Top Student Exam Answers, Deals, Spring 2009

Duddleston should first be informed that a failure to deliver the property would constitute default under the terms of the contract (K).¹ The independent consideration (3.2) effectively gives Purchaser an option to buy the mall under the terms agreed to but no obligation to do so. While JBM might suggest that the $100 is sham consideration, it would certainly be considered sufficient under TX law. Thus, failure to deliver the property would almost certainly be considered default.

Once JMB has defaulted prior to closing, Purchaser would be entitled to (1) terminate the K and recover the Earnest Money; (2) enforce specific performance, or (3) waive the breach and proceed to closing. Thus Purchaser could proceed to Closing and a TX court or arbitrator could force the sale. Further, the court would impose attorneys’ fees and expenses (10.3). Since Purchaser has satisfied all obligations, failure to deliver the property could have costly consequences for JMB and this should be avoided.

This analysis does not necessarily mean that JMB should not request a higher price. Purchaser still values the property and paying 5% more may not deter it from buying. They may wish to agree to the additional price on the day of Closing and avoid further renegotiation or litigation. In this case, however, Purchaser would have little incentive to do so, since it would almost certainly prevail during litigation—probably at summary judgment—and can also recover attorneys’ fees. Indeed, the time involved in litigation seems to work against JMB’s interest since its business model depends on being able to sell quickly.

Whether Purchaser litigates or acquiesce and pays the additional $200K requested, JMB should realize the significant reputation loss it will incur. Its business depends on being able to sell property quickly. Future purchasers would be unwilling to enter into agreements with JMB if they anticipate holdup prior to closing or they will only do so by lowering the price they are willing to pay ex ante. This is likely an undesirable result for a possible return of $200K.

It may also be useful to explain to the client why it should not default. Before entering into the Agreement, both parties should have recognized that there are risks that the value of the property could change from the Effective Date to the Closing Date of up to 75 days later. In this case, the value increased by $400K due to some favorable circumstances that JMB was better able to control or anticipate. It was therefore efficient to assign those risks to JMB—the least cost-avoider. Purchaser would have only been willing to accept these risks at a substantially lower Purchase Price. The option also enabled JMB to locate a committed Purchaser relatively quickly and at a higher Purchase Price. Without the option or opportunity to inspect the property, Purchaser would discount the value since he would be more wary that it is purchasing a “lemon.”

The parties’ legal rights depend upon whether the Inspection Period has lapsed. (This is not evident from the facts presented.) If the Inspection Period is still in effect (1.1.11), then Robertson may withdraw from the Agreement with or without cause at her sole discretion (4.4) and will be entitled to a refund of the Earnest Money. In doing so, however, she must then submit her diligence to HZI, which would presumably demonstrate that the property value is about $3.6 mil. (4.5). Also relevant here is that Robertson may not disclose the contents of its diligence to outside parties (4.7), including Citi (and perhaps TARP). If the Inspection Period has lapsed, Robertson would be deemed to have defaulted, and HZI’s sole remedy will be to receive the Earnest Money of $100K. In this case, Robertson would also need to deliver diligence reports to HZI and maintain confidentiality.

Purchase Price Modification
The Agreement does not specifically contemplate modifications to the Purchase Price for inspection concerns. The parties may renegotiate, however, and make adjustments to which they both consent. In this case it appears that Robertson still wants the property—albeit for a lower price and in no circumstance more than $3.8 mil. We would therefore need to determine whether HZI would be amenable to a price reduction since its interest is obviously to obtain as high a price as possible.

Between Robertson and HZI, there may or may not be room for some renegotiation since it is unclear what HZI’s valuation of the property is prior to the contract. Obviously they were willing to sell for $4 mil., but there is also independent appraisal that it is worth $6 mil. Perhaps they agreed to sell to raise cash for other operations or they wanted to get rid of the property if they anticipate even greater declines in the market. However, assuming HZI’s valuation is closer to $4 mil.—this was after all the Purchase Price—and the diligence demonstrates that it has worth $400K less than expected, there could be room for negotiation. Both parties would have a sense of the other’s reservation price—$3.6 mil. (1) Absent the information about Citi and TARP involvement; (2) assuming that the deficiencies in the diligence reports are verifiable; and (3) assuming there was no outside potential buyer; the parties might be expected to agree on a new price of $3.6 mil. within the Inspection Period.³ When these assumptions and are relaxed, however, a number of alternative situations emerge.

