Guaranteed Bonuses Are Safe From Regulation?

In its quest to satisfy critics of Wall Street's bonus culture, the Securities and Exchange Commission is working on developing new rules on compensation structure for financial firms. It hopes to prevent employees from taking excessive risk in the long-term for big short-term profits that translate into large annual bonuses. One of the practices often criticized was the use of "guaranteed bonuses" to lure employees from one financial firm to another. It turns out that the SEC might not crack down on this practice. Should that worry us?

First, what is a guaranteed bonus? It's exactly what it sounds like: a promise to pay an employee some amount of money in future years. For example, if you're starting at a new investment bank, coming from a different financial firm, the bank could promise to pay you a bonus of $100,000 next year, and $200,000 the year that follows. That way, you have some certainty regarding future compensation, which provides stronger support for your decision to move to the new firm.

On one hand, guaranteed bonuses don't necessarily lead to risk taking. If your pay is already determined, you won't feel much need to take extra risk to increase profits: even if you make more money this year, it won't be reflected by a higher bonus anyway.

On the other hand, we saw how unsavory guaranteed bonuses can be with the bailout of AIG. Despite the company's deep losses, some employees still got lavish pay after the government stepped in, because their bonuses were already contractually promised.

It looks like the SEC is considering these bonuses more in terms of the former philosophy than with the latter worry in mind. Mark Schoeff Jr. at InvestmentNews reports:

The Securities and Exchange Commission's proposed rule change likely will be limited to pay practices intended to boost performance and won't veer off into incentives intended to influence hiring, according to an SEC official who spoke on the condition of anonymity.

"The rules are meant to get at incentives that could create inappropriate risks, and since the upfront bonus -- assuming it's unconditional and can't be clawed back based on performance measures -- doesn't create risks for future conduct, it wouldn't be covered," the SEC official wrote in an e-mail.

Should this bother us? It depends in large part on whether or not financial firms get bailed out again in future years. As just mentioned, guaranteed bonuses really only do harm when taxpayers bail out a firm and get stuck paying them. In other situations, a firm can be responsible for its choices.

In those other cases, guaranteed bonuses are just a problem for a firm to work through. For example, shareholders might be angry if certain executives receive big guaranteed bonuses in years when a firm posts a loss. Then, they must voice that concern to management by questioning its pay practices. The economy, however, is not harmed in any way by guaranteed bonuses. They do not have a role in inducing more aggressive risk taking; indeed, they likely do the opposite since profits won't affect compensation in such cases.

But let's come back for a moment to the bailout question -- because that's something that might concern regulators. If there's a fear of an AIG-like situation arising again, surely regulators do not want taxpayers to have to pay big bonuses after a rescue. Perhaps, however, the SEC assumes that the new financial regulation bill will actually work to end bailouts. The new non-bank resolution authority was designed to ensure that all firms can fail. And if a firm fails, then these guaranteed bonuses would be sorted out by a bankruptcy judge, and would amount to a general unsecured claim.

So whether or not regulators should be concerned with these bonuses depends on if bailouts are truly in the past. If they really are, then firms can feel free to provide guaranteed bonuses as long as their shareholders acquiesce. But if bailouts do occur again, then guaranteed bonuses would continue to pose the same problem that we saw in the past.