Executive Compensation: Conflicts of Interest and Moral Hazard

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).

In 2021, with Elon Musk making many 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: Share Buybacks and Conflicts of Interest

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; Sgobba, 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 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 United States. In this environment, the issue of conflicts of interest inevitably arises (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. Rather than investing in research and development or in other areas that could benefit the long-term strategy of the company, directors approve spending billions to drive the share price of their stock higher, undermining their corporate social responsibility duties (Schneider-Maunoury & Gouin, 2016).

Moral Hazard and Corporate Accountability

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 compelling 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 upward through artificial means, such as share repurchasing programs, the issue of moral hazard must be confronted. What are the consequences of spending billions on a company's stock rather than on the proper development of its products? Would these same companies so aggressively pursue a policy of share buybacks if it did not allow them to enrich themselves?

Shareholder theory suggests that share buybacks are good for shareholders and should therefore be considered a duty of companies. Yet stakeholder theory suggests the opposite: 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 has attempted to lay the blame at the feet of lower-level employees who are said to have gone rogue in their operations (Michaels & Tangel, 2021). This explanation, however, is not entirely credible, 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 have not been held accountable—and because they are so rarely held accountable, there is little consideration of risk on their part. Promised executive compensation and incentivized to prioritize personal profit over stakeholder satisfaction, they have little difficulty 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 Elon Musk—regardless of whether the company is financially sound or competitively positioned (Durden, 2021; Dzhanova, 2021).

The case of Tesla's CEO Elon Musk and his promotion of the autopilot feature as fully autonomous on national television is particularly instructive, 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 robotaxis by 2020—that appear increasingly 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 he had no such buyer (Rapier, 2019).

Conclusion

Executive compensation is an enticing incentive for executives and one that has been widely pursued across industries. It is, however, criticized for the perils it brings to the organization, its shareholders, and its stakeholders. These perils primarily surface in the form of conflicts of interest and moral hazard. Whether executive compensation is directly tied to share repurchasing programs or to company performance and market capitalization may vary in degree—but as the examples of Boeing and Tesla demonstrate, careful consideration should be given to the risks of using executive compensation as a governance tool. Boeing compensated its CEO handsomely in 2020 despite laying off tens of thousands of workers that same year; Musk has made billions in executive compensation to the frustration of shareholders and stakeholders alike.

Companies may favor executive compensation in theory because it is seen as a way to drive performance; but in practice it raises the risk of moral hazard. Would Boeing have delivered the unsafe 737 Max to consumers had executive compensation not been a factor? To what extent did executives push for the dubious handling of that plane's development and certification? These questions may never be fully answered in public. But other examples—from WorldCom to Tesla—suggest that executive compensation does appear to drive risk-taking among executives. The consequences of such risk-taking can be disastrous, as they were for WorldCom. Tesla has yet to face a comparable reckoning, but that story is far from over.

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