As the struggle for corporate control between advocates for long-term, sustainable economic growth and promoters of short-term financial performance rages on, we thought it made sense to highlight the point at which this battle manifests itself most frequently in discussions of executive pay: the selection of performance goals in incentive compensation programs. Specifically, we wanted to call attention to the brewing debate over the use of earnings per share and similar goals (EPS) in performance-based pay programs.
For many good reasons, EPS is among the most common financial performance metrics used by public companies in their incentive compensation programs. First, EPS is a key driver of share price, which many see as the ultimate measure of corporate performance. By tying pay to earnings, companies link pay to a metric over which management is viewed as having more control than share price itself. Moreover, by tying pay to per share earnings, companies provide management teams with incentives to not only increase earnings but to decrease share count if doing so is the most efficient use of company capital. These rationales are supported by a study by James F. Reda, which found that studied companies that use EPS growth as a performance measure are more likely to outperform companies that do not use such a metric, including those that use total shareholder return metrics.
While these rationales make sense, many, including BlackRock Inc.’s CEO Laurence Fink and even presidential hopeful Hillary Clinton, have become increasingly critical of short-termism in corporate America. Certain shareholders including union groups, most notably CtW Investment Group, question the advisability of the use of EPS as a performance metric. These shareholders have claimed that EPS and similar targets do not hold executives accountable for the size and sustainability of cash flows generated for reinvestment and for capital investments that they make. They further believe that use of EPS as a performance metric provides executives with too much control over whether the goal is met. Specifically, with share buybacks reaching ever-increasing heights in light of the Fed’s zero interest rate policies, they believe that managers can manipulate EPS targets via large-scale buybacks and earnings management.
The concern is that over the next several years shareholders such as CtW may gain the support of larger institutional holders such as BlackRock and Vanguard. In a letter to large cap CEOs, Larry Fink recently criticized “the acute pressure, growing with every quarter, for companies to meet short-term financial goals at the expense of building long-term value” and noted that “more and more corporate leaders have responded [to pressure from activists] with actions that can deliver immediate returns to shareholders, such as buybacks or dividend increases, while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.” Mr. Fink put a fine point on the interplay between short-termism and executive pay when he wrote that supporting management is “more difficult to do where management has not articulated a clear long-term vision, strategic direction and credible metrics against which to assess performance. [emphasis added]”
While in the recent past shareholder pressures on executive compensation largely focused on the eradication of so-called “egregious pay practices,” shareholders today are more focused on performance measures and goal setting. As we have previously advised, the best way for companies to avoid getting caught in the cross hairs of executive pay controversy is to make sure that pay programs reward executives for achievement of stated strategic, financial and operational goals and that such goals are consistent with the company’s attempt to achieve sustainable, long-term growth. We note that there is no one size fits all approach to executive pay and corporate governance, but in the upcoming years companies should anticipate an environment in which EPS and similar goals are more closely scrutinized.
The preceding post is based on a memorandum published by Jeremy L. Goldstein & Associates, LLC on August 20, 2015.