Armed with the diligence report, HZI could seek an alternative buyer. It could then negotiate an Agreement but without permitting the Inspection Period or making any warranties regarding the condition of the property. This alternative buyer might then discount the Purchase Price, to account for the risk that it could be a “lemon”. But if this is greater than the $3.8 mil. that Robertson was willing to pay, it would be better off selling to this alternative buyer. This result seems unlikely since the alternative buyer would be extremely suspicious of a Seller that would not permit an inspection and discount the Purchase Price substantially. Also, it appears that closing within a week is in HZI’s interests, so they might be unable to find a suitable buyer in the interim that would be willing to pay $3.8 mil. without inspection.

HZI could discount the value of the information in the diligence believing it to be biased or designed to give Robertson an advantage in renegotiating. It might believe that the deficiencies in the property could be remedied for less than $400K. If for example, HZI believed that the proper adjustments could be done for $100K, and the Purchase Price reflects their reservation price, they would accept no less than $3.9 mil. and no deal would result.

Despite these previous two obstacles to renegotiation, the TARP plan gives HZI a very powerful incentive to close in the next week and therefore improve Robertson’s negotiating position. HZI would be able to reduce its indebtedness to Citi by $1 mil. Knowing this Robertson could offer between $3 mil. and her reservation price of $3.8 mil. and probably still acquire the property. If the Inspection Period is still in effect, she could holdup HZI to extract a significant portion of the surplus created by the TARP bailout.

1. I assume that the additional rent from the early opening of the anchor is not a proration within the meaning of 8.1.

2. This analysis makes the following assumptions: (1) Robertson’s total outlay in obtaining the property is the Purchase Price. (2) The mortgage only exists between Citi and HZI and Robertson is not assuming that debt. (2) TARP subsidy is paid to Citi.

3. If the Inspection Period had lapsed, Robertson would require an additional $100K ($3.7 mil.) to compensate her for the loss of the Earnest Money.

^ TOP

Question 1, Answer 2

A. JBM

In deciding how to renegotiate the contract for the sale of the Westlake Mall, JBM will need to consider first, what remedies are available to the Purchaser should JBM not agree to complete the transaction at closing and second what the costs associated with not closing are and how those compare to any gains from the change in value of the mall. The following analysis is based on the assumptions that there are no environmental liabilities that would allow JBM to terminate the contract under §4.11 of the Purchase and Sale Agreement (PSA) and that if the sale is delayed, seller keeps any revenues from the continued operations of the mall.

The remedies available to the purchaser should JBM not perform its obligations under the contract are established in §10.2 of the PSA and include 1) termination of the agreement, 2) the right to enforce specific enforcement, and 3) the option to waive the failure and continue to closing. Assuming the Purchaser refuses to renegotiate, the best of these options for JBM is probably for the Purchaser to select option 1 and terminate. This would allow JBM to seek another buyer at the higher true value of the property. Option 3 is probably second bets for JBM, as it leave JBM in the same situation as it is now without imposing much in the way of undue costs on JBM. Option 2, litigation and specific enforcement, is the worst outcome for JBM. Without getting into the merits of any litigation, JBM would be forced to hold onto the property throughout the period of the suit, incurring carrying costs, would have to pay attorney’s fees for the suit, and might well be liable for Purchaser’s costs of litigation.

Given the remedies available to the purchaser and the issues those remedies create (particularly litigation expenses), JBM two options in relation to the sale: make some sort of negotiating offer to seek some of the excess value of the mall or play it safe and continue to closing. There are two options for negotiating a new price: first, JBM can ask for additional money or threaten to walk away, or second, JBM can ask for one of two alternatives—additional money or the ability to exercise the lease option in the contract—under the threat to walk away. The second option would entail asking the purchaser to allow the exercise of the option, even though the deadline has passed, and is based on the assumption that the added value of the property comes from increased revenues, and thus could at least be partially recouped through operating the mall under lease.

The question of which of these options (either negotiating option or continue as contracted) to choose depends on a number of considerations for both JBM and the purchaser. For JBM, the best option depends on the expected value of litigation costs, the ongoing debt servicing costs, and the reputational costs associated with walking away. First, JBM needs to consider whether the combination of the debt servicing costs for the mall (stated to be high) and the costs of litigation assuming a loss exceed any additional value JBM can expect by both holding and eventually selling the mall. These costs are presumably quite high and therefore should be considered a worst-case outcome. The other costs JBM needs to consider are the reputational costs from walking away. Here JBM needs to consider how other purchasers will be affected by the information that JBM has walked away from other contracts and how JBM’s funding sources will treat the information. If JBM expects that it will face higher debt costs because funders are less certain that they will move through deals quickly, JBM may incur long-term ongoing costs in addition to any outcome related costs. On the other side, the purchaser, in developing a response, will need to consider lost revenues from the delay in closing and the time value of litigation, which may not be recoverable.

