Peter DeMarzo: Some Corporate Crises Require Big Executive Bonuses

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Peter DeMarzo: Some Corporate Crises Require Big Executive Bonuses

Big bonuses tempt executives to gamble with company money, but they may make sense for a company in crisis.
A football player throwing a Hail Mary pass.
Executive bonuses can drastically increase the temptation to try a Hail Mary pass. | USA TODAY Sports photo by Andrew Weber

In a results-driven world, corporate executives often live and die by the sword. They earn huge bonuses when profits are climbing, and they can lose their jobs quickly if results turn sour. But when a company plunges into a true crisis, new research suggests that offering executives the right kind of bonuses, and even some forgiveness for bad results, can be the key to company survival.

Those two ideas may come as jolt. Critics and business theorists have long argued that bonuses, especially those tied to short-term results, tempt executives to gamble with shareholder money.

As the housing bubble neared its disastrous peak, Wall Street executives pocketed huge bonuses by chasing the higher returns on increasingly toxic mortgage securities. When the bubble burst, banks like Citigroup and Merrill Lynch all but collapsed, yet the executives kept their payouts.

Balancing Motivational Risks

In a crisis, bonuses can drastically increase the temptation to try a Hail Mary pass. The executives know they’re likely to be fired if things don’t improve quickly. If they bet the company and lose, they’ll get fired anyway. If they bet the company and win, they’ll be treated as heroes and pocket their bonuses.

Those kinds of motivational risks pose a dilemma for shareholders. They don’t want desperate risk-taking, but they do want serious commitment and bold decisions.

A new research paper, coauthored by Peter DeMarzo at Stanford Graduate School of Business, offers suggestions on how corporate boards can use bonuses to balance those competing needs.

When a company gets into real trouble its future may depend on the expertise and herculean efforts of its existing executives. It may need the CEO’s loyalty and dedication. And that may require dangling bonuses that are two or three times bigger than normal — but only if the payouts are deferred until the company returns to unquestionable health.

DeMarzo acknowledges that this can sound unfair. If a CEO has just presided over a bad stretch, why offer forgiveness or even more rewards?

The reason, he says, is that the CEO may still be the company’s best chance of survival. And if that’s the case, shareholders need that executive to throw everything he or she has into restoring the company’s health.

DeMarzo, who teamed up with Dmitry Livdan and Alexei Tchistyi at the University of California’s Haas School of Business, describes what resembles a slow-motion poker game: shareholders and the board of directors on one side of the table, and hired managers on the other side.

The unspoken premise is that executive loyalty and good intentions come with a price. If the executives don’t have enough “upside” potential, they won’t work as hard to achieve big profits. And if the company falls into a crisis, executives may put top priority on saving themselves or looting the coffers.

The scholars’ recommendations are based on a branch of business research known as optimal-contract theory. Their models are abstract, but the logic is pretty straightforward.

The scholars agree that bonuses tempt managers to take risks at the expense of shareholders. In a crisis, however, shareholders need executives who have a stake in the company’s long-term success. A CEO who expects to be fired, or who won’t reap any reward for saving the company, is likely to keep his head down and just try to collect his paycheck.

Shareholders don’t want desperate risk-taking, but they do want serious commitment and bold decisions.
Peter DeMarzo

To keep executives from assuming they are about to be fired after a patch of bad performance, companies must “forgive and forget” some of the time. This selective forgiveness avoids putting the firm in the hands of the “walking dead”: Managers who assume they are about to be fired. It keeps them guessing, and gives them a reason to stay committed if a true crisis arrives.

Larger, Later Bonuses

Perhaps the most startling suggestion, however, is on how to treat top executives when a crisis does arrive. At that point, it may make sense to substantially increase performance incentives. That may seem perverse, since the executives in charge may be partly responsible for the problems. But they may still be the company’s best chance for recovery. The key is to offer long-term incentives, which only pay off if and when the company survives.

“During bad times, when things are going really poorly, you lose motivation and control over people if you punish them too severely,” DeMarzo says. By contrast, big incentives pegged to the company’s future health can spur the management team to put everything it has into a turn-around. “If things go well, the manager will get a huge bonus and have a big stake in the firm. He will care about the firm’s survival,” DeMarzo adds.

Big bonuses got a bad name after the financial crisis, especially since the biggest bonuses had been going to Wall Street executives who had a major role in the crisis itself. Many were outraged when American International Group awarded some $165 million in retention bonuses to executives just after the federal government had bailed it out.

DeMarzo says the size of the AIG bonuses may have been justified, but definitely not the timing of the payouts. The promised bonuses should have been deferred into the future and paid when and only if the company was fully restored to health. If a company offers very high-powered incentives, but with deferred payouts, it is effectively upping the stakes for its hired managers. The managers have big incentives to fix the problems, but they know the company can still fire them if they don’t turn things around quickly.

“It’s not to say you should never fire them,” DeMarzo says. “But if you’re not going to fire the manager, you should go with high-powered long-term incentives.”

Peter M. DeMarzo is Mizuho Financial Group Professor of Finance at Stanford Graduate School of Business.

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