Do CEO Stock Options Mean Trouble?

It’s the season for fretting about chief executive compensation. Annual proxy statements for most public companies are in. The numbers have been crunched. Now it’s time for the hand-wringing.

200401764-001But there are some surprises this year. The New York Times, using data compiled by Equilar, reports that average compensation for the 200 best-paid CEOs last year was $19.3 million, down 15 percent from 2014.

This follows an analysis by Equilar and the Associated Press of a larger group of CEOs that found pay was up, but at a slower rate compared to past years. The AP story noted that public companies are increasingly relying on performance-based compensation such as stock grants or options.

The theory, of course, is that CEO pay should be aligned with the interest of company shareholders. But there’s an active debate over whether stock options — a very common part of CEO compensation packages — are the best way to do that.

That’s where we find this proxy season’s most interesting news about CEO pay. In the latest issue of the Harvard Business Review, Dylan B. Minor offers evidence that stock options not only encourage CEOs to pursue bold innovation, but also to take dangerous risks.

Minor, a visiting assistant professor in Harvard’s business school,  summarizes in his article the results of a recent research paper. Minor compared two kinds of CEOs, divided by what kind of equity-based compensation they received. His conclusion: those who got stock options were more likely to get their companies in trouble than those who got straight shares.

Others have made the case that stock options create a perverse incentive. Shares reward a CEO for success, just like options. But unlike options, shares also penalize the CEO for failure. Some argue that shares therefore provide a better incentive for CEOs to pursue long-term benefits.

Minor offers some hard data to back up this argument. He compared the two groups of CEOs against two measures of risk-taking.

The first analysis looked at whether companies were linked to an environmental disaster or brokeThinkstockPhotos-466936217 environmental laws. He found that those with CEOs getting options were 65 percent more likely to get in trouble than companies with CEOs receiving shares.

Minor then looked at whether companies ran into financial irregularities. He found that those with CEOs receiving options were 50 percent more likely to be investigated by the SEC for an earnings restatement than were companies with CEOs receiving shares.

“In sum, higher powered incentives can increase both good and bad risk-taking,” Minor writes. It’s a good lesson for companies of all sizes: In providing incentives to top executives, think carefully about the behavior you’re encouraging.