Paying for Long-Term Performance
46 Pages Posted: 14 Jan 2010 Last revised: 8 Oct 2010
Date Written: December 1, 2009
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.
Keywords: executive compensation, executive pay, equity-based compensation, restricted shares, options, risk-taking, long-term, retention, backdating, spring-loading, unloading, insider trading, hedging, derivatives
JEL Classification: G28, K23
Suggested Citation: Suggested Citation