Executives of companies that fail because of mismanagement, should be contractually obliged to return their bonuses, and their penalties should be proportional to the size of the company and the harm caused. Conditional rewards can be a tool for shareholders against moral hazard. And higher penalties in case of huge losses because of a company’s size will create an implicit market for accountability: the larger the company, the harder it is to run and the less attractive for executives without sufficient skills.
It seems executives often can only win, with little downside risk: successful high-risk transactions lead to bonuses, and those that go wrong, bring the (lesser) benefit of a golden parachute. This is moral hazard. It means that the executive can let the company take more risk than appropriate, because if things go wrong there is still the golden parachute. The company has more to lose than the executive.
Luckily, in the financial crisis most governments acted wisely, and conscious of the principal-agent problem. At the rescued financial institutions many executives lost their jobs, and often their severance packages. Governments really rescued the institutions, and not the executives. In a sense, the executives ran a higher risk than the company.
However, the accountability of executives should be defined more clearly. This is primarily a task of shareholders. They should make more bonuses conditional on performance from a future perspective (5–10 years from now). Policymakers can help shareholders with easily applied legal tools. Worst case, the government should apply clawback on its own, when a bail out occurs, or when a huge portion of employees becomes unemployed.
That victims of corporate failings are less visible than, for example, victims of murder, does not mean penalties should be lighter. When executives knowingly commit fraud or do not perform their jobs responsibly, investments get wrongly allocated. This in the end causes a loss of wealth and welfare. Wealth that might have found a way to healthcare for example. Penalties should be determined accordingly. Robbing society of billions of wealth, should not be taken lightly.
Top executives should therefore bear responsibility proportional to the size of their company and the harm caused. Might that lead to heavy prison sentences for executives of huge corporations when they commit illegal acts, or do not do their jobs? Yes. The Enron case is a good example where executives indeed got heavy penalties for the wrongs they committed.
A market for accountability
Why is that not unreasonable to these top executives? Is it really reasonable to penalize heavier when their company is bigger? Yes.
“If you can’t stand the heat, get out of the kitchen.”
Executives are, supposedly, paid handsomely for the responsibility they take on. If they deem the risk, that they cannot run the company responsibly, bigger than the reward: get out. Then we might have companies that cannot find an executive anymore because they are too large and complex to run responsibly: a market for management accountability. That is exactly what we need. Companies should not become bigger than is possible to handle. The larger the company, the bigger the responsibility, the higher the penalty when an executive does wrong.