Executive Bonuses in Failing Companies

The ethical issues surrounding the AIG debacle would fill a thick book, not a short column, so I am going to focus here on one aspect of salient ethical interest: the bonuses paid to people not involved in the colossal losses.

A little background: AIG is (was?) one of the world’s largest insurance companies. In addition to normal insurance, they issued various kinds of “financial” insurance, including a kind of bankruptcy insurance known as credit default swaps. (Remind you of Enron? It should.) In September 2008 AIG’s credit rating was downgraded, requiring them to post collateral against hundreds of millions of dollars of these instruments. The amount owed also increased as default risk rose. The result was that AIG became insolvent. Because many financial institutions were owed money by AIG, the US government was afraid that letting AIG fail would lead to a financial collapse (the 21stcentury equivalent of an old-fashioned bank run). The result was that AIG was bailed out and effectively nationalized by the US government.

When a company goes bankrupt through the courts, there is a strict procedure for distributing its assets to creditors, including suppliers, employees, debt holders etc. But when it goes bankrupt through Congressional takeover the deal is negotiated, in this case by Senator Christopher Dodd. The deal stipulated that the company would be allowed to pay certain bonuses. However, when the public discovered that this meant that many individual in the same division that caused the blowup were getting millions of dollars in bonuses, immense public pressure was created to reduce the bonuses retroactively. Subsequently, Congress imposed a confiscatory tax of 90% on bonuses in companies receiving bail-out funds.

Many ethical claims have been made against this clawback of bonuses, above and beyond the practical claim that it may discourage talented employees who are now working for the American taxpayer. I will deal briefly with one piece of the puzzle: Jake De Santis, the former Executive Vice President of AIG’s Financial Products Division, wrote an emotional and indignant letter of resignation over the bonus debacle, which was published as on Op-Ed in the New York Times and afterwards widely distributed over the Internet. De Santis argues that his bonus is completely deserved.

I consider the letter a monument of misdirection. Let me present some examples:

De Santis writes, “Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid.” The one dollar was salary, but the letter reveals that De Santis’ compensation was over a million dollars. What a laudable sense of duty. He didn’t accept the salary of $1 because of a sense of duty, he accepted it because his real compensation was in the form of a bonus.

The more subtle misdirection is the following triumphant defense: “I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G.” The problem at AIG was not that they were involved in CDS’s particularly; the problem is that they were involved in extremely risky bets. Let us suppose that one division was involved in selling earthquake insurance; another tsunami insurance; a third volcano insurance, and so on. All divisions are racking up huge profits because these natural disasters are rare and because they are not using the premiums to create a fund as insurers are normally required to. One year a tsunami comes and the company goes under and can’t pay workers. The guy who sold earthquake insurance is now indignant: after all, he made money last year! Meanwhile, the guy who sold tsunami insurance is cursing his luck – ignoring the fact that if tsunamis never came, no one would ever buy insurance against them.

I can’t be sure that De Santis was personally involved in reckless investments, but since that is fundamentally what he is accused of, that is the charge he has to defend himself against. The defense just does not relate to the substance of the outrage. The only sentence that would have reassured me would be something like this: “I was in no way involved in – or responsible for – the high-risk unhedged financial transactions that have hamstrung AIG.”

Another problem is that De Santis was not just a low-level trader; he was an Executive Vice President of Financial Products, which according to news reports is the exact division that sold the CDSs. If you are an Executive Vice President, you can’t brush off responsibility for company-risking actions taken beyond your direct division. Given his status, he could only reassure me if he asserted that he actively worked to reduce exposure to CDSs.

De Santis also writes: “We have worked 12 long months under these contracts and now deserve to be paid as promised.” Well, AIG is now insolvent and cannot pay everyone as promised. The question he has to answer is not whether he is deserving but rather why he should be first in line. It’s hard to think of any other creditor more culpable than the Executive Vice President of the piece of AIG that directly pulled it under.

What about this one: “I know that because of hard work I have benefited more than most during the economic boom.” Is that the reason you benefited more than most? Or is it because of the scandalously generous conditions that AIG offered traders? Congresssman Barney Frank obtained a copy of the bonus agreement and discovered that AIG traders were rewarded even more generously than the breathtaking conditions offered traders elsewhere on Wall Street.

The clawback remains a complex ethical issue, but the De Santis letter doesn’t shed any new light on it. It does tell us a lot about something else: the culture of entitlement that permeates Wall Street.