CHAMPAIGN, Ill. — Firms whose chief executive officers also own company stock often delay the decision to recall faulty medical devices until long after they become aware of a defect, according to a new paper co-written by a University of Illinois Urbana-Champaign analytics expert.
The net effect of slow-walking the decision to recall a defective medical device ultimately ends up magnifying the stock market penalty attributable to the recall, particularly for high-severity problems, says Ujjal Kumar Mukherjee, a professor of business administration at the Gies College of Business at Illinois.
“We find that a 2% increase in the percentage of shares owned by the CEO is associated with a 26-day delay in recall initiation,” he said. “This indicates that firms with CEOs who own greater amounts of company stock may, intentionally or unintentionally, allow dangerous medical devices to linger in the market. It’s an enormous public health risk, and such examples of recall delays are all too common in the medical device industry.”
Mukherjee’s co-authors are George P. Ball of Indiana University Bloomington, and Jessica L. Darby and David J. Ketchen Jr., both of Auburn University.
Contrary to popular belief, firm executives – not regulators such as the U.S. Food and Drug Administration – decide whether and when to recall faulty medical devices in the U.S.
“Although the FDA establishes guidelines for when to recall faulty products, they rely on firms to actually initiate those recalls,” Mukherjee said. “By contrast to other regulatory agencies or other consumer products, the FDA takes a more measured and cooperative approach with medical device companies. Broadly speaking, you can think of the recall decision as a process, which is why some recalls occur immediately after a problem is discovered, but many are delayed for weeks, months or even years.
“Ultimately, though, the company’s CEO plays a big role in terms of making the final decision to recall a medical device. And that decision not only has significant market consequences, but also significant public health repercussions.”
To understand the effects of CEO stock ownership on recall timing, the researchers collected data on 2,144 medical device recalls across 50 public medical device firms from 2002-2015 and then examined whether the stock market penalized firms differently based on recall decision-making speed. They also analyzed whether the penalty varied with recall severity.
“We found that delaying the initiation of a recall significantly magnified the stock market penalty experienced by the recalling firm, particularly for devices with severe defects,” Mukherjee said. “For example, waiting an extra three weeks to initiate a recall nearly doubles the stock market penalty, on average – an effect that is most prominent for high-severity recalls and not significant for low-severity recalls.”
The findings of the study provide practical implications for corporate boards and public health policymakers, Mukherjee said.
“Our study highlights an ownership characteristic of firms that are more likely to delay recalling faulty medical devices,” he said. “Boards of directors can use the insights from our study as they oversee product-quality decisions and determine the level and form of CEO compensation. The FDA can use our findings to identify companies that might warrant extra scrutiny.”
The findings also point to a need for oversight mechanisms to mitigate the recall-slowing effects of CEO stock ownership.
“Given the significant societal costs associated with failing to quickly recall faulty medical devices, we formulated three suggestions for practice and public policy,” Mukherjee said.
First, the FDA has called for a recall process that is as swift as possible, and “our findings show that high CEO ownership stakes is characteristic of firms that are more likely to have slower recalls,” Mukherjee said.
“Given that CEO compensation information is readily available for public firms, a key implication for the FDA is to consider using this information to identify firms that may need additional oversight in initiating recalls of medical devices with dangerous defects, such as additional plant inspections or more stringent new product submission regulatory reviews to ensure product quality,” he said.
Second, for boards of directors, “our findings indicate a potential need for closer scrutiny of recall decision making, especially for executives with high ownership stakes or whose compensation is driven by stock options,” Mukherjee said. “Providing stock options for a CEO and the top brass comes from the idea that those options will motivate them towards the best interest of the company and the shareholders. Well, as we show in the paper, you can go too far in that direction.”
Finally, for CEOs, the study offers empirical evidence of the stock market penalties associated with delaying recalls.
“Our study can arm CEOs with this new knowledge that the waiting game doesn’t ultimately work and hopefully encourage quicker initiation of medical device recalls, which could result in a win-win for public health and shareholders,” Mukherjee said. “It’s all about finding the balance between financial incentives versus being a socially focused company. These aren’t problems you can just sweep under the rug.”
The paper was published by the journal Manufacturing & Service Operations Management.