CEO compensation, especially stock options, is a hotly debated topic for management and society. While CEOs earn several hundreds times more than average workers, largely through stock options, adding to growing inequality in our society, it is argued that such stock options are important to appropriately incentivize and remunerate CEOs for the enormous responsibilities they undertake.
Interestingly, the impact of CEO stock options on firm performance remains controversial. Agency theorists suggest that CEO stock options encourage risk taking, the latter is necessary to pursue new growth opportunities and innovation that drives long term success for a firm. On the other hand, behavioral agency theorists suggest that given human beings in general experience losses more severely than potential gains, CEO stock options can negatively impact CEO risk taking because it exposes CEO stock based compensation to market risks.
The notion of mixed gambles suggests that at any point in time CEO stock options can lead to both potential losses to their current value of their stock options and gains due to the prospective value of their option wealth. That is, the risk preferences of CEOs can be influenced by the current and future value of their option wealth. If CEOs stand to lose a lot from taking risky decisions, they may be more cautious. However, if they believe that the potential gains from future option wealth outweigh the losses to their current option wealth, they may be more willing to take on short-term risks. As a result, the value and risk exposure of their current option wealth, as well as the potential gains from future option wealth, can play a significant role in shaping the risk appetite of CEOs when making strategic decisions.
In my recent paper published in the Journal of Management, we argue that the risk appetite of CEOs as described above is likely to be impacted by the perceptions of fairness of their stock option pay. Research shows that employees’ satisfaction with their compensation (and hence their contribution towards work) depends on whether they perceive their compensation as fair. We argue that the same is also applicable in case of CEOs who, despite their exorbitant pay checks, evaluate the fairness of their compensation relative to their peers (“distributive justice”) and in terms of the processes through which pay is established (“procedural justice”). By extension, conditions reducing perceptions of distributive or procedural justice are likely to trigger behaviors that seek a re-establishment of fairness. In case of CEO stock options, we argue that unfairness in compensation is likely to trigger excessive risk-taking to increase the value of CEO stock option wealth in the future. Such excessive risk-taking appetite can tunnel CEO vision towards substantial potential gains from risk-taking (as opposed to losses from it) setting the stage for short-term decision making that may prove costly for other stakeholders.
Indeed, our longitudinal analysis of 838 U.S. companies from 2001 to 2018 finds robust evidence that when CEOs perceived unfairness in their stock option pay, relative to peers in their own industry, or due to perceived flawed pay-setting processes (i.e., adoption of a clawback provision), CEOs took more risks. These risks were associated with more irresponsible actions harming stakeholders as well as resulting in fines and penalties for firms. In economic terms, our results show that when CEOs perceive distributive unfairness in their stock option pay, corporate irresponsibility on average increases by approximately USD 260,000 and when CEOs perceive procedural unfairness in compensation, then corporate irresponsibility increases on an average by USD 510,000.
Aside from theoretical implications for the behavioral agency theory, this research has important managerial implications. At the outset, CEOs can have a direct and significant impact on corporate irresponsibility. While anecdotal evidence of Volkswagen and Boeing highlight this, we provide a systematic theoretical and empirical explanation of why this happens. We also caution policymakers and boards of directors about the unintended effect that perceived unfairness in CEO stock option pay can have on CEO risk-taking and consequently on societal harm. Procedures that are often construed as responsible in governance terms (such as adoption of a clawback provision) could be viewed as unfair triggering unexpected behaviors from CEOs. This demonstrates that establishing a responsible governance culture in firms is not a straight forward process.
Dr. Tanusree Jain (PhD ESADE) is an Associate Professor of Corporate Sustainability at Copenhagen Business School, Denmark. Her research interests are situated at the intersection of Corporate Governance and Corporate Social and Environmental Responsibility.
