High-powered incentives and fraudulent behavior: Stock-based versus stock option-based compensation

Abstract

Abstract.In this paper shareholders face the trade-off between providing managers with incentives to exert beneficial effort and to engage in costly fraudulent activity. We solve for the optimal compensation package, given that shareholders can either grant (restricted) stock or stock options and given fixed average compensation costs. We show that if the negative effect of fraud on the company's value is sufficiently large then stock based compensation is optimal. Otherwise, stock option based compensation is optimal. Furthermore, we show that the fraud to effort ratio is increasing in the strike price and that the optimal strike price is decreasing in the size of the negative effects of fraud on the company's value.

Equity‐based incentive contracts and behavior: Experimental evidence

“…In Period 3, the market price is formed according to Equation 3 and the manager exercises the option if S M 3 >K. 6 In Period 4, with probability p any fraud is detected and the manager pays sanction x(f). The sequence of events described above implies that in Period 1, prior to the realization of e μ, for any effort-fraud pair, (e, f), the risk-neutral manager's expected utility is 4 Andergassen (2008) and Santore and Tackie (2013) theoretically compare the incentives created by simple equity and options when a manager can provide value enhancing effort as well as misrepresent firm value by committing fraud. 5 The results continue to hold for a more general expected sanction function, such as X(f) = p(f)x(f), as long as X(f) is a convex function.…”

“…6 Our assumption that the manager is able to exercise the option prior to fraud being detected is similar to Goldman and Slezak (2006). Andergassen (2008) assumes that the manager does not receive the proceeds from the illegal activity if the fraud is detected.…”

Managerial Incentives, Fraud, and Monitoring

“…It thus appears that the solution to one agency problem, equity compensation, may create a second agency problem. Goldman and Slezak (2006) and Andergassen (2008) both provide principal‐agent models in which equity‐based compensation, while inducing greater effort from managers, also provides incentives for managers to artificially or fraudulently inflate a firm's stock price 2 . And, empirical evidence of this phenomenon is provided by Johnson, Ryan, and Tian (2009), who find that while corporate fraud is relatively rare, executives in firms that committed fraud had significantly more equity‐based compensation than those in firms where no fraud occurred.…”

Managerial Incentives, Fraud, and Monitoring

“…Goldman and Slezak (2006) and Andergassen (2008) both provide principal-agent models in which equity-based compensation, while inducing greater effort from managers, also provides incentives for managers to artificially or fraudulently inflate a firm's stock price. Goldman and Slezak (2006) and Andergassen (2008) both provide principal-agent models in which equity-based compensation, while inducing greater effort from managers, also provides incentives for managers to artificially or fraudulently inflate a firm's stock price.…”

“…Previous work has assumed that fraud is costly regardless of whether or not it is detected (Goldman and Slezak, 2006;Andergassen, 2008), due to the diversion of the firm's resources required for the manager to commit the fraud. Previous work has assumed that fraud is costly regardless of whether or not it is detected (Goldman and Slezak, 2006;Andergassen, 2008), due to the diversion of the firm's resources required for the manager to commit the fraud.…”