Stock Options Spur Risky CEO Behavior

Large stock-option packages have created a breed of gunslinger CEOs who often shoot for big gains and come up empty-handed, says a new study.

The study, which was co-written by Penn State professor Donald Hambrick and Brigham Young University (BYU) professor Gerard Sanders, examined the investment behaviors of 950 companies that were selected at random from Standard & Poor's 500, Mid-Cap and Small-Cap indexes. The study's authors first classified the different companies by the size and kinds of stock option incentives they gave their CEOs. They then tracked the size and success of the companies' investments over the years, separating them into research and development costs, capital expenditures, and mergers and acquisitions.

Overall, they found that the more stock options the CEOs had, the more likely they were to take riskier investments that were on the whole negative for the company's future performance. The reason for this, they say, is that stock options reward CEOs for good performance but do not punish them for poor performance. Because options do not obligate CEOs to invest their own money in company shares, the study says, the executives will often try to push the stock price up higher with far less risk aversion than if they actually owned shares.

Such all-carrot, no-stick incentives can produce a culture that encourages "very extreme outcomes" where "option-loaded CEOs undertake big projects that are long-odds in nature." The study finds that such high-risk investments mostly did not pay off and were detrimental to company performance.

"We're not saying [CEOs] don't do any analysis before undertaking risky investments, but they tend to ignore or downplay the level of risk," says Sanders, who chairs the department of organizational leadership and strategy at BYU's Marriot School. "Some of the option-loaded CEOs make good choices, but on average, many of them make bad investments and they take huge losses."

"These findings may help put the nail in the coffin of executive stock options," says Hambrick, who is a chaired professor of management at Penn State's Smeal College of Business. "And even if not, they certainly ought to give the corporate world pause in using them nearly as extensively as they have been used in the recent past."

As an alternative to lucrative stock-option packages, Sanders says companies should consider either limiting stock-option compensation or choosing different methods to give incentives for good performance. Among the alternative methods Sanders suggests are forcing CEOs to purchase a certain amount of stock, which will tie them down more directly to shareholder fortunes; granting CEOs restricted stock that they must own for a certain number of years; and long-term incentive plans where the company rewards CEOs for strong performances in such measureable metrics as earnings per share. The last option, he says, gives CEOs the most incentive to run their businesses with an eye toward long-term growth instead of short-term gains that temporarily boost stock prices.