The House of Representatives' rush to tax the AIG bonuses at 90% expresses a true cry from the heart across the country against the bonuses. Fortunately for common sense and the rule of law, the Senate will probably dramatically cut back on the House's populist outrage. I may never say this again, but the Senate Republicans ultimately have it right. House Democrats may have gotten a catharsis, but they are ultimately wrong on changing confiscatory tax laws to tax income received before the tax law was changed.
Part of the PR problem here is that people don't understand, and neither AIG nor the Treasury Department has decently explained, what the bonuses are all about. Another part of the problem is that even the base salaries are so much larger than what most of us are used to that it doesn't seem possible that someone might be entitled to payment of a bonus on top of that -- particularly if the business is losing money. It's a little like the Washington Nationals -- Major League Baseball's worst team last year -- paying bonuses to its players. After all, bonuses are supposed to be rewards for excellent performance. But many Major League Baseball players have contracts that give them a bonus for simply playing in a certain number of games. If you get your bonus for playing in 150 games a year, it doesn't matter to the bonus that you couldn't hit your way out of a paper bag; you still get the bonus. Nationals fans may complain, but the contract is the contract. The player gets the bonus. The only thing that is different is that the Nationals players aren't being paid with tax dollars.
Like Major League Baseball players, many Wall Street financial professionals work on a system that has a base salary and a bonus. The base salary may be $250,000 a year, with a bonus calculated on any of a number of criteria -- perhaps revenues generated, perhaps simply sticking around. In some cases, those bonuses may be many times larger than the base salary. Such a system is not new, and it is not unique to companies being bailed out.
Like Major League Baseball players, many of these bonuses are retention bonuses. A MLB player may get a bonus just for still being on the MLB roster at the end of the season. On Wall Street, it is fairly common, when stock prices are falling and stock options have no value, for companies to tell their employees, "If you stick with us to the end of the year, we'll pay you a big bonus." That gives the employees an obvious incentive to not leave to go somewhere else. And AIG's stock was falling during the beginning of 2008. AIG's stock had traded at around $70 a share as late as October, 2007, when the Dow was over 14,000. Both AIG and the Dow fell about 20% by February, 2008 -- what seemed at the time like a general market correction. But the first indication that the outside world had of a potential problem at AIG was in February, when AIG dropped 15% in a matter of days, at a time when the Dow and most financial stocks were not falling. In May, June and July, 2008, AIG dropped another 30%, and was down about 70% from the October, 2007 highs. On June 15, 2008, the AIG president, Martin Sullivan, resigned. If you want to compare AIG's stock performance to that of the Dow and Bank of America, look at this stock chart. So if you were an AIG employee whose compensation package had usually included stock options (of value only when the price of the stock is generally rising), you might need some other sweetener to stay -- a retention bonus, perhaps, payable in a year.
The important point to make here is that the retention bonuses were agreed to a year earlier. They were NOT bonuses agreed to in March, 2009, to be paid to people in March, 2009, for agreeing to stay with the company after March, 2009. They were agreed to in 2008 to induce people to stay through some later date, like January, 2009. For example, Joe Bondtrader's contract with AIG, signed in January, 2008, might give him a large cash bonus payable in 2009 if he remained with AIG through December 31, 2008. Such bonuses were almost surely negotiated before AIG's peril was understood. There is plenty of reason for anger about the financial recklessness that led to the demise of AIG, but the bonuses were apparently negotiated in good faith by AIG at a time when AIG thought that it was solvent, and at a time when AIG thought that the people to whom the bonuses were to be paid were doing what AIG wanted them to be doing.
One frequent complaint we have heard this week is, "Why should these bozos get a bonus when they lost so much money?"
Believe it or not, it is not a violation of a contract to be bad at your job. Under most of these contracts, for a trader to lose money may be grounds for non-renewal of the contract, but unless the trader has covered up the losses or stolen money in the process, it is not grounds for termination before the end of the contract. There is no indication in any of this that any of the recipients could have been or should have been terminated for having violated company policy, or for having sexually harassed a secretary.
