Coronavirus Stimulus, Executive Compensation, and Share Repurchase
Congressional leaders are currently debating a stimulus to address the economic downturn caused by the coronavirus pandemic. Executive compensation in companies that receive the stimulus funds has become a point of major disagreement. Policymakers are concerned that stimulus funds should be used to safeguard the solvency of these companies and paychecks for the rank-and-file employees, and not be used to increase executive compensation. However, executives have to be compensated today like everybody else, but, more important, their compensation has to give them the correct incentives to stay with the company and plan for a rapid and strong comeback of their company as the pandemic subsides and economy picks up later in the year. We propose an executive compensation plan that addresses concerns of both sides.
The Case for Restricted Equity Plans
There are three criteria to consider in evaluating executive compensation policies: simplicity, transparency, and a focus on creating and sustaining long-term shareholder value. Simplicity and transparency in incentive compensation packages mitigate public skepticism toward high levels of executive pay in conjunction with public funds being used to keep the company solvent. Focusing on creating and sustaining long-term shareholder value would channel management’s attention to the longer term profitability of an investment strategy.
We propose that the incentive compensation of senior corporate executives should consist only 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 one to two years after their last day in office. Many compensation contracts currently require the forfeiture of restricted shares when an executive leaves the firm, but boards may want to consider using restricted shares that are not forfeited when the executive departs and only vest after the executive leaves the company and over the course of a few years.
Under this restricted equity compensation plan, all incentive compensation would be driven by total shareholder return instead of being directly related to accounting-based measures of performance such as return on capital, return on equity, or earnings per share. Accounting-based measures of performance tend to mostly focus on short-term performance. 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 Fortune 500 director respondents said they consider total shareholder return to be the best measure of company performance compared to accounting based measures.
A restricted equity plan will, no doubt, encourage managers to seek a considerably higher proportion of fixed cash salaries to compensate for the restricted ability to realize the value of equity incentive awards. Hence, we are recommending a cash salary maximum of the average cash salaries they received in the past three years (2017-2019).
The Flip Side
There are three important concerns with this compensation plan structure. First, if executives are required to hold restricted shares and options, they would most likely be under-diversified. Second, if executives are required to hold restricted shares and options post-retirement, they may be concerned with lack of liquidity. Third, this kind of a compensation plan could lead to early managerial departures as executives seek to convert illiquid shares and options into more liquid assets after the one- to three-year waiting period.
The deliberate under-diversification brought about by being subject to a restricted equity plan would lower the risk-adjusted expected return for the executive. One means of bringing an executive’s risk-adjusted expected return back up to the previous level would be to increase the expected return by granting additional restricted shares and options to the executive. As a result, the amount of equity awarded under the restricted equity plan will be higher than that awarded under a short-term incentive plan.
Concerns regarding lack of liquidity and early departure are also valid. To address these concerns, managers should be allowed to annually liquidate 5 percent to 10 percent of their awarded incentive restricted shares and options. The requirement that they must retain the majority of the shares for several years after retirement or departure will provide sufficient incentive to advance long-term shareholder interests.
Unlike most other executive compensation proposals, this restricted equity plan does not place a ceiling on (the present value of) executive compensation. This compensation structure only limits the annual cash payouts an executive can realize. The present value of all salary and stock compensation can be higher than senior managers have historically received. Of course, the higher value would only be realized were they to invest in business strategies that lead to value creation that persists in the long-term, in which case we have a win for long-term investors, and a win for employees through their ESOP holdings and improved employment prospects. Also, a focus on creating and sustaining long-term shareholder value would minimize the likelihood of a future bailout which would be a win for taxpayers.
Each Company Is Unique
Board compensation committees may want to consider adopting a restricted equity plan as the preferred mechanism for aligning management’s incentives to long-term shareholder wealth. In implementing the proposal, corporate boards should be the principal decision-makers regarding:
1. The mix of restricted stock and restricted stock options a manager is awarded.
2. The amount of restricted stock and restricted stock options the manager is awarded.
3. The maximum percentage of holdings the manager can liquidate annually.
4. Number of years post retirement/resignation for the stock and options to vest.
However, 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 the restricted equity plan to serve as their executive incentive compensation plan, ensuring that the resulting plan is focused on serving the interests of long-term shareholders – which would also serve the interest of employees and the public fisc.
Discourages Share Repurchase
Typically, companies engage in share repurchases with their better-than-expected cash flow as a signal of better future company prospects, and this results in an increase in the company’s share price. Some managers engage in share repurchase since it affords them the opportunity to sell their shares at the higher price.
Stimulus funds are related to the economic downturn caused by the pandemic, not the better-than-expected cash flow noted above. Funds provided by the stimulus are intended to keep the company afloat and meet employee payroll. Hence, stimulus funds should not be used for share repurchases.
The executive compensation program noted above has the added benefit of discouraging managers from engaging in repurchases for a short-term increase in their share price - which would be the result of a stimulus funds based share repurchase. Under the above executive compensation program, they will not be able to sell their shares at the temporarily higher share price; they would have to wait for a year or two after their departure from the company before they can sell their shares.
