Paying for Long-Term Performance

Lucian Bebchuk is the William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance at Harvard Law School. Jesse Fried is a Professor of Law at Harvard Law School.

How should equity-based plans be designed to tie executive payoffs to long-term performance? This question has been receiving much attention from firms, investors, and regulators. We seek to answer this question in a study, Paying for Long-Term Performance, which is available here.

In our 2004 book Pay without Performance, we warned that standard executive pay arrangements were leading executives to focus excessively on the short term, creating perverse incentives to boost short-term results at the expense of long-term value. Following the financial crisis, there is now widespread agreement about that importance of avoiding such persevere incentives and of tying compensation to long-term results. There is much less agreement, however, on how this should be done. Building on ideas put forward in Pay without Performance, our study provides a detailed blueprint for structuring equity based compensation, the primary component of modern executive pay schemes, to tighten the link between pay and long-term results.

Here is a bit more detail about the content of our study: To improve the link between equity compensation and long-term results, the time when executives become free to unwind equity incentives should be separated from the time such incentives vest. Thus, vesting conditions should be accompanied by restrictions on unloading, and our study analyzes the optimal design of such restrictions.

We argue that it would be undesirable to require, as some commentators and reformers have proposed, that executives hold their equity incentives until retirement. Instead, we advocate that firms adopt a combination of grant-based and aggregate limitations on the unwinding of equity incentives. Grant-based limitations would allow executives to unwind the equity incentives associated with a particular grant only gradually after vesting, according to a fixed, pre-specified schedule put in place at the time of the grant. Aggregate limitations on unwinding would prevent an executive from unloading more than a specified fraction of the executive’s freely disposable equity incentives in any given year. Together, we suggest, these limitations would ensure that executives place sufficient weight on long-term results.

We also explain 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 “spring-loading” (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 incentives are granted, and gaming at the “back end,” when equity incentives are cashed out.

Finally, we put forward the case for a broad adoption of anti-hedging provisions 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 executives’ use of any hedging or derivative transactions that would enable them to profit or at least protect them from declines in their company’s stock price.

Any comments on or reactions to our study, which is available here, would be most welcome.

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