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Option-loaded CEOs swing for the fences, but strike out much more than they hit home runs, new study finds

October 1, 2007

For more information, contact: Benjamin Haimowitz, HHaimowitz@aol.com

Is the ascendancy of the executive stock option at an end? Since options still amount to the largest component of ever-increasing CEO pay in the U.S. and are a growing factor in chiefs' compensation abroad, it may seem premature to write their epitaph, even though U.S. companies have moderated their use somewhat during the past few years.

Still, a study in the current Academy of Management Journal finds that CEO stock options have inherent flaws that ought to spell an end to the preeminence they have had at the pinnacles of corporate America since the 1990s. In doing so, the research fills a critical gap in the understanding of these popular management tools, previous research on their effect on firm performance having been surprisingly scant.

By their very nature, stock options in large numbers motivate CEOs to "swing for the fences," conclude the study's authors, W. Gerard Sanders of Brigham Young University and Donald C. Hambrick of Penn State University. Even more important, "option-loaded CEOs have a disproportionate tendency to generate more big losses than big gains; they strike out much more often than they hit home runs."

The authors note that the basic purpose of options has been to promote managerial aggressiveness in top executives, even if they sometimes led them "to undertake large-scale risky investments that tended to deliver extreme company performance." What was not envisioned, they write, "was that the extreme performance delivered by option-loaded CEOs was more likely to be in the form of big losses than big gains. Investors -- even risk-neutral investors -- would not have desired this outcome."

In striking at a feature of CEO options intrinsic to their basic purpose -- fostering managerial aggressiveness -- the study sets itself apart from many critiques that find fault with other failings of companies' options use. For example, it has been pointed out that options can reward top executives for share-price increases that are owed more to a rising stock market than to the execs' own efforts or that companies may award options to CEOs so liberally that chiefs are satisfied with growth that fails to match the true cost of capital. Such critiques tend to produce fixes to spur CEO aggressiveness -- for example, measures that make option payoffs contingent on the amount a company's share-price rise exceeds industry or market averages or requirements that CEOs partially meet the cost of options out of their own pockets.

In contrast, the problem identified by the new study is not that options may fail to achieve their basic purpose, to promote aggressive risk-taking, but that they often achieve it all too well.

And this problem cannot be fixed by making complex adjustments in the way these instruments are administered. If there is a solution, it is eminently simple: award options on a very limited basis or don't award them at all, supplanting them with restricted stock.

"These findings may help put the nail in the coffin of executive stock options," comments Hambrick. "And even if not," he adds, "they certainly ought to give the corporate world pause in using them nearly as extensively or heavily as they have been used in the recent past."

Sanders and Hambrick arrived at their conclusions through an analysis involving 950 companies selected at random from the Standard & Poor's 500, Mid-Cap, and Small-Cap indices. For each company, they measured the proportion of CEO compensation paid in stock-option grants over three-year periods and its relationship to the magnitude of company investments in the fourth year and to the company's financial performance in the fifth year.

The professors examined three types of investments -- research-and-development funding, capital investments, and acquisitions. They assessed financial performance in terms of extremeness -- that is, how far two key measures (a company's return on assets and total shareholder returns) deviated from the performance expected of the company in a given year based on "a comprehensive set of control variables known to affect firm performance" -- such as the company's size, its international scope, current general-economic conditions, current industry conditions, and the company's performance in the previous year.

Sanders and Hambrick discovered that the higher the percentage of CEO pay represented by stock-option grants, the higher the level of company investment spending and the more extreme the firm's financial performance, particularly stock performance. This extremeness, they found, is not an automatic outcome of high investment spending. But high levels of CEO stock options coupled with high levels of investment produce what the authors call a "combustible combination" that "bring[s] about very extreme outcomes" in companies' share prices. This probably happens, the authors surmise, because "option-loaded CEOs undertake big projects that are long-odds in nature."