These considerations suggest that JBM should pursue one of the negotiating options, but should be prepared to back down relatively quickly. On the one hand, the language in the agreement leaves little room for JBM to back out of the agreement and thus leaves a high potential cost for walking away. On the other hand, the purchaser will be reluctant to forego revenue and expend effort on litigation and thus might be willing to compromise partially. This is where the negotiating strategy of seeking the lease option or an adjustment in the price creates the most room for compromise. Assuming JBM would be willing to take the lease (which would require that the higher revenues cover debt payments and still produce some income), the lease option will be preferable to purchaser over the alternative of litigation, but will deny purchaser a share of the excess revenues. Purchaser might, therefore, be willing to pay a lump sum to JBM to get it to not seek this option in order to keep revenues and avoid hassle.

B. Diatryma

For Diatryma Investors (DI) there are two issues: 1) the remedies available to the sellers, and 2) the seller’s incentives to accept a lower purchase price. The analysis of these options is based on the assumptions that the document review period has ended and that the one-week deadline for the bank and the government are hard deadlines.

DI is in a strong position based on the remedies available to the seller and its reservation price of $3.8 million. The seller’s remedies are established in §10.1 of the PSA and are limited to liquidated damages in the value of the earnest money ($100k). Given that the most DI is willing to pay for the property is $3.8m, the loss of $100k is less than the expected loss of $200k should they complete the closing. DI also has less to worry about in terms of reputation costs here, as their focus on distressed real estate puts them in a position where the sellers are presumably somewhat less picky about the purchaser than in normal real estate transactions.

Given that DI is willing to walk away and the costs of doing so are less than the costs of completing the deal, DI is in a particularly strong negotiating position relative to the seller and the other parties to the agreement (the bank and the government). It is assumed that the government will not negotiate and is holding the bank accountable for dealing with its toxic assets. As such, DI should focus on seeking as much of the difference in value in the transaction as it can. It should also not limit itself to negotiating with just the seller, but should also focus on the bank which is in a similarly difficult position. DI should therefore take one of two options, either it should push the sellers alone to adjust the price by as much as possible or it should approach the seller and the bank together and leave them to negotiate amongst themselves to determine who will absorb the difference in value.

The critical questions for DI are what incentives the other parties will have in this negotiation. First, DI will need to consider what flexibility and limits the seller has. The seller is personally liable to the bank for $1m, which means that if DI seeks the entire difference in value from the seller ($400k), the seller will be indifferent between foreclosure and adjusting the sale price in terms of value (though foreclosure might have higher costs to the seller in the long run). Because of that, anything less than the $400k, the seller should be willing to pay to complete the transaction to take advantage of the favorable write-off of the loan. The important question here is whether the seller has additional assets to put into the deal. If $500k is the max seller can pay, then there is a hard upper limit before he will opt for bankruptcy or some other option. The other important question is what the bank is willing to do. The bank has a real interest in closing out the loan and completing the deal, as it is receiving contingent money from the government to write off the loan. Given that the alternative is foreclosure and sale, along with recovery from the seller, the bank should be willing to adjust its write-off in order to complete transaction.

Given that both the bank and the seller have an interest in completing the deal in the next week, even under adjusted terms, the best option for DI is to demand that the price be adjusted and leave it to the bank and the seller to negotiate the difference. DI will need to decide how much of the $400k to demand, but it should probably seek as much as possible because the other two parties will probably come a fair way and, regardless, even if the deal falls apart, DI will finish in a stronger position than if it completes the transaction.

^ TOP

Question 2, Answer 1

1) AIG’s compensation scheme is poorly designed, because it insulates employees from the consequences of risky behavior in the past, makes little effort to distinguish between persons taking good risks and bad, and encourages future abusive risk taking.

This compensation scheme not only eliminates the downside from past risky behavior, but guarantees rewards based on prior risk. Under 3.01 a person is guaranteed their total economic reward from 2007 in 2008 and 2009 (senior managers are only guaranteed 75%). Combined with 1.29 defining total economic activity as bonuses, this essentially means the 2007 bonus is guaranteed for the next two years. Even if the bonus pool is underfunded, under 3.02, a shortfall will still be paid by AIG.

