Throwing caution to the wind: the effect of CEO stock option pay on the incidence of product safety problems

Do CEO stock options negatively affect product safety? Possibly, according to this study.

They compared CEO stock options and product safety recalls on FDA regulated companies between 2004 – 11.

PS. Keep an eye out for next week’s compendium on leadership research 👍

Background:

· “A central premise of agency theory is that organizations can align the interests …CEOs and shareholders by designing compensation arrangements that reward CEOs for gains in shareholder value”

· “Such incentives are thought to be useful in counterbalancing a CEO’s natural tendency toward risk aversion, which stems from a desire to avoid the substantial personal losses (including their income, reputation, and job) that can result from risky initiative”

· “evidence suggests that options encourage risk taking such as increased acquisition activity .. and decreased hedging … But in an interesting paradox … CEO options have been shown to increase the likelihood of earnings manipulation .. and shareholder lawsuits”

· “It seems that options do prompt aggressive responses by CEOs, but whether these responses reflect the best interests of the organization is less clear”

· “pursuit of stock option payoffs may cause CEOs to overlook product safety concerns in their decision making”

· “a CEO’s response to … options would “cause CEOs to not be attuned to early signs of project failure and generally careless about risk mitigation”

Results:

· They demonstrated that “stock options may cause CEOs to overlook or otherwise de-prioritize the internal practices that go into making a safe, high-quality product”

· “Our study thus underscores the idea that managerial opportunism can affect a variety of organizational stakeholders”

· “we demonstrate the potential in studying the effects of executive incentives on a broader array of firm constituents”

· They provide an example of the 1982 Tylenol recall – observing J&J had “developed a strong reputation for prioritizing product safety above all else—including quarterly earnings”

· The CEO from 2002 received 56% of pay via options, and cut costs to raise operating margins to 26%

· “With less financial emphasis on quality control, product quality began to suffer, and J&J found itself recalling an increasing number of products because of safety concerns”

· CEO characteristics also influence the consequences – “the influence of option pay on product recalls becomes less pronounced as CEO tenure advances”

· “the effect of options depends on whether the CEO founded the firm. These findings suggest that individual motives can importantly influence how a given executive will respond to incentive compensation”

· There are likely to be a lot more CEO characteristics which influence the consequences that were not studied