So when AIG decided to pay the retention bonuses, it was honoring a contract. It had no basis for NOT honoring the contract. The essence of AIG's bailout was to allow it to pay off its contractual obligations to Deutsche Bank and other counterparties; if we were giving AIG money to pay off billions owed to other banks, it would make little sense to deny AIG the power to pay off hundreds of thousands or millions owed to individuals.
It is also important to note that the typical Wall Street compensation agreement has a clause that says that if the employee is NOT paid the bonus on time, the company can be found responsible for treble damages. A $1 million bonus not paid when the contract provides would lead to a payout of $3 million, plus the attorney's fees necessary to enforce the agreement.
The only power that AIG would have had to refuse to pay to contractually obligated amounts would be if AIG went into bankruptcy; Bankruptcy Court would have the power to void or modify the contracts, under certain circumstances. And if AIG had filed for bankruptcy just to try to avoid paying its bonuses, it would be colossally messing up the company.
So who do we blame?
For starters, we can blame the Treasury Department going back into the Bush Administration (though including the Obama Administration) for not making sure that the Secretary of the Treasury and the President knew that these payments would have to be made. The Bush Treasury Department was aware during much of 2008 of the fact that AIG was hurting. The Federal Reserve and the Treasury Department were monitoring AIG fairly closely starting over the summer of 2008. On September 16, 2008, when the Fed essentially took over AIG in return for 79.9% of the company stock, Treasury and Fed officials were now on the inside. (It is worth noting that when we are talking about "the Fed," the lead oar was being pulled by the New York Federal Reserve Bank, whose President was Tim Geithner.)
And in September, AIG filed a document with the SEC -- a 10-K -- that outlined the retention bonus plan already in place. In November, Treasury and Fed officials restructured the AIG bailout, and there were specific negotiations over the terms under which A.I.G. could make the retention payments.
We know from various news reports that the executive bonuses were on the Treasury Department radar screen at least as early as December, 2008 -- CNN's Joe Johns reported on December 11 that although AIG's top 60 executives would forego their bonuses, there were still retention bonuses due to another 168 employees, totaling perhaps $150 million. http://www.cnn.com/2009/POLITICS/03/20/aig.bonuses/index.html?section=cn... Perhaps in response to this news, Democratic lawmakers asked in December to hold a hearing about the payments. It didn't happen, but the story did not go away. CNN's Mary Snow had a story in January, 2009, putting an estimate of $450 million on the retention bonuses. New York Attorney General Andrew Cuomo raised a stink about the AIG bonuses, and a New York Times story from January 30, 2009, says that he had extracted a promise from AIG officials that no future bonuses would be paid. (Is it important here that the AIG compensation agreements are controlled by Connecticut law, not New York law?) On at least a couple of occasions during February, the Fed and Treasury officials discussed the bonus plan.
And on March 3, when Tim Geithner was testifying before the House Ways and Means Committee, Representative Joseph Crowley (D-NY) asked Geithner directly, in an open hearing, what could be done to stop AIG from paying $165 million in bonuses to hundreds of employees in the very unit that had nearly destroyed the company.
Geithner responded with a general answer -- executive pay in the financial industry had gotten “out of whack” in recent years, and he pledged to crack down on exorbitant pay at companies like AIG that were receiving federal bailout money.
Geithner now claims that he did not know the magnitude of the bonus issue until March 10 -- one week after being asked a direct question that set forth the facts that he said he didn't know until a week later. (To be fair, Congressional questions are often so laden with dubious "facts" that no one should assume that the "facts" are correct; however, Crowley is not a crank, and someone should have at least wondered what he was talking about.)
So how about blaming Chris Dodd?
Dodd has been guilty primarily of playing trying to play politics with a hot-button issue. In January, he was trying to insert into the stimulus bill a provision that would have permitted what is sometimes called a "claw-back" of the bonuses. Simply put, the claw-back provision would have given the government the power to "claw back" the bonuses from the highly-paid employees of companies that received federal bail-out dollars. The consensus at the time was that there were few legal remedies; claw-back provisions really can't be used to interfere with amounts that are contractually due.