This makes little sense: a bonus should align interests of the employee and company by providing rewards to the employee when the value of the company appreciates. But here the bonuses are paid even though the company may lose money and losing money had become a real possibility at the end of 2007. Further, this compensation scheme creates a significant moral hazard. Employees seeing that the company is shielding them from the downside of risks will want to engage in deals with greater upside in the future, even if the downside is disproportionately large.

A further problem of this bonus scheme is it does nothing to examine individual success. In fact, likely those getting the largest payments in 2007 were those taking the biggest risks, not those taking best risk to return ratios. At the end of 2007, it was clear that market would change, and riskier policies would payout less, but the contract still guaranteed payments to essentially the biggest risk takers. This is a particularly perverse strategy and it guarantees poor performers in 2008 a certain payout even if fired under 3.04c.

Pegging to ones previous success makes sense where the company cannot verify an individual employee’s track record. However, measuring performance for AIG-FP is easy. It is clear which employees make which deals and it is clear how the individual deals perform, particularly because many of the transactions involve liquid policies. When it is easy to see whose products are adding value to the company and whose products are not, it makes little sense to make bonuses that discriminate based on past not current success.

This is not to say everything the retention plan does is bad. First, the plan recognized that AIG-FP was about to significantly underpay its employees. AIG-FP’s payment plan likely had very low base salaries. In which case, in order to retain employees when facing a bad year. AIG-FP had to increase their fixed salaries, which it did do by guaranteeing past bonus payments. However, this perhaps fixed the payment to the wrong measure, likely paid a much larger retention payment than was necessary, killed a bonus’s incentivizing value and created perverse incentives in its place. It would have been much better to raise the fixed salary on a measure unrelated to bonus and still provide for separate bonus payments related to individual performance.

Second, if those under previously signed up for deferral program must continue take AIG stock as compensation, (it is a little hard from the contract to tell whether those in the deferral program can opt out from year to year under 3.05), then this is a continuing effective way to encourages participants to increase the value of the company.

Third, under 2.06, the contract does not treat mark to market gains and losses as realized gains and losses for purposes of calculating the bonus pool. This is the right treatment. It discourages employees from engaging in transactions that will have short term gain but long term loss, and instead encourages transactions whose net result will be a gain for the corporation.

The contract also carries forward bonus losses, which at least partially mitigates the overpayment from one year by using to potentially offset a good year (if ever one again occurs). And finally, persons can be terminated under 3.04c for failing to add value to AIG-FP and at least there 2009 guaranteed payment will be forfeited.

2) While a heavily incentive based scheme is necessary where the government has become the de facto monitor, uncertainties as to AIG’s actual value require a uniquely devised payment scheme that offers significant value to AIG employees a few years into the future.

The government wants to pay as little as possible while retaining its employees and incentivizing those employees to perform well. AIG employees likely want payments similar to past bonus payments to. Further, employees might more willing to quit than ordinary because of the prospect of a demoralizing working environment and the prospect of having an overarching bureaucracy as a boss. Although, whether such a threat is credible is by no means certain because the available alternatives for AIG employees were clearly slim.

The best compensation scheme for senior employees would likely be one that incorporated both a fixed payment and bonus component part. The fixed component would have to be large enough to not force hard hit, now risk averse senior managers from quitting. But in this case a heavily system heavily titled towards bonus payments is necessary. This is particularly necessary because the government is likely even a more incompetent supervisor of the company’s performance than a shareholder elected board was. Thus bonuses based on rewarding good behavior become even more important, where owner monitoring is going to be worse.

The real difficulty is how is the government is going to reward particular employee behavior. The government cannot simply tie bonuses to profit, because AIG will not profit. The government for the short term wants to pour in as little bailout money as possible, which means stemming losses, and likely get out of AIG as fast as possible, which means that AIG is transformed into a sellable company without a toxic balance sheet.

Unfortunately, the government has really no way to measure either of these categories. The problem with the first suggestion is that it should be based on a calculation of projected and actual losses. But the government never had a clear idea where AIG’s floor would be (and still doesn’t). It is also not very easy to measure how the company takes steps that it make it sellable in the future. The best measure is stock value, but the whole problem is that the market is so volatile and AIG’s price is so tied up in past credit default swaps that any valuation based on the little remaining shares is too uncertain to serve as a yardstick for future corporate success.

