Endogenous Compensation in a Firm with Disclosure and Moral Hazard

James C. Spindler
2009 Social Science Research Network  
I model a where shareholders choose the manager's compensation in light of the manager's dual roles of exerting effort and making disclosures regarding the 's value. Because of limited contracting ability and the divergence of short-term interest between shareholder and manager, shareholders may be unable to obtain their -best choices of effort and disclosure policy; where agency costs are too large, shareholders will be unwilling to award performance-based compensation, which induces both
more » ... t and fraudulent reporting. The principal are (1) fraud and effort are positively correlated, and given a poor outcome fraud is more likely to obtain when effort is exerted in equilibrium, (2) the incidence of fraud-inducing compensation increases as agency costs decrease, and (3) reductions in agency costs actually increase the incidence of fraud when agency costs are high. Abstract I model a ...rm where shareholders choose the manager's compensation in light of the manager's dual roles of exerting e¤ort and making disclosures regarding the ...rm's value. Because of limited contracting ability and the divergence of short-term interest between shareholder and manager, shareholders may be unable to obtain their ...rst-best choices of e¤ort and disclosure policy; where agency costs are too large, shareholders will be unwilling to award performance-based compensation, which induces both e¤ort and fraudulent reporting. The principal ...ndings are (1) fraud and e¤ort are positively correlated, and given a poor outcome fraud is more likely to obtain when e¤ort is exerted in equilibrium, (2) the incidence of fraud-inducing compensation increases as agency costs decrease, and (3) reductions in agency costs actually increase the incidence of fraud when agency costs are high. Hosted by The Berkeley Electronic Press value of their stock options and other equity compensation." Co¤ee (2006 at 39). 1 Put another way, the manager's compensation contract is seen to be the principal motivation for committing fraud. That begs the question: why do shareholders choose to award such compensation contracts? And how does this ...t with the claim that securities fraud is a product of agency costs, a typical conjecture in the academy? 2 This paper sheds some light on these questions by examining the relationship between corporate fraud, compensation, and the e¢ cient exertion of managerial e¤ort. The crux of the model is that shareholders designing the compensation of the manager may only be able to get some, not all, of what they want: given the limits of contractibility, shareholders can achieve their preferred level of e¤ort or preferred disclosure policy, though not necessarily both. In particular, performance-based compensation -in the form of an equity share in the company -tends to induce managers not just to exert e¤ort, but also to falsely report in the event that the ...rm does poorly (i.e., commit fraud). The model incorporates agency costs in the form of managerial short term interests: the manager may be more likely to sell his equity share than are the shareholders. This captures the commonly expressed concern (for example, as in the Enron prosecution against Ken Lay and Je¤rey Skilling) that managers' in ‡ated reports of value are designed to increase the value of short term stock compensation. Shareholders are then faced with a tradeo¤: while high equity compensation can induce managers to exert themselves, it also leads to a greater degree of fraud than shareholders would desire. One result of this model is that e¤ort and fraud tend to go together; indeed, fraud in the event of poor ...rm performance is in a sense more likely to occur when managerial e¤ort has been exerted. The reason is twofold: (1) performance-based compensation rewards the faking of performance, and (2) there is more to lie about in an equilibrium where managers will exert e¤ort and hence have a higher likelihood of high payo¤s. Singlemindedly enacting policies, then, that may limit fraud may also have the e¤ect of suboptimally limiting managerial e¤ort. Conversely, singleminded policies that force performance-based compensation will have the e¤ect of also inducing a greater degree of fraud than optimal. Second, the degree of agency costs in ‡uences the compensation that shareholders pay. When the manager's interests are such that she would commit much more fraud than shareholders desire, shareholders 1 Arlen and Carney (1992 at 724-7) and Talley and Johnsen (2004) provide empirical support for this assertion. 2 Just a few examples are Arlen & Carney (1992), Alexander [ ], Co¤ee (2006), and the Paulson Committee Report [ ]. 2
doi:10.2139/ssrn.1481300 fatcat:ixbi3lqkofcgbal3iox7ufltme