The Tale of Stephen Hilbert

The Law School, like others around the country, was abuzz yesterday with the start (or false start thanks to the Jewish holiday) of the new Supreme Court term.  While no opinions were handed down yesterday, the Court did make a decision of interest to corporate types: it turned away the petition of Stephen Hilbert, the founder of the insurance firm Conseco.  This case is interesting not so much for the legal issues in Hilbert’s petition or the lower court opinions, but for what it reveals about how firms use (or, rather, used) deferred compensation of various sorts to discipline management. 

In 1995, then CEO Hilbert created a loan program for executives through which they could borrow at low or no interest to purchase Conseco stock or real property.  About 150 executives at Conseco participated in the program, which was similar to one run by nearly every large firm.  Hilbert was the largest user of the program, borrowing about $80 million to buy Conseco stock.  This alignment of the CEO’s personal fortune with that of shareholders is something academics and corporate observers would praise, after all, Hilbert had clear incentives to maximize the value of Conseco shares.  Allegations surfaced, however, that Coneseco executives engaged in accounting fraud related to certain mortgage-backed securities offered by subsidiary Green Tree Financial.  After the scandal broke, Conseco quickly slide into bankruptcy making Hilbert’s shares, and thus the collateral for the loan, worthless. 

Critics of these corporate loans believed that they were simply giveaways to greedy executives.  After all, Hilbert set up a program to give himself a low interest loan and at many firms similar loans were forgiven at some later date.  The criticisms were successful: federal law now bans corporate loans of this type.  Instead of being a cautionary tale of managerial excess that supports the ban, however, the story confirms the value of these loans as an incentive device for firms with imperfect information about executive behavior.

As co-author James Spindler and I show in a recent paper, the reason is that deferred compensation—corporate loans and the like—can squarely benefit shareholders:  deferred compensation allows the firm to yank back compensation later on when it turns out that a retired executive has behaved disloyally or performed poorly in the past.  Consider the basic problem of corporate governance:  given the enormous power of management, firm owners (that is, shareholders) face the challenge of keeping managers from enriching themselves at the benefit of the firm.  A primary constraint on such cheating—which comprises anything from padding expense accounts or manipulating accounting data to falsely inflating earnings—is reputation.  Reputation can be much more powerful than law, since not all bad actions are illegal, and even those that are require costly prosecutions or lawsuits to enforce.  Reputation is relatively costless, can cover all bad actions that are difficult to prove in court, and is very powerful.  A former CEO with a tarnished reputation may well never work again, even if she cannot be convicted of any crime. 

But reputation has a few drawbacks.  It can take time to discover cheating, as demonstrated in scandals from Adelphia to Worldcom.  And if, during this time, the executive can steal enough money to retire, cheating becomes an attractive option.  After all, you don’t care as much about your reputation when you’re sipping rum on your private estate in the Caymans, with money in the bank. 

This is where deferred compensation, corporate loans, and post-retirement perks are useful deterrent.  The virtue of deferred compensation is that it is paid in the future, and can be conditional on the firm's determination that the employee has not cheated in prior years.  For instance, if it turns out an employee has behaved poorly, a corporate loan may not be forgiven, or a retirement perk may be yanked away.  These forms of compensation can thus help to reduce cheating because employees wouldn’t want to run the risk of the firm refusing to pay the deferred compensation, forgiving the loan, or providing the corporate jet.  A firm that pays less cash, and more perks and deferred compensation, retains a mighty stick with which to hit executives who cheat. 

And this is not merely an ivory-tower fantasy—firms do this with regularity.  In just the past few years, at least ten prominent executives of Fortune 500 firms have had their post-retirement compensation totaling more than $300 million rescinded after their former employer uncovered various forms of cheating.  Firms likely chose this course since rescinding retirement benefits is easier than suing to reclaim salaries and bonuses paid (and likely spent) in prior years.

Take the example of Walter A. Forbes, former CEO and Chairman of Cendant Corporation.  Forbes retired in 1998, receiving a retirement package of $35 million in cash and options valued at about $13 million.  A few years later, Cendant discovered that he had been stealing from the firm (and thus shareholders) to the tune of several million dollars and was possibly involved in what turned out later to be one of the largest accounting frauds in American history.  Cendant accordingly took steps to rescind his retirement package.  Tyco, WorldCom, and Wal-Mart have also taken similar steps when they learned of misbehavior of their CEOs or other senior executives.  These firms likely chose this course since rescinding retirement benefits is easier than suing to reclaim salaries and bonuses paid (and likely spent) in prior years.

Back to Stephen Hilbert, the Supreme Court’s denial of his petition for certiorari means that the judgment of the Indiana courts stands, and Hilbert will be forced to repay the loans.  Had Hilbert not cheated, his loan might very well have been forgiven by Conseco, since its purpose was, after all, merely to defer compensation to a later period when the firm could make such a decision about his behavior.  The fact that many loans were forgiven at other firms does not necessarily suggest that the practice was abused, but rather that the deterrent worked well in those cases.

To be sure, there were cases where greedy executives abused loans, but some executives also misused cash and options and other forms of compensation.  It was just a handful of abuses that caused President Bush to criticize corporate loans in a speech before the New York Stock Exchange, which in turn led to a last minute amendment to Sarbanes-Oxley banning them in all forms.  This outright ban perversely removes a way in which firms (and thus shareholders) can try to reduce the risk of fraud, and is a dangerous symptom of the increasing federalization of corporate law.  A much wiser course would have been to enhance procedural safeguards for this type of compensation, preferably through state law reforms.  This classic case of possible unintended consequences should be considered by regulators looking to further constrain the way firms and managers write employment contracts.

Comments

[Bob]

I can't believe you're worried about "federalization of corporate law." What little there is left to legislate will undoubtably come soon. It's already too late.

The USG has the power to make any laws it likes. It is already federalizing the criminal codes.

Although the constitution is an inclusive (where powers of government are listed) document, it is treated as exclusive (where powers not given to government are listed), thanks to the general welfare phrase. Therefore, when legislating laws, the constitution is ignored, and, therefore, is obsolete.

Today, there is no such thing as an unconstitutional federal law. Mostly, the supremes tolerate and accept every federal law. Occasionally, they may deem a state law to be unconstitutional (that way they can encroach on state powers and further increase their judicial domain), but how many federal laws have they deemed unconstitutional?

[NoName]

Of course, Sarbanes-Oxley has nothing to do with corporate law. SOX applies only to publicly-traded firms. Private firms are still perfectly able to use executive loans. Indeed, you might very well put your theories to the test by trying to understand to what extent private companies (in particular, private equity backed companies) continued to use executive loans after the passage of SOX.

Another data point to consider. Traditional deferred compensation (as opposed to executive loans, which I would consider to be like deferred compensation to the extent required repayment is tied to performance) has effectively been outlawed for all firms, public and private, by new IRC Section 409A. What do you make of that?