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Paying For Long-Term Performance

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Paying For Long-Term Performance by SSRN

Lucian A. Bebchuk

Harvard Law School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR) and European Corporate Governance Institute (ECGI)

Jesse M. Fried

Harvard Law School; European Corporate Governance Institute (ECGI)

December 1, 2009

University of Pennsylvania Law Review, Vol. 158, pp. 1915-1959, 2010

Harvard Law and Economics Discussion Paper No. 658


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.

Paying For 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. The crisis of 2008–2009 has led to widespread recognition that pay arrange-ments that reward executives for short-term results can produce incentives to take excessive risks. Leading public officials, such as Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner, as well as top business leaders such as Goldman Sachs’s CEO Lloyd Blankfein, 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.” The Troubled Asset Relief Program (TARP) bill, subsequent legislation amending TARP, and the Treasury regulations im-plementing TARP 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 Compensa-tion 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. The Treasury’s plan for financial regulatory reform called on federal regulators to issue standards for all financial firms to avoid excessive risks, and a bill recently passed by the House of Representatives requires regulators to adopt such standards. In the meantime, regulators have been moving on their own in this direction: the Federal Reserve Board of Governors requested comments on a proposed guidance contemplating the scrutiny of pay arrangements by banking su-pervisors, 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.

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. 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.” 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.

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.

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