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04/07/2008

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Jack

Geez! This is quite a different tune played on a different harmonica than that of "Medicare inefficiency".

John

It is a different tune. Probably because paying millions of dollars to a handful of CEOs, if inefficient, isn't nearly as inefficient as paying the healthcare bills of millions of elderly Americans.

Jeff V.

If the billable hour were such an inefficient method of compensation, one would expect to see firms start to devise other compensation methods for routine litigation matters such as employment litigation. There, the GC really could tell the boss that he is trying to cut costs without worrying for being blamed if the company loses. I haven't seen much evidence that this has occurred, though, which makes me think that the billable hour may be more efficient than you think.

Brian Davis

I'll only comment on lawyer comp. Great private-sector lawyering still happens every day in America at a "set" fee. It happens in our criminal-law and sometimes family-law courts. The fee is "set" because - win, lose or draw - it's usually the only compensation the lawyer's going to see. And it's usually collected at the time of hire. "Inefficient" is too charitable a term for the wasteful multiplication & protraction of lawyer comp that's tolerated if not accepted on the civil side.

Jim

Judge Posner,

Suddenly I realize that you are a philosophical conservative. Changing an imperfect system might get you something even less desirable. Could you talk to Hillary and Barack for us?

dcuser

One of the big problems with implementing set-fee lawyering in big cases is that it's extremely tough at the outset of a case to predict how much lawyer time the case will take.

It makes a huge difference whether the case is dismissed or settled at the 12(b)(6) stage, or whether it proceeds to discovery. Often, that just can't be predicted. It also makes a huge difference whether the case is resolved at summary judgment or proceeds to trial.

Frequently, sophisticated corporate clients may be in a better position to estimate costs than the outside lawyers. A lawyer might think the case looks easy based on the client's description -- but then discovery reveals a smoking gun in the client's files that prevents summary judgment.

You could figure that it will all average out among repeat players -- that the corporation will pay a per-case flat fee that roughly matches the average dollar value of the run of its cases, and that the law firms will think likewise in their billing. But that certainly doesnt work for big cases (think of the Microsoft antitrust suit) that can represent a huge share of a law firm's work or the corporation's legal budget during the time in question. And there's a great human tendency to resent the overpayments (or the undercharging, if you're the law firm) in any individual case. (Think of what the anti-plaintiffs groups say about the lawyer who takes her 30% cut of the accident victim's quick settlement -- they're outraged at someone getting paid so much money for the small amount of work done in the individual case; they don't consider it balanced out by the vast number of unsuccessful cases the lawyer also takes and works hard on.)

David Heigham

Judge Posner points to a problem that is becoming more and more generalised. The economies of the world are featuring human capital more and more prominently in their production functions. Human capital is less homogeneous than physical capital; and the contribution of human capital to a desired outcome is often intrinsically more uncertain.

However the patterns and difficulties in rewarding both forms of capital appropriately are analagous. Where there is a fair degree of homogeneity it makes as much sense to pay an hourly market rate to an engineer as it makes to pay the market rate for the work station he sits at. If the supplier of work stations persuades you to to pay for a model with twice the capacity you need because you are not able to judge what capacity is required, he is doing no more and no less than the firm of attorneys who persuades you to pay for their juniors who have nothing to do. You may expect to suffer as any firm will that loses control of its inputs.

But what it is worth paying for access to IBM's Blue Gene computor, for hiring an excellent lawyer, a top-flight geologist, a really good manger or any other piece of clearly non-homogeneous capital really is a gamble. The place to look for a pattern of billing which will encourage both good buying and effective supply is probably the theory of repeated games. For eaxample, I would reason from that theory that a pattern of billing that charges per professional hour a rate that just keeps the lawyers in business, combined with a substantial margin dependant on the levels of client satisfaction achieved, is likely to achieve a better long term result for both the law firm and the client company in Judge Posner's example; and it would probably tend to enhance the general counsel's status in the corporation.

