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Paying for Long-Term Performance (a normative view)

Bebchuk and Fried wrote in 2009 a since then classical article on “Paying for Long-Term Performance”, in which they addressed one of the problems that if not at the roots of the 2008 economic crisis, nevertheless helped increase the damages generated by it, (particularly within the financial sector). (1) We will in this post summarize the Eight Principles they recommend to consider when designing a Long-Term Incentive Plan, and what is more, when the equilibrium between short-term pay and long-term pay is considered.

In 2009 Treasury Secretary Geithner urged corporate boards to “pay top executives in ways that are tightly aligned with the long-term value and soundness of the firm”. In fact, a belief was widely shared, that pay arrangements before the 2008/2009 crisis were flawed as they forced executives to focus in the short-term and to take excessive risk, to the expense of the long-term value of the firm, (that sometimes was a systemic risk entity).

Even if there was agreement on that, how to do it was not a common ground. Bebchuk and Fried tried to define the best way to tie equity-based compensation to long-term performance, (1).

Bekchuk and Fried first describe the diverse limitations to equity awards realization to be introduced in order to force executives to look for the long-term.

  1. Separating vesting and freedom to unwind. In general stock options and restricted stock have a gradually vesting formula, so that in a certain year, a number of options or shares vest, a period of free unwinding following the vesting date. Usually executives unwind their positions immediately, which forces companies to give them more equity awards to maintain their equity exposure and alignment, (thus increasing the dilution generated by the plan); even more, it concentrates in that date the efforts that executives could deploy to “manipulate” the stock price. That leads B&F to propose the separation of the two dates, (except for the amount necessary to cover for the taxes that eventually accrue upon vesting, (the firm could withhold a certain amount of awards or acquire the shares). That is Principle 1.
  2. Retirement-based holding requirements. The date where an executive is allowed to sell his shares, once separated from the vesting date, can be linked to his retirement date, (totally or partially). Although this solves problems cited in a), it also creates other problems: first, the executive (even more the most successful ones) could retire (even if the firm wishes to retain him) at certain high stock price periods; second, the date concentration would attract the manager to pursue short-term results even at the expense of long-term value, around this date. This is Principle 2: date of unwinding must not be placed upon retirement.
  3. Grant-based limitations on unwinding. B&F suggest that instead of upon retirement, executives should be allowed to unload a certain percentage, (20%, for instance) of each equity grant two years after vesting, so that 20% would unload every year onwards. This would help avoid the two problems arising in b), and the gradual approach is also relevant to circumvent excessive focus on certain dates. This is Principle 3.
  4. Aggregate limitations on unwinding. Even if gradualism is introduced, after a number of years executives would be free to sell “significant” anounts of stock, thus the problem of date concentration arises again. B&F suggests to introduce a percentage cap on what executives can sell over their total “not subject to grant-based limitations and vested” number of shares, a limit that should still apply upon retirement, at least for a number of years. This is Principle 4.

B&F consider the possible outcome of certain behaviors that seek to maximize the proceeds stemming from the designed pay structure drafted above, (the now abandoned back-dating, springloading, insider information and stock price manipulation). As for the grant date, (what they call the Front End), two gaming problems arise:

  1. The timing of Equity grants. As stock options are usually granted at the money, there is an incentive to advance the grant date to good news disclosure. The case of restricted stock grants is the same, as if the stock price is reduced an executive would receive a higher number of shares or units. Thus, Principle 5 states that equity grant dates should not be discretionary, but be settled at predetermined dates.
  2. Stock price manipulation around equity grants. Bad news disclosure before the grant date and similar actions disguise in the money options into at the money ones, so that terms and amounts of (post-hiring) equity awards should not be based on the grant date stock price. This is B&F`s sixth Principle.

As for the Back End, (the ), some other gaming problems also emerge: if executes are free to decide when they sell their shares, they can use insider information or manipulate the stock price before their unwinding. They can even take business decisions addressed to produce short-term results at the expense of more longer-term profits. In order to tackle these issues, companies may take some decisions:

  • Executives could be forced to sell their shares at an average price in each period; executives could sell their shares to the company at market prices, so that months afterwards an adjustment would be made to consider an average price. Alternatively the executive would only be allowed to sell the shares gradually.
  • Other steps: average prices can reduce but not eliminate gaming at the back-end.
    1. Companies could also force the executives to disclose their planned unwinding actions.
    2. Firms could otherwise determine the dates in which executives would be allowed to sell well in advance, (at vesting date, for instance).

So, Principle 7 emerges: if the executive can decide on the timing of sales of equity not subject to unwinding limits, they should announce their sale in advance or have it decided in advance.

The eighth Principle is a reasonable corollary; if a certain level of ownership is required, the executive shouldn`t use any hedging strategy that would prevent him from being aligned with shareholders` interests. Even more when it is considered that hedging might also involve some use of insider information.


(1) Bebchuk, Lucian A. and Fried, Jesse M., Paying for Long-Term Performance (December 1, 2009). University of Pennsylvania Law Review, Vol. 158, pp. 1915-1959, 2010; Harvard Law and Economics Discussion Paper No. 658. Available at SSRN: http://ssrn.com/abstract=1535355 or http://dx.doi.org/10.2139/ssrn.1535355


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