Employees behaving badly: how high CEO pay can encourage wider wrongdoing

Research suggests that CEO stock option schemes combined with a large pay gap can encourage and motivate lower-ranking employees to commit illegal behavior

This article is republished with permission from I by IMD, the knowledge platform of IMD Business School. You may access the original article here.

Why did managers at German automaker Volkswagen install software to cheat on emissions tests? And why did staff at US bank Wells Fargo create millions of fraudulent savings and checking accounts without customers’ consent? A proliferation of corporate scandals in recent years prompted Stephen J. Smulowitz, Term Research Professor at the IMD Global Board Center, and Juan Almandoz, a Professor in the Department of Managing People in Organisations at IESE business school to examine what drives people to commit wrongdoing.

Previous research had considered how pay schemes that link compensation to stock market performance, particularly in the form of option pay, can encourage a CEO to take risks that might result in wrongful behaviour. Likewise, in companies with particularly large pay gaps between the CEO and the rest of the top management team, disgruntled executives who perceive the pay policies to be unfair may be more motivated to steal from the organisation. However, no research had asked the question: Can CEO pay drive other employees in the firm, not receiving the pay, to commit wrongdoing? 

Using a sample of US bank holding companies from 2007 to 2013, Smulowitz and Almandoz examined whether there was a link between CEO option pay and the pay gap with the probability of individuals in the wider workforce committing wrongdoing.

Publicly traded bank holding companies provided an excellent research context for several reasons. First, they use high amounts of incentive pay and are required to disclose compensation data, making it possible to compare CEO pay to the average pay in the organisation. Second, the regulatory requirements and risk management schemes in the banking industry make it easier to detect incidents of wrongdoing. Indeed, between 2007 and 2013, more than 2,000 individuals were banned from working at a US bank by regulators due to alleged wrongdoing, such as embezzling funds, forging documents, or accepting bribes. Third, banks’ central role in the functioning of the economy, as shown by the 2008 financial crash, makes the study of wrongdoing in this industry particularly relevant.

The researchers found strong evidence that both CEO option pay, and the pay gap between the CEO and average employees, increased the likelihood of wrongdoing. Indeed, this effect was quite large. In banks with no CEO option pay plus a low pay gap, there was only a 5 per cent probability of wrongdoing, compared with firms with high CEO option pay and a high pay gap where the probability of wrongdoing leapt to 33 per cent – an almost sevenfold increase. 

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Admittedly, a high pay gap between the CEO and the average worker could be reflective of a corporate culture lacking in caution or broader ethical or governance issues at a firm that encourages fraud rather than being the driver of wrongdoing, say the researchers. Nonetheless, they note there exists a vast literature suggesting that CEO incentive pay and pay inequity can either influence a culture of ethics and good governance, or one of wrongdoing. For example, previous research has shown that employees may resort to unethical behaviour when they cannot meet their goals through legitimate means, or may act in competitive rather than cooperative ways with colleagues. This was the case at Wells Fargo, where employees opened millions of accounts in clients’ names without their knowledge, forged signatures, and even transferred customers’ money to try to meet sky-high sales goals. Indeed, the bank has been fined millions of dollars because top executives failed in their oversight of the bank, while those same executives also took home fat pay packages.  

This research is particularly relevant, because in recent years the gap in pay has risen along with societal inequality, stoking concerns of greater social and economic instability. In fact, CEO pay at the largest US firms has grown to 299 times that of the average worker, according to paywatch.org, while at the same time, incidents of fraud and wrongdoing at companies have increased. Given this backdrop, what steps can companies take to limit wrongdoing?

Take responsibility

CEOs and top executives have major influence over the culture in their organisations. They can set the tone for the entire organisation by, for example, how they punish incidents of wrongdoing in the firm, and how they set pay schemes for lower-level employees. However, interviews with top executives in banks exposed divergent views about how much the buck stopped with them in terms of preventing wrongdoing. In interviews, some top executives in banks took personal responsibility for preventing wrongdoing. Others literally shrugged their shoulders when asked what they can do to make their organisation behave more ethically. It is not surprising that there were such divergent outcomes in terms of wrongdoing when top managers’ attitudes on personal responsibility also differed so much.  

Punish bad behaviour, even at the top

Previous research shows that the incidence of wrongdoing declines significantly when the probability of detecting it and the severity of punishment is high. Potential wrongdoers are more likely to be deterred if they know they face negative consequences if caught. This sounds like common sense. However, some companies have different rules for executives than for the rest of the firm. This double standard is always noticed, and it can fuel resentment and make it more likely that lower-ranked employees will justify their own inappropriate behaviour.

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Redesign pay schemes

When boards of directors are designing pay packages for CEOs, they need to consider the effect on other stakeholders, such as employees. Elevated levels of option pay can incentivise risky behaviour and divert attention away from risk management, providing greater opportunities for others to commit wrongdoing. Moreover, while big pay packages for the CEO and other top executives can act as a carrot to motivate people to work hard and climb the corporate ladder, they can also induce feelings of envy and resentment. This can make employees slack off, have lower job satisfaction, cooperate less with colleagues, and even quit their jobs more frequently. At the more extreme end of the scale, feelings of inequity and injustice with respect to pay can lead to wrongful acts, such as theft. As a result, boards of directors should be wary about implementing aggressive CEO compensation schemes if there is already a high pay gap within the company.

Make the disclosure of pay data mandatory

The study, along with previous research, found pay can be a key driver of behaviour in firms. This information can help regulators predict wrongdoing in banks and can also be useful for investors considering where to put their money. For this reason, regulators should consider making public disclosure of pay data mandatory for all banks.

This article is based on Predicting employee pay wrongdoing: The complementary effect of CEO option pay and the pay gap by Stephen J. Smulowitz and Juan Almandoz. The research was first published in Organisational Behavior and Human Decision Processes 162 2021 p. 123–135. DOI: 10.1016/j.obhdp.2020.10.018