Vol 11 (2014) - Issue 5

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The Derivative Solution to Perverse Incentives and Poor Pay-Performance Sensitivity in Executive Remuneration Contracts – Part Two

Introduction
This article is Part Two of a two-part series intended to highlight and propose a solution for perverse incentives and poor pay performance sensitivity in executive remuneration contracts.
Having outlined the key problems with existing executive remuneration contracts and the corresponding solutions proposed by Bebchuk & Fried in the first half of this paper, I begin the second half by presenting a possible solution. I will suggest that whilst Bebchuk & Fried’s work raises valid concerns, their proposed solutions are overly complex and that the same goals could be achieved in a much simpler fashion through a correctly structured compensation contract including a cash derivative linked to the average share price of the firm.
If structured as proposed, I contend that such a contract would successfully avoid the pitfalls evident with current remuneration mechanisms while achieving the desired goal of linking pay to long-term shareholder value. I will present this point as a contractarian argument rather than a proposal for legislative reform. The average share price derivative is a mechanism available to remuneration committees with potential benefit to executives and shareholders alike.
In Part 6, I will set out further details of the proposed compensation mechanism, suggesting an appropriate term for calculation and the introduction of 'relative performance evaluation'. I will conclude in Part 7 by considering why such compensation contracts are not already in use.

5. A proposal: the average share price derivative
Thus far, I have outlined the existence of two key problems with existing executive compensation contracts. Firstly, their structures have a propensity to promote perverse incentives in the form of 'short-termism' and 'gaming' and, secondly, pay-performance sensitivity levels are often too low to truly align executive and shareholder interests.
I have also described the solutions Bebchuk & Fried propose in order to combat the first of these two problems. In short, they advocate a complex and convoluted compensation scheme involving grant-based limitations, aggregate limitations, restrictions on derivative transactions, pre-specified grant dates for equity awards, immediate and gradual cash out schemes and mandatory disclosure requirements. Whilst I do not challenge the likely effectiveness of these measures, their complexity suggests that firms will be unwilling to adopt them. More importantly however, I believe there to be a much simpler and elegant solution available.
It appears as though the complexity of Bebchuk & Fried’s proposals results from their insistence on modifying existing equity-based compensation schemes rather than attempting to re-design the optimal compensation contract from first principles. Indeed, they do not appear to have considered the creative use of secondary instruments such as derivatives as part of a compensation package.
Derivatives are contracts whose value is based on the performance of an underlying asset or security and are a method of gaining exposure to the asset without having to own it. As executive interests should be tied as closely as possible to long-term shareholder value, a derivative could be constructed to provide a customised linkage between the two.