The directors of Southern Community Financial (SCMF) have taken an unusual step in their response to the financial crisis by reducing their own pay packages.
Executive compensation should be designed in such a way that directors share in the pain, and not just in the gain.
SCMF is breaking with the status quo in doing that. All kinds of financial companies have gone ahead with huge compensation packages for their brass, even as their share prices cratered. While this is a story with a certain populist appeal, shareholders are the real losers. Compensation systems don't work and there is little that can be done as long as boards maintain their current practices for nominating and electing.
I am going to contrast the decisions by SCMF, a small bank from Southeastern North Carolina, with AIG. AIG is
the behemoth that made a major contribution in destabilizing our financial system. AIG issued swaps on all kinds of exotic MBS and ABS. When things went south, they were supposed to provide a backstop. Unfortunately, that backstop turned out to be a bit like a batting cage trying to block a tsunami. AIG did have a solid insurance business. That business remains in force today. It was the other side that caused the problems.
Gramm-Leach-Bliley hadn't cut all of the firewalls between insurance and banking.
Most banks create pay-for-performance standards that conflate their awards by comparing their firm to much larger competitors. Then, the Compensation Committee establishes a set of performance criteria that are laughably simple. Meeting those standards can then trigger a series of options awards that are priced at current market valuations but with long-term exercise privileges. The length of the exercise period creates a very valuable benefit when calculated through Black-Scholes, yet it masquerades as a reward that is purely based on performance. Think about it - if someone offered you 1,000 options to buy shares in McDonald's for $81 (today's price) anytime for the next three years, would you take that as a gift with no value? No. You would recognize that any stock is likely to fluctuate in price. In some instances, that fluctuation will not even be statistically significant. But the higher the beta, the greater the value.
The only real way to tamp down rewards is to drop. In the last year, the Directors of SCFMO decided to:
- reduce base salaries of directors
- reduce 401 (k) matches. Later, they eliminated all matches.
- waived the right of directors to get reimbursements on their country club expenses.
- freezed accrued benefits.
- granted no annual cash bonuses for 2008, 2009, and 2010.
- forced directors to hold option awards.
Granted, the performance of SCMF shares has been lousy. The shares were trading at about $5 when Lehman Brothers went belly up, and now they are below $2. Still, there are plenty of financial services firms that have lost more than 60 percent of their value.
Witness the story of AIG, where the stock became virtually worthless. AIG executives didn't pare their own takings. In fact, they argued that they need to get more cash in order to motivate executive staff to remain interested in working for the company. That assessment of the loyalty of its staff was all-too-true: one AIG executive famously opted to take a severance package worth several million dollars rather than take a pay cut. AIG still hasn't paid back their TARP investment.
That didn't stop CEO Robert Benmosche from taking a $7 million cash salary for 2010, as well as another $3.5 million in incentive pay. The report go on to reveal that another top executive (Peter Taylor) took home 120 percent of his incentive pay even though he only worked 11 months.
A government executive in charge of overseeing compensation for TARP recipients said that no staff should get more than $500,000 in cash per year, except for "exceptional cases for good cause."
AIG stock, adjusting for splits, was selling for over $1000 per share in 2005. Currently, shares trade for about $30. It is great that those executives are staying motivated!