Firms, investors, and regulators around the world are now seeking to ensure that the compensation of public company executives is tied to long-term results, in part to avoid incentives for excessive risk taking. This Article examines how best to achieve this objective. Focusing on equity-based compensation, the primary component of executive pay, we identify how such compensation should best be structured to tie pay to long-term performance. We consider the optimal design of limitations on the unwinding of equity incentives, putting forward a proposal that firms adopt both grant-based and aggregate limitations on unwinding. We also analyze how equity compensation should be designed to prevent the gaming of equity grants at the front end and the gaming of equity dispositions at the back end. Finally, we emphasize the need for widespread adoption of limitations on executives' use of hedging and derivative transactions that weaken the tie between executive payoffs and the long-term stock price that well-designed equity compensation is intended to produce.
INTRODUCTION I. LIMITATIONS ON UNWINDING EQUITY INCENTIVES A. Separating Vesting and Freedom to Unwind B. The Problem with Retirement-Based Holding Requirements C. Grant-Based Limitations on Unwinding D. Aggregate Limitations on Unwinding II. PREVENTING GAMING A. The Front End 1. The Timing of Equity Grants 2. Stock-Price Manipulation Around Equity Grants B. The Back End 1. Gaming Problems at the Back End a. Using Inside Information to Time Equity Unwinding b. Stock-Price Manipulation Around Unwinding 2. Addressing Gaming Problems at the Back End a. Average-Price Payoffs b. The Need for Additional Steps c. Pretrading Disclosure d. "Hands-Off" Arrangements III. LIMITATIONS ON HEDGING AND DERIVATIVE TRANSACTIONS CONCLUSION APPENDIX: PRINCIPLES FOR TYING EQUITY COMPENSATION TO LONG-TERM PERFORMANCE INTRODUCTION
In the aftermath of the financial crisis, regulators, firms, and investors are seeking to put in place executive pay arrangements that avoid rewarding executives for short-term gains that do not reflect long-term performance. This Article seeks to contribute to these efforts by analyzing how pay arrangements can and should best be tied to long-term performance. Our analysis focuses on equity-based compensation, the most important component of executive pay arrangements.
In our 2004 book, Pay Without Performance: The Unfulfilled Promise of Executive Compensation, we warned that standard executive pay arrangements were leading executives to focus excessively on the short term, motivating them to boost short-term results at the expense of long-term value. (1) The crisis of 2008-2009 has led to widespread recognition that pay arrangements that reward executives for short-term results can produce incentives to take excessive risks. Leading public officials, such as Federal Reserve Chairman Ben Bernanke (2) and Treasury Secretary Timothy Geithner, (3) as well as top business leaders such as Goldman Sachs's CEO Lloyd Blankfein, (4) have all emphasized the importance of avoiding such flawed structures.
Recognition of the significance of the problem has generated substantial interest in fixing it. Treasury Secretary Geithner has urged corporate boards to "pay top executives in ways that are tightly aligned with the long-term value and soundness of the firm." (5) The Troubled Asset Relief Program (TARP) bill, (6) subsequent legislation amending TARP, (7) and the Treasury regulations implementing TARP (8) all required the elimination of incentives to take "unnecessary and excessive risks" in firms receiving TARP funds. The Interim Final Rule on TARP Standards for Compensation and Corporate Governance, which appointed Kenneth Feinberg as the Special Master for TARP Executive Compensation, instructed Feinberg to focus on tying pay to long-term performance. (9) The Treasury's plan for financial regulatory reform called on federal regulators to issue standards for all financial firms to avoid excessive risks, (10) and a bill recently passed by the House of Representatives requires regulators to adopt such standards. (11) In the meantime, regulators have been moving on their owaa in this direction: the Federal Reserve Board of Governors requested comments on a proposed guidance contemplating the scrutiny of pay arrangements by banking supervisors, (12) and the Federal Deposit Insurance Corporation (FDIC) requested comments on a proposal to raise deposit insurance rates for banks whose compensation arrangements create excessive incentives to take risks. (13)
At the international level, the Basel II framework has been recently amended to require banking regulators to monitor compensation structures with a view to aligning them with good risk management. (14) At their September 2009 meeting, the G-20 leaders "committed to act together to ... implement strong international compensation standards aimed at ending practices that lead to excessive risk-taking." (15) The U.K. Financial Services Authority has adopted regulations aimed at ending such practices, (16) and other countries have been moving or considering moves in such a direction. (17)
While there is thus widespread recognition that improving executives' long-term incentives is desirable, there is much less agreement as to how this should be accomplished. The devil here, not surprisingly, is in the details. In this Article, building on our earlier work, we seek to contribute to pay-arrangement reform by providing a framework and a blueprint for tying executives' equity-based compensation--the primary component of their pay packages--to long-term performance.