Ben F

I find a problem with assuming that since (experience has borne out) the billable hours model is as efficient as it is going to get, the same must be true regarding inefficiency in executive compensation models. Maybe the inclusion of the example of billable hours is just that, an example; but it reads as if it is supposed to be evidence toward the inefficient solution conclusion, not just an incedental example.
Second, apparently a conclusion is reached that an inefficient solution for executive compensation is the best solution--without even discussing or leaving the door open for potential alternatives (with the minor exception of mentioning private-equity firms).

(((btw, i commend the use of a hyphen in "private-equity")))

Elle

CEOs receive over 360 times the average workforce salary. If we replaced each CEO with 100 qualified people, each earning $150,000, would not a company, shareholders, and economy be more productive, creative, and profitable?

Yet it is possible that even without CEOs companies would still exist. That is, large corporations usually don't succeed or fail based on one person, but one person can also make a significant difference. In fact, many investors bet on the jockey and not the horse, so to speak, and winners find a way to win. So, how do companies value or decide who is a winner and what that person is worth? Is the formula based largely on track record, pedigree, friendship, and connections?

Whatever the formula, companies don't always hire winners. Even executives with poor track records are hired and some continue to make bad decisions and lead companies to bankruptcy. For example, Morrison Knudsen, Enron, Worldcom, Merrill Lynch, Citibank, Countrywide, Bear Stearns (and the list goes on), all had well compensated CEOs who destroyed their companies while collecting inflated paychecks and still the companies continued to reward the CEOs, even with golden parachutes.

Over-inflated CEO salaries would be more acceptable if CEOs were also punished for poor performance. It is frustrating to the shareholders, workers and public in general when someone like Merrill Lynch’s former CEO, Stan O’Neal, received over $160 million when Merrill Lynch reported its largest ever quarterly loss of over of $2 billion and a total loss of over $8 billion for 2007 (New York Daily News).

According to CNN, Citigroup's former CEO, Charles Prince, received over a $10 million bonus for 2007, and was allowed to keep $28 million in stock because he resigned rather than be fired. Why did Charles Prince receive millions in bonuses when his company lost billions? On a smaller scale, if a mailroom employee had lost comparatively much less, say several thousand dollars because of bad decisions, he would be fired without recourse let alone a golden parachute.

According to USA Today, Countywide's CEO, Anthony Mozilo, earned $120 million despite losses of $1.2 billion in 2007. Of what value is Mozilo's pay when his company lost so greatly? Mozilo should be required to pay back the wages “earned” to help cover the losses of his company!

Over the past five years Bear Stearns’ executives have received millions in compensation and were some of the most highly compensated investment banking executives on Wall Street. Why aren't Bear Stearns’ executives required to pay back some of their earnings from the past five years to help cover their losses?

Even more alarming, if you look at private equity and hedge fund managers compensation in 2006, each of the top 20 managers earned an average of over $650 million, i.e. more than 15,000 times the earnings of the average worker and over 40 times average earnings of CEOs.

The highest paid hedge fund manager earned $1.7 billion in 2006. Is a hedge fund manager worth $1.7 billion? This is gratuitously excessive, yet hedge fund managers’ earnings are taxed at the long-term capital gains rate of 15% instead of the (higher) income tax rate, which is the tax rate of regular workers.

According to Business Week surveys, which take a regular look at the nation's largest public companies, in 1980 the average CEO made over 40 times the average workers’ wage. If the average workers’ wage had grown over the past 20 years at CEO pace the average worker would be earning well over $100,000 instead of $41,000. Did the value of the CEO increase and the value of the employee decrease? Has immigration both legal and illegal caused the huge earnings gap between CEOs and their employees? Are the CEO salaries a function of the growth of the company’s stock, the stock market, productivity, creativity, innovation, vision, etc?

