How did the Sarbanes–Oxley Act affect managerial incentives? Evidence from corporate acquisitions

Abstract

We examine the impact of incentive compensation on the riskiness of acquisition decisions before and after the passage of the Sarbanes–Oxley Act (SOX). Before SOX, equity-based compensation was positively related to changes in risk around acquisition decisions, but this relationship weakened after the introduction of SOX. The drop in post-SOX acquisition-related risk stems from how managers respond to compensation-based incentives in the new regulatory environment. We show that executive stock options and pay-risk sensitivity drive post-SOX managerial responsiveness to risk-taking incentives. We also document a post-SOX value-enhancing effect on long-term stock-price performance and total factor productivity through these same incentive compensation mechanisms. The results are robust to selection bias, simultaneity, measurements of risk, and the definition of incentive compensation.

Lessening Effects of SOX on the Relationship between Executive Compensation Components and Cost of Equity Capital

“…Prior research (e.g., Coles et al 2006;Deutsch et al 2010;Devers et al 2007;Harford and Li 2007;Hillier et al 2022;Larraza-Kintana et al 2007;Sanders and Hambrick 2007;Williams and Rao 2006;Wright et al 2007) show that executive stock option compensation discourages executive risk-aversion and leads to greater firm-level risk-taking. Executives are more likely to make riskier decisions when stock option compensation is awarded because stock options propose potential upside risks but restrict downside risks (Agrawal and Mandelker 1987;Devers et al 2008;Rajgopal and Shevlin 2002;Sanders 2001;Williams and Rao 2006;Wright et al 2002).…”

“…Chang et al (2009) find that SOX impacts earnings quality and the cost of equity. In addition, Hillier et al (2022) find that SOX changes the effect of incentive compensation on managerial behavior.…”

“…The effect of each compensation element on the cost of equity capital can be different due to the unique features of each element. The behavioral agency model indicates that each component of compensation has a different implication for risk-taking (Devers et al 2008;Hillier et al 2022). Larraza-Kintana et al (2007) find that cash and the different forms of equity-based CEO pay have different impacts on firm risk.…”

“…The third contribution to the literature is the consideration of SOX as a weakening effect on three important types of executive compensation. Previous studies (e.g., Chang et al 2012;Cohen et al 2007;Hillier et al 2022;Peráček 2021;Žofčinová et al 2018) investigate the laws and regulations governing compensation in different countries and their impacts on many aspects. For example, Hillier et al (2022) report that SOX weakens the relation between incentive compensation and risk-taking activity.…”

“…Previous studies (e.g., Chang et al 2012;Cohen et al 2007;Hillier et al 2022;Peráček 2021;Žofčinová et al 2018) investigate the laws and regulations governing compensation in different countries and their impacts on many aspects. For example, Hillier et al (2022) report that SOX weakens the relation between incentive compensation and risk-taking activity. However, these prior studies do not make a connection between the potential impacts on compensation and investor's pricing.…”