Part I analyzes how executives should be encouraged to focus on the long term rather than the short term. The key principle should be, as we argued in Pay Without Performance, (18) that managers must hold a large fraction of their equity after it vests. The analysis in Part I focuses on the optimal design of limitations on unwinding. We argue against the proposal that executives should be prevented from unwinding equity incentives until their retirement. Tying the freedom to cash out to retirement, we show, can distort executives' decisions to retire as well as undermine their incentives to focus on long-term value when approaching retirement. Instead, we put forward unwinding limitations designed to prevent executives from attaching excessive weight to short-term prices without creating perverse incentives to retire. An executive receiving an equity-based grant should not be free to unwind the received equity incentives for a specified period of time after vesting, after which she should be permitted to unwind the equity only gradually. In addition, an executive's unwinding of shares should be subject to aggregate limits on the fraction of the executive's portfolio of equity incentives that the executive may unwind in any given year.
Part II describes how executive compensation arrangements should be structured to prevent various types of "gaming" that work to increase executive pay at public shareholders' expense and, in some cases, worsen executives' incentives: so-called "springloading" (using inside information to time equity grants); selling on inside information; and the manipulation of the stock price around equity grants and dispositions. We discuss how to control both gaming at the "front end"--when equity is granted--and gaming at the "back end"--when equity is cashed out.
At the front end, the timing of equity grants should not be discretionary, and equity awards should be made only on certain prespecified dates. In addition, the terms and value of equity grants should not be linked to the grant-date stock price, which can easily be manipulated. The combination of these two steps at the front end would substantially reduce both springloading and stock-price manipulation around equity grants. At the back end, we propose arrangements that would reduce executives' ability and incentive to time dispositions based on inside information, as well as reduce executives' ability and incentive to manipulate the stock price around the time of disposition. Executives could be required to announce their intentions to unwind equity in advance. Firms could also use "hands-off" arrangements under which an executive's vested equity incentives are automatically cashed out according to a schedule specified when the equity incentives are initially granted.
Finally, Part III advocates that firms adopt arrangements designed to ensure that executives cannot easily evade the proposed arrangements--both those that require executives to hold equity for the long term and those that prevent gaming. Deploying arrangements that are desirable in theory will have little effect if they can be easily circumvented in practice. We therefore explain the importance of placing robust restrictions on the use of any hedging or derivative transaction that would enable executives to profit, or would protect them, from declines in their company's stock price.
During the course of our analysis in Parts I through III, we distill our conclusions into eight "principles." In an Appendix, we assemble them into a list of eight principles for tying equity-based compensation to long-term performance.
Before proceeding, we would like to comment on the scope of our analysis and note several issues that fall outside of it. To begin, our analysis focuses on equity-based compensation and does not extend to bonus compensation, which also needs to be reformed to prevent executives from attaching excessive weight to short-term results. As for equity-based compensation, we do not analyze the elements of long-term shareholder value for which executives should and should not be rewarded. Thus, we do not consider here whether executives should be paid with restricted stock or options, or the extent to which the payoffs from these equity instruments should be designed to filter out changes in the stock...