New Research Finds Excessive Stock Option Compensation Leads CEOs to Ignore Product Safety Problems

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By Scott Klinger, Center for Effective Government

When CEOs receive a large quantity of stock options in their pay packages, they are more likely to ignore safety problems with the products they market, concludes a new study, Throwing Caution to the Wind, by a trio of professors at Notre Dame’s Mendoza School of Business –Adam Wowak, Michael Mannor, and Kaitlin Wowak.

Stock options give corporate executives the right to buy shares of stock at a set price. If the stock rises after the option is granted, the executive can realize huge amounts of income. If the stock declines in price, the executive isn’t penalized, since he or she paid nothing for the stock option.

Those who advocate for “shareholder capitalism” promoted this form of compensation as a way to ensure that the interests of senior managers align with those of investors, who benefit when stocks rise. Previously, investors were concerned that senior managers cared more about the long-term health of the company and the well-being of other employers – i.e., that they put employee interests and companies interests above investor interests.

But growing evidence suggests there are perverse impacts on firms and markets when stock options play a large role in compensation.  It can lead CEOs to focus on short-term market gains, and unwise cost-cutting.  It may make them more willing to entertain mergers and acquisitions that push up prices but don’t make good business sense.  And now we find that it may make then more willing to cut corners on safety.

Corporations that use stock options most widely are more likely to have to recall a product it produces, according to the report. They concluded that stock options reward CEOs for taking risks, even if the risk is selling a product that could be dangerous to consumers. Because CEO tenures average less than ten years, there is urgency to quickly make one’s mark. The gamble is whether product safety concerns will come to light during the CEO’s tenure.

Interestingly the researchers also found that long-tenured CEOs and those who founded the corporations they lead were much less likely to have product recalls. Because both long-tenured leaders and founders already own large amounts of company stock, they are less concerned with the value that new stock option presents. And they seem to have more to lose should the company’s reputation suffer in the wake of a product safety crisis.

It doesn’t have to be this way. Laws and policies support these perverse incentives.  They can be changed.  Here are three fixes.

First, Congress can reduce taxpayer subsidies for excessive CEO pay. In 1995, Congress passed and President Clinton signed legislation intended to limit skyrocketing excessive pay. The law said corporations could not deduct more than $1 million in compensation per executive from their tax bill – but then added a loophole exempting pay that was “performance based.”  So instead of increasing annual salaries by double digits, corporate directors (often hand picked by the CEOs)  gave executives stock options, which by definition are dependent on performance (of the company’s stock). Today, the typical CEO receives about half of his or her pay in stock, companies deduct this pay from their corporate tax returns, so taxpayers in effect, subsidize a third of the typical CEO’s excessive compensation.

Second, companies can expand “clawback” provisions to include cover-ups of product problems and product safety lawsuits. Many companies have adopted “clawback” provisions that allow corporations to recover prior bonuses and other incentives payments in case of fraud or earnings manipulation. Extending clawbacks to include significant product recall and product liability problems, could provide positive incentives to produce quality products and to deal with any safety concerns, rather than ignoring them.

Third, Congress should adopt the recently introduced Hide No Harm bill sponsored by Senators Richard Blumenthal (D-CT) and Bob Casey (D-PA). This bill would make CEOs and other executives criminally liable for product safety and employee health and safety problems that resulted in death.

Without sound policies that balance the one-sided rewards provided by stock options, with disincentives for ignoring public health and safety, CEO pay practices will continue to result in avoidable social harm.

Originally posted here.

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