The eye-popping numbers involved with annual bonus payments in the securities industry each year leave even hardened veterans agog. But gone, at least for this year and a few more to come, will be much of the usual gut-wrenching suspense and pathos at bonus time. Pleasant surprises, in the world of compensation management, are a waste. The key challenge for financial firms most of the time is to meet the expectations of their people, and to pay no more.
“The only time I’ve ever seen a grown man cry,” says one amused consultant, “was when an investment banker received a $3 million dollar bonus.” They weren’t tears of joy. The banker, it seems, had been expecting $5 million for the year on top of his salary. And Wall Streeters like him don’t forget their disappointments. They have a nasty habit of walking out.
“Bonuses are misunderstood,” says Alan M. Johnson, another New York-based compensation adviser who heads the firm that bears his name. “They seem so straightforward, but there’s a general lack of clarity about what they are.”
Those uninitiated in the ways of Wall Street can be forgiven for concluding that these payments are a type of profit-share, handy for controlling the bottom line. It also seems obvious that bonuses should represent a way to encourage bankers and traders to go the extra mile. The cynical, meanwhile, just dismiss them as the high-end version of a tip one might give to a barber or a bellhop.
European and Japanese banks, of course, have had a difficult time relating to the concept. Yet, relate they must, if they want to be players in US markets or simply to hire American bankers to work for them elsewhere. The results of this annual ritual, sometimes humorous and sometimes cruel, have been setting off a rising number of disputes, according to attorneys who specialize in the area. In extreme cases, they even have triggered the demise of some of Wall Street’s most venerable firms.
Lawsuits have become routine. “The proportion of people who litigate against their employer,” says Jeffery Liddle, a New York attorney who represents Wall Street executives, “is about five times greater than in the rest of corporate America. That’s amazing in an industry where people are paid substantially more than the rest of the world.”
“In the securities industry,” continues Johnson, “a very large proportion of bonus pools – at least 60% and maybe 70% – is really deferred salary. The misperception that year-end bonuses are somehow optional causes more pain than you can possibly imagine.”
Or, is it annual leave? Deutsche Bank once hired a London banker on a two-year guaranteed bonus who told the bank that he had committed to a nine-month round the world yacht trip for charity. Deutsche paid him the full amount anyway.
Even apparent miscreants seem to qualify. Credit Suisse First Boston dismissed David Crisanti in March of last year following allegations that his trading group tried to manipulate the Swedish stock market. But a New York Stock Exchange arbitration panel in June awarded him $2 million of the $4.25 million bonus that the firm had promised him for 1998.
Johnson thinks that firms are going to pay at least 60% of peak-year bonus pools – maybe not to any individual, but certainly in aggregate to their operating groups – almost regardless. The notion that pay in the securities industry is now essentially variable and will rise and fall in line with a firm’s profitability is simply mistaken. “People don’t understand what they were promising at the front end,” he says. “They talk in terms of paying for performance without recognizing that they’re taking on very large fixed costs if they want to continue in the securities business. That is not obvious even to some analysts who cover the industry and nobody wants to talk about it.”
Steven Hall, a compensation adviser with Pearl Meyer Partners, puts it this way: “We talk about Wall Street being the last bastion of the wild west where you’re going to be paid money if you make money for the firm and you’ll walk away with nothing if you don’t. But let’s not kid ourselves, that’s nonsense.”
Perceptions are bound to catch up with reality and soon. “This is the first time Wall Street has thrown out guarantees so early in the year and down so far in the organization,” says John Rogan, managing director and head of the global banking and markets practice at Russell Reynolds Associates. “I would say that 70% of the industry already knows what they are going to be paid,” he says.
The war for talent had been confined to a very limited theatre, pitting firm against firm inside the financial community until this year. But then, the dot coms entered the picture, hiring away a bevy of star producers. And the reaction on Wall Street has been swift. Many firms, particularly in the equity markets, were flush with cash, already having exceeded their annual profit goals when the markets were going through the roof in March and April. So, they spent heavily and early this year to lock up their people. The counteroffensive, it seemed at the time, was well within their means.
