There’s a better path than regulation to fix stock buybacks
The SEC recently has proposed rules designed to hamper corporations’ repurchases of their own shares, a practice that boosts share prices, providing enormous benefits to investors. The proposed rules will require the company to report the share repurchase within a day of the transaction, rather than the current practice of a quarter-long delay. Additionally, the proposed reporting would be more comprehensive.
Part of the motivation for this rule is a concern that share repurchases enable managers to sell the shares they have received as incentive compensation at “inflated prices.” To resolve this, we propose a simple and transparent executive compensation plan that would allow companies to address this concern without any additional regulations: The incentive compensation of senior corporate executives should consist primarily of restricted equity (i.e., restricted stock and restricted stock options). That is, restricted in the sense that the individual cannot sell the shares or exercise the options for six to 12 months after their last day in office.
Under this plan, most incentive compensation would be driven by total shareholder returns instead of short-term accounting-based measures of performance such as return on capital, or earnings per share. This view is consistent with the results of a recent survey of Fortune 500 directors conducted by the Rock Center for Corporate Governance at Stanford University, where 51 percent of respondents said they consider total shareholder return to be the best measure of company performance compared to accounting-based measures.
The rationale for restricting stocks six to 12 months after an executive’s departure is to eliminate perverse incentives to make self-interested decisions during the “end-game” immediately prior to retirement. In particular, the delay would eliminate incentives to engage in share repurchases just to sell vested shares at an artificially inflated price immediately after leaving the company.
Of course, the proposal imposes some costs on executives. To begin, if executives were required to hold restricted shares and options their savings would most likely be under-diversified, with a resulting decrease in risk-adjusted expected return. In addition, if executives are required to hold restricted shares and options post-retirement, they may be concerned with a lack of liquidity.
To address these concerns, we recommend increasing amounts of equity awarded slightly from current levels in order to bring the risk-adjusted expected return back up. Additionally, managers should be allowed to liquidate annually, with board approval, a reasonable percentage of their restricted shares and options.
It can be argued that incentive schemes along these lines would encourage young executives to leave companies after a period of good stock performance in order to lock in gains to their incentive schemes. But any such temptation is offset by concerns that executives who develop a reputation for early departures from firms will soon find they have fewer high-quality career opportunities.
The problem of misaligned executive compensation leading to corporate scandals and worse has been studied extensively. This research shows that senior executives of companies like Enron, WorldCom, and Qwest made misleading public statements regarding the earnings of their respective companies and these misleading statements led to a temporary rise in the companies’ share prices. Certain executives liquidated significant amounts of their equity positions during the period while their companies’ share price was temporarily inflated.
Additionally, there is evidence that misaligned incentive compensation played a substantial role in the share-price run-up of the big banks prior to the 2008 financial crisis, and the subsequent implosion of these big banks during 2008. CEOs of the big banks that received government bailout funds during the 2008 financial crisis sold significantly more (in both absolute and relative basis) stock prior to the crisis than CEOs of banks that did not ask for or receive government bailout funds.
In the above cases, if these executives’ incentive compensation had consisted of only restricted equity that they could not liquidate for six to 12 months after their last day in office, they would not have had the financial incentive to engage in fraud and share price manipulation.
We recognize that one size does not fit all. Corporate boards need to use their understanding of the unique circumstances of their companies’ opportunities and challenges to amend their compensation plans to ensure that such plans are focused on serving the interests of long-term shareholders. In implementing the proposal, corporate board compensation committees should be the principal decision-makers regarding the mix and amount of restricted stock and restricted stock options a manager is awarded, the maximum percentage of holdings the manager can liquidate annually and the number of months post-retirement/resignation for the stock and options to vest. But directors must focus on these issues in order to avoid onerous new regulations that harm shareholders and weaken capital markets.
Sanjai Bhagat is provost professor of Finance at the University of Colorado, and the author of “Financial Crisis, Corporate Governance, and Bank Capital,” published by Cambridge University Press.
Jonathan R. Macey is the Sam Harris professor of Corporate Law, Corporate Finance and Securities Law at Yale University and professor in the Yale School of Management. Macey is the author of several books including “Corporate Governance: Promises Kept, Promises Broken,” published by Princeton University Press.
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