Throwing Caution to the Wind: Effects of CEO Stock Option Pay
Summary
Many companies offer options-based compensation plans to their CEO’s to incentivize a management style that pursues growth. Stock options give the recipient the right to purchase shares at a set price during a specific time period. The belief is that if the compensation is linked to the stock price of the organization, the CEO will be motivated to adopt strategies to maximize share price and in turn benefit the shareholders as well.
This article highlights an interesting paradox. CEO’s that receive options-based compensation take higher risks while simultaneously increasing the chance that they manipulate earnings and are named in shareholder lawsuits. A prior study (Sanders and Hambrick, 2007) found CEO’s more likely to generate big losses than big gains due to options-based compensation. The reason for this finding is the asymmetric payoff of options. If the stock price goes up, the CEO makes a large amount of money. If the stock price goes down the CEO can choose not to exercise the option.
This research examines the effect options-based compensation has on product safety. The study contributes new insights related to the consequences of options-based compensation on consumers by focusing on product safety problems in organizations with significant levels of options-based compensation.
Hypotheses
- CEO stock option pay is positively associated with the likelihood of a subsequent product safety problem,
- The influence of CEO option pay on subsequent product safety problems will be weaker for longer-tenured CEO’s than for shorter-tenured CEO’s, and
- The influence of CEO option pay on subsequent safety problems will be weaker for founder-CEO’s than for non-founder-CEO’s.
Research Methods
The sample is composed of companies regulated by the FDA. The FDA’s responsibility is to ensure product safety for consumers over many industries from food to medical devices. The sample included companies in the food, beverage, and medical device industry exclusively. These industries contained over 85% of all recall activity over the time period studied in this research. Finally, the study collected recall data using weekly enforcement reports by the FDA on Class 1 and Class 2 product recalls.
Dependent Variables
- Likelihood of product recall – measure of whether a company experienced a recall in a given year
- Number of product recalls – the number of recalls in a given year
Independent Variables
- Stock option pay – looked at proportion of total pay that was options-based
Results
The study found that options-based compensation was positively and significantly associated with the likelihood of product safety concerns. The tests of Hypothesis 2 generally supported the idea that CEO options-based compensation was a weaker factor for longer-tenured CEO’s than for shorter -tenured CEO’s. Finally, the influence of CEO options-based compensation on founder CEO’s is weaker than on non-founder CEO’s.
Original Article Source: “Throwing caution to the wind: The effect of CEO stock option pay on the incidence of product safety problems“, Strategic Management Journal, 2014
