Friday, July 08, 2011

Daredevil CEOs, Options, and Risk

Wharton Professor Todd Gormley, Northwestern's David Matsa, and Washington University of St. Louis' Todd Milbourn have published a new paper titled "CEO Compensation and Corporate Risk Taking: Evidence from a Natural Experiment."  Many scholars have argued that stock options increase executive risk-taking, since there is a huge upside with limited downside associated with options grants.  These scholars use a fascinating natural experiment to test this theoretical prediction.   The researchers looked at firms affected when the federal government added certain chemicals to the list of known carcinogens.   They looked to see whether firms took concrete steps to reduce cash flow volatility (i.e. cut risk) after this threat emerged.  The scholars found that executives with a high amount of option-based compensation were less likely to try to cut risk to offset the increased risk/threat from the carcinogen finding by the federal government.  

I find the study quite fascinating and persuasive in providing data to support its conclusion.  However, in the article on the Knowledge@Wharton website, I must dispute one key point.  Gormley addresses the question of whether risk-taking is always necessarily a bad thing for shareholders.  According to the article, "Gormley points to the case of defense contractor General Dynamics as an example of risk paying off."  He argues that executives there in the early 1990s took the risk of not diversifying, but rather than focusing on defense, after the national defense budgets began to be cut.    He's right that the risk paid off handsomely, as General Dynamics provided handsome shareholder returns through the 1990s.  

There's only one problem with this argument.  I worked at General Dynamics at the time, and I've taught a case study about the firm during that period.   When Bill Anders became CEO in 1991, a very aggressive pay-for-performance compensation scheme was put in place for the top 25 executives.  However, the compensation scheme was heavily weighted toward cash bonuses.  It became very controversial because the executives received large cash bonuses if the stock rose by $10 and stayed there for 10 days.  The incredible short-term orientation of that bonus scheme set off criticism from many quarters.  60 Minutes even did a very critical feature on the company.   After that, General Dynamics eliminated the cash bonus scheme and shifted to an option-based compensation structure.  However, the key decision to not diversify into commercial ventures, but instead to focus on defense, had already been made by Anders and the top team before the options scheme was put in place. 

Despite this slight inaccuracy, the paper provides a terrific look at a natural experiment with implications for how Boards compensate CEOs.   I recommend taking a look.

1 comment:

Amanda Kline said...

If you are interested in this, I highly recommend the book, "Little Bets" by Peter Sims. I have not read it completely, but a friend of mine highly recommends the book in helping with confidence building, design thinking, and emerging an idea into the business world.

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