Juicy guaranteed bonuses were only the beginning. Much of the bonus money is going straight into a brand new array of longer-term investment pools that vest after several years. These deals are essentially venture capital investments, which are at least cleverly structured to tie employees to the firm. The idea is to earn 25% to 30% every year. And they are leveraged on top of that. For every dollar employees contribute, they borrow another four. So, people could end up by leaving lots of money on the table, if they decide to jump ship. At least, that’s the plan.
Jazzed-up bonus plans may have been a necessity in the face of the dot com onslaught. But they certainly weren’t suYcient. “Firms can’t solve the human capital problems of retention, recruiting, motivation with the annual bonus process,” says Ira Kay, a consultant at compensation advisers WatsonWyatt Worldwide in New York. “They must have various deferred plans that create hooks into these high-paid employees that link them to the overall performance of the entity and have vesting.”
In broad stroke, how do the bonus plans work? Firms typically set aside between 15% and 25% of gross proWts to fund these year-end payments, says James Reda, a consultant with Arthur Andersen in Atlanta. Reda, a former Wall Street hand, is the author of Pay to Win. How Wrms distribute all that money is becoming more and more discretionary. Firms seem to be moving away from a rigid, easily-understood formula.
And the bigwigs usually try not to let much trickle down. “Managing directors might collect six to 12 times the bonuses that they pay people at the associate level,” he continues. And the more people make, the more they are expected to take in equity instead of cash. Industry sources say that Reda’s numbers are representative, but actual outcomes vary across a much wider range.
There’s a multitude of pitfalls to confront those venturing into this area. Firms often run into problems by not deWning bonus programmes to Wt their business needs. “Sometimes it’s just lack of foresight,” says Laurence Cagney, a partner with the law Wrm of Debevoise&Plimpton in New York, “sometimes it’s carelessness.” Cagney thinks that it’s OK if a funding formula produces meagre payouts when performance is bad and lots of money when times are good. “But you don’t want to get to the point where they produce more money than they should when performance isn’t that great,” he continues, “and not enough money when Wrms do extremely well.” That type of problem comes up because Wrms target sales at a particular level and then end up in a diVerent ballpark.
But choosing the right benchmark can be tricky, particularly when Wrms are converting to generally accepted accounting principles for the US. A case from beyond Wall Street that experts on securities industry pay have taken note of is that of Martin Sorrell, chairman and CEO of the WPP Group (the advertising agency). Sorrell’s bonus was based on the growth of earnings per share. But conversion to US GAAP sent a positive eps result into negative territory for the base year. That created a vexing maths problem when eps climbed out of the cellar a little bit later. Was growth of the key indicator linear, inWnite or what? WPP apparently had quite a rough time untangling that one.
Arthur Andersen’s Reda is a leading exponent of relying on cash-based measures, not accrued proWts. Pegging bonuses to accounting benchmarks of unrealized gains can make it easier for employees to collect big bucks as a result of cooking the books. And markets, of course, can shift violently. Barings went down the tube after Nick Leeson began committing fraud in Singapore to pump up his annual bonus take. Leeson went rogue in 1993, and the problem grew larger and larger until his chicanery brought down the bank three years later. Leeson had been collecting, in the Barings system, based on trades that weren’t closing.
Kidder Peabody ran into a similar problem with Joseph Jett, in New York. “One of the classic gaVes,” says Reda, “is to base the bonus on an unrealized amount or an appraisal, especially in the bond market where it’s tough to price the assets. I try to steer clear of plans that pay on something that’s not monetized.”
Yet, much of the industry has continued with accrual-based systems. Many Wrms don’t want to encourage their traders to close out proWtable positions just before bonus calculations, when it may be in the Wrm’s best interest to ride a winning trade longer. So, they hold back a lot of the money just in case they don’t realize the proWt. But Reda thinks that degree of caution leaves the door open to a lot of trouble. “Cash doesn’t lie,” he says. “You really need to be careful about how you create these bonus pools. Firms should just Wgure out what part is for traders and what part is for the company and call it a day.”
