From Lehman Brothers’ 2005 Annual Report

Bank Executive CompensationandCapital Requirements ReformSanjai Bhagat Brian Bolton University of Colorado Portland State University2012 Conference on Corporate Governance of Financial InstitutionsBank of Netherlands / University of GroningenNovember 8-9, 2012

From Lehman Brothers’ 2005 Annual Report “The Lehman Brothers standard means…fostering a culture of ownership, one full of opportunity, initiative and responsibility, where exceptional people want to build their careers.”

From Goldman Sachs’ 2002 Annual Report “The core of the Goldman Sachs partnership was shared long-term ownership…By making all of our people owners, the firm would benefit by strengthening the culture of ownership”

From Goldman Sachs’ 2006 & 2007 Proxies Goldman Sachs grants “Long-Term Compensation Awards” with Restricted Stock Units.From 2004-2006, 40% of all “Restricted Stock Units” vested immediately.In 2007, 100% of all “Restricted Stock Units” vested immediately (including grants from prior years).

Motivation: Incentives Matter • Bebchuk, Cohen & Spamann (2010) • Clinical analysis of the executive compensation structures at Bear Stearns and Lehman Brothers • “…given the structure of executives’ payoffs, the possibility that risk-taking decisions were influenced by incentives should not be dismissed but rather taken seriously”

Motivation: Incentives Do Not Matter • Fahlenbrach & Stulz (2011) • Larger sample analysis of losses experienced by financial institution CEOs during the crisis, based on their ownership of company stock • The poor performance of banks is attributable to an extremely negative realization of the high risk nature of their investment and trading strategy • “…Bank CEO incentives cannot be blamed for the credit crisis or for the performance of banks during that crisis”

Investment Scenario #1 Consider the following investment strategy: • 6 possible cash flow outcomes • 5 outcomes of +$500 million • 1 outcome of –$5 billion • Each with equal probability • Investment strategy has a negative NPV • Probability and magnitude of the cash flows are known only to the bank executives • Should the bank invest in this project?  NO

Investment Scenario #2 However, the investing public is led to believe that the trading strategy leads to the following: • 6 possible cash flow outcomes • 5 outcomes of $500 million • 1 outcome of –$1 billion (not $5 billion as before) • Each with equal probability • Investment strategy has a positive NPV • Should the bank invest in this project?  YESStock price goes up, managers potentially liquidate shares and take money off the table since they know the true outcomes

“Managerial Incentives Theory” • Incentives generated by executive compensation programs led to excessive risk-taking by banks leading to the current financial crisis • The excessive risk-taking would benefit bank executives at the expense of the long-term shareholders. • Testable Implications: • Managers are acting in own self interest, sometimes dissipating long-term shareholder value • Net Manager Payoff during and prior to financial crisis period should be positive

“Unforeseen Risk Hypothesis” • Bank executives were faithfully working in the interests of their long-term shareholders; the poor performance of their banks during the financial crisis was the result of the bank’s investment and trading strategy. • Testable Implications: • Managers are consistently acting to enhance long-term shareholder value • Net Manager Payoff during and prior to financial crisis period should be negative

Data & Setting Analysis of stock, option and compensation structures at 100 of the largest U.S. financial institutions from 2000-2008 The Sample:3 Main Subsamples: • TBTF – “Too Big Too Fail” • 14 firms • 9 original firms required to take TARP funding in October 2008 Bank of America Merrill Lynch Bank of New York Mellon Morgan Stanley Citigroup State Street Goldman Sachs Wells Fargo JP Morgan Chase • Bear Stearns and Lehman Brothers – likely would have been included had they been independent going concerns in October 2008 • Mellon Financial and Countrywide – acquired by Bank of New York and Bank of America just prior to (or during) the crisis • AIG, American International Group