In general, Sanders and Hambrick find, "big losses were more common than big gains under high levels of stock-option pay." For example, in companies where stock- option grants constituted half or more of the CEO's pay, 10.1% sustained big shareholder losses, while only 6.8% enjoyed big gains, a significant difference. In addition, 6.9% suffered extreme losses in return on assets, while only 3.9% reaped extreme gains, again a significant difference.

In contrast, no such disparity existed when stock options constituted less than 20% of CEO pay; in fact, extreme shareholder gains outnumbered extreme losses. Further, whereas big shareholder losses occurred about 10% of the time when options represented half or more of CEO pay, they occurred at about one fourth that rate (about 2.5% of the time)  when options made up less than 20% of chiefs' pay.

In seeking to account for the tendency of option-loaded CEOs to sustain big losses, Sanders and Hambrick conjecture that the answer rests with the basic nature of options. "Because option-loaded CEOs benefit from share price increases but lose nothing if share prices drop, they can be expected to sort investment alternatives according to the expected values of gains while paying little attention to the likelihoods or magnitudes of losses. If we accept the commonsense idea that the projects with the biggest possible upside are likely to also have the biggest possible downside, and then couple it with the assumption that option-loaded CEOs have little concern with the size or probabilities of downside outcomes, it is straightforward to expect that option-loaded CEOs have a relatively high likelihood of delivering big losses."

In sum, "option-loaded CEOs are riveted on upside possibilities, with little concern for downside. Not only does this asymmetry affect the selection of strategic initiatives...but it may also cause CEOs to be inattuned to early signs of project failure and generally careless about risk mitigation."

While the professors allow that executive stock options may have their place in moderation or in special situations, they conclude by wondering if a better course would be a widespread supplanting of options by grants of restricted stock -- that is, stock that can only be sold after a certain amount of time passes or a certain goal is achieved. While the study did not test the effect of restricted-stock grants specifically, it did assess the effect of CEO stock ownership on risk-taking.

"CEOs who held large amounts of stock delivered results that were not as lopsidedly negative" as those recorded for option-loaded chiefs, they report. "Thus, CEO shareholdings seemed to promote a more prudent type of risk-taking than was generated by stock options."

The professors add in conclusion: "Stock ownership causes CEOs to be equally concerned about gains and losses, whereas stock options encourage CEOs to think primarily about upside potential and little about downside... The current trend toward motivating CEOs with restricted stock may be generally sensible."

The study, entitled "Swinging for the Fences: The Effects of CEO Stock Options on Company Risk-Taking and Performance," is in the October/November issue of the Academy of Management Journal.  This peer-reviewed publication, now in its 50th year, is published every other month by the academy, which, with about 18,000 members in more than 100 countries, is the largest organization in the world devoted to management research and teaching. The academy's other publications are the Academy of Management Review, Academy of Management Perspectives, and Academy of Management Learning and Education.

Media Coverage:
Bloomberg Press Service. CEO Stock Options Lead to Risks, Losses, Study Says. (Friday, October 12, 2007).
Bloomberg Press Service. Large Stock-Options Grants May Hurt Investors: Graef Crystal. (Wednesday, October 17, 2007).
Deseret Morning News. Big Losses for Bosses. (Friday, October 12, 2007).
Economist.com. Out of Options. (Tuesday, October 09, 2007).
Human Resource Executive Online. Options for Risky Behavior. (Wednesday, October 24, 2007).
International Herald Tribune. Take a risk, chief, it's not your money. (Friday, October 12, 2007).
Reuters. CEO Option Grants Seen Harmful. (Friday, October 12, 2007).
Salt Lake Tribune. Stock Options May Be Big Risk for Companies. (Tuesday, October 23, 2007).
Slate. Chattermailbox: If Evelyn Y. Davis Can.... (Monday, November 12, 2007).
The New York Times. Rethinking Risk's Role in Bosses' Pay. (Friday, October 12, 2007).
The Observer. Buccaneering bosses are the worst of all options. (Sunday, November 18, 2007).
United Press International. Study: CEO pay prompts aggressiveness. (Friday, October 12, 2007).
USA Today. Options' impact on performance is questioned. (Monday, May 04, 2009).

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