Financial Mathematics

DPRA Financial Mathematics - Public Version

How To Protect Investors and Taxpayers And Promote Good, Long-Term Management Practices

Probably the worst kept secret in America is that Corporate Executive and Wall Street bonuses are real while Corporate and Wall Street profits may not be.  Senior executives have co-opted from shareholders all meaningful independent oversight and control of companies and executive pay. While highly paid consultants tell senior executives they are under paid and doing a great job, shareholders lose their life savings.  A cornucopia of board of directors’ and senior executive indifference, incompetence, and malfeasance has crushed equity and debt values and robbed employees and other stakeholders of major public U.S. companies in recent years. A very select few senior executives in the most egregious cases are now enjoying the hospitality of the old Gray Bar Inns. But generally board members of very poorly performing firms have suffered no real damage to their reputations and continued with their other professional activities untroubled by meaningful consequences.  Many of the senior executives of suddenly and "surprisingly" poorly performing companies have suffered only a loss in reputation. With tens to hundreds of millions of dollars in their banks or mattresses, however one can get along pretty nicely with just about any reputation.

Many corporate frauds and financial meltdowns have common features: accounting, valuation, or control failures and enormous executive payouts for performances that later prove illusory. I have a modest proposal for the compensation and performance monitoring of the Management – board members and senior executives such as CEOs, CFOs, and COOs – of publicly traded U.S. companies. First, establish revocable compensation trusts for the Management of publicly traded companies and second, set up financial results and board voting performance reports for each Manager. Open both trusts and performance reports to public scrutiny, allowing investors to see exactly how Management is compensated and has performed historically. Each Manager’s trust would receive all compensation the Manager is to receive. Base salary, bonus, stock, stock options, etc. would go into a Manager’s trust rather than to the Manager directly. Companies could compensate their Managers, through these trusts, in any amount and in any fashion they like; however, other than a maximum monthly salary set by law or regulation, once received by the trust, compensation could not be given to its executive for, say, four years while that Manager is at the company and for, say, two years once she left the company. Individual companies could make longer vesting periods, but the trusts would ensure a minimum delay before Managers can “get their money.”

These trusts would be set up so that they can only disperse their holdings to their executives while the company is in good financial health and there is no evidence of gross mismanagement, material malfeasance, or problems with the books. If there are problems, the trust would return all its remaining assets to the company. Shining a light on executive compensation packages and historical performance would embarrass boards agreeing to outlandish or foolhardy pay structures and generally force them to move toward a best practices approach. Some may believe this will cause Management compensation to rise rapidly as boards start a race to the top of the observable pay scale. Unfortunately that is already happening. Boards know where the top is. Public trusts would make the whole scale observable to even the lowly general public making it easy to know when pay schemes offer unreasonable rewards and performance reports effectively hold board members accountable. Two of the most important jobs of Management are building the management bench and keeping the books straight.  Building the management bench and keeping the books straights may not be sexy and are not sufficient, but they are prerequisites and necessary requirements for good management. The post-retirement delay in compensation will focus careful attention on locating and grooming quality replacements and forcefully encourage prudent accounting, valuation, and control methods. Good business practices will not be hindered. But aggressive accounting is likely to be quickly discovered and undone when new Managers come in, inflicting both embarrassment and losses of wealth on previous Managers. Some will argue that this approach will reduce Managements’ willingness to take risks. It will. It will reduce Managements’ willingness to take imprudent risks. Under this proposal, a diversified equity investor is likely to have slightly more appetite for an individual firm going bankrupt than that firm’s Management. But, under this proposal Managements’ interests and risk appetites are going to be better matched and aligned with all the other stakeholders, especially regular employees, debt holders, and, in cases with systemic risk, society in general.

The combination of publicly viewable, compensation-delaying trusts and truly informative reports on Management seem reasonable steps to take for substantially better aligning Management interest with good management practices and providing real incentives to Management for responsible accounting, valuation, and control. They are required because the board members and senior executives of public companies have close ties, are paying each other with “other people’s money,” and have more information sooner than the public. If one claims to perform like a champion, he or she should be willing to back up those claims by waiting and proving their results are real and not just hot air.