05 Apr 2017
Reforms will help put long-term value over short-term profit
Corporate governance reforms outlined in a report published today by the Business, Energy and Industrial Strategy (BEIS) Select Committee have been welcomed by a London Business School (LBS) expert who gave evidence to the committee.
The report said Long-Term Incentive Plans (LTIPs) should be scrapped from 2018. Instead, executives should be given equity that they must not vest in one go and which they would have to hold for a minimum of five years.
Alex Edmans, Professor of Finance at LBS, who gave oral and written evidence to the committee, said: “I strongly endorse the recommendation to replace bonuses based on financial targets with long-term equity, as recommended in my written evidence. This is backed up by a decade of research that I have done on this topic, and will help ensure executives pursue long-term social value, not short-term profit.”
According to Professor Edmans, complex and opaque LTIPs distort executive behaviour, with CEOs gaming the system to affect share prices in the short term.
“Despite the name, evidence shows that long-term incentive plans lead to short-termism as the end of the evaluation period approaches. If the stock price is just below £4, the CEO may cut R&D to boost earnings and get the short-term stock price over the hurdle. The CEO might also gamble. If the gamble fails, the stock price falls to £3, but the LTIP wouldn’t have paid off anyway, so the downside is limited. If the gamble succeeds, the stock price rises to £5 and the CEO cashes in. Effectively, the LTIP gives a one-way bet.”
Scrapping LTIPs is one recommendation put forward by MPs on executive pay. Other wide-ranging reforms in the report include implementing a new governance code for the largest private companies and a new traffic light tiering system, introduced by the Financial Reporting Council, to hold directors to account.
The MPs’ inquiry was launched last year following major corporate governance failings at BHS and Sports Direct.