So what to do? I would suggest that the company create a bonus pool derivative based on the current value of the company. Each employee would be given a certain percentage of the derivative. At the end of 3-5 years the derivative would pay off based on a certain percentage of the value increase of AIG at the time of the bail out to its value at execution. The value of AIG at the time of bailout though wouldn’t be determined till the execution date (when hopefully volatility had died down and a much clearer picture would exist of its past value and its then current value). To make it more fair to employees, it would be valued by an independent appraiser, perhaps a bank.

This payment scheme would have the advantage of measuring longer term activity rather than a one year payout. It would incentivize persons who decided to stay to stay for at least the full 3-5 year period.

One problem is a three-year payment scheme would likely be less attractive to an employee than a one-year scheme, so fixed salaries would have to be increased as a result. Further, employees would want some guarantee that they wouldn’t be dismissed early losing the whole package, so an employee terminated without cause would have to be guaranteed that when bonuses were paid out, they would get there appreciated bonus pro-rated for how long they worked. Also, this bonus scheme wouldn’t be based on individual performance, but here where the goal is to save a company not earn the largest profit possible, I think a scheme based on company performance as a whole might encourage more sound growth that the government is interested in.

Finally the overall scheme should lean in favor of large payments to employees. This would go against public opinion and political sentiment which would want lower payments to punish AIG-FP employees for past transgressions, but low salaries risk chasing away knowledgeable employees who have the best chance of maximizing the value of the company. I think the employees have a credible threat of leaving because despite other opportunities are slim, the work environment seems so bad that if one has any money saved up it would be better not to be at AIG, even if that meant unemployed.

Question 2, Answer 2

(A)

1. Introduction

Based on the objectives of AIG’s Employee Retention Plan, it appears that AIG foresaw a potential retention problem for the employees best situated to stem losses from its investments in derivatives, as the discretionary and incentive compensation of these employees was set to be erased by these losses. However, AIG appears to have made a number of false assumptions which resulted in a lack of flexibility in the Guaranteed Retention Awards (“GRA”) under the Plan, and certain drafting changes might have improved its chances of success. For discussion, I assume that under the AIG General Guarantee Agreement AIG is obliged to pay any GRA amounts exceeding the Bonus Pool, not including any GRA amounts covered by the Deferred Compensation Plan.

2. Advantages and Disadvantages

The Plan’s main success is that its arrangements do speak to retention, however bluntly. Yet by failing to account for the risk that retention payments may be unnecessary, and failing to replace the performance incentives erased by AIG-FP’s losses, the Plan fails in providing shareholders with a cost-effective plan for retaining the talent necessary to carefully unwind AIG’s failing assets.

At the time of contracting, it appears that discretionary and incentive payments for AIG-FP employees were tied to “Distributable Income,” which before the Plan seem to have been reducible by Realized Losses, Market-to-Market Losses, or both. Thus, the Plan correctly foresaw the coming dramatic increase in such losses, with a resulting drop in incentive payments for AIG-FP employees, who were at that time likely receiving the lion’s share of their compensation through these “bonuses.” Such a dramatic drop in employee pay certainly raises retention problems. However, the employee’s perspective on compensation is tied to alternative employment options, and this is where the Plan falls short. By failing to consider that the market for financial talent would dry up along with AIG’s assets, the Plan resulted in inordinately large payments to many employees who would have taken (and after public and political pressure, did take) smaller payments.

The Plan fell short in another important aspect in its replacement of AIG-FP’s disappearing bonuses: performance incentives. By fixing previously discretionary and incentive-based compensation for the next two years, employees trained to chase their cut of profits now have an incentive to slack off. This may have been done under the false assumption that performance incentives must be tied to profit or stock options. While there is a threat of termination for low performance under 3.04(c), such an employee is still guaranteed to receive the 2008 GRA. Further, during the downturn, much of AIG’s concern is in stemming losses from its structured financial products, and the Plan is at best not tied to ensuring the effectiveness of this goal at all. This lack of performance incentive combines with the excessive and guaranteed retention payment (in light of a lack of employment alternatives) to offer covered AIG-FP employees the rare luxury of slacking off during a downturn.

3. Adding Flexibility

To address the lack of flexibility in the current Plan, AIG could have implemented a number of changes. First, because the “retention” aspect of the Plan was heavily reliant alternative employment options, retention payments could have been tied to an industry benchmark. For instance, the GRA could have been tied to the stock prices of a basket of other financial firms, such as Goldman Sachs and Morgan Stanley. While not the clearest indicator of hiring, it is a readily available and objective benchmark. Thus, if shares of Goldman Sachs, Morgan Stanley, et al. dropped significantly then the retention payments would be reduced accordingly, roughly tracking the reduction in hiring of these and other financial firms. The formula could be tweaked depending on how strong of a retention incentive management thought necessary, perhaps capping it at the 2007 GRA in the case of an increase.