Data & Setting Analysis of stock, option and compensation structures at 100 of the largest U.S. financial institutions from 2000-2008 The Sample:3 Main Subsamples: • TBTF – “Too Big to Fail” • L-TARP – “Late TARP” • 49 firms • Using the sample of financial institutions provided in Fahlenbrach and Stulz (2011), we identify those institutions that eventually received funding through TARP • No-TARP – “No TARP” • 37 Firms • Using the sample of financial institutions provided in Fahlenbrach and Stulz (2011), we identify those institutions that never received funding through TARP

Data: Sources • Insider trading data from Form 4 filings • Obtained from Thomson Insiders’ database and actual filings on SEC website • Insider and director ownership from proxy statements • Obtained from RiskMetrics and from actual filings on SEC website • Insider compensation data from 10-K and proxy statements • Obtained from Compustat Execucomp and from actual filings on SEC website • Financial and stock price data from Compustat & CRSP

Data: Key Variables + Value of Stock Sales– Value of Stock Buys– Value of Option Exercises(1) = Value of Net Trades+ Value of Net Trades+ Value of Salary & Bonus Compensation– Unrealized Value Lost .(2) = Value of Net CEO Payoff

TBTF Data: CEO Trade Information Trades by TBTF CEOs, 2000-2008 (Table 3A)Total # of Sales 2,048Total # of Buys 73Total # of Option Exercises 470+ Value of Sales $3,467,411,569– Value of Buys $36,400,641– Value of Option Exercises $1,659,607,191Value of Net Trades $1,771,403,737  $1.77 billion of cash taken off the table by bank executives(High of $428m at Lehman Brothers Low of -$7m at AIG)

TBTF Data: CEO Trade Information Total CEO Payoff by TBTF CEOs, 2000-2008 (Table 4A)+ Value of Net Trades $1,771,403,737 + Total Cash Compensation $ 891,237,300 + Realized Cash Payoffs to CEO $2,662,641,037 – Unrealized Paper Loss, 2008 $2,013,683,157Net CEO Payoff: 2000-2008 $ 648,957,880 (High of $377m at Countrywide Low of -$311m at Lehman – but CEO Dick Fuld had already realized cash of over $400m) Estimated Value Remaining, 2008 $ 939,328,179

Trade Information: TBTF, L-TARP & No-TARP CEOs

Net CEO Payoffs: TBTF, L-TARP & No-TARP CEOs

Stock Returns: 2000-2008

Abnormal Stock Returns

Summary of Results • Bank executives at these 14 institutions took billions of dollars ‘off-the-table’ from 2000-2008, yet shareholders most likely lost considerable amounts of money • Consistent with our Managerial Incentives hypothesis • Yes, they did lose considerable sums in the crash of 2008...But, the 2008 paper losses were far less than the cash already realized from compensation and sales • Inconsistent with our Unforeseen Risk Hypothesis • Bank executives’ compensation was not aligned with the returns shareholders received during 2000-2008 or with the risks the firms took

Additional Analyses • Findings hold for 2001-2008, 2002-2008 & 2004-2008 sub-periods • Findings hold for firms that had only 1 CEO throughout the sample period (TBTF=4, L-TARP=22, No-TARP=17) • Similar findings for sample of All Insiders, including officers and directors • TBTF experienced the largest write-downs and had the lowest Z-Scores – consistent with Gande & Kalpathy • Ratio of Net Trades to Concluding Holdings • Highest at TBTF firms, lowest at No-TARP firms • Annual Net Trades to Beginning of Year Holdings • Highest at TBTF firms, lowest at No-TARP firms

From The World of Phsyics “The problems that exist in the world today cannot be solved by the thinking that created them.” ~ Albert Einstein

Restricted Equity Proposal Proposal to reform executive compensation • Annual cash compensation: $2 million limit • Executive incentive compensation plans should consist onlyof: • Restricted stock & Restricted stock options • This compensation would be “restricted” in the sense that the shares cannot be sold and the options cannot be exercised for a period of 2-4 years after the executive’s resignation or last day in office • “Super-Escrow” with time & performance vesting elements

