Published 08/09/11

TARP: The Value of Having Some Skin in the Game

August 2011

The great recession of 2008 and the related crash of financial stocks compelled the United States government to orchestrate a rescue of most top financial firms. In part to help prevent a recurrence and in part to satisfy public outcry about excessive top executive pay at those firms,  Kenneth R. Feinberg, the government’s newly appointed special master for executive compensation, went looking for ways to slash executives’ pay at Citigroup, Bank of America, Wells Fargo, JP Morgan Chase, Morgan Stanley, and AIG.

The cuts to compensation imposed in the Troubled Asset Relief Program, or TARP, were a source of a satisfaction to investors hard hit by the economic downturn and outraged by what they viewed as extremely high compensation.           

But Kwadwo N. Asare, Ph.D., a Bryant assistant professor of accounting with a keen interest in corporate governance, didn’t see the government crackdown as an occasion for Schadenfreude. He viewed it as a research opportunity.

“It was fascinating stuff,” says Asare of news reports about the talks. "I couldn’t wait to grab the paper." He turned Feinberg’s negotiations of executive compensation into a case study about what happens when a powerful CEO sits down to talk compensation with an equally powerful shareholder.

At the table with Uncle Sam

In this case, the shareholder wasn’t part of a diffuse group of investors easily outmaneuvered by a CEO who has the backing of board of directors. It was the U.S. government.

“When the government invested in these firms to save them, I thought it offered a rare opportunity,” Asare says. “Now you have a single shareholder who is under pressure to make sure that compensation is aligned with shareholder interests. And this shareholder happens to be the majority shareholder, and very powerful. So how will such a powerful shareholder, the U.S. government, bargain at a compensation table with CEOs? And how good a job will this powerful shareholder be able to do, where individual shareholders have failed?”

Linking pay with performance

Asare was intrigued by these questions because for decades people concerned about the disconnect between CEO performance and pay theorized that the only way to correct the situation would be to give shareholders greater power.

In 2006, for example, Warren Buffett lamented that ''too often, executive compensation in the U.S. is ridiculously out of line with performance.

“A mediocre-or-worse C.E.O. -- aided by his handpicked V.P. of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo -- all too often receives gobs of money from an ill-designed compensation arrangement,” Buffett wrote in his annual letter to Berkshire Hathaway shareholders.

Only big institutional investors such as pension funds have the clout and expertise needed, Buffet argued, to prevail against such CEOs feathering their nests.

So how did Feinberg do? Not badly, according to Asare, who outlined his findings in a joint Faculty Research and Engagement Day presentation with Assistant Professor of Management Eileen Kwesiga, Ph.D.

Aligning interests

During the brief period that the troubled companies were in the TARP program, Feinberg got them not only to slash salaries but also to change the way they compensated executives, moving the companies away from fixed salaries and bonuses and into stocks and stock options.

“What he did was he made the stocks and options, probably around 90 percent, a big chunk of the total pay,” Asare says.

The result, he says, was to subject the executives to risk and thus better align their interests with the interests of shareholders. If the company did well, both the shareholders and the executives would make money. If it performed poorly, both groups would lose.

It didn’t last. The TARP companies beat a path for the exit. Asare says, “In 2010, a lot of them didn’t like the effect the government had on their pay, so they rushed to pay the government back, even though the government was essentially lending them really cheap money.”

Stock prices are back up, and so is executive compensation at the TARP firms. “Is this necessarily wrong, that the CEOs are now going to be making so much more money after they caused this distress to the whole economy?” Asare asks.  “It’s a rhetorical question. And, I think the answer is it’s not necessarily bad. It’s O.K. if they make money, if they have real skin in the game.”