Wall Street’s backwards rewards system gives executives a direct incentive to commit crimes

Published September 27, 2016 by lagmen
A CEO unscathed.The public scourging that the US senate banking committee gave Wells Fargo CEO John Stumpf on Sept. 20 was cathartic to watch. Senator Elizabeth Warren particularly summed it up when she said, “You should resign. You should give back the money you took while this scam was going on and you should be criminally investigated by both the Department of Justice and the Securities and Exchange Commission.”

Early in the hearing Strump sort of took responsibility for the massive fraud perpetrated by Wells Fargo, but he ultimately blamed it on his employees, who he said “did not do the right thing.”

Hopefully, this hearing will reignite our conversation about using jail time to hold Wall Street executives accountable when they cause deep, structural harm to the American public’s financial well-being. But we also need to have a conversation about the inherent economic risks involved in public corporations’ executive pay practices.

We so often talk about skyrocketing CEO and executive pay in terms of fairness and morality—and the fact that CEOs are paid 276 times what the typical worker earns is, on its own, a justice issue. But we also need to be talking about the way executive pay—which is heavy on equity and particularly stock options—puts our own personal wealth and economic stability at risk.

I have written extensively on the economic costs of CEO pay, but the issue I want to highlight here is that executives who receive equity-heavy pay (also called “performance pay”) have a greater tendency to behave fraudulently. In other words, it induces them to commit crimes.

One notable study examined the relationship between the likelihood of securities fraud allegations—such as misreporting financial results—and the “option intensity” of the CEO’s compensation. The authors find that CEOs of “fraud firms” have greater option-based compensation, indicating that the greater the incentive for CEOs to maximize the company’s stock price, the greater the incentive the CEO has to engage in fraudulent activities to accomplish this goal. (The authors also tested whether the option intensity prompted the fraud allegations, but their results held.)

Some of you might remember the backdating scandal in the mid-2000s. Many companies found a way to eliminate any risk of losses for their executives by simply changing the date when stock options were granted, typically to an earlier date when the stock price was lower, to make them more valuable. Backdating itself is not illegal if it is authorized by the board, fully disclosed, and complies with reporting and tax rules. Secret backdating, however, is illegal, and indicates that corporations are underreporting their taxable income to the IRS.

Eric Lie’s research was the first to show evidence that abnormal stock returns (negative before option grants and positive afterward) were due to backdating of option grant dates. This was hugely influential to SEC investigations in the late 2000s. According to Lucien Bebchuk and colleagues, about 12 percent of firms—or 2,000 in total—backdated CEO stocks from the mid-1990s to mid-2000s, in turn boosting executive compensation by 20%.

Understanding the role that equity-heavy pay can play in executive behavior puts the Wells Fargo scandal in a different light. They created and perpetuated a system and corporate culture of fake performance at the customers’ expense. Stumpf called Carrie Tolstedt, the former head of the retail banking business where this fraud took place, a “standard bearer” of Wells Fargo culture. Yet instead of being held accountable, or at the very least by clawing back her pay, Wells Fargo allowed Tolstedt to retire with almost $125 million in mostly stock and options.

We absolutely need to be talking using criminal charges and more enforceable pay clawbacks to hold executives accountable. Wells Fargo charged customers undue fees that ruined credit ratings. (Imagine the effects this has had on people trying to secure a mortgage or buy a car.) But we also need to address the inherent problems of equity pay, and the costs these executive pay practices impose on the American public.

For more on policy solutions to the performance pay issue, see Understanding the CEO Pay Debate: A Primer on America’s Ongoing C-Suite Conversation and Executive Excess 2016: The Wall Street CEO Bonus Loophole.

Follow Susan on Twitter at @SusanRHolberg. An unedited version of this post originally appeared at Roosevelt Forward. We welcome your comments at ideas@qz.com.

 

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