Tuesday, October 14, 2008

Getting Paid to Fail

By now the demise of Lehman Brothers (LEHMQ: PK) is old news. However, I expect fallout from the compensation parting gifts given to Lehman executives as they walked out the door. Yes, I am predicting that after all is said and done in this Crisis of 2008, executive incentives will again come under scrutiny.

Lehman executives were a well paid bunch. In fiscal year 2007, the top five executives were paid $81.1 million in a combination of cash and stock. Only $24.0 million was paid in cash and the balance was paid in a combination of Lehman stock and other equity securities. Now most analysts and investors looking at that relatively small proportion of cash would call it a great compensation program - likely to inspire the executives to work hard and build the company’s value.

Clearly something went awry, because from the outside looking in it appears management failed entirely to build Lehman’s value. They either failed to recognize the potential risk in Lehman’s investing and securitization activities or they simply failed to do anything about it. Either way is was not a performance deserving of reward.

Yet the compensation packages put into place last year and disclosed in Lehman’s proxy filing in March 2008, laid out a plan to reward executives based on near-term stock performance and not on long-term enterprise value. Yes, bonuses are paid on the achievement of profit goals, but only in the near-term. If risk management decisions ultimately turned out to be ill-advised, there is no penalty for the management that put those policies into place.

Here is how this happens. First, employment agreements provide for accelerated vesting of equity awards upon a change in control or certain termination events. That means that equity compensation can be secured and divested long before any of the proverbial chickens come home to roost. Second, executives get to leave with a “goodie bag” under almost all circumstances except when they are fired for cause. The likelihood of a board of directors at any firm actually firing a senior officer for cause is slim. At Lehman the chances are practically nil given that the CEO, Richard Fuld, was also the Chairman of the Board.

So all these many years Lehman personnel have been leading the way among the “slicers and dicers” of mortgages, spinning out and investing in one collateralized debt obligation after another and securitizing one loan after another. Where was the incentive to reign in the risk or even do the typical scenario analysis used to quantify the risk of defaults among the underlying securities?

Revenue grew 26.3% in 2007 and earnings had increased 5.2%. In 2006 sales and earnings grew 44.1% and 21.2%, respectively. Only a fool would have turned this fountain off since it meant a great bonus that the employment agreements nearly insured could be kept no matter what happens.

It is not enough for senior officers to be paid with equity or to be paid based on the achievement of profit goals in the near-term. There has to be a penalty for failure or at least an incentive to consider the long-term ramifications of strategic decisions. Vesting must be contingent upon continued strong performance and not just on the passage of time.


Neither the author of the Small Cap Copy web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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