Commentary by David F. Larcker, James Irvin Miller Professor of Accounting & Director, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.
In its most recent proxy, CIT outlined the compensation of newly hired CEO, John Thain (formerly CEO of Merrill Lynch). Thain will receive a base salary of $500,000. He will also receive restricted stock units worth $5.5 million and a cash incentive award of $1.5 million.
The restricted stock units vest upon grant and are subject to a holding period. $2.5 million must be held for one year before being sold. The remaining $3.0 million must be held for three years.
The cash incentive award vests two years after the grant date and is subject to an additional one-year holding period. The cash incentive award also contains a clawback provision that requires that the amount be repaid, “if it is determined that Mr Thain has taken excessive and unnecessary risk.”
The inclusion of both holding periods and clawbacks makes this an interesting case study. From our perspective, holding periods are a very effective tool to align the interest of managers and shareholders. By requiring an executive to retain stock awards (rather than simply cash them out), the company is encouraging the executive to consider an extended time horizon when making operating and investment decisions. In this way, the executive becomes a real shareholder and is more likely to manage the company with shareholder interests in mind.
While clawback provisions are intended to have the same effect, they are much less likely to do so. The board has the right to reclaim bonuses if the company later falters, but practically speaking it is difficult for them to do without provoking a lawsuit. This is why we rarely, if ever, see clawbacks implemented. Instead, clawbacks only tend to punish executives in extreme circumstances, making them unreliable as an incentive mechanism.
By contrast, holding periods force executives to suffer in accordance with the quality of their decisions. If their decisions are marginal, the value of their holdings will decline marginally. If their decisions are abysmal, so will be the value of their payout.
Shareholders should decide who they trust more to reclaim lost value: the same market that punishes them without remorse, or the board of directors that oversaw the “excessive and unnecessary risks” in the first place.