Retrospective Leadership

March 2009

Two of the most over-used terms in the business world these days are risk and leadership. Evidently, much of our economic problems are due to taking on too much of the former because of the lack of the latter.

It is certainly easy to find plenty of examples these days of poor leadership and over leverage. Just look at what those greedy fools at ________ (fill in the blank) did. Let us enjoy our brief moment of self-righteous satisfaction from pointing out the mistakes, greed, and inept leadership that is all around us. After we take that pleasant time-out, let us figure out what, if anything, we can do differently in our own businesses with respect to executive pay and risk management to avoid a similar fate. Unfortunately, it is a lot easier to point out poor judgment after the fact then to avoid it in the future.

I recently reviewed an employment agreement that allowed a CEO to be terminated “for cause” in the event that he made a decision detrimental to the Company’s financial well being without the board’s approval. The board was generous enough to allow the CEO complete flexibility to make all the good decisions he wanted without the board approval.

Similarly, at one company I used to work, leaders were encouraged to take “prudent risks”. Maybe this is a bit better formulation than the Employment Agreement but still, after watching a colleague get a dressing down for trying something that did not work out, you cannot help but puzzle over the meaning of Prudent.

Or, consider the TARP rules on executive pay. They require the Compensation Committees of companies taking TARP funds to certify that the compensation for senior executives does not encourage “unnecessary and excessive risks” that threaten the value of the financial institution. Further the rules require that executive compensation be aligned with creating long-term value. As I have commented previously, these are certainly good guidelines that Boards should be following whether TARP recipients or not. But no Board or management team that I have encountered has ever expressed a desire to create short-term value at the expense of long-term results or to take unnecessary and excessive risks.

While easy to poke fun at, who can argue with any of these? In all three cases management (or the Feds in the case of the TARP rules) are merely practicing good governance in trying to protect company assets against employees taking undue risks.

But let us face some perhaps uncomfortable facts about risk and pay. First, risk cannot be judged objectively. It is in the eye of the beholder. You can study the mathematics around standard deviations and VAR all you want but you cannot avoid the reality that one investor’s/executive’s idea of a reasonable risk is another’s imprudent and reckless adventure. Second, no amount of risk analysis can consider the unforeseen risk. Financial institutions like Freddie Mac, AIG and Lehman Brothers were highly leveraged in derivatives that ultimately were based on home prices and the ability of individuals to pay off their mortgage obligations. These derivatives seemed to be profitable in every situation except one: if the entire nation entered into a prolonged period of declining home prices and individual income.

And third, you cannot completely align the risk preferences of employees with the risk preferences of owners. Owners invest their savings. Employees invest their time and a portion of their compensation.

Business is all about balancing risk and rewards. Not only is there no government rule or reform that would have stopped or even ameliorated the current mess but there is nothing, except barring investment altogether, that will avoid the next systematic bankruptcy.

In one way executive compensation worked as it was supposed to. Most senior executives of large public companies receive 50%+ of their annual compensation in the form of equity grants that vest over a period of three years. While these individuals still received large base and bonus payments, the executives at the bankrupt or near bankrupt financial institutions have had their equity positions all but wiped out. They are not destitute but they are not laughing all the way to the bank either.

So what is to be done? A few suggestions:

Individual financial limits of authority need to be reviewed by Boards periodically along with stress testing of overall corporate investments.

Consider revisiting the mix of cash bonus and equity compensation to any individual in the organization who makes investment decisions. This would mean potentially granting larger equity stakes and smaller (or $0) cash bonuses to sales managers and traders as well as those members of the executive suite usually eligible for equity.

Consider stretching out vesting periods and/or stock holding periods from the more traditional three years to five or even 10 years depending on investment life-cycles. Perhaps the vesting period would vary by job.

To reduce the unfairness of the market, consider emphasizing relative stock performance when determining vesting thresholds and/or grant amounts.

Sales bonus/commission compensation should be tied to profitable cash flow rather than deal closings.

If Earnings are used to determine annual executive cash bonuses, adjust them by a measure of risk such as firm-wide leverage.

I have noticed that pick-up basketball games tend to be much cleaner and have fewer arguments when there is no referee. When a referee is added to the mix, players feel it is within their rights to push the rules to the limit as long as the referee does not call it.

All the risk management rules around compensation cannot substitute for management that is prudent and ethical. So my final bit of advice to Boards is to find the management team that does not need any of this sort of oversight.