04:51 PM
Bernie McSherry
Bernie McSherry

Revamping The Street’s Bonus Structure

McSherry is SVP of Strategic Initiatives at Cuttone & Company.

It appears that early bonus payments have become the canary in a coalmine for Wall Street firms. Whenever you see someone trying to rush out early bonus payments, it’s probably a good idea to keep your hand on your wallet.

First, there was Bernie Madoff, whose effort to pay over $200 million in Christmas bonuses two months ahead of schedule sowed the seeds of suspicion that supposedly caused his sons to confront him about his alleged Ponzi scheme. The outraged sons then called the feds to turn the former NASDAQ Chairman in. At least that’s their story, and they’re sticking to it.

Now, we have news that Former Merrill Lynch CEO John Thain paid nearly $4 billion in bonuses to employees several weeks earlier than normal and just three days before the closing of Merrill’s sale to Bank of America on January 1, 2009. Recent revelations that Merrill’s losses had ballooned in the months before the closing had some observers speculating that Thain had somehow secretly slipped the bonuses to his subordinates under the noses of neglectful–and apparently unconscious Bank of America monitors. Thain quickly released a statement that everything was done with the permission and sanction of Bank of America, and the bank has said nothing to contradict that version of events. It appears that someone had to take the fall for the disastrous deal, and Thain was the best candidate. He has since tried to salvage his reputation by going public with his version of the story with mixed success. Now about that $1,405 wastebasket…

Bonus culture is deeply embedded in the traditional Wall Street model and this year like others, despite a massive government bailout, billions have been paid out by the banking industry. The banks have been the beneficiaries of enormous amounts of taxpayer largess and millions of hard working Americans, most of whom have seen their life savings dwindle as a result of the actions of those very same banks, are apoplectic. It’s hard to blame them, frankly. Clearly, these times don’t call for business as usual. Wall Street must change.

Investment banks have long set aside a significant portion of revenue for employee compensation. That portion may be tweaked slightly to compensate for profitability, but it usually exceeds 50 percent of total revenue. In a large investment bank (now mostly extinct) the total compensation pool could easily exceed $10 billion. Much of that pool is normally set aside to be paid as bonuses. Bonuses typically make up an enormous portion of an employee’s take home pay, in many cases more than 75 percent of the total. Management liked the fact that the promise of year-end bonus money had the ability to discourage high producers from exiting the firm, and employees came to see bonuses as a normal part of their compensation, regardless of firm profitability.

Traditional methods of Wall Street compensation are likely to come under fire simply because most of the public thinks of bonuses as something that are paid during good times to reward productive and faithful employees. For most working folks, bonuses are a pleasant surprise seldom exceeding a few hundred, or a few thousand, dollars in a good year. They certainly wouldn’t expect a bonus if their employer was on the brink of failure, they’d be merely happy to keep their job. In this economy, the promise of continued employment is bonus enough.

So where does that leave Wall Street? The argument supporting high bonuses has been that firms had to pay them to discourage poaching of employees by rivals. That doesn’t appear to be much of an issue this year. Few firms are hiring, and employees–even high producing ones–are loath to risk jumping to a new firm. It must be acknowledged that bonuses are often paid out in non-cash compensation like company stock, much of which has proved to be worthless given recent market conditions. Even so, the average compensation for financial services employees continues to far exceed that of normal working stiffs.

Many high-ranking, high-profile executives have foregone bonuses this year as an exercise in public penance. Firms have recently enacted clawback provisions to enable them to rescind bonuses if businesses subsequently turn bad. These moves have been positive, but why not go further and pay all employees on a risk-adjusted basis? An employee who generates $1 million profit with $100,000 in potential downside risk should be compensated better than one who earns $1 million on a bet with $5 million in downside risk. That seems like a common sense proposition to most folks, yet Wall Street often paid both employees identically in past years. Risk adjusted compensation must become the norm.

Another move that should become the norm is the reduction of the bonus pool/base salary ratio. The payment of unrealistically low base salaries undermines the concept of a bonus as a reward for performance if a significant portion of that bonus will be paid out in any case. If an employee can reap a high six-figure bonus in a year like last one, where is the incentive to perform? Realistic base salaries and bonuses that truly reward individual and firm performance would be a meaningful way to restore the link between performance and compensation. The risk that an individual’s bonus could be zero, if the firm were to struggle, would be a great motivating force to align individual, firm and societal goals. Taxpayers would be less likely to grouse if they perceived the system as being fair.

It’s clear that the financial services industry will have to change the ways it does business. Yielding to more intrusive regulation, taking less risk and operating with greater transparency are givens in the years ahead. A rational approach to compensation may help assuage an angry public, but for now, expect legislation that will limit compensation for employees of government-supported entities. Can you think of a better motivation for these firms to pay back their government loans as quickly as possible? I can’t.

About Bernie McSherry

McSherry is senior vice president of strategic initiatives at Cuttone & Company, where he is a member of the management committee involved with strategic planning and market strategy. He has served in a number of leadership positions within the Industry and has chaired several New York Stock Exchange committees, including the Equity Traders Advisory Committee. He was also a member of the Market Performance Committee and served as a New York Stock Exchange Governor for six terms. He is a past President of the Alliance of Floor Brokers, an industry trade group and is a member of both the Security Traders Association of New York (STANY) and the National Organization of Investment Professionals (NOIP).

McSherry began his career as an options trader, overseeing floor operations for Walsh, Greenwood and Company. He founded McSherry & Company in 1988, eventually growing it into one of the largest independent brokerage firms on the floor of the NYSE. In 2000, McSherry & Company was acquired by SunGard Global Execution Services. Mr. McSherry served as CEO of its New York and London-based Broker Dealers for two years following its acquisition. He then joined Prudential Equity Group and held the position of Head of Sales Trading and NYSE Operations before joining Cuttone & Company in 2007.

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User Rank: Apprentice
2/23/2013 | 2:47:19 PM
re: Revamping The Street’s Bonus Structure
Hmmm. where does that leave the gold trader who cleared a cool billion for himself ....Guess Dodd Frank and Sarbanes Oxley does not apply to him ....
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