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Business Day
Safety Suffers as Stock Options Propel Executive Pay Packages
SEPT.
11, 2015
Outsize
executive pay packages have
frequently been a flash point for stock market investors. Lavish
executive compensation at publicly traded companies should be a
significant concern for consumers, too.
That’s
the message of a new study by three academics at the University of
Notre Dame. Their research focuses on companies that rely heavily on
stock options in executive compensation. They have found a correlation
between generous option grants and the incidence of serious product
recalls.
Stock
options have been the jet fuel propelling some of the biggest
executive pay packages over the years. From an investor’s point of
view, these instruments are problematic because they provide an
executive with little downside if the company’s underlying shares fall
but oodles of upside on the rise.
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This
heads-I-win, tails-I-barely-lose arrangement encourages executives to
swing for the fences, an array of academic research has shown. Eager
to reap the riches from a rising share price, option-laden executives
have been found to make unwise acquisitions or, even worse, to
undertake aggressive accounting practices.
Now
comes evidence that product recalls are often linked to abundant
option grants handed to chief executives. The
study, “Throwing Caution to the
Wind: The Effect of C.E.O. Stock Option Pay on the Incidence of
Product Safety Problems,” concluded that “C.E.O. option pay was
associated with both a higher likelihood of experiencing a recall as
well as a higher number of recalls.”
The
study’s authors are Adam J. Wowak, Michael J. Mannor and Kaitlin D.
Wowak, all assistant professors of management at the Notre Dame
Mendoza College of Business.
In an
interview on Tuesday, Mr. Wowak said that he and his colleagues wanted
to build on past analyses of how stock options induce risk-taking
among executives. “If options are generally causing C.E.O.s to be more
aggressive, then it makes sense that more mistakes could occur and
consumers could be affected,” Mr. Wowak said. “Options could be making
C.E.O.s ignore the downside potential of some of their actions.”
The
researchers scrutinized companies in two industries that are closely
regulated by the Food and Drug Administration. All of the companies
had sales and assets of at least $10 million. The academics looked at
the size of stock options in proportion to a chief executive’s total
pay and calculated a two-year average, finding that recalls tended to
be more prevalent at companies with higher option percentages. The
names of specific companies were not cited in the study.
One
group of companies produced consumer staples like foods, beverages and
personal care products, while the other manufactured health care
products, including medical devices and pharmaceuticals. Over the
period studied — from 2004 through 2011 — these two sectors together
accounted for over 85 percent of all recall activity reported by the
F.D.A., the professors said.
Their
analysis examined two significant types of product recalls: those in
which a product could cause serious harm or death and those in which
exposure to a product might cause temporary or medically reversible
health consequences.
The
study examined the pay packages of 386 chief executives. One curious
finding emerged: Product recalls were less common among companies
whose chief executives founded the companies or had long tenures
there. Such executives may be more risk-averse because they are
generally large shareholders and may also feel that their personal
reputations are intertwined with their companies’ actions.
“It
was interesting for us to see that options don’t affect everybody the
same way,” Mr. Wowak said in the interview. “When boards design pay
packages, it would be beneficial for them to think about how their
C.E.O. might respond and tailor the package around that.”
Mr.
Wowak acknowledged that among publicly traded corporations over all,
stock option grants as a percentage of total pay had declined
recently. Many companies are dispensing restricted stock instead,
making sure that executives feel the pain of a falling share price
alongside their stockholders. With options, a falling stock price
represents a lost opportunity for a future gain, not an actual hit to
executives’ wallets.
But
stock options remain popular. Data compiled by
Equilar, an executive compensation
analytics firm in Redwood City, Calif., shows that among the companies
in the Standard & Poor’s 500-stock index, option grants totaled 16.1
percent of direct pay for chief executives in 2014. In 2010, that
figure was 20.1 percent.
“Of
course, not every product recall that happens is caused by stock
options,” Mr. Wowak said. “And it’s possible to pay a lot in options
and not have a product recall. But boards are wise to have a balanced
view of the potential downside to building in heavy option components
to executive pay.”
The
researchers’ focus on health care companies was appropriate: These
companies are the biggest users of stock options, Equilar found. Last
year, 84.4 percent of chief executives at these companies received
options, while 67.3 percent of top managers at consumer goods
manufacturers were recipients, according to Equilar. At utility
companies, by contrast, only 27.6 percent of chief executives were
granted options.
Among
the top dispensers of stock options as a percentage of total C.E.O.
pay, Equilar found, are Monster Beverage, with 87.1 percent; Avago
Technologies, a semiconductor maker, with 84.2 percent; and Stericycle,
a medical waste management company, at 69.7 percent.
Representatives from the three companies did not respond to requests
for comment.
Having
fielded complaints from shareholders about excessive executive pay for
decades, corporate boards say they have gotten the picture that chief
executives’ pay should be aligned with their owners’ interests. As
this new study shows, directors should understand that executive pay
needs to line up with consumers’ interests as well.
A version of this article appears in print on September 13, 2015, on
page BU1 of the New York edition with the headline: Safety Suffers in
Executive Pay Packages.
© 2015 The
New York Times Company |
