When Boeing Co. CEO Dennis Muilenburg was ousted from the company in 2019 for his mismanagement of the 737 Max crisis, he left with stock options worth at least a net $18.5 million. At the same time, Boeing’s shareholders took a beating, with the stock losing 25% of its value. Muilenburg, in other words, left with a big payout of options even though his former firm’s performance was cratering. Such discrepancies between firm performance and CEO compensation are unfortunately all too common, and is largely the result of the indiscriminate awarding of stock options and other incentive compensation.
Stock options are supposed to ensure that CEOs deliver high returns to shareholders, but they often fail to do so. And yet firms continue to engage in the practice. In 2019, the last year for which we have figures, average CEO compensation, including the value of stock options granted (whether exercised or not), grew by 14% to $21.3 million, continuing an ongoing pattern. Given this spotty record, we wondered: Should firms issue stock options at all?
Relying on prior research and using financial data from 2010 to 2015, we analyzed 7,750 observations from 1,815 publicly traded companies in 341 industries representing the bulk of the American economy. We sought to test our hypothesis that stock options and other interventions help a firm’s performance only when its managers might otherwise misuse firm resources — activities known as opportunism. Such opportunism is defined as “self-interest seeking with guile” and involves managers deploying firm resources for their own benefit, rather than to help shareholders achieve a higher return on investment. If such a risk exists, then stock options should reduce the misallocation of funds. If such a risk does not exist, then stock options are an expensive waste of money.
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To test this proposition, we included both external and internal factors widely used in business research that indicate which firms have a higher potential for top manager opportunism and which firms have a lower such likelihood. First, for firm performance, we calculated Tobin’s Q, a measure of firm long-term growth. Second, we measured potential opportunism by assessing the level of discretion available to managers to allocate firm resources and the amount of such resources available to direct for their own purposes. We did this in three ways: (1) a combination of absorbed slack multiplied by managerial discretion; (2) a combination of absorbed slack multiplied by whether the CEO serves on the board; and (3) the firm’s debt ratio.
The first data point we looked at was a firm’s absorbed slack, which is a measure of its excess costs that are available to management. Managers are aware of where the resources are, of course, but outside shareholders (although they know the firm could in theory operate more efficiently) are not able to put their fingers on where those resources are located. As a result, absorbed slack represents a pool of money that CEOS can arbitrarily allocate relatively free from shareholder inspection.
In environments where CEOs have greater discretion (the second data point), they can abuse these resources, spending them on activities that benefit themselves personally rather than the shareholders. Thus, where absorbed slack and managerial discretion are high, shareholders should be legitimately concerned about opportunism.
The third data point was whether CEOs were also directors of their firms. Research has shown that CEOs who are also directors are more powerful. Directors are more likely to criticize a CEO who is simply their employee than one who is sitting in the room with them as a fellow board member. In addition, since the board formally supervises the CEO, CEO board membership is likely to further reduce oversight. Just as with managerial discretion, a more powerful CEO with more absorbed slack available has the ability to behave opportunistically. However, if the CEO is less powerful — in other words, not serving on the board — or if the firm does not have resources available for the CEO to misuse, opportunism is less of a concern.
The final data point that we considered was the debt load a firm carries. High debt restricts a CEO’S potential for opportunism in three ways. First, it reduces available resources since some must now be allocated for interest and debt repayment. Second, borrowed funds often come with loan covenants that restrict the CEO leeway of action. Third, high debt also invites higher lender scrutiny of CEO decisions and behaviours.
We found that where firms had a higher potential for opportunism on any of the three measures, stock options were indeed associated with higher returns for shareholders. But where managers had little potential to behave opportunistically, such options actually hurt performance.
Using our data, we can identify firms from our sample listed on the Fortune 500 that revealed either a high potential for opportunism or a low one. For example, Unitedhealth Group Inc., Kroger, Citigroup Inc., Comcast Corp. and, yes, Boeing all had a low potential for opportunism, and should therefore have refrained from issuing stock options. On the other hand, Alphabet Inc. (Google), Facebook, Proctor & Gamble Co. and Nike all demonstrated a high potential for opportunism, and so should have included stock options as a large part of the CEO’s compensation package.
The bottom line is that stock options can be an effective tool if used when needed, but they should not be issued under all circumstances. Our results suggest that directors do the following things when deciding whether or not to issue stock options:
— Ask if there is a substantial risk of opportunism. Such a risk is higher at firms with high managerial discretion combined with high absorbed slack; the CEO serving on the board of directors in combination with high absorbed slack; or a low debt ratio.
— Issue stock options only if there is high absorbed slack combined with either high managerial discretion or the CEO serving on the board of directors.
— Don’t issue stock options if there is a low debt ratio.
— Don’t avoid stock options just because they are expensive. (They might be well worth it.)
— Don’t issue stock options just because they are popular. (They might be an expensive and harmful waste of money.)
— Regularly check to see if opportunism risk has shifted since the last stock options decision. (Slack, discretion, debt and board membership can all change.)
Our research demonstrates that this form of CEO compensation is not a panacea, and there exist situations where issuing them is damaging. But where the potential for CEO opportunism is high, stock options can be a useful tool to align top managers’ interests with those of their bosses: the firm’s shareholders. Thus, rather than being “good for what ails you,” CEO stock options, our study suggests, should be “taken only when needed.”
MICHAEL GREINER & SCOTT JULIAN Michael Greiner is an assistant professor of management for legal and ethical studies at Oakland University. Scott Julian is an associate professor of management at the mikeilitch school of business at Wayne state university
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