When companies do well the boards praise and reward the CEOs with enormous compensation packages for jobs well done, yet when companies do NOT do well the boards still reward the CEOs with enormous compensation packages. The absurd paradigm is frustrating to the workers and common taxpayers who are shouldered with the burden.

CEOs’ salaries are similar to or at the level of celebrity salaries, yet the public is not outraged at celebrity salaries. The public is more accepting of the enormous earnings of athletes, artists, musicians, actors, authors, because if these people don’t perform well, their earnings go down. Unlike CEOs, these people are responsible for their own success or failure and compensated accordingly.

If we changed our tax code so companies were allowed to deduct up to $100,000, annually, per individual, companies could pay a CEO or any employee whatever they wanted. This would apply to sports teams/organizations, partnerships, LLC's, hedge funds, law firms, PTPs, ad firms, movie studios, everyone. With this change to the tax code, enormous compensation packages would no longer be on the backs of the taxpayers.

By limiting the tax deduction to $100,000 per employee, companies would have to evaluate if multi-million dollar pay packages were prudent, since companies would not be able to reduce their profits and thus tax liability through million dollar salaries. Boards would have to decide whether CEOs were truly worth millions in compensation that could not be deducted.

Under this plan, the government is not telling companies what they can pay a CEO; the government is merely limiting the deduction. Companies would decide if they want to absorb the cost of the CEO compensation or use the money for other purposes.
Limiting the tax deduction to $100,000 (including stock options and more) per individual, allows companies, not the taxpayers, to feel the full impact of the boards/stockholders decisions.

Only the board of directors should decide what is fair compensation, but whatever the board decides should not be on the shoulders of taxpayers. The public has had enough of this burden.

Jack

Elle: Excellent analysis of the socialism for the rich that is destroying our nation. The real heroes of business are the "CEO's" of America's millions of small businesses who most often operate with inadequate capital and for whom the downside is complete ruin and personal bankruptcy.

I like your idea of limited deductibility as it seems the concept of deductible business expenses were meant to apply to costs of goods sold and legitimate mfg and distribution costs so that only profits were to be taxed. The other reason for a deduction would bt that of a societal good such as spurring more research or providing affordable housing. Exorbitant salaries seem neither of these.

But, given the run-up of the last 25 years and an interlocking directorate of an old boy's club would even respond to the additional tax bill or take it too out of the hides of those of average or median wages.

One thing is sure that some form of flattening is necessary so that those who've been squeezed the hardest can re-enter the market place and mop up some of the world's over-capacity by fulfilling at least a few of their long, unmet needs; even billionaires can only use so many goods and services.

But, Ha! perhaps, if, as more than a few suggest, it's 1928 again, it flattens itself and Barack? becomes by necessity the FDR of another New Deal?

MIEK GAO

Hallo nice to see your blog here
I am so happy to make a friend with you

Jie

Dear Becker and Posner:

I recently heard about the case of Alton Logan, a wrongfully convicted murderer in the state of Illinois. Even though two public defenders knew that one of their own clients was responsible for the killing, they did not speak out to prevent the wrongful conviction. Lawyer-client privilege was the argument. The economics of it is simple: if the lawyer-client privilege is not in place, the whole system will break down. In other words, suspected criminals will not seek legal counsel and furthermore, will not reveal any thing that will incriminate themselves. In theory and on paper, it is logical, but does it make practical sense in real life where one's life is at stake? Lastly, codes of ethnics are only bare minimums.

Michael Martin

"It is efficient to live with a good deal of inefficiency."

To wit, Warren Buffett has made a lot of money of those inefficiencies over the years:

"I mean, you don't want a capital market that functions perfectly if you're in my business. People continue to do foolish things no matter what the regulation is, and they always will. There are significant limits to what regulation can accomplish."

http://money.cnn.com/2008/04/11/news/newsmakers/varchaver_buffett.fortune/index.htm?source=yahoo_quote

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