Why aren’t performance shares illegal?

Posted by Marc Hodak on September 15, 2013 under Executive compensation, Irrationality |

A pair of recent studies show that about a quarter of the compensation earned by CEOs is now paid as restricted stock. Furthermore, one of the studies notes that an increasing portion of that stock is being granted based on performance rather than automatically vested over time, and that stock price is one of the most common performance measures used to determine the number of shares granted. In other words, if the stock price goes up (or goes higher than some benchmark), then the executive would benefit from both the larger number of shares granted and the higher price per share. If the stock price goes down, the executive will get fewer shares at a lower price, or maybe no shares at all.  The governance mavens are praising this trend.

There is a lot to like about ‘performance share’ plans, and stock-based stock grants provide an exceptional level of motivation and accountability for total shareholder returns over a wide spectrum of performance over time.  So, I’m wondering:  Why is this kind of plan legal?

Consider how a ‘performance share’ plan works.  Let’s say that its designed such that: if the stock price falls 15 percent over three years, the plan would yield no shares to the executive; if the stock price grows 20 percent over that period, then the plan would provide a ‘target’ number of 30,000 shares; if the stock price doubles, the plan would provide 60,000 shares; and performance between these points, i.e., negative 15 percent and 100 percent, yields a proportionate number of shares, i.e., between zero and 60,000 shares. This plan provides a strong pay-for-performance profile.

Now, let’s say that instead of the ‘performance share’ program described above, we award the executive 100,000 shares, and lend them cash for 85 percent value of those shares, with the stipulation that they repay the loan from the proceeds of the stock at the end of the three-year period.  Let’s add that if the value of the shares is less than the loan, the repayment shortfall is forgiven. This ‘leveraged share’ program creates a mathematically identical pay-for-performance result as the ‘performance shares’ plan. Well, there is one difference between these types of plans, and it’s kind of big:  While the ‘performance share’ program is praised by the governance mavens, the ‘leveraged share’ plan is condemned by them, and is in fact illegal.

OK, let’s forget about the ‘leveraged share’ program, and instead offer 100,000 stock options granted 15 percent in-the-money. That is, the options would lose their value only if the stock price falls by 15 percent. Otherwise, as the stock price goes up, the executive makes more money. This ‘in-the-money option’ program is also mathematically identical to the ‘performance share plan,’ with correspondingly identical incentives and cost. The difference is that the ‘performance share’ plan is praised by the governance mavens, while grants of ‘in-the-money options’ are condemned by them, and essentially illegal (via punitive taxes) due to their disdain.

So, ‘performance shares’ are surging in use due to the applause of the governance mavens, while identical alternatives have been banished by those same mavens. I’m curious if this rule-based distinction between these three equity grant mechanisms strikes anyone else in the governance community as odd. Does anyone else see this as evidence of Geert Hofstade’s theory that risk-averse cultures have an emotional need for rules, even when they are arbitrary and ineffective?

  • Tony Bergmann-Porter said,

    An interesting proposition, but I’d offer the alternative hypotheses that this has to do with 1) “optics” (your alternatives take a bit of thought); (2) dilution (100k vs 60K shares in your example); (3) the fact that most of the legal/regulatory/governance crowd are attorneys, who (as a group; obviously, there are exceptions)are not very numerate.

  • Marc Hodak said,

    Good points, Tony, particularly (3), which kind of subsumes the other two.

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