Abstract:

Executive compensation has undergone a radical shift in the United States over the last two decades, from a cash-based system to a stock-based system. This shift, which was intended to improve firm performance, is often said to have two main shortcomings: it generates excessive risk-taking, and it drives managers to engage in manipulative practices. Some scholars consider these problems to be so severe that they blame the first for the 2007-2010 financial crisis and the second for the wave of Enron-style fraud in 2001-2002. Interestingly, to date, no one has investigated the interaction between these two types of adverse incentives, for risk-taking and for manipulation. This Article seeks to fill this gap in the literature. We show that these two undesirable types of behavior—both of which generate benefits for managers at the expense of
shareholders—substitute for each other, from a manager's perspective. Managers therefore face a tradeoff between risk taking and manipulation. Greater manipulation, counter-intuitively, restrains excessive risk-taking. As a result, when regulation improves disclosure and impedes manipulation, risk-taking may erupt. Policy-wise, improved disclosure and anti-manipulation regulatory policies should be accompanied by measures designed to prevent excessive risk-taking by managers.