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Student Research Journal > Spring 2014 Issue
Spring 2014 Issue

The Ethics of Bonuses and Executive Compensation

Randall J. D. Logan

Abstract

Each of the past four decades has experienced a major financial catastrophe. This article discusses the role that bonuses and excessive executive compensation may play in financial disasters with a focus on the most recent global financial collapse, which began with the failure of Lehman Brothers in 2008. The question of executive compensation and bonuses is more a problem of form than of amount. Front-loaded bonuses to Wall Street executives are an easy target for public scrutiny when they are not linked to measures of profitability and positive performance of the firms. Federal regulations have failed to contain the key problems and to address the fundamental questions of executive compensation. Regulation and reform may be reactive, but firms always have their fiduciary duties and ethics. While it may be argued that executive compensation has become excessive, unjustified, and perhaps even led to unethical behaviors contributing to financial catastrophe, it is important to note that the concepts of “ethical” and “legal” are not necessarily mutually inclusive. The ethics of bonuses and executive compensation are subjective and outside of the laws regulating contractual agreements between corporations, their chief executives, and their board of directors. However, if history is any guide, financial fraud will always be a possibility where the penalties are not great enough to be a deterrent. The solution must come from within the corporation, its Board, and the individual employees by linking compensation to a long-term philosophy.

Introduction

In the history of the U.S financial industry’s economic cycle, there have often been periods of great turmoil resulting from wide spread fraud. It may be argued that executive compensation has become excessive and unjustified and that it is the root cause of such wide spread financial fraud. In addition, huge bonuses may be leading entire corporations and industries to focus only on their short-term financials instead of a more profitable financial position for their shareholders in the longer term. Government legislation such as the recent Dodd-Frank Act of 2010 has attempted to regulate corporate social responsibility without much evidence of success. Ultimately, corporations and individuals must assume responsibility for ethical behavior, fiduciary trust, and financial accountability.

Compensation and Incentive Packages

Executive pay and compensation packages of today are complex and have a multi-component structure. Above and beyond base pay, packages typically include additional components such as short-term bonuses which are traditionally paid out annually. Fundamentally, a bonus is compensation above base salary which companies use to thank and reward an employee or executive for achieving certain predetermined goals, or it can be used as an incentive or enticement to increase the likelihood that the employee or executive will reach certain goals. The former of these is reactive and the latter is proactive or more commonly referred to as a “front-loaded” bonus. Often these front-loaded bonuses are a contractual agreement whereby the company is legally liable to pay them regardless of executive performance.

Given the global economic collapse of 2008, front-loaded bonuses to Wall Street employees are an easy target for public scrutiny when they are excessive and not linked to measures of positive performance of the firm. In the years leading up to the last global financial crisis, between 2005 and 2009, 60% of a typical Wall Street employee’s compensation was in an annual bonus and awarded in cash (Sharfman, 2011). These annual cash bonuses for financial industry employees ranged from $99,200 to $191,360 per person in those years (Sharfman, 2011). But this mean payout understates the amounts of short-term bonus compensation paid out to top executives. In 2008, the very year of the collapse, Goldman Sachs paid a total of $4.82 billion in bonuses, almost half of which was in cash, with 74 employees receiving $5 million or more, and J.P. Morgan awarded $8.7 billion where two-thirds was a cash payout and 84 employees received more than $5 million each (Sharfman, 2011). While both of these financial firms received tens of billions of dollars in tax-payer funded government bailout assistance, paying any employee a bonus of $5 million in those circumstances is easily labeled excessive and unjust.

Paying-for-Peril and Short-termism

Companies paying huge or excessive front-loaded bonuses can lead to a corporate culture focused only on maximizing personal short-term gains at the expense of longer term concerns that benefit the shareholders (Sharfman, 2011). This phenomenon of rewarding short-term gains, or “short-termism”, and suffering long-term losses is referred to as “Paying-for-peril” and may encourage risky and unethical behavior (Donaldson, 2012). Paying-for-peril is a matter of time frame and is related to short-termism, which is defined as an excessive focus on short-term results with a lack of concern for the long-term, fundamental value of the firm (Dallas, 2012). Companies pay huge bonuses to employees for high performance today but do not see the corporate benefits or peril until much later. Often, firms do this with the full support of their Board of Directors and shareholders because they are all demanding ever-increasing profits, stock prices, dividends, and payoffs on a quarter-over-quarter basis. This emphasis on increasing annual or quarterly performance measures, regardless of consequences, takes the focus off of longer term value creation by the firm and places it onto the short-term. As a result, short-termism fueled with excessive front-loaded bonuses provides the incentive for individual employees to pursue their own interests creating a moral hazard (Sepe, 2011). If the rewards or bonuses are great enough and tempting enough, an employee may be enticed to play the system by faking the short-term performance. This may result in excessively risky transactions with a high chance of larger returns but also with a smaller possibility of complete financial disaster. The current system allows financial industry managers to make high-risk transactions because they only experience the upside with huge bonuses at the end and no downside if their speculation fails and disaster strikes. It is not their money that they are playing with. They only benefit from the profits in the way of bonuses, but are not affected by the losses (Donaldson, 2012).

A firm’s reward structures have a direct impact on its corporate culture and individual employee behavior (Dallas, 2012). Financial firms with trading operations such as Lehman Brothers and Bear Stearns tend to have intense competition amongst individual brokers who focus on their short-term profit-generating skills (Dallas, 2012). These characteristics are associated with corporate cultures that demonstrate tendencies towards unethical behavior such as individual employees seeking personal financial profit at the expense of their employers (Dallas, 2012). The “greed is good” mentality has given rise to the “normalization of danger” where people live with danger long enough that it becomes normal and accepted behavior (Donaldson, 2012). The practices of paying-for-peril, short-termism and normalized danger may have led to what we now call “Dark Monday”. “On September 15, 2008, ‘Dark Monday’, the world witnessed the beginnings of a radical reshaping of Wall Street as Lehman Brothers and Merrill Lynch fell into extinction and AIG pleaded for $40 billion in bailout funds” (Donaldson, 2012, p. 5).

