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Executive Compensation

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  • Category: Finance

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1. Introduction
Executive Compensation is a composite phenomenon. It is an aspect of executive hiring that includes salary, cash, bonuses, stock option, pension contributes and other components that create the earnings of a top executive (Finkelstein & Hambrick, 1989). This paper focuses on providing an analysis of arguments in a debate whether the executive compensations the main performance drive and the reason for the financial crisis 2007-2009 because over the past three decades, the level of the executive compensations raised excessively. (Frydman & Jenter, 2010). “From the mid‐1970s, compensation levels grow dramatically, differences in pay across managers and firms widen, and equity incentives tie managers’ wealth closer to firm performance” (Frydman & Jenter, 2010).

Especially after the financial crisis of 2007-2009 many had the opinion that this type of payment to the executives “might have encouraged excessive risk-taking” (Bebchuk, Cohen, & Spamann, 2010). Firstly, this paper will demonstrate how executive compensations at Lehman Brothers lead to the bankruptcy of the bank during the financial crisis. Secondly, this paper will explore how Apple uses executive compensation to insure that executives focus on long term profitability of the company. Finally, there is an explanation how the two examples fit in into the empirical research cycle. 2. Executive compensation at Lehman Brothers

A well-known example where executive compensation came under scrutiny from the broad public and authorities is the failure of Lehman Brothers during the financial crisis of 2008. The compensation showed increased over the consecutive years as deregulation in the United States enabled banks to take more risk. Following 9/11 the interest rate from the Federal Reserve Bank (FED) had decreased to only 1%, which also made banks more eager to loan money to people who beforehand were unable to do so.

Banks were allotted more freedom by the FED under the leadership of Alan Greenspan, a firm believer in the self-regulation of free markets. In 2005, Greenspan went on the record claiming that the private sector had done a better job than regulation would have ever done. He withdrew this opinion after the crisis in 2008 and called upon his successor Ben Bernanke to regulate the market (Lanman & Matthews, 2008). This firm believes of Greenspan turned out to be incorrect and the US government eventually had to intervene as banks had been taking too great risks. Even credit rating agencies such as Moody’s and S&P rated these types of mortgages as AAA, meaning the safest possible investment (Van Voris & Hurtado, 2012). Lehman Brothers went bankrupt during the financial crisis in September 2008, after many sub-prime mortgages became worthless, because people couldn’t afford them.

They would never pay back what was loaned to them, leading to foreclosures. Between 2003 and 2008 the bank awarded over $700 million in executive compensation to its top 50 executives (Hamilton, Tangel & Pfeifer, 2012). This ever increasing compensation caused executives to focus on short-term goals rather than the long-term goals that were in the interest of the company. The vicious circle that Lehman Brothers kept paying higher compensation was the desire to achieve higher profits in the short-run. The higher compensation would make the executives more motivated and would also keep talent within the company. The belief within the bank was that these high pay-outs would enable the bank to make more profit. The bank’s desire to keep talent would take compensation to levels to unprecedented level, with the highest individual compensation being over $50 million in 2007. The question is whether this vicious circle is within the interest of the company. In hindsight, it can be said that the ever rising compensation would only interest executives in profit in the short run, and not as to in what shape they would leave the company behind. The ever higher compensation would also convince the executives that they were doing the right thing, with shareholders satisfied and ever rising profit.

The philosophy fits within the traditional model of science, where Lehman believed that the higher compensation leads to higher profit (X causes Y). Initial observations between 2003 until the first problems started to emerge in August 2007 when the first two Bear Stearns hedge funds folded (Investopedia, 2009). The company however still achieved $885 million in profits between June and August 2007 (BBC News, 2007). Lehman Brothers became victim to its own executive compensation scheme. The executives were encouraged to achieve high profits in the short run and were rewarded for this without keeping in the mind that the risks would endanger the company in the future. Lehman Brothers could have prevented this by awarding bonuses in a way that would encourage employees to think about the long term future. This can be seen in our next example, Apple. 3. Executive compensation at Apple

Executive compensation can vary considerably between different companies. A vastly different example compared to Lehman Brothers is Apple. Apple is one of the largest companies in the world with over $100 billion of revenue and 28.3 billion in profit in 2011 (Golson, 2011). In the late 90s, Apple was almost bankrupt when Steve Jobs returned to Apple after he was earlier fired. From there, the company saw rising revenue and profit. Steve Jobs was well known for his $1 dollar salary (he took additional compensation in bonuses and stocks, but didn’t take any after 2003). While there’s an obvious difference between founders and appointed CEO’s in terms of their relationship with the companies, even after Steve Jobs death Apple tends to have lower than average salaries for its executive team. The basic salaries of Apple executives tend to be lower than their counterparts at other firms. Tim Cook earned $4.2 million (all compensation included) in 2012 while Meg Whitman (CEO of HP) earned $17 million. Besides the compensation Apple tends to give rewards that require the executive to stay for a longer period time.

