Treasury Secretary Timothy Geithner
announced on Wednesday the Obama administration's strong belief in tying
executive compensation to long-term company performance. The regulations
issued that day direct the new "compensation czar" to ensure that
financial firms receiving "exceptional assistance" from the government
don't "reward employees for short-term or temporary increase in value."
Companies not covered by regulations are also currently seeking to tighten
the link between pay and long-term performance. The question is how this
could best be done.
About the Authors
Lucian Bebchuk is
professor of law, economics and finance and director of the
program on corporate governance at Harvard Law School. Jesse
Fried is professor of law at Berkeley's Boalt Hall and
co-director of its Center for Law, Business, and the Economy.
This piece is based on Mr. Bebchuk's testimony at the House
Financial Services committee on Thursday and their forthcoming
white paper, "Equity Compensation for Long-Term Performance."
With respect to equity compensation – a
central component of modern executive pay arrangements – companies should
prevent executives from cashing out vested grants of options and shares
for a fixed number of years. But companies should avoid arrangements that
block executives from cashing out options and shares until the executive's
retirement, or any other event that is at least partly under that person's
Grants of equity incentives – options and
restricted shares – usually vest gradually over a period of time. A
specific number of options or shares vest each year, and the vesting
schedule provides executives with incentives to remain with the company.
Once options and shares vest, however, executives typically have
unrestricted freedom to cash them out, and executives often liquidate them
quickly after vesting.
The ability to cash out large amounts of
equity-based compensation has provided executives with powerful incentives
to seek short-term stock gains even when doing so involves excessive
risk-taking. This short-termism problem, which was first highlighted in a
book we published five years ago, "Pay without Performance," has become
widely recognized in the aftermath of the crisis – including by business
leaders such as Goldman's Lloyd Blankfein in a Financial Times op-ed.
The short-term distortions can be addressed
by separating the time that options and restricted shares can be cashed
out from the time that they vest. As soon as an executive has completed an
additional year at her firm, the restricted options or shares that were
promised as compensation for that year's work should vest, and they should
belong to the executive even if the executive immediately leaves the firm.
But the executive should be allowed to cash them out only down the road.
This would tie the executive's payoffs to long-term shareholder value.
Some experts have called, including at
Thursday's hearing at the Financial Services Committee of the House of
Representatives, for permitting executives to cash out shares and options
only upon retirement from the firm. Shareholder proposals have also been
urging companies to adopt such "hold-till-retirement" requirements. Such
requirements, however, would be the wrong way to go.
Hold-till-retirement requirements provide
executives with counter-productive incentives to leave the firm in order
to cash out accumulated options and shares and diversify risks.
Perversely, the incentive to leave will be strongest for executives who
have served successfully for a long time and whose accumulated options and
shares will thus have an especially large value. Rather than supplying
retention incentives, equity compensation with hold-till-retirement
requirements would have the opposite effect.
A similar distortion arises under any
arrangement tying the freedom to cash out to an event that is at least
partly under an executive's control. Following the requirement adopted by
Congress in February as part of the stimulus bill, Treasury's new
regulations mandate that TARP recipients preclude executives from cashing
out granted shares before TARP funds are repaid. To the extent that TARP
recipients adopt the regulations' minimum restrictions on cashing out,
executives would have incentives to return TARP funding even when they
shouldn't be doing so.
To avoid the above problems, the period
during which vested equity incentives may not be cashed out should be
fixed. For example, when an executive's options or shares vest, one-fifth
of them could become unblocked, and the executive would subsequently be
free to cash them out, in each of the subsequent five years. Because the
blocking period would be fixed, the executive's actions wouldn't be
distorted by a desire to accelerate the cashing out of equity incentives.
And as long as the executive is working for the firm and options and
shares continue to vest, the executive would always have an incentive to
care about the company's performance several years down the road.
The devil, as is often the case, is in the
details. Well-designed blocking periods can do a great deal to curtail the
perverse incentives that we have seen – and to provide executives with
desirable incentives to enhance the long-term value of their firms and