For his part, Johnson points out that Wrms, over and over again, agree to a bonus formula without taking into account capital or risk. “The message there is for traders to use as much capital or take as much risk as possible,” he says, “because those people will get, say, 20% of the upside and none of the downside.”
Foreign Wrms taking on the tough challenge of breaking into the US market have been particularly prone to run into trouble in this area. And their situation is especially precarious now that multi-year guarantees have become so widespread. They see many thriving businesses on Wall Street and want to get into them. Unfortunately, there’s a catch. Newcomers need to hire away top producers from American Wrms. But those same people aren’t likely to be nearly as eVective in a new setting. So costs can easily outweigh beneWts.
Such pressures have led to some amazing missteps. One of the most common gaVes is ignoring the realities of American law, however unbelievable and strange they may seem from a distance. ING, for example, Wred its entire New York-based Latin American equity group of 143 people on February 9 1997, one day before bonuses were due to be paid. They also selectively Wred about 20% of the remaining people in New York.
But then came a most amazing Xip-Xop. Fernando Gentile, head of ING’s North American operations, testiWed in an arbitration at the New York Stock Exchange that he went to a board meeting in Amsterdam Wve days later. The chairman of ING’s board said that he felt very badly about what had happened and he realized that it was probably wrong. So, the word went out to rehire the people. Jilted staVers, of course, then were in the driver’s seat. And that was about to cost ING plenty. Those who decided to return were able to recover 100% of the previous bonus and negotiated a two-year no-cut contract.
And there’s more. ING then hired Mizrahi from Chase to run global investment banking. Mizrahi, no fool, quickly determined that those people were going to pick ING’s pockets. So, the company Wred the ones that they rehired yet again. JeVrey Liddle settled 24 of these cases. They got the 1997 bonus, plus attorneys’ fees. ING, it seems, unwittingly had created a no-win situation for itself.
Sometimes these same problems plague American Wrms, but that’s far less common. The presence of a foreign parent, however, can lead to more turmoil, even if the Wrm is generally considered to be American. Credit Suisse First Boston Wts into this category. The Wrm and its Swiss parent spent many years learning how to avoid blundering when it called the shots from Zurich. It was notorious for mismanaging bonuses and bonus expectations. “Credit Suisse did some unbelievably weird things,” says Liddle. Management in Zurich, for example, decided at the end of the 1980s to place a limit on the number of managing directors at CSFB. The limit – at 89 – was low enough to force some of the previous managing directors to give up their titles.
Aiming to contend with the morale problems that followed, Credit Suisse delivered a contract on December 26 1989 to all managing directors and to anyone else in line to receive a bonus of more than $200,000 that year. The contracts were due three days later. The key provision required that these people return 60% of their bonus payments to CSFB, if they left the Wrm during the next several years. The company told its people that it would not pay a bonus to anyone who refused to sign the contract.
Several managing directors simply quit. But it turned out that Credit Suisse was completely out of step with American law. “The reality was that people were entitled to the bonus,” says Liddle, “that they had earned for that year in accordance with the plan that had been in eVect. The plan was based on their individual performance as well as their department’s performance, and not on whether they subsequently stayed with the Wrm.”
Another hornet’s nest: America’s age, race and sex anti-discrimination laws. Such laws are not so prominent in Europe and Japan. “Firms from those parts of the world are happy doing it [discriminating],” says Liddle. But the consequences can be dire and far-reaching. It’s not diYcult for an employee seeking bonus money lost for any reason to bring an arbitration against a Wrm, because they’re registered with the stock exchange. These procedures typically last several days and bring out the background about why the person didn’t get more than he or she did. The lost business opportunities resulting from tying up the Wrm’s senior executives can far outweigh legal fees or even the amount in dispute.
