Blog: Do Stock Options Affect Consumer Safety?

Cooley LLP

Yes, according to a new study, “Throwing Caution to the Wind: The Effect of C.E.O. Stock Option Pay on the Incidence of Product Safety Problems,”  from the University of Notre Dame, as reported in this NYT column by Gretchen Morgenson.   The study showed a correlation between a high proportion of stock options relative to total CEO pay and the incidence of serious product recalls.

The reason for this result, so the argument goes, is that stock options fuel excessive risk-taking behavior among executives: according to the study authors, their “‘results are consistent with prior research showing that option-heavy pay arrangements engender aggressive risk-taking by CEOs, who stand to benefit greatly from future increases in share prices but lose nothing if share prices fall.’ The researchers theorized that higher levels of stock option pay would cause CEOs to favor aggressiveness over thoroughness in their decisions, a consequence of which would be a higher likelihood of mistakes in the design, production and distribution of products. [According to one of the study authors, this] isn’t to say that CEO options are always the culprit when product recalls occur, but our findings suggest that recalls can potentially be an unintended consequence of using options to motivate risk-taking in CEOs….’”

The study examined the pay packages of 386 chief executives at companies with sales and assets of at least $10 million in two regulated industries over the period from 2004 through 2011. In particular, the study authors considered the size of stock options relative to total CEO pay and calculated a two-year average.  The study also evaluated two 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 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.” One of the study authors speculated that “[o]ptions could be making C.E.O.s ignore the downside potential of some of their actions.”

Interestingly,  researchers reported that the correlation between options and product recalls was strongest for CEOs with shorter tenure in their positions, while there were fewer recalls where CEOs had longer tenure.  In addition, at companies where the CEO was a founder, product recalls were less common.  One of the study authors speculated that “founders may be more motivated by an intrinsic desire to protect their companies than by an extrinsic desire for large financial payouts.” Accordingly, the study authors recommend that boards take these potential differences into account: “[w]hen 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.”

The study authors recognized that companies have increasingly turned to restricted stock grants instead of options.  A study author suggested that, arguably, restricted stock may offer “a more balanced trade-off between upside and downside outcomes, as stock-owning CEOs actually stand to lose money when risky actions backfire. Alternatively, making a CEO hold on to the stock for several years after exercising an option could also generate a more balanced view on risks and rewards.”   Morgenson concluded that “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.”

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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