The Perils of Executive Compensation

Introduction

Executive compensation acts as an incentive for CEOs to enhance an organizations performance and is common practice across industries. Michael Eisner was famously rewarded handsomely via executive compensation for his stewardship of Disney in the 1990s (Downes et al., 2007). Elon Musk has even more famously accrued substantial personal wealth via executive compensation for meeting targets related to Teslas share price (Jones, 2021). While executive compensation may appear to be a positive perk that drives executives to push the company forward, there are conflicts of interest that should be considered from a risk management perspective. As Brickley et al. (2016) note, in the early 2000s governance scandals generated public concerns about whether managers run corporations primarily for their own benefit (e.g., to receive excess compensation and perquisites), as seen in companies like WorldCom (p. 583). It 2021, with Elon Musk making many several billions of dollars in executive compensation for steering Tesla toward a market cap of three quarters of a trillion dollars even as the company itself is hardly profitable based on product sales alone (Ramey, 2021), it certainly appears that criticism of executive compensation is warranted from an ethics standpoint.

The Gordian Knot

One of the problems of executive compensation is that it is often inextricably tied to share buyback programs that public companies implement at great cost to themselves but also at great benefit to shareholders. Boeing, for example, spent billions on share buybacks in the years leading up to its 737 Max disasters, which came about primarily because the company did not want to spend extra money to train pilots on the new equipment or to provide software overhauls (Mudede, 2021; Sgoba, 2019). Yet the company enriched shareholders by approving share repurchasing programs that alsoand here is where the conflict of interest comes into playenriched executives who stood to gain from a rise in share price thanks to options incentives that were part of their executive compensation packages.

Before 1982 it was illegal for companies to purchase their own shares on the open market because it was viewed as market manipulation. When the Securities and Exchange Commission passed Rule 10b-18, what was once illegal became legal (Reda, 2018). To comprehend the enormity of capital that is allocated to share repurchases, Egan (2018) points out that in 2018 alone nearly half a trillion dollars went to cover share buybacks by public companies in the US. In this environment inevitably arises the issue of conflicts of interest (Choi & Maldoom, 1992). Company executives commonly receive executive compensation in the form of options while simultaneously supporting share repurchasing programs that inflate the price of the shares of the company over which they have stewardship. But instead of investing in research and development or in other areas that could benefit the long-term strategy of the company, directors approve spending billions to drag the share price of their stock higher, undermining their corporate social responsibility duties (Schneider-Maunoury & Gouin, 2016).

Linked to the problem of creating conflicts of interest among directors and executives is the problem of moral hazard. As Smith (2013) puts it, moral hazard means risk has been separated from consequence. Boeing provides a rather good example of how this Gordian knot can strangle a company. When a companys directors and executives are incentivized by stock options and executive compensation to drive the companys share price upwards through artificial means, such as share repurchasing programs, the issue of moral hazard has to be confronted. What are the consequences of spending billions on a companys stock rather than on the proper development of a companys products? What would happen if executive compensation were substantially reduced or removed period? Would these same companies so aggressively pursue a policy of share buybacks if it means that they do not get to enrich themselves? Surely there is an argument found in shareholder theory that suggests that share buybacks are good for shareholders and thus should be considered as a duty by companies. Yet stakeholder theory suggests just the opposite, which is that governors have a duty to protect stakeholders, including customers and members of the community in which the organization operates. Boeing demonstrated clear disregard for stakeholders in its handling of the 737 Max development, and the company is currently in the process of attempting to lay the blame at the feet of lower level employees who are said to have gone rogue in their operations (Michaels & Tangel, 2021). But this is not entirely believable, as Laris (2019) points out. Decisions to withhold important information concerning problems related to the 737 Max were certainly made at the upper levels of C-Suite operations. Yet executives will not be held accountable:...

Executive compensation thus acts as a significant incentive for managers to do whatever they can to meet agreed-upon thresholds, whether they are performance-related or stock price-related. It should be said that not every manager who accepts executive compensation has done so unethically or violated the interests of shareholders or stakeholders. But the reality is that the temptation to do so certainly grows larger when that incentive is present. Governance can be conducted in a way that places restrictions on executive compensation, as Brickley et al. (2016) also note. However, when an executive like Eisner or Musk can also hold a position on the board and appoint friends to that board who will support him it only adds to the issue of conflict of interest and increases the risk of moral hazard. Eisner, for instance, at Disney was very successful at forcing out older board members who disagreed with his approach, thanks to his support from friends on the board (Downes et al., 2007). Thus, without a truly independent board it is unlikely that conflict-free governance can be obtained.

Conclusion

Executive compenation is an enticing incentive for executives and one that has been pursued in numerous companies. It is, however, criticized for the fact that it brings perils to the organization, its shareholders and its stakeholders. These perils primarily surface in the form of conflicts of interests and moral hazard. Whether executive compensation is directly tied to companies authorizing share repurchasing programs or whether it is tied to company performance and market cap may matter to different degreesbut as the examples of Boeing and Tesla show, some consideration should be given to the risk of using executive compensation. Boeing compensated its CEO handsomely in 2020 despite laying off several thousands of workers that same year; Musk has made billions in executive compensation to the chagrin of shareholders and stakeholders alike. Companies may like executive compensation in theory because it is a way to drive performance oversight; but in reality it raises the risk of moral hazard. Would Boeing have delivered an unsafe product in the 737 Max to consumers had executive compensation not been a factor? To what extent did executives push for the dubious handling of bringing the plane to market? These questions may never be answered in public, but other examples, from WorldCom…