Commentary by David F. Larcker, James Irvin Miller Professor of Accounting & Director, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.
A recent article in the Wall Street Journal highlights changes made to the long-term compensation contracts at AIG. AIG is in the unique situation of being close to bankruptcy and significantly owned by the U.S. government.
Under the program, executives will receive incentive compensation that is more heavily tied to the change in value of its subordinated debt than its stock price. In lieu of restricted stock, executives will instead receive long-term performance units (LTPU), 80 percent of the value of which is based on the change in value of the company’s 8.175% Series A-6 junior subordinated debentures and 20 percent of which is based on the company’s common stock. Interest coupons on the debt are converted into new LTPU shares. This structure is intended to align the interest of employees not only with shareholders, but also with U.S. taxpayers. According to the Wall Street Journal, the U.S. government holds $102 billion in senior debt and $49 billion in convertible preferred stock.
In designing efficient contracts, the board of directors aims to select performance measures that are correlated with management performance. In doing so, it tries to avoid measures that have a lot of “random volatility.” That is, the board wants the measure to be truly indicative of management performance, as opposed to reflecting lots of things that are not under the control of management. When there is too much volatility around the measure, you get capricious rewards—either way too much compensation or way too little, relative to what was merited. This is the common critique of stock option plans during the bull market of the 1990s—many executives got rich simply because the broader market went up, not because their decisions were making the firm relatively more valuable.
Boards tend to select share price as the best indication of long-term performance, although others are often included as well. This makes sense in the case of a liquid, solvent company that is trying to maximize shareholder value. (It is also consistent with the legal duty of the board to serve in the interest of shareholders). Share price is not perfect—it can be subject to changes in interest rates, economic conditions, and market whims that are outside the control of management—but it clearly aligns interests with those of investors.
When a company is close to bankruptcy, however, the value of the share price as a performance measure can begin to deteriorate. The stock becomes extremely risky. Changes in stock price may not be highly correlated with managerial performance. It would be natural for the board of directors to search for either supplemental or alternative performance measures for rewarding executives.
In the case of AIG, the price of debt instruments may become a more informative measure about whether management is adding value. This may explain the rather unusual choice of performance measures by the AIG board. An obvious alternative explanation is that there was implicit pressure from the government to focus direct managerial attention to paying back the TARP funds. In many respects, the government and other debtholders are really “AIG equityholders” because they are fundamentally the residual claimants if the value of AIG is below the face value of debt outstanding.
This raises some questions: holding aside the formal legal duties of the board to maximize shareholder value, when does it make sense to consider changes in the value of debt as a performance measure to evaluate managers? Is this only an issue for companies in dire financial straits? Might there be some reason to use debt to evaluate managerial performance in more healthy companies?
Sources:
-Serena Ng, “AIG Changes Pay Plan for its Stars,” The Wall Street Journal, June 24, 2010.
-AIG: Form 8-K, Filed May 28, 2010, with SEC