008” (Bebchuk, Cohen & Spamann, 2010, p.4). However there are two views in this respect. On one hand some experts comment that the financial crisis and downfall of the company was not owing to the short-term goals of the executives and their performance based compensation or risk taking incentives inherent in the pay structure. According to these analysts the problem cam up owing to the short sightedness or lack of proper knowledge rather the mistake in decision making of the executives which in turn brought them huge losses too. They do not agree with the fact that the payment design of the executives have led to the outcome of faulty decision making or short term focus. It is rather an error or mistake. The pay structure does not entail a cut back of previous gains when the company was suffering losses. This was identified as the problem but as stated earlier some experts do not consider the pay design or incentive based structure to be a problem or a cause of bankruptcy. One side of the controversy blames it (incentive for risk taking) on the short-term goals of the executives and lack of awareness of the danger, which lay ahead. To analyze this better it is important to look at the gains made before the crunch occurred instead of merely studying their losses. In order to look at the reason (incentives for risk taking) of the executives for investing for short-term benefits, one needs to look at the gains accruing to them for a longer period rather than during the crunch itself. Hence despite the losses of 2007 and 2008, throughout the entire period 2000-2008 the gains to the executives or the net payoffs were positive. In fact they were able to sell larger number of stocks (2000-2007) than they were holding in 2008 at the time of crisis. The top executives of the two firms under our study pulled out huge compensation or cash flows before the fall of the firms. The CEO of Lehman brothers had drawn out a cash flow of $470 million during 2000-2007. These incentives were coupled by the bonuses even during the bad time of the companies. Apart from this they were entitled to fixed salaries irrespective of performance. (Bebchuk, Cohen & Spamann, 2010) Both the companies based on their stock performance gave out huge bonuses to their executives. This was especially awarded for the fiscal years 2000-2007 and mainly for 2006. Although in 2007 Bear Stearns refrained from awarding bonuses based upon the fall in financial performance of 2007, Lehman continued to provide incentives to the employees in terms of cash bonuses. The most negative part was that none of the banks’ structures of compensation put any condition to demand the employee to pay back their cash bonuses received in the previous years during the fall of the firms in 2008. None of the compensation accruing to the executives in terms of short-term gains was pulled back into the company despite the waning away of the financial outcomes maintained as records. It is also significant that the leading executives of the firm acquired cash flows almost every year during the period 2000-2008. Hence the incentives for short-term gains might have been present for them throughout. (Bebchuk, Cohen & Spamann, 2010) This would negate the argument, which states that the blame cannot be laid on the incentives for their short-term motives. When one looks at the destruction that the performance of the companies caused to the stockholders, one might claim that the performance-based incentives provided to the executives were more than necessary or feasible. It cannot be said entirely that the excessive losses suffered were due to the wrong decision making of the executives, rather one can easily blame on the incentives, which compelled them to take risks. The main beneficiaries of such a pay structure were the executives at high ranks and the main sufferers or victims were the stockholders and the firm as a whole. Performance based compensation and principal agent theory Principal Agent model in economics is a crucial model to understand business operations or operation management. The principal agent model might be expressed as “a principal has a primary stake in the performance of some system but delegates operational control of that system to an agent” (Plambeck & Zenios, 2000, p. 240) To explain the principal agent model simplistically one might think of a particular task assigned by the principal to its agent. In such a case the success of the operations would depend on thee similarity of goals and objectives and honesty of the agent. The task is delegated to the agent based on certain qualities or virtues used a parameters and the principal usually trusts the agent to get his work done. However in many cases the agent might make use of the situational and informational advantage, which he enjoys over the principal. However the model originally assumes that the principal and the agent have access to the same information when the contract is signed or the agreement is entered (Brickley, Smith & Zimmerman, 2006, p. 411). The agent agrees to look into the interest of the principal in exchange of compensation or payment. In the current context the top executives for instance, the CEO is the agent while the stockholder is the principal. The compensation guaranteed