Restricted Equity Proposal • Proposal will provide superior incentives compared to unrestricted stock and options plans for executives to: • Manage corporations in investors’ longer-term interest; • Diminish their incentives to attempt to achieve short-term stock price appreciation by: • Making aggressive public statements about performance or investments • Manage earnings • Accept undue levels of risk

Senior Executive stock grants are restricted according to the following provisions: From ExxonMobil’s 2012 Annual Report Executive stock grants are subject to the following vesting provisions: • 50% of each grant is unvested for 5 years; • 50% of each grant is unvested for 10 years or until retirement – whichever is later. (This has been the policy since 2002, when restricted stock was granted to more than 5,300 employees)

Caveats #1: Under-diversification • Under-diversification: If executives are required to hold restricted shares and options they would most likely be under-diversified • Problem: This lowers the risk-adjusted expected return for the executive • Solution: Grant additional compensation to the executive • Would require some prohibition against engaging in creative derivative transactions (such as equity swaps) or borrowing arrangements that would hedge the payoff from the restricted shares/options

Caveats #2: Liquidity • Lack of liquidity of executives’ compensation • Problem: Given that the average tenure of these CEOs is about 5 years, a CEO may have to wait 7-9 years before being allowed to sell shares/options and realize their incentive compensation • Solution: Allow sale or exercise of some portion of the executive’s portfolio, possibly 5-15% of their shares/options • But, for some CEOs, this could be $100+ million in sales • Limit the annual ownership position liquidations to a dollar amount of $5-10 million

2 Key Points • We are not advocating more compensation-related regulation • Boards of directors, not regulators, should determine: • The mix and amount of restricted stock and restricted stock options a manager is awarded • The percentage and dollar amount of holdings a manager can liquidate each year, prior to retirement • The number of years post-retirement/resignation required for the stock and options to vest. • This need not reduce executive compensation • The net present value of all salary and stock compensation can be higher than historical levels, so long as the managers invest in projects that lead to long-term value creation • This proposal limits annual cash amounts, not total amounts

Caveats #3: Capital Structure • Banks should be financed with considerable more equity than they are being financed with currently • Solutions based on equity-based incentives for executives • High current levels of debt (~90-95%) will magnify losses • Note Bear and Lehman were at 3-4% in 2008 • As a bank’s equity value approaches $0 – as the did for some banks in 2008 – equity based incentive programs lose their effectiveness in motivating managers to maximize shareholder value

Caveats #3: Capital Structure • Banks should be financed with considerable more equity than they are being financed with currently TBTF Firms 7.01% equity in 2007 L-TARP Firms 9.80% equity in 2007 No-TARP Firms 10.17% equity in 2007 • For the corporate sector as a whole, the debt ratio is about 47% (53% equity) • Since high current levels of debt will only magnify losses, banks need to adjust their equity levels to become more like the corporate sector as a whole for equity incentive programs to be effective in bad economic times

Conclusion • Clinical analysis of the cash compensation received by CEOs at 14 large financial institutions shows that their interests were not properly aligned with shareholders’ • They had incentives to maximize short-term gains and cash-out at the expense of long-term value creation • Behavior by directors was just as bad, if not worse • When compared to 86 other financial institutions, we observe the same tendencies: • TBTF sample showed the greatest misalignment • L-TARP sample showed substantial misalignment • No-TARP sample showed best relative alignment

Conclusion • Incentive compensation plans should use only stock and options that cannot be converted to cash for 2-4 years after the CEO leaves the firm • Limits on annual cash compensation • CEOs can sell some annually for liquidity purposes • Similar structure should apply to directors and other executives • In order for equity incentives to be effective, banks need to be financed with more equity than they currently are: possibly on the order of 20-30% or more • These compensation recommendations do not necessarily apply to just financial institutions • Objective is to prevent executives from taking short-term motivated risks at the expense of long-term value creation

From Lehman Brothers’ 2005 Annual Report