Are CEOs Encouraged to Take Too Much Risk?

CEO compensation typically consists of cash and long-term equity. While the benefits of cash are to some extent fixed, the value of equity-based compensation depends on the market value of the firm. The latter is the key mechanism for motivating managers to act in the best interest of shareholders’ long-term wealth.

In order to maximize the incentives provided by the equity component of their compensation, executives should take risks to maximize their firm’s market value. How they do so can, of course, vary. The most desirable approach would be to engage in more risky projects that would bring long-term returns. However, research finds[1] that equity-linked incentives encourage short-sighted risk-taking including financial fraud or accounting manipulation. In a new paper, we explore the relation between CEO compensation and workplace misconduct.

Recent research shows that managers may compromise on workplace safety and employee well-being in order to meet performance expectations[2]. By compromising on workplace safety, the CEO might increase short-term equity value if employees become more productive. However, equity value can drop if, as is likely, the revelation of workplace violations results in reputational damage and significant penalties. The U.S. National Safety Council[3] reports that in 2017 the total cost of work injuries, including wage and productivity losses, was $161.5 billion.  This amount translates into a cost of $1,100 per employee.

To empirically examine whether CEO compensation is related to workplace misconduct, we examine a large sample of industrial firms and related records of health and safety violations, non-compliance with labor laws, and other workforce-related violations. Sampled firms have on average 0.415 violations per year with an average penalty of $141,000. To identify a direct channel through which equity incentives could motivate CEOs to compromise on workforce well-being, we examine the sensitivity of CEO compensation to changes in stock price volatility and workplace violations. We employ several econometric methods to test the robustness of our results. We show that CEO risk-taking incentives are positively related to the frequency and the severity of workplace violations.  These results are statistically and economically significant.

Further, to attribute causality to the relationship between CEO risk-taking incentives and workplace violations, we consider a shock created by the implementation of Statement of Financial Accounting Standard 123(R) in 2005. This standard required the expensing of stock-based compensation in the income statement and led to a drop in the use of stock options in executive compensation contracts. Hence, the implementation of this standard resulted in a reduction in the sensitivity of CEO compensation to changes in stock price volatility. We show that following the implementation of SFAS 123(R) there was a reduction in the frequency and severity of workplace misconduct.

Our work sheds further light on executive compensation in general, and the use of stock options in particular. Specifically, we show that the CEOs who are paid in stock options are likely to have greater incentives to take risks even at the expense of employees’ welfare.

ENDNOTES

[1] Erickson, M. and Wang, S.W., 1999. Earnings management by acquiring firms in stock for stock mergers. Journal of Accounting and Economics, 27(2), pp.149-176. Sletten, E., Ertimur, Y., Sunder, J. and Weber, J., 2018. When and why do IPO firms manage earnings?. Review of Accounting Studies, 23(3), 872-906.

[2]  Caskey, J. and Ozel, N.B., 2017. Earnings expectations and employee safety. Journal of Accounting and Economics63(1), 121-141. Heese, Jonas, and Gerardo Pérez Cavazos. “When the Boss Comes to Town: The Effects of Headquarters’ Visits on Facility-Level Misconduct.” Harvard Business School Working Paper, No. 19-093, January 2019. (Conditionally accepted to The Accounting Review.)

[3] https://www.nsc.org/company.

This post comes to us from professors Justin Chircop at Lancaster University Management School, Monika Tarsalewska at University of Exeter Business School, and Agnieszka Trzeciakiewicz at Hull University Business School. It is based on their recent paper, “CEO Risk Taking Equity Incentives and Workplace Misconduct,” available here.