One example of this is the compensation that was awarded to Tim Cook. In 2011, he was given a one-time $376 million stock grant which in order for him to collect it would require him to stay with Apple for at least 10 years. This type of compensation is fundamentally different from as seen with Lehman Brothers. The 10 year term requires Tim Cook to focus on the long-run objectives of the company rather than focusing on the short-run profit. In that sense, Tim Cook’s reward is directly tied to the performance of the company over the long term. In contrary to first example Apple had a different strategy to prize his executives. The method ties the rewards of executives and company performance for a longer period of time. However, Apples strategy proved to be better in keeping talents for longer time and for well of the business. 4. The empirical cycle

The empirical cycle of research is the cycle of Observation, Induction, Deduction, Testing and Evaluation which can be used to draw conclusions from observations. The examples of Lehman Brothers and Apple fit within the empirical cycle of research. We observe the bankruptcy of Lehman Brothers and find that executive compensation soared in the last years prior to the outbreak of the financial crisis. From there conclude through inductive reasoning that excess executive pay leads to poorer performance and possibly even bankruptcy. From this general statement, we look through deductive reasoning to apply the general theory to a specific company (Apple’s bonuses lead to poorer performance of the firm). This is a refutable hypothesis and can easily be proven false by comparing the numbers, which show an increase in profits for Apple. In Apple’s case large stock grants (Tim Cook’s $376 million) do not lead to taking too much risk. Through testing the hypothesis we conclude that our hypothesis is not correct and that we’ll need to evaluate our hypothesis to come up with a new hypothesis that better suits the reality of the variety of firms and the variety of corporate cultures.

The nature of the compensation could help us in refining the hypothesis we previously made. In Apple’s examples the largest part of the bonus can only be collected in 10 years, while in the case of Lehman Brothers compensation was mostly immediately or within the short term. We could refine the hypothesis as “Long term executive compensation leads to better performance of the firm)”. Through inductive reasoning we then can classify what would be considered ‘long term’ and ‘short term’ given that these are rather vague principles that cannot be tested properly. By continuously using the empirical cycle of research we can improve hypotheses and in the end come up with better results in our research. This is not just done by academics. Companies like Apple try to learn from mistakes made by other firms. This can also be seen as an empirical cycle where Apple observes the behaviour of other firms and uses this information (such as the excessive executive compensation in the case of Lehman Brothers) to improve their own executive compensation to make sure that the problems that they faced won’t occur at Apple. 5. Conclusion

High executive compensations are not the only reason for the financial crisis 2007-2009. The very low FED interest rate and insufficient creditworthiness check allowed people to borrow more than they could afford. Nevertheless, this high risk loans plus the way to high compensations are the main causes of the mortgage crisis. The Lehman Brothers downfall showed that constantly increasing compensation does not improve the CEOs performance in the long-term. In this case the CEOs ambition is to show better performance in the short run, at the expense of long-run essential value. Unfortunately, this led to extremely high loses for particular firm. On the contrary the way Apple tends to give bonuses requires the chief executives not only to perform in a high level but also to stay longer at the company.

6. References

BBC News. Profit falls at Lehman Brothers. (18. September 2007). Retrieved on 21. January 2013 from BBC: http://news.bbc.co.uk/2/hi/business/7000802.stm Bebchuk, L., Cohen, A., & Spamann, H. (2010). The wages of failure: executive compensation at Bear Stearns and Lehman 2000-2008. Working paper. Finkelstein, S., & Hambrick, D. (1989). Chief Executive Compensation: A Study of the Intersection of Markets and Political Processes. Strategic Management Journal, 121-134. Frydman, C., & Jenter, D. (2010). CEO Compensation. Annual Review of Financial Economics, 2(1), 75-102. Golson, J. (18. October 2011). Apple Records Q4 2011 Earnings of $6.6B on $28.3B in Revenue, Tops $100 Billion in Sales for Fiscal 2011. Retrieved on21. January 2013 from 8

http://www.macrumors.com/2011/10/18/apple-records-q4-2011-earnings-of-6-6b-on-28-3b-in-revenue-tops-100-billion-in-sales-for-fiscal-2011/ Hamilton, W., Tangel, A & Pfeifer, S. (23 April 2012) Lehman Bros. elite stood to get $700 million. Retrieved on 21. January 2013 from http://articles.latimes.com/2012/apr/27/business/la-fi-compensation-20120427 Investopedia, S. (2. April 2009). Case Study: The Collapse of Lehman Brothers. Retrieved on 21. January 2013 from http://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp#axzz2IcOOyEBL Lanman, S., & Matthews, S. (23. October 2008). Greenspan Urges Tighter Regulation After `Breakdown’ (Update1). Retrieved on 21.

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