to the agent is performance based such that the interests of the executives or the agents are in tune with that of the stockholders or the principal. Coordination is the essence of operations within an organization (Milgrom and Roberts, 1992). The tragic story of the investment banks as related above might be explained with the help of this theory. In fact in the absence of financial novelty and any proper regulations risk incentives of the compensation package might lead to disastrous results. This is especially true when the principal is not aware of the risks involved in the long run and when the agent gets the compensation based upon the present performance of a company. For instance when a sub prime loan is given in 2005 the lender would be getting a high return when the prices of houses are increasing but exact opposite would take place when the housing market suffers a downfall or crash. In the previous example it could be observed that the agents could not decipher the long run instability, which was due and instead focused on short run incentives based compensation, which urged them to take risks. Such a model can function only when the appropriate performance based payment is designed and proper regulatory measures are adopted. In order to convert a short-term action into a long-term interest goal, several small adjustments need to be made at either steps with a commitment to long run objectives. Therefore considering a stipulated system of compensation the managers need to devise a strategy or a plan by choosing the production strategy along with consumption strategy with “incentive compatibility constraints” (Plambeck & Zenios, 2000, p.247). The two strategies should be optimized based upon the constraint (incentive/ compensation). Parallel to this, one may devise the problem of the owner (principal), in this case, the stakeholder. The latter would like to optimize the consumption strategy along with the set of instructions to guide the managers in production by maximizing his profit expectations. Problems however will come up when the actions of the manager cannot be gauged or assessed by the managers and the manager is risk averse. This is a kind of contradiction to what has been discussed before. The idea here is that being risk averse or risk taker is not the solution when the decisions are guided by short sightedness and conflict of interests between the principal and agent. Selection of the first best compensation design leads to the satisfaction of the risk adverse executive or manager. He gets his guaranteed wage and is expected to carry out the first best production method chosen. Next, the problem of the manager might be examined from the angle of the owner or principal (in case of a public company the owner is the stockholder). A set of production processes in line with incentive and participation are designed for a particular compensation design. In the second stage the optimal production strategy is chosen for a compensation pattern, which might be implemented at a low cost. The model usually assumes that the production or the output is the only parameter by which the effort of an agent or an employee can be evaluated (Brickley, Smith & Zimmerman, 2006, p. 401). The model also takes it for granted that despite the freedom of both parties to enter contracts, labor laws would restrict them. Employees gain motivation by getting paid on the basis of their individual output generated. However bonuses come into play when the group attains its target (Brickley, Smith & Zimmerman, 2006). The owner or the principal is essentially concerned with the hard work of the employee and hence effort is one dimensional within the organizational set up. Conclusion Therefore, in conclusion one may say that the principal agent model might find its application within the organizational operations especially with respect to the executives and stakeholders provided there is information symmetry, proper regulatory measures and suitable monitoring coupled with long-term stability. The problem lies in the optimization of both the employer’s profit and the manager’s compensation package. Risk taking might be encouraged only under strict surveillance of the owner and proper insight about long-term stability. The cases of Lehman Brothers and Bear Stearns suggest the need to design a justified and rational pay package, which would not merely reward the agent’s performance but also maintain the principal’s interests. References Bebchuk,L.A., Cohen,A.& H. Spamann (2010), “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008”, Yale Journal on Regulation, Vol. 27, pp. 257-282 Brickley, J., Smith, C. & J. Zimmerman, (2006), Managerial Economics and Organizational Architecture, McGraw-Hill, New York Keller, C. & M. Stocker, (2008), “Executive Compensation's Role in the Financial Crisis”, The National Law Journal, Corporate Counsel, available at: http://www.law.com/jsp/cc/PubArticleCC.jsp?id=1202426091714 (accessed on November 30, 2010) Milgrom, P. & J. Roberts, (1992), Economics, Organization, and Management, Prentice Hall. Plambeck, E.I. & S.A. Zenios, (2000), “Performance-Based Incentives in a Dynamic Principal-Agent Model”, Manufacturing & Service Operations Management, Vol. 2, No. 3, pp.240-263 Read More