How the current employment law protects CEOs from losses
Credit crunch fatigue is probably setting in for many people, but I am sure that even they have some venom left for those individuals who presided over the whole debacle and yet walked away with millions of dollars and pounds. How was it possible that we “allowed” this to happen? Why is it that there is not a regulation that stops all this?
Well the short answer is that there are lots of regulations, but most of these are focused on stopping an organisation from doing things it should not. The officers of these organisations can be held personally responsible if it can be proved that they deliberately endangered the business entrusted to them or behaved fraudulently. The problem is that 99% of these bosses were just incompetent and when they are hauled up in court by angry shareholders, the judge is going to say that whilst the fellow was clearly a fool that is not grounds for suing him and as an employee, he has rights under statute that mean the company have to pay him off. Why is this?
Well employment legislation is (quite rightly) heavily weighted toward the employee. The employee is seen as subject to the power of the employer and so in a vulnerable position. If an employer imposes a clause in a contract with the employee which the judge finds unreasonable, it can be struck out on the grounds that the employer must have bullied or fooled the employee into accepting it. The judge effectively acts as a retrospective lawyer for the employee. The reverse is not true of course.
These days we have a situation where individuals who have not created a giant public enterprise are entrusted to run it for a short period of 3 to 5 years. They may well have fought hard to achieve this position of tremendous responsibility and they will certainly have a detailed employment contract put in place setting out terms they get and they probably feel they have a relatively short time to maximise their gains and establish their reputation before they move on. They will not think like the entrepreneur who started the original business. They will not see the institution which they work for as all important but rather think that they are important because they run the institution.
People have long recognised this problem and thought that loading an executive with options would motivate him or her properly by aligning interests with other shareholders. However this method of incentive has been proven to not have succeeded if the objective was to increase shareholder value. Indeed, I suggest that shareholders, remuneration committees and others can make up new schemes as much as they like but they will not solve this problem. The hired hand does not think like the person that built the business. He or she is either good at their job or not. The individual < either behaves responsibly and takes long terms matters into consideration or not. In fact, some schemes provide perverse incentives to do the wrong thing. For example an acquisition might not make complete sense, but if a £10 million bonus is on offer for doing it and £0 for not doing it, it would take a person of extreme integrity to call it off.
Some people might argue that levels of pay should be capped or taxed out of existence. I say that this makes no sense. If someone succeeds, they should be rewarded, the issue is people being rewarded for failing and that is where employment law steps in.
Companies can try to impose a claw back of bonuses and pay in the event of failure, but, apart from the problem that they will probably not get many applicants for the job, their lawyers would probably advise them that it may not be enforceable to claw back pay that has already been paid, rendering the contract less effective. This is because under current employment law it would be seen as unreasonable to take back money paid in return for services already rendered even if it was by mistake.
If however, the law created a new definition of employee, let’s call it a Super Employee, this issue could be dealt with much more easily. The Super Employee would be seen as an equal to the employer not subordinate. The Super Employee would indemnify the Employer to a level that the two parties would freely negotiate with each other in the same way that a supplier may indemnify a client. I would suggest that this amount would be limited to say 80% or 90% of the money received under the contract (over several years potentially). Importantly the Super Employee would be considered to be in breach of the contract if he or she was proven to be incompetent. So in the same way that a supplier provided you with faulty equipment you can demand your money back, so too will the shareholders be able to reclaim their money if the Super Employee does not provide the services they said they would.
Whilst it is clear that the CEO of a large enterprise falls into this category, the concept could be used with highly paid employees as well. All these multi-million dollar bonuses for bankers were thoroughly deserved no doubt, but what if some people actually lost their bank lots of money having earned millions in bonuses in previous years? I think that a company might put in place a policy which said that if an employee wants to earn more than say £250,000 they have to agree Super Employee status. That way the shocking news that John Thain signed off $4 billion of bonuses for Merrill Lynch employees in a year where Merrill Lynch lost $28 billion would just not happen. Right now it is entirely rational behaviour for the individuals concerned as even if the institution loses the money the individual gains a reward irrespective of success. The worst sanction they can get is to be given a large sum of money to leave. Indeed, only in the nuclear situation where the business is bankrupt will the employees potentially lose out, but let us bear in mind those long suffering shareholders who are wiped out by bankruptcy.
The concept of Super Employee should also spread to fund managers, because of course the wiped out shareholders are not the individuals managing the money on behalf of millions of small investors in pensions, insurance funds and unit trusts. The fund managers make the decisions to invest or not. They get the big bonus if things go well, it is your pension that gets it in the neck if they fail and they just move on. Because they want to be paid large bonuses they put pressure on the CEOs to make bigger returns, which generally requires the CEOs taking on more risk. Because the CEO is not around for long, he or she happily complies with this. This suits the investment banks that make their real money from juicy transaction fees. The result is a focus on personal gain through visible action (such as an acquisition) rather than steady improvement.
All these institutions feed off each other and when something goes wrong with one it affects the others. However, the individuals who run them are not affected financially and the incentives put in place to “motivate” them do not encourage the right behaviour in all cases. There will always be failures, but the law inadvertently over-protects the people with the power to make a difference. The solution is to change the balance of legal power to a more balanced position where enforcing a rebate is relatively easy provided loss can be proven.
Once that is done, hopefully the danger of perverse incentives encouraging CEOs (and others such as traders) to take foolish risks will diminish. I don’t think that it will stop risk taking but rather align interests strongly. After all there can still be great rewards for success. Nor will it stop CEOs trying to wriggle out of their commitments as it will still be hard to prove that it was the CEO’s fault, but the key element is that if they are to blame it would be possible to get the money back. This is currently impossible unless a crime has been committed. Most of all, it would leave the problem where it deserves to be left – with the shareholders. It would be their decision to sue or not and their decision to give a CEO an easy contract or not, their decision to hold the CEO accountable if they wish.
Summary
The crisis involves the destruction of institutions by the individuals who run them
The individuals who run them have employment law on their side
The individuals can earn large sums by taking risks with the institution whilst experiencing no risk themselves
All the institutions are interlinked so destruction of one can lead to the destruction of the others
The public interest is therefore at stake and yet there is no accountability
Super Employees will lose the protection of normal employment status making it much easier to claw back remuneration using existing laws
Super Employees will only take well calculated risks if they too can lose all they have made