In recent years, CEOs have been questioned all around the world whether their compensation is fair. Professor Tanusree Jain of Copenhagen Business School delves into how CEOs’ compensation can have an impact on the decisions they make and the potential for increased corporate irresponsibility practices.

Fairness, Risk, and Responsibility: CEO Compensation Dynamics by CoBS EditorAna Sofia Bello. Related Research: Jain, T., Zaman, R., & Harjoto, M. (2023). Behavioral Agency Model and Corporate Social Irresponsibility: Uncovering the Implication of Fairness in CEO Compensation. Journal of Management, 0(0). https://doi.org/10.1177/01492063231174873.

Stock options and stakeholder impact

Many CEOs are getting paid around $5 to $8 billion solely through stock options of their companies. This figure might be shocking to some when the average salary in The United States is around $58,000 in 2024. Compensation allotted for CEOs continues to be a controversial topic because the received stock options provide CEOs with a compensation that is several hundred times that of a typical employee. The decisions that CEOs make influence their stock valuations, but how do these incentives influence corporate practices?

Many behavioural studies have theorized that executives’ risk preferences are influenced by the balance between potential gains and losses to their stock options. However, a latest study led by Professor Tanusree Jain of Copenhagen Business School explores how perceived unfairness in CEO compensation can lead to CEOs towards more risk-taking behaviours consequently harming stakeholders. 

Indeed, there has been a significant effort in investigating the performance outcomes of CEO stock options, but this new research investigates its implications on stakeholders. To do so, instead of utilizing the classic agency theory, it utilizes an alternative explanation of agentic behaviour under the direction of the behavioural agency model (BAM).

BAM and CEO compensation

Previous studies suggest that CEO compensation comprises mostly of stock options. This is what allows CEOs to earn ‘too much’ or, as some may even say, ‘not what they deserve’. This issue has sparked a considerable amount of controversy especially since CEOs’ decisions will have an immense impact on their compensation. The behavioural agency theory approach suggests that CEO stock options ultimately negatively influence CEO risk-taking.

In other words, CEOs are seen to be more risk-averse if the decisions they make have an impact on their income. Professor Jain suggests that CEOs, just like any other employee, should be prone to feeling dissatisfied and demotivated if they believe their compensation is unfair – so how does this impact the predictions of BAM?

BAM theory proposes that when it comes to risk preferences, CEOs are not described as risk averse, but rather they are loss averse. In simpler terms, CEOs prefer certainty of their compensation rather than less certain and volatile forms of compensation (i.e., stock options) driving them to avoid decisions that they think will expose their compensation to market risk.

The stock options that CEOs earn are more of a mixed gamble in this sense. This mixed gamble includes both the chance of experiencing losses and the possibility of achieving gains linked to strategic choices.

However, previous studies indicate that employees – including CEOS – often compare themselves socially, with their workplace attitudes, behaviours, and performance and are greatly influenced by how they perceive the fairness of what they think they should receive (and deserve) compared to what other CEOs receive and deserve.

As a result, CEOs, like other employees, strive to maximize their self-interest, but only as long as they believe fairness norms are being upheld. For example, in the case a CEO is being underpaid, the CEO will attempt to amend this perceived unfairness by either increasing their compensation (i.e., making decisions that drive the value of their stock options upwards) or by stepping back from firm responsibilities.

CEO decision-making dynamics

We already know that every decision made by the company or CEO has an effect, big or small, on other stakeholders in addition to their shareholders. Per BAM, loss aversion seen in CEOs manifests in two different types of behaviours that have an impact on a company’s stakeholders.

The first is that when CEOs try to reduce their losses, they are no longer concerned about increasing the value of their option stocks. In this manner, CEOs are relieved from behaviors that result in short-termism – the latter is highly worrisome to stakeholders since this has been regarded as the reason “for the worst excesses of the global financial crisis” including “environmental damage and other negative externalities to society that aren’t represented in financial statements”, says Professor Jain.

Second, when CEOs existing wealth from stock options goes up, they also tend to become more cautious in their decision-making to protect this wealth. This caution can help prevent excessively risky behaviours that could harm both CEOs wealth and other stakeholders’ interests.

It should be noted that to satisfy stakeholders who are not investors, such as employees or the community, CEOs must focus on creating long-term value rather than just short-term profits. And this approach is imperative when promoting sustainability initiatives aiming to better both the environment and society.

CEO compensation and corporate responsibility

This issue led Professor Jain to conduct a study analysing 838 publicly listed American firms over the period 2001-2018 to investigate the relationship between CEO stock options and corporate social irresponsibility. They found that CEO risk preferences, influenced by perceived injustices in compensation, play a significant role in amplifying risk-taking behaviours that lead to corporate social irresponsibility (CSI).

Specifically, the researchers observed that current option wealth tends to attenuate risk-taking, reducing the likelihood of CSI, while prospective option wealth increases the likelihood of such irresponsible behaviour.

Altogether, Jain’s research contributes to understanding CEO compensation’s impact on risk-taking behaviours by highlighting the role of distributive and procedural justice. Additionally, it argues that perceptions of unfairness in compensation arrangements can lead CEOs to engage in aggressive risk-taking, even at the expense of long-term damage to their companies and stakeholders. Furthermore, advancing research in behavioural agency by examining the conditions that foster such behaviour has expanded our understanding of the performance implications of CEO stock options.

Prof. Jain’s study underscores the significance for board compensation committees and consultants to acknowledge the procedural fairness of policy adoption processes, including provisions like clawbacks, which may be perceived as unjust by executives. Emphasizing transparency in adopting these measures could effectively mitigate excessive risk-taking by executives, thus curbing corporate engagement in irresponsible behaviours.

However, quantifying executives’ perceptions of “fair” compensation is challenging with firm-level data. Future research is encouraged to delve into how various forms of justice interact to influence CEO compensation’s performance outcomes.

Addressing compensation structures and governance

Prof. Jain’s research findings emphasize the critical role of organizational policies and management practices in shaping CEO behaviour, highlighting the significance of well-designed compensation structures and governance mechanisms.

By recognizing and addressing issues of distributive and procedural injustice, organizations can effectively manage CEO risk-taking tendencies and promote responsible corporate behaviour. We can expect that stressing the need for continual evaluation and refinement of governance mechanisms will align executive incentives with broader societal welfare objectives.

Useful links:

• Link up with Prof. Tanusree Jain on LinkedIn
• Read a related article: How boards can fix corporate social irresponsibilit, A look at the CG-CSR interface, and Business ethics research – long due for an overhaul.

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