Spero Consulting

Archive for December 9th, 2008

The Wall Street Jour­nal has an arti­cle today enti­tled, Mack and Thain Lose ’08 Bonuses.

We’re nei­ther sym­pa­thetic nor antag­o­nis­tic towards Mr. Thain, who has only been in his posi­tion for a year; so, we take no glee in his being shut-​out. Hope­fully, he’ll be able to make-​do with his $750,000 salary, $15-$20 mil­lion sign­ing bonus from late 2007, and his other accu­mu­lated wealth from his past exec­u­tive positions.

What inter­ests us in the arti­cle is the men­tion that Mor­gan Stan­ley plans to imple­ment com­pen­sa­tion schemes that include “claw back” fea­tures. That means that in the future, the firm could recoup ear­lier bonuses if, say, a trader later blows up.

Please note that we are writ­ing in gen­er­al­i­ties and not attempt­ing to con­struct an opti­mal con­tract, but we do see claw-​back fea­tures as mov­ing in the right direc­tion for both firms and employ­ees. (We’ve writ­ten pos­i­tively about sim­i­lar fea­tures before.)

At first glance, such claw­backs may seem to impose more risk on employ­ees, but if they’re struc­tured and used prop­erly, they need not; thus, we’d expect them to be wealth-​maximizing for the firm and expected-​utility max­i­miz­ing for employ­ees. That’s if they are con­structed intel­li­gently.

We’d hope that Morgan’s scheme is so con­structed – to, say, claw back por­tions of a 2008 bonus because trades or invest­ments made in 2008 sub­se­quently go bad.

We hope that the firm does not attempt to claw back a por­tion of say, a 2008 bonus because the trader made a money-​losing trade in 2009. We under­stand the aver­ag­ing effects of long-​term con­tracts, but believe that such rep­ri­mands would likely be per­ceived as being arbi­trary and capri­cious and sub­jec­tive and would likely have two effects: (1) before-​hand, many traders would leave to join hedge funds or to trade for them­selves, and (2) those traders who did stay and win large bonus awards could be expected to become sub­stan­tially more risk-​averse in the future (because both the cur­rent period’s bonus and past bonuses were all still at stake). In gen­eral, it doesn’t seem that most trad­ing and invest­ing firms want to induce traders to min­i­mize risk; instead, it is to man­age risk intel­li­gently or effi­ciently. If the goal were, in fact, to min­i­mize risk, then pay­ing a bonus as a func­tion of prof­its would be a huge mis­take in the first place. There’s much cheaper ways to induce that behavior.

The Good: Besides claw backs, we’d rec­om­mend that firms con­tinue to pay bonuses on earn­ings even after traders have left the firm – solely to induce them to behave and act in the firm’s long-​term inter­ests while they are employed. It is very tempt­ing to want to pun­ish for­mer employ­ees for leav­ing or for a vari­ety of real or per­ceived trans­gres­sions, but it is not nec­es­sar­ily the wis­est pol­icy nor fidu­cia­r­ily responsible.

Unfor­tu­nately, it seems that UBS may have taken that course.

We’re very grate­ful that the WSJ arti­cle men­tions that UBS imple­mented claw­backs in mid-​November because we had pre­vi­ously missed that announce­ment in the press.

The Bad: In August, we com­mented on UBS’s plans to use phan­tom shares in its com­pen­sa­tion schemes in Incen­tives at UBS and in Gen­eral. That plan seemed to impose a sub­stan­tial – we mean exces­sive – amount of risk on its employ­ees. W would strongly encour­age inter­ested par­ties to read that post.

From our read­ing of a few arti­cles more recent arti­cles, espe­cially this Lon­don Times arti­cle, UBS’s plan seems down­right vin­dica­tive. While that may be jus­ti­fied in the cases of for­mer senior exec­u­tives and while it may be sat­is­fy­ing to stiff employ­ees in bad times, it’s gen­er­ally not wealth-maximizing; it seems quite sub-​optimal.

UBS calls a neg­a­tive bonus a “malus.” Get it? It sub­sti­tutes “mal” for “bon” to get the oppo­site. Very clever!

The Ugly: Accord­ing to a Tele­graph arti­cle, UBS will attempt to claw back pre­vi­ously awarded, but not dis­trib­uted bonuses, if the bank under-​performs, and it could recover up to two-​thirds of the cash por­tion, which would be held in escrow for at least a year. So imag­ine that you, Joe Trader, or more pre­cisely Josef Trader, had a par­tic­u­larly good year in 2009, but the firm had com­pletely hor­ri­ble year in 2010; so, not only do you not get a 2010 bonus, but your 2009 bonus is gone, gone, gone. How would you feel? What are the odds that it could occur? Is it worth tak­ing the chance (bear­ing the risk) of such per­sonal losses? If it’s not, you may want to seek employ­ment elsewhere.

The Times arti­cle men­tions that Share-​based bonuses won’t vest for three years and exec­u­tives will be required to retain 75% of those shares for sev­eral more years, and the “malus” sys­tem will apply to shares, too. As we wrote in August and repeated above, such plans impose sub­stan­tial risk on employ­ees. UBS should expect to pay higher com­pen­sa­tion on aver­age and expect an exo­dus of employ­ees. We’d guess that it would lose many of its best, most con­fi­dent employ­ees, and many of its most risk-​averse, and espe­cially the inter­sec­tion of the two. Would you, dear reader, tol­er­ate such a scheme?

By the way, for exit­ing employ­ees, all bonuses paid on depar­ture will be sub­ject to the “malus” sys­tem. What are the chances that will be manip­u­lated against the employee (as, say, a short-​term way to boost current-​period profits).

In that regard, we love this quote from the bank that appeared in the Tele­graph arti­cle: “This should pre­vent any pay­ments that prove to be inap­pro­pri­ate in the near future.” But, when did pre­vent­ing any, which we take to mean “all” inap­pro­pri­ate, pay­ments become the goal?

In eco­nomic mod­els, profit-​maximization in the short-​term or wealth-​maximization in the long-​term do not imply the all costs can be elim­i­nated. We, and every other econ­o­mist that we know, teach that there is an eco­nomic level of costs that max­i­mizes prof­its. Like­wise, in decen­tral­ized orga­ni­za­tions, all dys­func­tional behav­ior can­not be elim­i­nated with­out also elim­i­nat­ing the ben­e­fits of auton­omy; it is throw­ing the prover­bial baby out with the bath-​water or being penny-​wise and pound-​foolish. (See just about any­thing that we’ve writ­ten in our Illus­tra­tions and Fal­lac­ies sec­tions, espe­cially about extrem­ists in Com­mon Man­age­r­ial Mis­takes in Decen­tral­ized Orga­ni­za­tions.)

We what find to be espe­cially galling is the fact that intelligently-​applied claw­backs are a great idea for both firms and employ­ees, but unfor­tu­nately, if (as an early adopter) UBS botches its imple­men­ta­tion – which given the infor­ma­tion in the press seems highly likely – then other firms will likely be hes­i­tant to use them. That’s a shame.

If large firms want to elim­i­nate risk, then we encour­age to elim­i­nate pro­pri­etary trad­ing and oper­ate rel­a­tively low-​risk, low-​margin businesses. That’s what we’ve rec­om­mended for government-​insured firms in our aptly-​titled post Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions.

We’ll likely edit and add to this post in the near future.

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