Product recall and CEO compensation: Evidence from the automobile industry
Introduction
The automobile industry has been under regulatory scrutiny many times over the past decades, owing to the increasing number of recalls and the subsequent financial toll on various stakeholders. Between 2010 and 2020, more than 323.4 million vehicle recalls were issued, an 81.8% increase from the previous decade (Wayland, 2019). Recalls lead to multibillion-dollar losses and can tarnish a company's and the CEO's reputation. Volkswagen CEO Martin Winterkorn stepped down in 2015 amid an emission scandal that resulted in the recall of millions of cars (Chappell, 2015).1 General Motors CEO Mary Barra admitted that the recall crisis of 2014 forever changed her leadership style (Feloni, 2018).2 This study examines how product recalls in the automobile industry affect CEO compensation, an unexplored research topic in the literature. We focus on the automobile industry for several reasons. The number of recalls and their intensity in the automotive sector have grown significantly over the past 20 years (Aragon et al., 2019), and CEOs are facing backlashes dealing with these recalls. Moreover, the industry's recall risk landscape is evolving owing to technological enhancements, regulatory scrutiny, and high litigation costs (Hu and Yeong, 2021). Hence, the automotive industry offers an interesting setting for testing the association between product recalls and CEO compensation.
The literature on CEO incentive systems is complex and has been subject to extensive debate. According to agency theory, there should be an alignment between compensation contracts and managerial performance outcomes (Murphy, 1999; Roberts, 2005). A pay-for-performance policy can alleviate principal-agent conflicts and motivate CEOs (agents) to act in the best interests of shareholders (principals) (Jensen and Meckling, 1976; Jensen and Murphy, 1990a). Consistent with the principal-agent theory, CEOs are compensated with stocks, options, and bonuses instead of a flat salary only (Frydman and Jenter, 2010). Previous studies have identified a strong positive association between CEO pay and performance outcome factors such as the firms’ operating profits (Defeo et al., 1989; Dechow et al., 1994) and stock market returns (Hall and Liebman, 1998; Boschen et al., 2003). Building on the concept of pay-for-performance and principal-agent theory, we argue that poor managerial performance, specifically in the form of product recalls that result in a decline in sales and operating profits, reputational and brand equity damages, and specifically negative stock market reactions, will adversely affect CEO compensation. Therefore, we hypothesize that product recalls will be negatively associated with CEO compensation, reflecting the negative impact of such events on a firm's financial performance and reputation.
There are several other firm-specific factors that also determine CEO compensation such as firm size and leverage (Nourayi and Daroca, 2008; John et al., 2010; Vemala et al., 2014; John et al., 2010), and corporate governance factors (Matsumura and Shin, 2005; Petra and Dorata, 2008). The literature also focuses on CEO characteristics, such as age, gender, power, and narcissism, that significantly influence CEO compensation (Graham et al., 2012; Aabo et al., 2022; Kulich et al., 2011; Bugeja et al., 2012). While prior literature highlights the influence of firms’ economic performance and CEO characteristics on compensation, this study focuses on the impact of a negative event such as product recall on CEO compensation.
Existing product recall literature documents significant negative stock market reactions because of recalls in both the automotive (Rupp, 2004; Barber and Darrough, 1996; Jarrell and Peltzman, 1985) and non-automotive industries (Dowdell et al., 1992; Chu et al., 2005; Chen et al., 2009; Chen and Nguyen, 2013; Unsal et al., 2017). Davidson and Worrell (1992) find that post-recall negative abnormal returns are more negative when products are replaced than when they are repaired. However, Govindaraj et al. (2004) argue that the market initially overreacts negatively to recall news; later, this overreaction is corrected as information on actual recall costs becomes available. In addition to negative market reactions, recalls can result in other adverse consequences, such as higher costs of debt and loan prices (Zhang et al., 2022). Recall events also pose significant costs not only to the recalling firms but also to other firms in the industry and key suppliers (Kini et al., 2013). Considering the negative stock market reactions to recalls and stock performance as one of the key determinants of CEO compensation, we hypothesize that product recalls are negatively associated with CEO compensation.
However, the association between product recalls and CEO compensation is not straightforward. CEOs can try to defend themselves to avoid recall blame when there is someone else to hold responsible, especially past CEOs. Mayo et al. (2022) argue that product recall is higher for a firm immediately after a new CEO appointment. Schulte and Kleine-Stegemann (2022) show that the risk of product recall decreases when top executives have a longer tenure. Byun and Al-Shammari (2021) find that CEO narcissism also affects the likelihood of product recalls, depending on whether they hold structural or ownership power. The above discussion shows that there is tension in the nature of the relationship between product recalls and CEO compensation, which requires empirical investigation. Thus, our study offers the first insights into the association between product recalls and CEO compensation.
We collect data on product recalls related announcements for the U.S. automobile industry from the National Highway and Transportation Safety Administration (NHTSA) website. Our sample covers the period from 1999 to 2018 and consists of 3744 firm-year observations, where 1512 observations are for recalled campaign firm-years and 2232 are for non-recalled firms. Our analysis shows a significant negative association between product recalls and CEO compensation. This finding is robust to the total number of recalls and voluntary recalls after controlling for firm performance variables and CEO characteristics, firm-fixed effect model, and a propensity score-matched sample. Additional analysis reveals that recalls have negative impacts on CEOs’ long-term compensation but have no impact on cash compensation.
Our study extends the CEO compensation literature by documenting product recalls as a new factor that explains the variability in CEO compensation. While recall literature extensively examines the impact of recalls on the equity market (Jarrell and Peltzman, 1985; Chen et al., 2009), only a few studies focus on CEOs in this context (Mayo et al., 2022; Byun and Al-Shammari, 2021). Our study complements this strand of the product recall literature. Despite the increasing prevalence of recalls and their negative stock market reactions, there is no evidence of their impact on CEOs’ equity incentives. Our study empirically demonstrates a direct negative link between CEOs’ long-term compensation and product recalls. The findings of our study are of interest to managers, investors, boards, and compensation committees.
Section snippets
Data and methodology
We collect data on recall campaigns in the U.S. automobile industry from The NHTSA website. The NHTSA requires manufacturers, who determine that a product has a safety defect, to file a defect and noncompliance report, in compliance with the National Traffic and Motor Safety Act 49, Part 573. The NHTSA database includes specific NHTSA recall campaigns and product type information. To accurately establish the number of recalls, we consider only unique recall instances. For example, multiple
Product recalls and CEO compensation relationship
Table 2 presents the baseline regression results for CEOs’ total compensation and product recall events. The first four models include total recall campaign announcements as key variables. The last model uses a dummy variable for firms with recalls. Our results are consistent across all models, showing a strong negative association between the total number of recall announcements and CEOs’ total compensation. We also find that stock returns of the firms positively affect total compensation.
Conclusions
We use product recall campaign announcements from the NHTSA database for the U.S. automobile industry and find evidence of a negative association between product recalls and CEOs’ total and long-term compensation. However, we find no association between cash compensation and product recalls. Our results are robust to different methodologies. Our study contributes to the literature on CEO compensation and product recall, and our findings will be beneficial for managers, boards of directors,
CRediT authorship contribution statement
Mahfuja Malik: Conceptualization, Data curation, Formal analysis, Methodology, Writing – original draft. Fatima Jebari: Conceptualization, Data curation, Formal analysis, Methodology, Writing – original draft.
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