Crazy Compensation and the "Solution"

We are doing a series on San Antonio Fire & Policy v. Amylin Pharmaceuticals, a decision by the Delaware Chancery Court approving poison puts. 

Nonetheless, we couldn't help but notice the editorial in the WSJ yesterday by Alan Blinder on "Crazy Compensation and the Crisis."  The piece notes that "the ruckus has been over the generous levels of compensation, or the fact that bonuses were paid at all, not over the dysfunctional incentives that inhere in the way many compensation plans are structured."  In other words, nothing has been done to eliminate the perverse incentives to take excessive risk built into the current system of executive compensation.

• Amazingly, despite the devastating losses, these perverse pay incentives remain the rule on Wall Street today, though exceptions are growing. For now, excessive risk-taking is being held in check by rampant fear. But when fear once again gives way to greed, most traders and CEOs will have the bad old incentives they had before -- unless we reform the system.

So what is the solution? 

• Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. These boards, I'll remind you (and please remind the board members), are supposed to represent the interests of stockholders, not those of managers. Quite plainly, many were asleep at the switch, with disastrous consequences. The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

The emphasis on fixing the process in the board room is right but look at the solutions at the bottom of the paragraph.  They have nothing to do with the board or fixing the process.  In other words, Blinder correctly puts his finger on the problem but recedes when it comes to suggesting the proper response.

The answer is straight forward.  Rather than try to regulate every aspect of the compensation process, Congress needs to strip away from Delaware the right to set to standards.  Instead, there needs to be federal legislation that quite simply prohibits excessive executive compensation and provides a private right of action for violations.  The provision could likewise contain a provision that defines excessive as the inclusion of compensation incentives that encourage excessive risk taking.

This problem will not fix itself and Blinder is right to say that matters will drift back to the way they were.  The efforts by financial institutions to pay off TARP funds is, at least in some cases, no doubt motivated by a desire to get out from under even the modest compensation limits imposed on these companies.  In other words, they want to go back to the way it was.  And, absent some type of federal intervention, that's exactly what will happen.