Jesse M. Fried
89 Texas L. Rev. 1113
Executives of public companies receive most of their pay in equity compensation, which is intended to better align their interests with those of the firm’s shareholders. However, most equity compensation is tied to the short-term stock price, which may shift the executives’ focus from long-term value. Professor Fried identifies a different problem, which arises when the executive is free to sell stock in the short-term or must hold it for the long-term. Tying payoffs to the stock price, argues Fried, fails to align executives’ interests with the maximization of aggregate shareholder value, which is the amount of value flowing to all the firm’s shareholders over time. Fried shows that tying payoffs to the future stock price can even encourage executives to take steps to destroy aggregate shareholder value.
Two distortions result from tying executives’ payoffs to the future stock price. When the current price is below its actual value, executives whose pay is tied to the future stock price are rewarded for funding bargain-price share repurchases rather than making productive investments in the firm. When the stock price is higher than its actual value, these executives are rewarded for issuing new shares even if the firm cannot productively use the consideration received in exchange. Fried calls these “costly contractions” and “costly expansions.”
These distortions arise because the executives’ interests are aligned only with investors who do not buy or sell shares until the executive cashes out her equity. Executive interests are not aligned with those shareholders that either sell or purchase shares before the executive cashes out.
Fried proposes a mechanism that would perfectly tie executive pay to aggregate shareholder value, which he calls the “constant-share” approach. Accordingly, executives must adjust their equity holdings in the firm whenever it purchases or sells its own shares to keep them constant through the transaction, selling shares whenever the firms repurchases its own stock and buying whenever it issues new equity.
Fried acknowledges that problems with this approach exist. It will make it more difficult for executives to personally benefit, so they can be expected to resist its adoption. Also, it may lead to a lower stock price, which could in turn increase the likelihood of a takeover attempt or proxy fight. So, directors may also be against adopting it.