Addressing the lost performance incentive is more difficult. Without trading profits from trading and fees which are readily divisible into “bonuses,” AIG settled on a fixed-compensation scheme. But I would argue that the situation is actually cause for an elevated performance concern, since employees lack the ready metric of trading profits by which to measure themselves. Because employees may be engaging in tasks relating to stemming losses which escape automated measurement, a significant portion of the GRA should be discretionary, to be determined by each employee’s manager. Also, special provisions guaranteeing 2008 bonuses should be removed, and employees should only receive a pro rata share for the portion of the year worked. Finally, employees should lose their GRA if dismissed even for “no cause,” with the exception of any earned pro rata share.

This leaves some question of whether AIG could simply have raised employee salaries instead of awkwardly tying “retention” to past payments which may have little relevance in the future. Even if paired with discretionary bonuses, such an approach may not make sense from the ex ante 2007 contracting position, since the talent market at this point was still quite fluid. In fact, such a change may actually create a near-term retention problem, encouraging AIG-FP employees to leave for financial firms offering compensation that more fully reflects the investment banking mindset. Thus, an effective plan should create little change in near term compensation, but adjust as necessary if the market falls to reflect the dwindling employment alternatives available to AIG-FP employees. A solution tying the GRA to a market index or basket of financial stocks, coupled with managerial discretion over a portion of the award, is one such solution.

(B)

1. Revising the Plan

A revision of the Plan in September 2008 would be a good opportunity to reconsider both the retention and performance incentive aspects of the agreement in light of recent market changes. At that time, compared to 2007, it would have been much clearer that the market for financial talent had dried up significantly. In this light, payments made in 2007 with a view to reward and retention would have little bearing on the amount necessary in 2008 and 2009 to achieve the same result. A simple solution would be to simply cut the payments by some percentage, but this approach would still fail to speak to performance incentives, and may still draw government ire. In this sense, the hands of AIG and its employees would be somewhat forced with regard to renegotiation of the Plan.

One solution would be to both cut the percentage of 2007 Total Economic Award used as a base level for 2008-2009, and then further reduce the Plan by the percentage of the government’s exposure or involvement in AIG. Another alternative would be to negotiate the cancellation of the Plan in exchange for a simpler, two-element compensation scheme: (1) increased base salaries paired with (2) modest discretionary bonuses. Under such a plan, where the majority of compensation comes from base salary, would be effective where AIG-FP is no longer operating in its former risk-taking capacity but is purely attempting to cut its losses most effectively.

Would such a scheme be acceptable to employees covered under the Plan? If AIG were to become insolvent, the payment of GRA claims would depend on their subordination in relation to other AIG obligations. I will assume that at least a substantial portion of the GRA would go unpaid upon insolvency. Thus, an employee would only prefer a new Plan if its expected value to him were greater than that under the existing Plan. But upon insolvency, the employee may not only lose her GRA, but would almost certainly lose her salaried position as well. While employees of AIG-FP may not be especially risk-averse, the prospect of unemployment in September 2008 was likely enough to cause an AIG-FP employee to place significant value on mere employment in their chosen profession.

2. Executive Compensation

The immediate prospect of insolvency and a government bailout would greatly affect the design of executive compensation packages. During a period of government bailout, the traditional alignment of principal and agent achieved through stock options is called into question, because changes in share price may reflect the whims of government or systemic risk more so than the executive’s performance. In such a period, perhaps the long view of shareholders is to emerge from insolvency and government control where the officers might again be free to maximize share value. But an executive might arrange to sell the stock options earned during this period. In this sense, an executive compensation package could still be based in stock options, but these options should only be granted upon the successful reemergence of the company. Thus, an AIG executive would have the incentive to ensure the successful reemergence of AIG at the highest share price possible.

Would AIG executives find this arrangement acceptable? They might have to, or face replacement at the government’s hand. In sum, assuming only partial recovery in the case of AIG’s insolvency, both executives and employees have limited bargaining power and would likely accept the above-proposed renegotiation.

^ TOP

Question #1, Answer #1	Question #2, Answer #1
Question #1, Answer #2	Question #2, Answer #2