Equity Compensation for Long-Term Results

From The Wall Street Journal:
By Lucian Bebchuk and Jesse Fried

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.

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 control.

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

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