Legislation, Regulation, and Reform

There have been many attempts at regulating risky and unethical corporate behavior brought about by financial fraud such as the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010. These attempts at reforming the financial industry have not succeeded in preventing continued fraud.

The Sarbanes-Oxley Act (SOX) was passed by the U.S. Congress then signed into law in 2002 by President George W. Bush in response to the Enron and WorldCom accounting fraud debacles in the early 2000’s (Dallas, 2012). In order to obtain large personal financial gains through bonuses, Enron executives manipulated their balance sheets by reporting large gains from the sale of unprofitable subsidiaries that they owned while still maintaining ownership of those divisions (Dallas, 2012). The SOX Act was passed in 2002 to regulate and prevent this type of financial fraud, known as “accounting earnings management”, by increasing the financial disclosure requirements, yet just six years later in 2008, Lehman Brothers reported its borrowing as sales, boosting its quarterly earnings (Dallas, 2012).

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, known as the Dodd-Frank Act, was signed into law by President Barack Obama on July 21, 2010. This legislation was a response to the 2008 global financial collapse and is intended to reduce high risk-taking in the financial markets, regulate the financial instruments implicit in the collapse such as MBS’s and CDO’s, avoid the “too big to fail” dilemma, and to protect consumers in financial service transactions (Austill, 2011).

Both the SOX and the Dodd-Frank Acts have provisions that address executive compensation and bonuses in the form of a “claw-back” requirement or policy. In both Acts the provisions require certain executives to return a portion or all of their bonus or incentive pay under certain circumstances. The SOX Act requires the CEO and CFO to return any bonus or incentive pay received within a 12 month period preceding their firm being required to make an accounting restatement due to misconduct (Fried, 2011). The Dodd-Frank Act requires publicly traded firms to adopt a policy to recover only certain kinds of executive incentive compensation that exceeds the amount that would have been paid under the restated financials, but regardless of any misconduct (Fried, 2011). Neither of these is enforced by the SEC, the Federal Government or the firms themselves. The SEC has only enforced the SOX claw-back in the few instances where executives have been convicted in criminal court, yet thousands of companies have been required to restate their earnings (Fried, 2011). In a survey, Fried and Shilon (2011) found that nearly 50% of all S&P 500 firms had no claw-back policy and of those that did, 81% made returning any excess pay following a financial restatement a voluntary act, with 86% of those firms stating that they would only recoup excess pay if the board found misconduct was present in the executive’s performance.

Conclusion

Executive compensation is at a record high. Excessive bonuses have led some to behave unethically and engage in fraud in order to receive huge personal, short-term financial gains. Congressional legislation to regulate and prevent fraud in the financial services industry has failed to contain the problem. Sepe (2011) suggests that the Dodd-Frank Act has missed the opportunity to address key problems plaguing corporate America in executive compensation because the problem is one of form and not the amount in which executives are compensated. If limits are simply placed on the amounts of executive compensation, companies will simply find ways around those limits. The way in which executives and managers are compensated is where any possible solutions may lie. In order to move away from short-termism, it is essential that executive compensation be tied to long-term performance of the firm. If history is any guide, financial fraud will always be a possibility where the consequences of committing fraud are less than the benefits and personal gains of doing so. The solution must come from within the corporation, its Board, and the individual employees by linking compensation to a longer term philosophy.

References

Austill, A.D. (2011). Legislation cannot replace ethics in regulatory reform. International Journal of Business and Social Science, 2(13), 61-71. Retrieved from ABI/INFORM Complete.

Dallas, L.L. (2012). Short-Termism, the financial crisis, and corporate governance. Journal of Corporation Law, 37(2), 265-364. Retrieved from ABI/INFORM Complete.

Donaldson, T. (2012). Three ethical roots of the economic crisis. Journal of Business Ethics, 106(1), 5-8. doi:10.1007/s10551-011-1054-z. Retrieved from ABI/INFORM Complete.

Fried, J. & Shilon, N. (2011). Excess-pay clawbacks. Journal of Corporation Law, 36(4), 721-751. Retrieved from ABI/INFORM Complete.

Sepe, S.M. (2011). Making sense of executive compensation. Delaware Journal of Corporate Law, 36(1), 189-235. Retrieved from ABI/INFORM Complete.

Sharfman, B.S. (2011). Using the law to reduce systemic risk. Journal of Corporation Law, 36(3), 607-634. Retrieved from ABI/INFORM Complete.



Randall “RJ” Logan is a senior at Athens State University pursuing a CPA-track degree in Accounting with an anticipated graduation date of Fall 2014. He holds a BA in Political Science/International Relations, a BS equivalent in Finance, and an MBA in Finance and Economics, all from Auburn University. He previously worked for 20 years in New York City within the magazine publishing industry in corporate strategic planning running forecast models for budgeting and financial analysis. He is a member of the ASU Accounting Club and holds student membership in the Institute of Management Accountants, the Alabama Society of CPA’s, the New York State Society of CPA’s, and the American Institute of CPA’s. RJ enjoys classic films, reading science fiction, Huntsville Havoc hockey, the NY Yankees, NY Rangers, NY Giants, NY Red Bulls, and attending performing and fine arts events.



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