Executive Compensation and Moral Hazard

The Perils of Executive Compensation

Introduction

Executive compensation acts as an incentive for CEOs to enhance an organization’s 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 Tesla’s 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 also—and here is where the conflict of interest comes into play—enriched 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 company’s directors and executives are incentivized by stock options and executive compensation to drive the company’s 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 company’s stock rather than on the proper development of a company’s 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: they rarely are. Because they are so rarely held accountable, there is little consideration of risk on their part. And because they are promised executive compensation and are incentivized to risk stakeholder satisfaction for the sake of personal profit they have no problem facilitating the rise of moral hazard. For them, personally, there is no risk: they will receive their millions (or billions, as in the case of Tesla’s Elon Musk—regardless of the fact that auto pilot has proven to be a fiasco resulting the deaths and injuries of several stakeholders) whether the company is financially sound or competitively positioned, just as Boeing’s CEO did (Durden, 2021; Dzhanova, 2021).

The case of Tesla’s CEO Elon Musk and his touting of the auto pilot feature as fully autonomous on national television is an important one to consider, because Musk’s executive compensation was tied directly to the company’s stock performance (Kiersz, 2021). Musk is currently being sued in Delaware by shareholders over his 2018 compensation package worth billions. As Kiersz (2021) reports, “the compensation agreement between Musk and Tesla is structured around 12 ‘tranches’ of stock options, each equivalent to about 1% of the total number of outstanding shares at the time of the agreement. Each tranche — which is basically a financial treasure chest that will be unlocked should certain conditions be met — vests and becomes available to Musk once a certain number of operational milestones and stock-market-capitalization goals have been achieved.” Musk has actively promoted Tesla on social media and has made promises (such as having a fleet of self-driving robo taxis by 2020) that appear more and more unrealistic with each passing year (Baldwin, 2020). He is essentially the de facto face of Tesla stock promotion. He was even sued by the SEC for stock manipulation when he claimed to have “funding secured”—i.e., a buyer ready—to take the company private at $420 per share when he knew full well he had no such buyer at hand (Rapier, 2019).

There is also the problem of inequity in terms of income: JP Morgan’s CEO Jamie Dimon earned 364 times more than the average worker of the bank thanks in no small part to executive compensation (McEnery, 2019). Likewise, Boeing’s CEO received $21 million in executive compensation in 2020—this despite the company’s 737 Max crashes that took hundreds of lives as well as the fact that the company was also laying off 30,000 employees (Dzhanova, 2021). Musk’s enormous executive compensation package was enough to bring lawsuits from shareholders, as has already been noted. The point is that these executives are making for more than the average worker and it creates a significant gulf between employees and those tasked with overseeing the company in terms of equity. Such a gulf can do more harm than good when employees feel they are being taken advantage of so that executives can obtain fat paydays.

Discussion

As Brickley et al. (2016) point out executive compensation should be fair. However, as reality shows, it is often rife with internal conflicts of interest and the risk of creating moral hazard. Real world examples are numerous, from WorldCom to Boeing to Tesla, and the problem was primarily created in 1982 when companies were legally allowed to begin buying back their own shares on the open market. It is this that created a real incentive to use executive compensation. At the same time, it is not the only option that executives have to secure a lucrative compensation package, as the example of Musk shows: all he had to do was win a substantial following of retail investors and fund managers (like Cathie Wood) to his side by promoting a vision of the company that would inspire investors to buy up shares in the company that the company itself could not purchase (for lack of funds). Yet Tesla has taken advantage of these investors by offering new shares at current market value, thus shoring up capital for itself (Wayland, 2020). This came after Elon Musk told investors just weeks prior that a capital raise “doesn’t make sense,” leading them to believe the company would not be issuing new shares and thereby diluting shareholder value (Ebbs, 2020). Still, Tesla’s stock has benefited from numerous short squeezes (being one of the most heavily shorted names, a short squeeze will often push a stock higher regardless of the company’s fundamentals), and even the reality of shareholder dilution has done nothing to prevent Tesla’s stock from soaring. Musk, meanwhile, has personally benefitted from the stock’s meteoric rise, which has given the EV maker a greater market cap than that of the three largest auto manufacturers combined. Shareholders have benefited; some are suing, as are stakeholders—and at the heart of all this is the question of Musk’s executive compensation.

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.