Asymmetrical Information - Megan McArdle

11.19.12

Big Losses, Bigger Paychecks

Why do managers of failing firms get paid so well?

Thoreau of Unqualified Offerings notes that as the firm headed into bankruptcy for the second time, Hostesss paid senior executives large amounts. Why does this happen?  More to the point, why is so much of the outrage focused on the union whose strike pushed the firm into liquidation, rather than executives who paid themselves big bonuses while driving the company into the ground?  

There are two answers to this.  The first is a matter of detail specific to the Hostess case: by the time the firm entered liquidation, the executives who had gotten the big paychecks were long gone.  The fellow who took over paid himself and his most senior henchmen a symbolic dollar for this year's salary (normal salaries were supposed to be paid next year, and I believe there was some deferred compensation that would have been paid if the firm had succeeded.)  So the reason that attention focused on the union was that in this particular case, it was the union who delivered the death blow--an opinion that seems to be held not just by outside observers, but by the members of other unions who had contracts with Hostess.  The executives were behaving exactly as the most devout left wing labor theorist would hope: they opened the books to the unions, paid senior management virtually nothing, and tried to cut deals that would save the company and salvage something of the grossly underfunded multi-employer pension plans of which they were a part.  You can argue that maybe the union was right to hold out, but if the Teamsters took the deal they were offered, I'm inclined to think that this was probably the best they could get.  

But that leaves the behavior of the former leadership.  And this highlights an important general question that has troubled bankruptcy law for years: how much should executives be paid at troubled firms?  

The knee jerk answer of most people is "minimum wage".  After all, these folks led the company into bankruptcy. Paying them as little as is legally possible seems to satisfy both our demands for justice--they should pay the price for making terrible decisions--and for good economic incentives.  Plus, if they were good managers, their company wouldn't be in bankruptcy, so it's not like we need to compete with other employers for their labor.  

This was approximately the logic behind the moves to restrict KERPs--otherwise known as Key Employee Retention Plans--in the 2005 bankruptcy reform.  Congress felt that they were being used as slush funds to allow senior management to loot the firm.  So they made it very hard to offer retention bonuses:  

In effect, as a threshold matter an insider must have in hand a better paid job offer, presumably with a financially sound company. If that is the case, why would the insider choose the uncertainty of staying with a Chapter 11 debtor that may or may not reorganize, for a stay bonus that is subject to a formulaic cap and is likely to be less valuable than incentives available to the executive prepetition. The company then has to demonstrate that the insider’s exit will cause the company to fail – that is, that the insider is irreplaceable. This is an impossible burden for any company that uses professional managers for which a relevant labor market exists. These provisions of the Bankruptcy Reform Act accomplish Section 503(c)(1)’s intended objective, effectively precluding any debtor from making retention benefits available to insiders in a Chapter 11 case.  

The passage highlights a bit of the problem with this approach: once they know that your company is headed for bankruptcy, employees are going to want to leave.  How do you prevent this?  By paying them to stay.  

Bah! you are probably saying to yourself.  Let them leave!  They clearly aren't very good at their jobs anyway!  

Perhaps not.  But you can't prove it simply by pointing to the firm's problems; bad management is neither a necessary nor a sufficient condition for corporate failure.  Even if it were, it would not therefore be true that all the managers are incompetent.  

And who is the most likely to leave you in your time of crisis?  The most competent ones--exactly the people you need if there is to be any hope of turning the crisis around.  In fact, turnaround experts will tell you that the brain drain typically begins long before the Chapter 11 filing.  But the minute you file, the conga line dancing up the street to your competitors really gets going.  

American bankruptcy courts place a much higher priority on keeping the firm going, rather than stripping out every last dollar for creditors.  I'd argue that this is the right focus: it preserves firm-specific human capital, jobs, and the economic fabric.  But keeping firms going means keeping employees there to operate them.   Which means paying them extra to stay at a firm that may well stop paying them at any moment.  You can think of a steady job as having a certain option value: workers have both today's wage, and a likelihood of tomorrow's wage.  When the firm enters bankruptcy the latter becomes very uncertain.  So you have to pay them more today, or lose them to some other firm that can offer greater security.

Again, you may be tempted to say, "Good riddance!"  But you have perhaps not considered the problem of who you will get to replace them.  Getting people to stay on a sinking ship may be challenging, but it is nothing compared to the task of getting them to leap off a safe vessel and onto your wildly pitching decks.  People who have worked for the firm have non-cash reasons to stay: they know the people and the routines.  People who don't work for the firm have all those reasons not to join you--unless they are so incompetent that no one else will hire them.  So keeping a tight lid on management pay during a turnaround makes it likely that you will lose your good people and have to replace them with someone else's bad people.  This is not a recipe for a good turnaround.  

And management does matter.  The chattering classes have an unspoken assumption that it can't be all that hard to just sit in meetings all day and issue BS mission statements, but if you fired the senior management of American Airlines and replaced them with the editorial board of the New York Times, the firm would be in liquidation pretty quickly.   For one thing, the skills that make a good manager, or even a mediocre manager, do not much overlap with the skills that make a good analyst--indeed, in some cases, they're actually opposed.  And for another, at least in the short term, a very smart person who has never run a ticketing operation is worse than a not-very-bright person with ten years experience.  

Incentive design principles that work very well when you're far from the edge of liquidation start to be counterproductive when you're actually tipping over it.  If you stick to your guns and say "no bonuses for the management screwups", you increase the chances that the firm will fail, leaving thousands of workers unemployed.  

Okay, you may say, but labor matters too. Why no retention bonuses for them?  In some cases they may be necessary. But usually when we're having this discussion, we're talking about union jobs, and the sad fact is that union workers rarely have a realistic alternative to staying with the firm, and hoping.  The very benefits of union jobs--seniority pay, generous pensions, above-market wages--greatly discourage labor mobility.  If they go to another firm, even a union firm, they'll lose their seniority and start at the bottom, and they will not realize the full value of their pension.  This is why it was such nonsense for the Obama administration to say that the bankruptcy court had to transfer money from creditors to union workers during the auto bailout in order to keep the plants running; any UAW worker who had a realistic alternative to their current job had long ago taken a buyout.  

And before you ask, no, you can't just do it in incentive pay, where they only get paid if the firm succeeds.  Most bankruptcy reorganizations fail, in part because firms usually wait too long to file, and in part because they're often driven there by unsolveable market problems, like "Making film for cameras isn't a good business anymore, and I'm not that great at anything else."  It is probably better for the economy, and certainly better for the workers, if we increase a company's chances of survival from 5% to 15%.  But 15% is still not high enough for many employees to be willing to bank on incentive pay.  A bump in base is often also needed.

All fine in theory, you will say, but what's to stop this from being used by irresponsible managements to loot the company before they abandon it to the liquidation vultures?  The answer is: nothing.  That's the problem with these arrangements, and why Congress wanted to curtail them.  Bad managements can and do "reward" themselves for subpar performance by granting themselves egregious salary and bonus packages on their way to bankruptcy court.  Judges have some power to curtail these, but unfortunately, judges, like the New York Times editorial board, are not actually in the business of running companies, so there's no way for them to reliably identify egregious pay packages, while leaving the necessary ones intact.  We're faced with an ugly tradeoff: give managers some room to loot, and also some incentive to save the firm, or restrict executive pay, and see an exodus of the very workers you most need.  I'm not sure what the right tradeoff is.  But I am sure that there's a tradeoff.