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Research of executive incentives based on short term stock price instead of long term production of goods and services


Source: The New York Times | Fair Game, September 13, 2015 column


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.

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

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For full size versions of the following graphs showing shareholder support for the compensation of executives responsible for companies referenced in the article for high levels of reliance on stock options, or for similar graphs of support levels for other companies in the Russell 3000 index, see the Forum's website for Shareholder Support Rankings.

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The Shareholder Forum from research data provided by Equilar, Inc., calculated as the percentage of total votes cast for, against and abstaining in advisory “Say on Pay” shareholder approvals of executive compensation.

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