Salomon Inc.'s new bonus plan is unusual in at least three respects. First, it applies to a single individual, not a group of executives. Second, bonuses under the plan are controlled by a rigid formula, rather than being subjected to after-the-fact rationalizations by the board of directors. And third, when everything is humming along at maximum efficiency, the single individual can earn a staggering sum of $24 million for only one year's work.
Why did Salomon decide to ask its shareholders to approve this new plan? Well, there's only one reason we can think of: because the company felt it necessary to satisfy the idiocy that goes under the handle of President Clinton's $1 million pay cap.
Despite the cap, any company will be able to pay any executive the moon and deduct the full amount from its income taxes, provided the compensation so delivered qualifies as "performance-based" compensation, and provided further that the compensation is determined according to a formula that can be comprehended by shareholders and provided finally that shareholders approve the pay plan.
So here comes Salomon Inc. It designs a formula-driven plan with a maximum payout of $24 million per year. It submits the formula to its shareholders, and the shareholders approve the plan. As a result, every cent of that $24 million will be fully deductible. Everybody wins. President Clinton gets to tell the electorate he has taken steps to curb abusive executive pay; Salomon gets to pay $24 million per year to its CEO. And, Salomon gets to deduct every last cent of whatever it pays. On top of that, a small army of compensation consultants and lawyers doubtless received some hefty fees for designing the new Salomon bonus plan. And don't forget, folks, those fees themselves are fully deductible, with the result that all us hapless taxpayers get to defray 35% of that tab, too.
The executive who stands to receive that $24 million annual bonus is Deryck C. Maughan, the chief executive officer, not of the parent Salomon Inc., but of its largest most famous subsidiary, Salomon Brothers. Mr. Maughan has been promised an annual bonus of $24 million, provided Salomon Brothers achieves at least a 30% after-tax return on its equity for a given fiscal year and provided further that that 30% return level is at least 10 percentage points higher than the average return on equity achieved by a panel of five competitors - Bankers Trust New York, Bear Stearns, Merrill Lynch, Morgan Guaranty and Morgan Stanley. Alternatively, if Salomon Brothers earns only a 5% return on its equity for a given fiscal year and if that return level merely equals the average return on equity earned in the same year by the aforementioned group of competitors, then Mr. Maughan will earn precisely nothing.
Now what's good and what's bad about this new plan? For openers, the plan is good because it "incents" what many analysts believe is the single most important income statement and balance sheet measure of economic performance, namely, return on equity. Moreover, it demands ROE be evaluated, not in a vacuum, which is the usual way ROE is evaluated, but rather relative to the ROE levels earned by comparable companies. Finally, the plan sets some hugely ambitious targets. During the past five years, for example, not one of the five companies in the comparator group has ever earned a 30% return on equity.
Although some people, who are called thoughtful in certain circles and closet socialists in others, may want to challenge the notion that anyone is worth $24 million for a year's work, there is no question the new Salomon bonus plan achieves an exceedingly tight fit between pay and performance. That, presumably, is why the plan was approved by Warren Buffett, the Omaha billionaire who, for all practical purposes, controls the company. He likely figured if Mr. Maughan ever did earn $24 million, he would earn many times that figure.
But there's plenty wrong with the new plan,too:
The $24 million size of the maximum bonus is staggering even by Wall Street standards. About the only bonus that comes close to it is the $16 million or so paid to another Wall Street denizen, Alan "Ace" Greenberg, the CEO of Bear Stearns.
The plan design goes against that part of the Lord's Prayer that asks: "Lead us not into temptation." Forget about ensuring the viability of Salomon Brothers over the long-term. The goal here is to maximize profits in a single year, cross the finish line and collect $24 million. So if you have to lay off a bunch of people, even if only for this year, do it and do it big. Once you collect your $24 million bonus, you can re-hire them next year. And don't upgrade the computer system this year or spend more than a few dollars on management training. It may be instructive to note that in an earlier era, when bonuses where much smaller, a number of top executives of Salomon Brothers nonetheless conspired to rig the government bond market and thereby to maximize the company's profits for the year. Mr. Maughan, fortunately, was not involved in the conspiracy.
In approving the new plan, shareholders did not consider whether Mr. Maughan's salary will stay at the comparatively low current level of $400,000 a year and/or whether he will be granted other forms of incentive compensation in the future, such as stock options. One reason they did not consider these factors was the company did not give them any information they could factor into their considerations.
On top of all these problems, the new bonus plan is in our view a monument to sloppiness in design.
The plan talks about exceeding the comparator group average ROE by 10%. If the comparator group average ROE is, say, 20%, does Mr. Maughan exceed the comparator group ROE by 10%: a) when Salomon Brothers achieves a 30% ROE; or b) when Salomon achieves a 22% ROE? The answer, which Salomon supplied in a chart shown at the annual meeting, but which was not otherwise communicated to the vast majority of shareholders who did not attend the annual meeting, is 10 percentage points.
There is no definition given of what is meant by the term return on equity. Is the numerator of the ROE fraction pre-tax profits? Does the numerator include or exclude overhead charges from the parent company? Does it exclude certain costs - for example, bonuses paid to other Salomon Brothers employees or to Mr. Maughan himself? Does the equity base consist of common shareholders equity or total shareholders equity (which would included any preferred issues)? Is the denominator of the ROE fraction equity as of the beginning of the fiscal year, at of the end of the fiscal year or an average throughout the year? (Salomon did tell us that the return on equity figure is an after-tax amount.)
Even if shareholders had been supplied with the answers to the above questions, they would still be able to determine only what Mr. Maughan's bonus would be under two scenarios out of an almost infinite number of scenarios. That is to say, they would be able to determine the performance required to earn the maximum bonus, and they would be able to determine the performance below which no bonus at all would be paid. But how about intermediate points in the performance spectrum? So although Mr. Maughan will earn $24 million bonus for a 30% ROE level (however defined), provided that level is 10% higher than the average ROE (however defined) of the comparator group, and although Mr. Maughan will earn no bonus if the ROE level is 5% (however defined), and if the same ROE level is equal to the average of the comparator group (however defined) - what bonus will Mr. Maughan receive if the ROE level is, say, 5.01% and if that 5.01% ROE level is 0.01% higher than the average of the comparator companies? Will he, for example, receive a bonus of $1,000, or just a tad more than zero? Or will he receive a bonus of $23,999,000, or just a tad under his maximum bonus of $24 million? The proxy statement wording, on which shareholders based their votes, was utterly silent.
Although Salomon's hands may not be totally clean here, the truly dirty hands belong to the U.S. government. For if President Clinton had not persisted in sponsoring legislation that made him look like a populist but, at the end of the day, permitted any company to pay anything it wanted, provided it paid enough money to its compensation consultants and attorneys, we figure Salomon Inc. never would have designed its new bonus plan in the first place.