Beware the pitfalls of CEO stock options

Awarding stock options to CEOs is a logical way to drive growth and innovation, aligning the self-interest of the individual to the long-term success of their company and encouraging CEOs to focus on increasing shareholder value by rewarding them when stock prices rise.

However, our recent research finds potential unintended consequences of this compensation strategy: it can increase the likelihood of workplace misconduct.

Our study in The Accounting Review looked at CEO vega – a metric that measures how sensitive a CEO’s wealth is to the volatility of their company’s stock price – across 2,000 US firms and found a positive correlation between high CEO vega and workplace misconduct.

Link between stock options and workplace misconduct

A higher CEO vega means that a CEO stands to gain or lose more based on stock price fluctuations, which can create significant financial incentives for risk-taking behaviour.

But this increased appetite for risk can spill over into decision-making that negatively impacts workplace integrity. We found that for every standard deviation increase in CEO vega, the number of workplace violations increased by 6.7%, and the value of penalties associated with these violations rose by 5.5%.

In other words, CEOs whose wealth is more directly tied to stock price volatility may be more inclined to engage in riskier decisions, not just in terms of company strategy but also in terms of ethical considerations in the workplace.

Such decisions may be financially beneficial in the short term but can lead to harmful practices in the workplace. CEOs may make cost-cutting decisions that jeopardise employee safety, reduce investments in safety protocols, or increase workloads to maximise productivity – all of which have been shown to correlate with higher levels of workplace misconduct. High-risk decisions may inadvertently put employees under greater stress, leading to unethical behaviour, unsafe working conditions and a decline in morale.

The Impact of SFAS 123R

To support this argument, we explored the introduction in 2006 of the Statement of Financial Accounting Standard 123R (SFAS 123R), a financial accounting standard which significantly reduced the use of stock options in executive compensation contracts.

We found that by reducing stock options SFAS 123R effectively lowered CEO vega, which led to a decline in workplace violations. This suggests that stock options, while effective at incentivising CEOs to drive short-term performance, may also encourage risky and unethical behaviours that can ultimately harm a company’s reputation and its employees.

What can senior leaders do? 

The challenge for businesses lies in finding a way to balance the potential benefits of stock options with the risks they pose in terms of unethical behaviour.

One practical recommendation to increase awareness of how compensation structures can drive risky executive behaviour.

Providing training and resources for executives that emphasize ethical leadership can help mitigate this risk.

The research also highlights the role of corporate governance, specifically the board’s ability to monitor the relationship between CEO incentives and workplace misconduct.

We find that effective board oversight – particularly by ensuring board members are not overcommitted (“less busy”) – can reduce the negative effects of high vega.

The paper CEO Risk Taking Equity Incentives and Workplace Misconduct, is co-authored by Monika Tarsalewska (University of Exeter Business School), Justin Chircop (Lancaster University) and Agnieszka Trzeciakiewicz (University of York) and published in The Accounting Review.