Executive Stock Options: The Effects of Manipulation on Risk Taking

By Hannes, Sharon; Tabbach, Avraham | Journal of Corporation Law, Spring 2013 | Go to article overview

Executive Stock Options: The Effects of Manipulation on Risk Taking


Hannes, Sharon, Tabbach, Avraham, Journal of Corporation Law


  I. INTRODUCTION  II. THE ADVENT OF EXECUTIVE INCENTIVE COMPENSATION AND ITS TWO        MAJOR SHORTCOMINGS      A. The Link Between Incentive Pay and Financial Misrepresentation      B. The Link Between Incentive Pay and Excessive Risk Taking III. THE TRADEOFF BETWEEN RISK TAKING AND MANIPULATION      A. The Tradeoff Between Manipulation and Excessive Risk Taking      B. The Interaction Between Manipulation and Beneficial Risk Taking      C. Backdating  IV. NORMATIVE IMPLICATIONS AND CONCLUDING REMARKS   V. APPENDIX      A. Model      B. Stock-Price Manipulation and Excessive Risk Taking      C. Stock-Price Manipulation and Beneficial Risk Taking      D. Backdating 

I. Introduction

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. (1) This shift, which was intended to improve firm performance, is often said to have two major shortcomings: it drives managers to engage in manipulative practices, and it generates excessive risk taking. (2) some scholars consider these problems to be so severe that they blame the former for the wave of Enron-style fraud cases in 2001 and 2002 and the latter for the 2007 to 2010 financial crisis. (3) Interestingly, to date, no one has investigated the interaction between these two types of adverse incentives for manipulation and risk taking. This Article seeks to fill this void.

The bottom line of this Article's analysis is that regulators should always couple anti-fraud measures with risk-restraining measures. This policy was not espoused in recent history: the regulation enacted in the United States in the wake of the Enron crisis imposed severe anti-fraud measures, yet these were only coupled with risk-restraining measures in 2010, after another mega-crisis occurred. (4) We show here that managers compensated in stock options and similar devices face a tradeoff between these two undesirable courses of action--manipulation and excessive risk taking--both of which generate benefits for managers at the expense of shareholders. In other words, greater manipulation could, remarkably, restrain excessive risk taking. Part of the explanation for this outcome is, in intuitive terms, that a manipulative manager will not want to jeopardize the fruits of her manipulative wrongdoing by taking on too much risk. Therefore, when regulation improves disclosure and impedes manipulation, risk taking may erupt.

The following simple example illustrates how our argument plays out. Suppose that a firm's manager must choose between two alternatives: a conservative project that would, with certainty, increase the firm's share prices by $5, from $50 to $55 a share, and an excessively risky project that would have equal odds of increasing share prices by $15, to $65 a share, or decreasing them by $15, to $35 a share. Under such circumstances, according to an argument well-established in the existing literature, option-based compensation would push the manager towards the excessively risky project because options allow her to benefit from the upside of a risky decision without suffering the consequences of its downside. In this example, and assuming the manager can exercise her options at the baseline price of $50 per share, the upside of the risky project is an average profit of $7.50 for the manager, (5) while the certain outcome of the non-risky project is a profit of only $5 per option. Figure 1 demonstrates this risk-inducing feature of stock options:

[FIGURE 1 OMITTED]

This familiar story about the risk-inducing nature of options does not, however, account for the tradeoff between manipulation and risk taking. If managers have the power to manipulate share prices, they may, counter-intuitively, forgo their preference for excessive risk. To understand this novel argument, assume that our manager can misrepresent the results of the firm's business operations to a certain extent.

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