Rewarding Executive Incompetence

What About Jail?

Researchers at Notre Dame’s business school “have found a correlation between generous option grants and the incidence of serious product recalls.”

How could that be? Companies need to maximize quality and profit. They try to hire effective managers. Everybody suffers when quality fails. Right?

Gretchen Morgensen, the business reporter for The New York Times, picked up on the disturbing results of the study and offered a plausible explanation. “This heads-I-win, tails-I-barely-lose arrangement encourages executives to swing for the fences.”

She notes that option-laden executives are often too eager to reap the riches from a rising share price but also have been found to make unwise acquisitions or, even worse, to undertake aggressive accounting practices. “Now comes evidence that product recalls are often linked to abundant option grants handed to chief executives.” (See the study, “Throwing Caution to the Wind.”).

But she also noted a less unexpected finding: “Product recalls were less common among companies whose chief executives founded the companies or had long tenures there. Such executives may be more risk-averse because they are generally large shareholders and may also feel that their personal reputations are intertwined with their companies’ actions.” They may also identify with their companies and believe the failures of the company reflect badly on them.

And they do reflect badly – if anyone ever stops to think about it. Family run businesses tend to care about such things because the pride and self-esteem of family members are wrapped up in the business. Fathers and grandfathers look down from walls of their board-rooms. Children and grandchildren look up at their elders. Many other businessmen and women feel keenly the impact of their mistakes on customers.

But then, on the other hand, many see business as an opportunity to exploit and mislead others. This morning’s paper brought news of Volkswagen’s deliberate efforts to defraud its customers and the government by installing “defeat devices” in cars so that emissions controls in diesel engines would work only when they are being tested.

“This is several steps beyond the violations that we’ve seen from other auto companies,” said Tyson Slocum, director of the energy program at Public Citizen, a consumer advocacy group. “They appear to have designed a system with the intention to mislead . . . . If that’s proven true, it would merit a heck of a lot more than just a recall and a fine. We would see criminal prosecution.”

Such egregious violations suggest that a kind of war is going on in the corporate world. Not all but, clearly, some corporations see few limits to the practices they are willing to engage in to beat the competition or raise profits. In real war, we have the Geneva Conventions to provide guidance to combatants. What would it take in business?

Morgensen concludes her account of how the judgment of executives is distorted by their craving for more money by emphasizing the responsibility of boards: “Having fielded complaints from shareholders about excessive executive pay for decades, corporate boards say they have gotten the picture that chief executives’ pay should be aligned with their owners’ interests. As this new study shows, directors should understand that executive pay needs to line up with consumers’ interests as well.”

But what kind of “defeat devices” would we need to dismantle in boards to make this happen?