A Bonus Post

On August the Twelfth, of all days, a self-respecting banker ought to be somewhere between Yorkshire and Inverness, the house-guest of a fine Victorian sporting lodge. After putting the finishing touches to a hearty breakfast of kidneys on toast and kedgeree, it's on with the walking boots and into the transport up the hill, for driven or walked-up grouse.

This, I submit, is the way to spend a sizeable city bonus - maintaining the splendid, unpredictable and thrilling sport of grouse shooting, for the benefit of the environment, local employment, one's friends, and one's own sense of well-being.

But what of the bonus culture? Are we really going to see a change in behaviour? Are the shareholders of financial institutions really going to hold them to account on remuneration policy? Or are those main shareholders merely 'other' financial institutions, for whom the current bonus arrangements are very suitable, thank you.

I don't mind people in the City getting bonuses, in fact I think it's the best way of paying people in an industry that is famous for its total lack of job security. But the logic is that, when the cupboard is bare, there is no discretionary bonus. But how to keep the key personnel? Who IS a key person? Is it a dozen, or 120, or 1200? Is it - wait for it - 39,000 of your best employees?

Judge Rakoff (you couldn't make up a more suitably ironic name) is questioning the validity of the Merrill Lynch scam whereby they sold themselves to Bank of America to avoid going bust and then paid themselves the thick end of $4Bn in bonuses. Judge Rakoff doesn't care that the SEC is fine with it; he wants some answers. Seeking Alpha takes up the story:

Oh, that Judge Rakoff is such a spoilsport, refusing to bless the SEC's settlement with Bank of America on the Merrill Lynch bonuses.

The Times said today that the judge (a nice man who once terrorized me in Contracts class) may hold a hearing to find out whether the bonuses - all $3.6 billion - were necessary. More specifically, he'd like to know if Merrill's management really tried to figure out "how many of the roughly 39,000 bonus recipients would have left had they not received their payouts."

In response, Bank of America's lawyer said the bank could prove "there were a number of companies that might have hired Merrill’s employees.” Which is nice, but doesn’t really address the judge’s concern.

Rakoff is asking about the process: Did the board ask management to prove these bonuses were essential, and did management meet that burden? To do so, I think, would have required them to muster empirical evidence on the following points:

- Exactly which employees were likely to stomp out the door if they got smaller bonuses, or no bonuses, and how management knew this in advance.
- Whether all hell would really break loose if some of these folks left.
- Whether or not the firm could recruit, on the streets of Lower Manhattan, some dazed but qualified victims of Wall Street’s bloodbath who'd be willing to work for less than $3.6 billion.

Did the board ask for such factual backup? I’m guessing no. The “science” of executive compensation is a strange kind of science, in that it’s pretty much devoid of both evidence and experimentation. Year after year, public companies assert in proxies that their compensation programs are exquisitely designed to retain each indispensable, irreplaceable employee. A less generous pay scale just wouldn’t do the trick, we’re told. But few firms tell us how they know this. Nor do they road-test different compensation schemes.

For empirical research on whether compensation methods actually work the way they're supposed to, we’ve got to resort to academics. Like these guys, who concluded a couple of years ago that stock options encourage foolhardy risk-taking. Hey, how about that.

How can you say your compensation structure is efficient and effective if you never experiment with a cheaper one, even when the world is coming apart at the seams and you have a perfect excuse for cutting pay?

Thanks to a crabby guy in robes, one company may soon have to answer that question.

Well done the judge. Time for a reality check.