Saturday, October 27, 2007

Employee negligence

I often speak with employers who've suffered a loss at the hands of an employee who didn't do such a great job. The employers want to know what they can do, in addition to firing the employee. The advice is usually pretty simple. First, you can look at the contract, if there is a contract. Second, depending upon what the employee does for the company, the loss may be insured. Third, if the employee was either negligent or committed some sort of an intentional tort, then you could sue the employee, but that opens up a whole can of worms.

The biggest worm in the can is that the loss the employer suffered is always much bigger than the employee could possibly pay. After all, the non-unionized worker on the JapanCo assembly line in Tennessee who's screwing lugnuts onto a tire rim for ten bucks an hour couldn't possibly pay the damages award when the wheel flies off and a church bus flips over. The second biggest worm is that suing your employees as a regular practice makes it hard to get employees. The third biggest worm is that you don't want to announce to the world that you're really bad at choosing whom you hire.

This week's Employee of the Week is Stan O'Neal, the head of Merrill Lynch. Today's New York Times reports that he's looking at a $159 million payday if he steps down. (Unclear what happens if he's fired for cause.) The speculation is that he's about to be sacked, having just announced an $8.4 billion (that's billion with a "B") writedown for failed mortgage and credit investments. The Times writes, "One thing that he surely will hold onto, though, are the giant paychecks he has collected," and it recounts that over Stan's five-year stint (he moved up from CFO to COO in July 2001 while Merrill Lynch was suffering a bad year and the line of succession to then-chairman/CEO David Komansky was in flux), the "giant paychecks" to date total $160 million over five years.

And exactly how did Stan do over his five years at the helm of Merrill Lynch? Well, before the $8.4 billion debacle, it looked like he was doing great, and he was well-paid for his performance. Under his predecessors, earnings per diluted share for 1997 to 2000 inclusive (before the 2001 debacle) averaged $2.78, but under Stan, for 2002-2006 the average was $4.76, working up the ladder to an astounding $7.59 in 2006. But, if you recalculate by deducting the $8.4 billion from the 2002-2006 figures, then under Stan's leadership Merrill averaged only $2.94 per share, a scant 5.9% higher than the 97-00 period. And remember, those are absolute (not inflation adjusted) numbers, so in real terms Merrill did worse under Stan than it did under his predecessors. All of a sudden, therefore, the third-of-a-billion that Stan may have in the bank solely from his earnings starts to look like a pretty good place to start recouping Merrill's losses.

In the words of one talking head quoted in the Times (Frederick E. Rowe Jr., a money manager and president of Investors for Director Accountability), “I lay the blame at the foot of the board. . . . He was paid a tremendous amount of money to create a loss that is mind-boggling, and he obviously took risks that should never have been taken.”

Putting aside the question of how Merrill's D&O policy would affect a claim, I wonder whether the Merrill board is asking the same questions of its lawyers that my clients ask of me?

Posted by Craig Albert


Paul Scott said...

To me, the most interesting thing about all this is Stan's thinking. Here is my quick analysis of the situation.

Stan is taking risks that, unless the market is woefully inefficient, Stan knows will eventually fail.

Stan probably also knows that the market on something as simplistic as high-risk mortgages is not inefficient.

So, how can Stan best profit from this situation. The answer is really apparent. He uses over-investment in the high-risk market to generate for himself impressive earnings statistics, then before the downside of his risks materialize, he leaves the company and parlays that "on-paper" success to a much bigger salary at another firm. He ends up leaving ML as a huge success and his successor gets fired one or two years later, going down as one of ML's greatest failures.

So, the question for me is did Stan never foresee this happening (a stunning revelation if true) or did he simply get a little greedy or was he putting this plan into effect and the timing just didn't work out (it's not as if there are that many places to move from COO of ML)?

Craig J. Albert said...

Your comment is right on the mark. In the financial markets, when you're playing with Other People's Money, and you're rewarded for past performance, then one sound strategy is to make high-risk bets with potentially huge payouts. If you win, you get a share of the upside in the form of bonuses, incentive pay, etc. But if you lose, well, the standard Wall Street package never involves covering any of the losses. So, given the choice between two bets each with the same expected value, the agent's incentive here is to play the bet with the higher variance (the "riskier" bet).

Economists call this class of problems "the principal-agent problem": how do you design a set of incentives so that the principal's (employer's) interests are aligned with those of the agent (the employee). It's not as easy as you might think.

Last week, in another field (yes, pun intended), the Steinbrenners sought to solve the principal-agent problem by changing Joe Torre's pay structure to base it on future performance, rather than past performance. Their reasoning was that Joe was being paid to put together a championship team, and his $8 million annual pay package had been designed after he had shown that he was a winner (4 World Series rings). Unfortunately, after his pay went up, his team's performance went down. So their idea was to give him the same $8 million if he performed the way that he did before he got his earlier, big contract. What happened? Torre was insulted, and he walked away. Of course, the problem might not have been so simple, because it's really hard to get a baseball team all the way to the World Series. By offering a $5 million base plus a $3 million performance incentive, then even if you assume that the Yankees on paper have a 25% chance of making it to the Series, the expected value of the offer made to Torre was only $6.5 million, which is a 20% pay cut.

Tam Ho said...

Good point re: Torre. Just to flesh that out a bit more - your point that the expected pay is less than the $8M he was getting is good evidence that it wasn't SOLELY the questioning of his professionalism (the suggestion that he needed an incentive to try harder, as if he wasn't already trying his best) that caused the insult. It was that in conjunction with the pay cut.

After all, suppose the offer was to let him retain whatever he was making, but add to that a $3M bonus for winning the World Series. That, too, questions his professionalism in the exact same way. It's hard to imagine, though, that he would have turned that offer down. Indeed, should one even feel insulted in that instance?

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