But the sober reality, compensation experts said, is that most if not all of the money that the banks have paid out is probably gone for good. The “legal means” Senator Dodd referred to are few. Unless actual wrongdoing is uncovered at the banks — and so far prosecutors have not disclosed any — the case for clawing back past pay is weak. “It’s not as easy as pounding the gavel on the table,” said Michael S. Melbinger, an executive compensation lawyer at Winston & Strawn in Chicago.
http://www.nytimes.com/2009/01/30/business/30pay.html The prevailing wisdom in January was that Dodd was arguing for it in part because he was feeling the heat for being too cozy with the financial industry. (He is now thought to be in a tough fight for re-election, being opposed by former Representative Rob Simmons; a Quinnipiac Poll conducted last week showed them essentially tied, 20 months before the 2010 election.)
The first version of the stimulus bill -- the version that passed the House -- had no limit on bonuses for bailed-out companies. The version that passed the Senate contained a provision that would have required that any bank receiving TARP funds had to pay back the government the same amount that they paid out in bonus money. (Note that this version did not prohibit paying bonuses -- it just made it expensive for a bank to pay them.) Because the House and Senate versions differed, the bill went to a Conference Committee.
Yet somehow, the version that was adopted by the Conference Committee was entirely different from the Senate version that had just passed the Senate. The Conference Committee Report, adopted on February 12, 2009, had been changed to substitute a whole different treatment for excessive compensation, golden parachute payments and bonuses. That provision barred golden parachutes and bonuses that met certain criteria, but included this caveat:
The prohibition required under clause (i) shall not be construed to prohibit any bonus payment required to be paid pursuant to a written employment contract executed on or before February 11, 2009, as such valid employment contracts are determined by the Secretary or the designee of the Secretary.
http://thomas.loc.gov/cgi-bin/query/F?r111:1:./temp/~r111wYnFba:e1285275: That is the version that was passed by both houses on February 13, and signed into law on February 16. On February 15, the New York Times had a story in which Obama Press Secretary is quoted as saying that the Obama Administration wanted to have another law passed to amend this caveat, so that it prohibited fewer bonuses. http://www.nytimes.com/2009/02/16/us/politics/16shows.html?_r=1 Rep. Barney Frank (D-MA) and Senator Richard Shelby (R-AL) said, in essence, "No. Enforce the one we passed."
So the great mystery this week has been, "How did the Conference Report come to include an exemption for AIG's retention bonuses?"
Senator Chris Dodd has now 'fessed up, though he says that the request to change it came from "low-level Treasury officials" who were afraid that a provision like what had passed the Senate was too harsh.
Personally, I blame Geithner and the Treasury Department for the PR disaster. It has been noted frequently by David Brooks of the New York Times that Geithner has almost no middle management people in office. He can call a senior staff meeting in the bathroom, with the stall door closed. The usual crop of Assistant Secretaries and Deputy Undersecretaries aren't in place. If they had been present, we at least might not have been blind-sided.
But in the long run, the Dodd/Treasury amendment is, in my view, the only result that is consistent with the rule of law. We can be angry that we are shelling out $165 million at a time of economic crisis, but the principle that the government honors contracts is an important principle to adhere to. We don't have to be happy about the payments; we have to hold our noses and do what the law requires.
So how about taxing it all away? The current proposal, which passed the House by a wide margin in about a day, would tax that income at 90%. With state and local income taxes, that is effectively every penny of the bonuses. To me, this runs afoul of two other basic principles -- we don't tax people that we decide we don't like just because we don't like them, and we don't change the tax laws to suddenly tax at a confiscatory rate income that the taxpayer has already received.
The Senate Republicans have indicated yesterday that they don't expect that the 90% tax will move forward any time soon. And that is the right answer. Our economic system requires that we be able to rely on certain things -- a stable tax structure is one of them. We choose to take certain economic actions in reliance on the tax structure, and the tax consequences of those actions. For example, if I am thinking of installing solar panels on my roof, and I am counting on getting a tax break for doing so, I may make the calculation that I can afford the panels only if I get the tax break. If the government were to decide three months later that they would rescind the tax break, so that people who have already bought solar panels this year would not get that tax break after all, those taxpayers would have every right to be angry.
The Republicans in the Senate are right to emphasize the need for economic actors to be able to rely on the government to react legally, not cathartically.
And President Obama was right to emphasize (as he did on Jay Leno Thursday night) that we need to change the culture that values deregulation even when the deregulated industry is able to take down our entire credit market.