Executive stock options: the effects of manipulation on risk taking.

Author:Hannes, Sharon
  1. 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:

    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. She can therefore manipulate share prices at the point in time when she is to exercise her options. More specifically, assume that the manager can cause share prices to be inflated by 20% in comparison to their fair value. This new assumption turns the outcome of our first example on its head and reverses the manager's preference for the risky project. Now, if she opts for the non-risky alternative, the manager could exercise her options for a profit of $16 per share (a $66 share price after misrepresentation--120% of $55--which is the certain outcome of the non-risky project without manipulation, minus the $50 exercise price). The risky project, on the other hand, would now offer the manager an expected return of only $14 per option: in the bad state of the world, the project would still generate zero returns for the manager, even after misrepresentation; (6) the good state of the world, which has a 50% chance of materializing, would yield an inflated profit of $28 per share ($78 share price after misrepresentation--120% of $65--minus the $50 exercise price). Because the risky project, with manipulation in play, would generate an average profit of $14 (50% of $28), which is less than the non-risky project's profit with manipulation ($16), the manager's preference for risk vanishes. More manipulation would only amplify this risk-reducing effect. Figure 2 presents the reversal of the manager's preferences when she can engage in manipulation:

    The outcome of this example is generalizable, (7) and it stems from a fundamental tradeoff between harmful risk taking and manipulation. Excessively risky projects will too often deprive the manager of the fruits of her manipulation. This deprivation will make her reconsider her preference for risky projects when she can engage in manipulation. Ironically, then, the prospect of manipulation aligns the risk-taking preferences of shareholders and managers. One type of harm, i.e., manipulation, counteracts a second type of harm, i.e., excessive risk taking. As we noted above, this implies that measures designed to prevent excessive risk taking should accompany improved disclosure and anti-manipulation regulatory policies. Otherwise, risk taking may erupt.

    This Article's analysis concludes with a look at a few open questions that tie our theoretical findings to the real world. The 2001-2002 securities fraud crisis and, most prominently, the mega-fraud cases of Enron and WorldCom, engendered the 2002 Sarbanes-Oxley legislation. A few years later, in 2007, a new monumental crisis emerged--one fueled by excessive risk taking orchestrated by the financial sector. This crisis, too, led to new legislation: the 2010 Dodd-Frank Act, which sought to reduce risk taking by financial institutions. As demonstrated above, our theoretical argument predicts that improved disclosure requirements and restraints on manipulation could drive managers towards excessive risk taking. The normative implication is, as we have noted, that measures directed against excessive risk taking must temper the side effects of disclosure. Hence, we speculate, the chronological proximity of the two crises may be more than mere coincidence: the measures implemented by the Sarbanes-Oxley Act may have caused the Dodd-Frank Act to become necessary. A thorough analysis of this point is beyond the scope of this Article, however. (8)

    Part II of this Article discusses the advent of executive incentive pay in the United States. Parts II.A and II.B consider the two major shortcomings of executive incentive pay: first, equity-based compensation, including compensation in stocks and stock options, is likely to bring about manipulation. Indeed, empirical studies reveal an abundance of whitewashing, sugarcoating, and outright misrepresentation in firms that compensate their executives generously in stock options and restricted shares. Next, we discuss the potential of stock options (as well as annual bonuses) to bring about excessive risk taking. The typical designs of these compensation schemes create a focus on the short run and allow managers to enjoy firm profits much more than they suffer firm losses.

    Part III presents the heart of the Article: an analysis of the tradeoff between risk taking and various types of manipulation. We begin with the manipulation of share prices at the point in time when a manager exercises his or her options, as illustrated in Figure 2. Many kinds of illicit behavior may cause manipulation, from the sugarcoating of accounting disclosures to earning management and sheer fraud. We show, first, that shareholders' and managers' risk-taking preferences align beyond a certain threshold of manipulation, so that if shareholders prefer a safer project, managers will too. Next, we discuss the opposite scenario, in which shareholders prefer the riskier option among alternative projects. Interestingly, in this case, manipulation would not cause a manager to opt for a safer project than that favored by the shareholders. Thus, while manipulation pushes managers away from excessively risky projects, it does not reverse their preference for beneficially risky projects. In intuitive terms, since manipulation makes options more likely to be valuable at the time of exercise, it causes the option-holder to think more like a shareholder. The ironic result is that manipulation, a reprehensible practice in itself, aligns managers' risk-taking preferences with those of their shareholders. We then turn to look at a different kind of manipulative practice: backdating. Backdating is the illegal practice of issuing options with a false, early grant date, one on which the company's share prices were particularly low. Backdating is thus a manipulation of stock-option exercise prices. We analyze the impact of backdating on risk-taking preferences and find that this prospect, too, counters managers' preference for excessively risky projects. Moreover, backdating does not cause managers to forgo beneficially risky projects. The effect of backdating on risk taking is thus similar to that of stock-price...

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