Handing CEOs stock options in their pay deals fosters styles of risk-taking that lead to workplace misconduct. That’s according to a recent paper published in US journal The Accounting Review and also available from Lancaster University.

Researchers cross-referenced data on misconduct penalties issued by more than 40 federal watchdogs with executive pay deals awarded at 2,000 companies from 2000 to 2018. The team linked a rise in ‘CEO vega’ – a shift in CEO wealth in line with share-price volatility – with an increase in the number and severity of workplace violations.

They also examined the impact of Financial Accounting Standard 123R, which was introduced in 2005 and requires all US companies to account for share-based pay awards on a fair-value basis. The team found that it sparked a major drop in stock offers in CEO pay deals – consistent with a parallel decrease in the number and severity of violations.

Not everyone is convinced by the links the paper draws. Indeed Alexander Pepper, London School of Economics Emeritus Professor of Management Practice, is rather sceptical about the paper’s conclusions. “Correlation does not prove causation,” he says. “Nowhere in the paper is there any explanation as to why CEO stock options might be related to workplace misconduct. CEO conduct, perhaps – but why misconduct by employees generally?”

Path to maturity

ICAEW Director, Corporate Governance and Stewardship, Peter van Veen shares Pepper’s view of the study’s conclusions. However, he does believe that the composition of CEOs’ remuneration directly influences companies’ short-term versus long-term risk strategies.

“If you are being remunerated on quarterly results, then each quarter you will work flat out to achieve those targets, at the cost of long-term profitability,” he says. “So a company’s risk appetite and culture are defined by the CEO’s pay package – because the organisation is fine-tuned towards meeting that individual’s goals. It would make no sense for a CEO’s remuneration package to be divorced from the company’s operations.”

A CEO who has lots of stock options in their contract with narrow vesting periods may focus on deals that will generate quick, short-term returns at the expense of those that may be more profitable in the long run, van Veen says. But another CEO provided with equity options tied down for, say, five years or more would naturally take a longer-term view. The danger for any company is when its leadership becomes obsessed with meeting aggressive, short-term targets over a long period of time. “That can embed a culture and set of behaviours that are deeply self-destructive,” he warns. “The risk is that the company’s performance becomes unsustainable, and you run it into the ground.”

For van Veen, an aggressive pursuit of short-term targets may be entirely appropriate for a hungry startup eager to get a series of early breakthroughs under its belt. “You’re unlikely to take a 10-year view if you’ve only just got off the ground,” he says. “But at some stage you’ll become a more mature business, or your business model will be to some extent proven. At that point, you’ll need to widen your horizon to the next two to three years. And when you’re much more established, it’ll be five to 10 years ahead, or even longer.”

In an established corporate, taking a quarterly view would be highly inappropriate, Van Veen notes. As the public has seen from recent news coverage of certain utilities companies, for example, leaders would resist investing in new or upgraded infrastructure. Instead, they would seek to extract as much shareholder profit as possible, which would only encourage the rank and file to focus on ’sweating the assets’. 

The company would attract recruits who are drawn to risk-taking – or what van Veen calls “financial engineering rather than actual engineering. It would also repel ‘steady hand on the tiller’ candidates with a flair for stakeholder management and building long-term, high-quality customer relationships. You don’t want a ‘move fast and break things’ culture in a major utilities firm with substantial investments that take years or decades to pay off.” 

Cascading effect

A mismatch between risk appetite and company type will always spawn the wrong culture, van Veen stresses. Risk-taking in an ill-suited environment creates potential for people to cut corners – particularly in business development, when the company goes after big deals. And such an ingrained, aggressive culture is hard to rectify.

“When a negative culture is deeply embedded, you end up having to remove the people in senior roles who are reinforcing these behaviours, because they’re not going to change,” he says. “And even if they did, they are associated with the old ways of doing business.”

The composition of a corporate CEO’s pay is determined by a remuneration committee, typically consisting of at least one HR expert and others with relevant task experience. Their considerations will revolve around four points: the type of culture the company wants to create or reinforce, how the level and type of award aligns with seniority and sectoral standards, whether the package requires regulatory sign-off – and how the award should be calibrated so its impetus cascades down the organisation.

On that final point, van Veen outlines key questions that the committee would explore: “In creating X type of package, how far down the company will its effects go? For example, are you looking to incentivise salespeople in exactly the same way? At what level of the business do you want to stop paying, say, performance-related bonuses – or is that a broad, cultural policy you’re going to set across the board?

“It’s a matter of creating a formula and deciding how widely to apply it, so you encourage the right behaviours and discourage the wrong ones.”