If discrimination were a factor, it may involve a pattern of behaviour that triggers an investigation by the Equal Opportunity Employment Commission, a US government agency. And the commission might scrutinize many of the Wrm’s other business practices, as part of such an investigation. The EEOC might uncover a practice of giving women low-proWt accounts, for example, inXicting lower income levels on them. “I often see this allegation in my practice,” says Jay Waks, an attorney who represents employers and who chairs the labour and employment practice at the law Wrm of Kaye, Scholer, Fierman, Hays&Handler in New York. “Disgruntled employees sometimes have been able to extract settlements considerably higher than the amount of a lost bonus when there’s an allegation of age or sex discrimination.”
Management of human capital on Wall Street, unlike in most other industries, is a central part of line management’s role and job description. That gives the business line managers inordinate power relative to staV organizations like human resources. “Many bonus-related problems can only happen because line managers make what are eVectively unilateral decisions that go against policy when it’s hard for human resources to challenge those decisions,” argues Kay.
When this power goes to the extreme, line managers have a back door to the payroll. So, frequently, they can get cheques cut that don’t show up in any bonus run. Kay witnessed a situation where, as a result, an employee inadvertently received two bonus checks for $1.5 million each. “So, there can be no back door,” Kay urges.
Alan Sklover, a New York attorney who represents Wall Street executives, thinks that management of expectations is the biggest issue confronting Wrms in this area. “The elevation of perception to obligation and commitment to pay a bonus as a result of loose talk,” says Sklover, “can be extremely corrosive, if the employer doesn’t follow through.” Sklover urges his executive clients to take the initiative with employers and review their performance relative to bonus targets at regular intervals. That avoids unpleasant surprises. And in both a practical and legal sense it can create real obligations, at least under US law.
Sklover thinks that employers are well served by working within that type of framework, as opposed to trying to maintain complete discretionary control. “I think that the purely discretionary programmes, in which you can get $1 or $1 million and it’s totally up to the boss, really breed distrust and problems,” he says. “I’m a much bigger believer in formula-based programmes or, at the very minimum, establishing some parameters for the payout.”
Indeed, basic deWnitions can represent huge stumbling blocks. “When I have a bonus case and the plan has that ugly word ‘discretion’ in there,” says Liddle, “I always try to set the record straight immediately as to what that means.” Many line managers making bonus decisions think that the word “discretion” means that they can do whatever they want. Yet, that is not at all what discretion means in these situations.
“The actual deWnition is ‘a reasoned judgment within certain legal bounds’,” says Liddle. Large diVerences between employees at the same level and with comparable performance can’t meet this standard. “A lack of understanding of what their own plan terms mean is another very big problem,” he points out.
What are the options for cleaning up a mess when something goes wrong? Reda thinks that Wrms have enormous Xexibility, under the Internal Revenue Service Code Section 162(m), unless the dispute involves one of the Wrm’s top Wve executive oYcers. For his part, Johnson urges Wrms to fund their plans, if they haven’t adequately done so and there’s still time. “If you’ve agreed to a formula that you can’t live with,” he advises, “go to the heads of the units and say you need to change them. Deal with it as directly as you can.”
But chances are people won’t be happy to accept such a cut just because the Wrm hasn’t made enough money. If a Wrm must spend more than it has in its budget, Johnson points out that it’s usually better to make up any diVerence by oVering stock, a note or some sort of contingent promise in lieu of cash.
Sklover reports that most Wrms are open to reconsidering bonus decisions, but they aren’t willing to establish a formal channel for appeals. That would invite more disputes, or so the argument goes.
The overwhelming view is that the history of guarantees has been less than successful. “I haven’t seen many companies come in and build eVective teams with guarantees,” warns Hall. “They’re almost like cocaine, hard to stop once you start.”
Executives typically try to negotiate their next guarantee, after the Wrst year of a two-year guarantee, often threatening to leave if the Wrm won’t cut a deal. “I don’t know how you break that cycle, short of Deutsche Bank acquiring Bankers Trust,” says Hall. “The kooky thing is that everybody feels under pressure to go along with it once somebody starts doing it.”
