Managerial Compensation and Stock Price Manipulation

• Author: JOSEF SCHROTH
• Date: 01 December 2018
• Published date: 01 December 2018
• DOI: http://doi.org/10.1111/1475-679X.12237

DOI: 10.1111/1475-679X.12237

Journal of Accounting Research

Vol. 56 No. 5 December 2018

Printed in U.S.A.

Managerial Compensation and

Stock Price Manipulation

JOSEF SCHROTH

∗

Received 25 January 2017; accepted 4 June 2018

ABSTRACT

This paper studies the role of optimal managerial compensation in reduc-

ing uncertainty about manager reporting objectives. It is shown that, para-

doxically, firm owners allow managers with higher propensity to manipulate

the short-term stock price to push for higher powered and more short-term-

focused equity incentives. Such managers also work harder, and manipulate

more, but may not generate higher firm profits. The model is consistent with

existing empirical findings about the relationship between manipulation and

equity pay, suggesting that heterogeneity in manager manipulation propen-

sities may be an important driver of heterogeneity in pay. Novel testable pre-

dictions are developed.

JEL codes: D82; D86; G30; M12; M40

Keywords: managerial compensation contracts; stock price manipulation;

private information; duration of equity incentives

∗Bank of Canada.

Accepted by Haresh Sapra. For helpful comments and suggestions, I am very grateful to

two anonymous referees, David Aboody, Toni Ahnert, Jason Allen, Antonio Bernardo, Anne

Beyer,Simon Board, Neil Brisley, Shane Dikolli, Itay Goldstein, Florian Heider, Christian Hell-

wig, Miguel Molico, Teodora Paligorova, Stefan Petry,Marek Pycia, James Thompson, Pierre-

Olivier Weill, seminar participants at University of Ottawa Telfer, and conference participants

and discussants at Canadian Economic Association Meeting 2015, International Banking, Eco-

nomics, and Finance Association 2016 Summer Meeting, and Northern Finance Association

Meeting 2017. Any views expressed are my own and not necessarily those of the Bank of

Canada.

1335

CUniversity of Chicago on behalf of the Accounting Research Center,2018

1336 J.SCHROTH

1. Introduction

Financial accounting scandals are well publicized, but legal forms of

manipulation—such as promoting alternative performance measures—are

vastly more common.1Managers can potentially affect the short-term stock

price by altering the timing of voluntary disclosures (Aboody and Kasznik

[2000]) or accruals (Bergstresser and Philippon [2006], Gopalan et al.

[2014]), or by varying the precision of management forecasts (Cheng, Luo,

and Yue [2013]). There may also be more subtle ways for managers to affect

stock prices; for example, by adjusting the tone of press releases (Feldman

et al. [2010], Davis, Piger, and Sedor [2012], Demers and Vega [2014])

and conference calls (Hollander, Pronk, and Roelofsen [2010], Mayew and

Venkatachalam [2012], Huang, Teoh, and Zhang [2013]).

What does ubiquitous legal manipulation imply for how top manage-

ment should be remunerated? On the one hand, equity pay is considered

to be an important part of top manager compensation (Hall and Lieb-

man [1998], Morgan and Poulsen [2001]). On the other hand, the pos-

sibility that managers may be able to legally manipulate stock prices in the

short run creates challenges for the design of firm-value-maximizing com-

pensation schemes (Bebchuk and Fried [2010]). These challenges are in-

creased by manager characteristics impacting reporting and manipulation

decisions (Francis et al. [2008], Bamber, Jiang, and Wang [2010], Demer-

jian et al. [2012], Dikolli et al. [2017]) as well as compensation (Graham,

Li, and Qiu [2012]).

This paper explores the role of manager characteristics in creating

links between manipulation and compensation. Specifically, I show how

differences in manager characteristics related to a manager’s propensity

to manipulate the firm stock price can generate compensation hetero-

geneity. The main contribution of the paper is twofold. First, it is shown

that model predictions about the relationships between manipulation and

compensation across firms are consistent with existing empirical evidence

(Bergstresser and Philippon [2006], Gopalan et al. [2014]). Second, the

model is used to generate novel empirical predictions about the relation-

ship between manager-specific manipulation propensities and compensa-

tion.

I build a model of optimal managerial compensation where managers

can influence market participants’ expectations about firm value. Such in-

fluence is a way for managers to manipulate the firm’s short-term stock

price but does not create any firm value. Managers cannot manipulate

long-term stock prices; however, basing compensation only on long-term

stock prices imposes a high cost in terms of risk on managers. An optimal

compensation scheme balances short-term and long-term incentives to op-

timally tradeoff costs due to risk against costs due to wasteful manipulation.

1Adjusted earnings systematically exceed accounting earnings at S&P 500 firms (The

Economist “Sweet Little Lies,” April 30, 2016).

MANAGERIAL COMPENSATION AND STOCK PRICE MANIPULATION 1337

There are two key assumptions in my model. First, managers privately ob-

serve their respective propensity to manipulate firm short-term stock prices

(as in Fischer and Verrecchia [2000], Peng and R¨

oell [2014]). Second,

managers are hired by long-term firm owners who do not actively trade

firm stock such that, as a result, firm owners reveal the manager compensa-

tion contract to market participants.2Under these two assumptions, in an

equilibrium, market participants correctly discount manager exaggeration

of firm value, short-term stock prices are unbiased, and managers earn in-

formational rents. Since firms offer information rents to separate managers

according to their unobservable manipulation propensities, the model gen-

erates cross-sectional predictions that are not driven by observable manager

or firm characteristics.

It is shown that firms do not find it worthwhile to induce managers with

low manipulation propensity to put high effort into increasing firm value

even though a manager’s manipulation propensity is independent of his or

her capability to increase firm value in the model. As a result, managers with

high propensity to manipulate receive, in addition to information rents,

higher powered incentives overall and, in particular, stronger short-term

relative to long-term incentives. The model predicts, consistent with the

evidence in Bergstresser and Philippon [2006] and Gopalan et al. [2014],

that overall—but especially short-term—equity incentives are positively cor-

related with manipulation activity, conditional on observables. Since man-

agers who manipulate more also have incentives to put more effort into

increasing long-term firm value, because of higher overall equity pay, the

net effect of a shorter pay duration on firm profit is ambiguous in the

model.

The channel that generates the negative relationship between equity-

incentive duration and manipulation activity in the model operates via firm

owners’ desire to keep manager information rents low. Managers receive

information rents to prevent them from understating their respective

manipulation propensity, since that would allow them to surprise market

participants with higher-than-expected manipulation. Such a surprise

in turn would boost short-term stock prices and increase the worth of

managers’ short-term incentive pay. Managers with high manipulation

propensity therefore receive information rents that increase with the

amount of short-term incentives given to managers with low manipulation

propensity. Since high-manipulation-propensity managers cannot be pre-

vented from manipulation, firms find it too costly, in terms of information

rents, to provide undistorted short-term incentives to low-manipulation-

propensity managers. The presence of managers with high manipulation

2The second assumption rules out an insider-trading motive for firm owners and implies

that firm owners prefer to relay information about the compensation contract to market par-

ticipants. In practice, in the United States, market participants can obtain information about

the compensation awarded to the top five managers, including the CEO, from proxy state-

ments that companies file with the Securities and Exchange Commission.