U.S. regulators are reconsidering the popular plans that let executives sell their shares without running afoul of insider trading rules. Known as 10b5-1 plans, they allow executives to buy or sell shares on a preset schedule, under the assumption that any future move could not have been affected by inside knowledge.
Earlier this year, the SEC began to explore changes that would bring improper use of these plans to heel. This new focus comes not so long after executives of pharmaceutical companies sold a collective half a billion dollars of stock in 2020 – frequently through such plans.
In examining 10b5-1 plans, the SEC has shown a spotlight on a pervasive problem trend in the realm of executive compensation – the use of supposedly long-term tools for short-term pay. The reasonable goal of a 10b5-1 plan is to schedule the sale of a set amount of stock on a regular basis. But about a third of plans since 2004 involve just a single trade. Clearly, what was intended to be a tool to provide structured liquidity over time is being gamed to provide one-off paydays instead.
Chairman Gary Gensler is right to call the use of 10b5-1 plans into question. Specifically, they allow for extreme flexibility in starting and canceling trades with very little disclosure – a setup that almost invites manipulation. But they are not the only means to manipulate long-term pay structures for near-term gains.
An entire generation of investors has lobbied companies to use total shareholder return (TSR) as the barometer for executive pay, with the goal of aligning executives’ interests with their own. The problem is similar to 10b5-1 plans, in that short-term TSR rewards immediate bumps in stock price rather than long-term performance. Over half of the largest US companies use a form of TSR in their compensation plans, but less than 2% use terms of five years or longer when evaluating performance.
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We know that financial incentives are a powerful motivator, and we know for certain that short-term incentives motivate short-term behavior. The current state of executive pay falls squarely into the short-term category – recent data puts average duration of compensation plans for CEOs of companies on the MSCI All Country World Index at 1.7 years.
Since an executive’s role is to manage a company for long-term success, having skin in the game is critical. Corporate compensation committees, and investors with the voting power to sway corporate decision-making, have the means to link the success of the company and the success of its executives over the long term. They can be thoughtful about the timing of compensation in terms of performance periods, vesting periods, or mandatory holding periods, all of which can create an arrangement where executives’ goals and rewards are distributed over time, rather than defaulting to incentives based on short-term metrics.
Some in the industry are proposing intriguing new alternatives. Norges Bank Investment Management, responsible for managing Norway’s oil wealth fund, has proposed that companies lock up their executives’ shares for 5-10 years, including after retirement or resignation. This, understandably, has not yet caught on, but the logic is appealing, as it would focus executives on the long-term success of the company, not simply their own short time in the seat.
Too often, compensation plans are driven by regulations and taxes rather than the company’s long-term business strategy. Having executives maintain a vested interest in the long-term performance of the organization should be encouraged, rather than discouraged, by policymakers.
By taking a closer look at the issues with 10b5-1 plans, the SEC has highlighted a far greater issue with the nature of executive compensation as a whole. Without structures that tie executives’ fortunes to the long-term performance of their companies, executives will be tempted to make the short-term decision to cash in. Whether through regulation, investor pressure, or corporate best practice, a reevaluation of existing rules and practices through the lens of promoting long-term performance and alignment could provide much-needed momentum to make incentive short-cuts a thing of the past.