The Sanctity of Contracts in a World of Bailouts

By Epstein, Richard A. | Chief Executive (U.S.), June 2009 | Go to article overview

The Sanctity of Contracts in a World of Bailouts


Epstein, Richard A., Chief Executive (U.S.)


Every firmand every CEOthat has received bailout money has to ask itself whether its employment contracts are immune from government revision.

Major public dustups have an unsettling way of forcing CEOs, who are often in the line of fire, to ponder funda- mental questions about the structure of this nation's economic order. Here are two examples. Exhib- it A is the brouhaha over executive compensation packages in the finan- cial services industry that erupted this past March after the public out- cry over $165 million in retention payments that AIG promised to key its employees. Unfortunately, these payments were often mislabeled as bonuses, and thus generated a public association with the windfall payments that failing firms made to the same individuals who drove their companies into the ground.

If that had been the case, public scorn would have been amply warranted. But the reality was otherwise. The retention payments were given selectively to those executives whose skills were judged essential to the preservation and revitalization ofthe firm. Doubtlessly, they were calibrated to the improvement in position that these key employees could bring about Just observing the size of defened pay- ments and the profit/loss position sup- plies no information about the marginal contribution that key work- ers make to the firm. No shortsighted accounting can possibly explain why AIG's former CEO, Edward Liddy, moved heaven and earth to keep his leading people- until the top-down Treasury pressure broke his will.

Exhibit B is the massive Treasury interference with the Chrysler and GM bankruptcies. For months, the Obama administration took steps outside of me bankruptcy courts to keep both firms alive. Yet that approach did not allow the two companies do what they had to do, which is to strip away the oner- ous collective bargaining agreement with the UAW and thin out the dealer- ship networks so as to create an efficient distribution system. But no matter how much money was pumped into the fell- ing firms, they continued to bleed cash because ofthe inability to rationalize their cost structures. Unfortunately, these overdue bankruptcies did not fol- low the ordinary mies, because most of the heavy lifting was done politically. The dealers had little clout and a huge fraction of them were terminated. The UAW pension and health funds fared far better. Even though they were unsecured, they were presented with a substantial interest in both companies. Their good fortune came at the expense ofthe various bondholders, who as secured creditors were entitled to be paid in full before the unsecured creditors got anything. But the political pressures inverted the priorities in favor ofthe UAW.

Private Oversight and Public Indifference

The chief lesson from these sorry events is that industry outsiders with partial knowledge- President Obama not excepted- often make bad judgments about the wisdom of practices they do not understand. In President Obama's case, the key weakness stems from his misguided prior conviction that all market transactions- from minimum wages to executive compensation-should be subject to political oversight. In fact, the sound approach calls for the opposite strategy: Olympian detachment by government officials, let the social critics say what they will. The posture of lofty indifference is, however, difficult to defend whenever blending of business and regulatory responsibilities makes it impossible for key government officials to do either job well.

The Broader Picture

Worse still, these episodes have influence that spreads far beyond the particular case. Right now, virtually every financial institution, and every firm that has received bailout money, has to ask whether its own employment and loan contracts are immune from government revision. That uneasiness has already destabilized the structure ofthe United States financial services and industrial sectors. Here's why. …

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