The Wages Of Failure: Executive Compensation At Bear Stearns And Lehman 2000-2008

Lucian A. Bebchuk

Harvard Law School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR) and European Corporate Governance Institute (ECGI)

Alma Cohen

Tel Aviv University – Eitan Berglas School of Economics; Harvard Law School; National Bureau of Economic Research (NBER)

Holger Spamann

Harvard Law School

November 24, 2009

Yale Journal on Regulation, Vol. 27, 2010, pp. 257-282

Harvard Law and Economics Discussion Paper No. 657

ECGI – Finance Working Paper No. 287

Abstract:

The standard narrative of the meltdown of Bear Stearns and Lehman Brothers assumes that the wealth of the top executives of these firms was largely wiped out along with their firms. In the ongoing debate about regulatory responses to the financial crisis, commentators have used this assumed fact as a basis for dismissing both the role of compensation structures in inducing risk-taking and the potential value of reforming such structures. This paper provides a case study of compensation at Bear Stearns and Lehman during 2000-2008 and concludes that this assumed fact is incorrect.

We find that the top-five executive teams of these firms cashed out large amounts of performance-based compensation during the 2000-2008 period. During this period, they were able to cash out large amounts of bonus compensation that was not clawed back when the firms collapsed, as well as to pocket large amounts from selling shares. Overall, we estimate that the top executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1 billion respectively from cash bonuses and equity sales during 2000-2008. These cash flows substantially exceeded the value of the executives’ initial holdings in the beginning of the period, and the executives’ net payoffs for the period were thus decidedly positive. The divergence between how the top executives and their shareholders fared implies that it is not possible to rule out, as standard narratives suggest, that the executives’ pay arrangements provided them with excessive risk-taking incentives. We discuss the implications of our analysis for understanding the possible role that pay arrangements have played in the run-up to the financial crisis and how they should be reformed going forward.

Executive Compensation At Bear Stearns And Lehman 2000-2008 – Introduction

In the aftermath of the financial crisis of 2008–2009, many believe that executive pay arrangements might have encouraged excessive risk-taking and that fixing those arrangements will be important in preventing similar excesses in the future. These beliefs have led firms and public officials to seek compensation reforms that would eliminate excessive incentives to take risks. For those companies receiving government aid, the Troubled Asset Relief Program (TARP) bill, subsequent U.S. legislation, and regulations implementing such legislation require the elimination of compensation structures that provide excessive risk-taking incentives. Furthermore, legislators and regulators have moved toward regulating compensation structures in all financial firms to eliminate such incentives. The U.S. House of Representatives voted in favor of a bill (now to be taken up by the Senate) authorizing such regulations, and the Federal Reserve Board requested comments on a proposed guidance contemplating scrutiny of pay arrangements by banking supervisors. The importance of such reforms was stressed by the G-20 leaders, who made a commitment in their September 2009 meeting “to act together to . . . implement strong international compensation standards aimed at ending practices that lead to excessive risk-taking . . . .”

At the same time, some commentators take opposing views: They dismiss the possibility that incentives generated by pay arrangements played a significant role in the risk-taking decisions financial firms made in the years preceding the financial crisis; and they have dismissed as well the potential payoffs from reforming such pay arrangements. These commentators stress that financial firms’ executives suffered significant losses when the stock prices of their firms fell sharply. In these commentators’ view, these losses imply that, to the extent executives took excessive risks, such risk-taking resulted fully from mistakes—excessive optimism, failure to perceive risks, or even hubris—rather than from incentives. The losses suffered by financial executives during the crisis, so the argument goes, indicate that “incentives cannot be blamed for the credit crisis or for the performance of banks. . .” and that executives “managed their banks in a manner they authentically believed would benefit their shareholders.” Commentators dismissing the role of incentives and the potential value of fixing them have made substantial use of the examples of Bear Stearns and Lehman Brothers. Bear Stearns sold itself in a fire-sale to JPMorgan in March 2008, and half a year later Lehman Brothers (“Lehman”) filed for bankruptcy, triggering a worldwide panic. According to the standard narrative of these financial disasters, the wealth of the two companies’ top executives was largely wiped out with their firms. This narrative has led observers to infer that risk-taking decisions made by the firms’ top executives (ultimately leading to the firms’ demise) must have been due to failure to perceive risks.

This paper presents an analysis of executive compensation at Bear Stearns and Lehman during the period 2000-2008. Using data from SEC filings, we find that the standard narrative’s assumed fact is incorrect. During the examined period, the companies’ top executives were able to pocket large amounts of performance-based compensation. Overall, we estimate that the top executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1 billion respectively from cash bonuses and equity sales during 2000-2008. These cash flows substantially exceeded the value of the executives’ initial holdings at the beginning of the period. As a result, the bottom-line payoffs of these executives during 2000-2008 were not negative but decidedly positive. Our analysis has implications for the continuing debates on whether financial executives had incentives to take excessive risks and whether pay arrangements need to be restructured.

Bear Stearns

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