Harley E. Ryan

Managerial Incentives and Corporate Fraud: The Sources of Incentives Matter*

Operating performance and stock return results imply that managers who commit fraud anticipate large stock price declines if they were to report truthfully, which would cause greater losses for managerial stockholdings than for options because of differences in convexity. Fraud firms have significantly greater incentives from unrestricted stockholdings than control firms do, and unrestricted stockholdings are their largest incentive source. Our results emphasize the importance of the shape and vesting status of incentive payoffs in providing incentives to commit fraud. Fraud firms also have characteristics that suggest a lower likelihood of fraud detection, which implies lower expected costs of fraud. Copyright 2009, Oxford University Press.Executives at fraud firms face greater financial incentives to commit fraud than do executives at industry- and size-matched control firms. After controlling for various firm, governance, and CEO characteristics, the likelihood of fraud is positively related to incentives from unrestricted stock holdings and is unrelated to incentives from restricted stock and unvested and vested options. Executives at fraud firms exercise larger fractions of their vested options, sell more stock, and receive greater total compensation during the fraud years than the control executives. Operating performance measures suggest executives commit corporate fraud following declines in performance. Stock prices fall approximately twenty percent on average upon the disclosure of potential fraud, which suggests that frauds inflated stock prices during the fraud period. Our results imply that optimal governance measures depend on the strength of executives’ financial incentives, especially following periods of poor performance, and that restrictions on an executive’s ability to sell shares could deter fraud. Corresponding author: Prof. Shane A. Johnson Dept. of Finance—MS 4218 Mays Business School Texas A&M University College Station, TX 77843-4218 Tel: (979) 862-3318 Email: sjohnson@mays.tamu.edu Acknowledgements: We thank Hao Li, Huihua Li, Stephen Smith, and Brooke Stanley for excellent research assistance, and Andrew Christie, Jay Hartzel, Jayant Kale, Omesh Kini, Scott Lee, Adam Lei, Kevin Murphy, Steve Smith, Bob Parrino, Jeff Pontiff, and seminar participants at the University of Arizona, Georgia State University, Notre Dame University, University of Waterloo, Queens University, McMaster University, and Drexel University for helpful comments. Johnson and Tian thank the Social Sciences and Humanity Research Council of Canada for financial support.

The Interactions Between R&D Investment Decisions and Compensation Policy

We use a system of equations to investigate the endogenous relation between R&D investment and CEO compensation. Growth opportunity is positively related to the use of stock options. Stock options positively affect R&D while restricted stock has a negative influence. These results suggest that CEO compensation should balance incentive alignment and efficient risk sharing with risk-averse managers. Stock options are also found to be negatively related to leverage, but positively related to convertible debt. Additionally, this analysis suggests that institutional ownership directly influences R&D investment by providing managerial oversight and indirectly by influencing the compensation policy.

Financial Advisors and Shareholder Wealth Gains in Corporate Takeovers

We examine the effect of financial advisor reputation on wealth gains in corporate takeovers. In view of the adversarial nature of a takeover, we construct a measure of the relative reputation of the advisor. We document that the absolute wealth gain as well as the share of the total takeover wealth gain accruing to the bidder (target) increases (decreases) as the reputation of the bidders advisor increases relative to that of the target. We also find that the total wealth created in the takeover is positively related to the reputation of bidder and target advisors. While bidder advisor reputation is positively related to the probability of bid success in our sample, we also present some evidence to suggest that bidders with better advisors are more likely to withdraw from potentially value-destroying takeovers.

Characteristics of Common Stock Holdings of Insurance Companies

This article investigates the stock market portfolios of insurance company portfolio managers and compares the characteristics of their equity holdings with those of other (noninsurance) institutional equity portfolios. The main finding is that the cross-sectional determinants documented by earlier researchers for aggregate institutional ownership levels in firms do not have the same explanatory power for levels of ownership of insurance companies. On the other hand, these same firm characteristics have significantly high explanatory power regarding the decision of insurance companies to invest in a firm.

Out-of-Court Restructurings and the Resolution of Financial Distress: Section 3(a)(9) Compared to Investment-Bank-Managed Exchange Offers

To avoid bankruptcy, financially distressed firms often undertake out-of-court restructurings, which take the form of exchange offers for firms with public debt outstanding. We examine the choice between potentially lower cost, faster offers of unregistered securities under Section 3(a)(9) of the Securities Act and investment-bank-managed exchange offers. We find that investment bank participation relates negatively to commercial bank debt outstanding but positively to bank loan concessions, firm size, number of debt contracts outstanding, and proposed debt reduction. Investment-bank-managed exchange offers result in greater debt reduction and better postrestructuring operating performance.

Capital expenditure announcements and anti-takeover barriers

Abstract In this paper, we compare capital budget announcements by firms with anti-takeover mechanisms in place to announcements by firms without takeover barriers during the period 1980 to 1995. We find that anti-takeover provisions do not affect investors’ average reactions to investment choices. Market responses are heterogeneous; however, and differ according to size, growth opportunity, the availability of free cash flow and exposure to the capital markets. We find evidence consistent with managerial entrenchment when firms are insulated from the threat of takeover and have enough free cash flow to avoid raising external capital. We also find that for small firms, the reaction to capital investment announcements are positively related to free cash flow when managers have high growth opportunities, but negatively related when investment opportunity is small. This result is consistent with Noe (1988) , who shows that restricting managers’ investment choices to positive NPV projects is necessary to obtain the pecking order results of Myers and Majluf (1984) .

Board-of-Director Monitoring and CEO Tenure

We examine how CEO tenure and board characteristics affect board monitoring, CEO turnover, and firm performance. We find that board meeting frequency declines as CEO tenure increases and the board has a greater proportion of insiders. The intensity of both relations varies by industry. Tenured CEOs are less likely to be fired, but CEO tenure does not influence the sensitivity of forced turnover to firm performance. Increases in the equilibrium level of monitoring do not relate to operating improvements, but tenured CEOs continue to perform well even when subject to less scrutiny. Our results support the premise that the level of board monitoring evolves over time as a constrained equilibrium influenced by bargaining, learning, and the firms environment.

Board Structure Mandates: Consequences for Director Location and Financial Reporting

We examine how the director independence mandates of the Sarbanes–Oxley Act (SOX) and related reforms affected board geography and the quality of financial reporting. Using 1998–2006 data on the residential addresses of individual directors, we document that the geographic proximity to headquarters of audit committees and other monitoring committees declined upon implementation of the mandates. The decrease in proximity was especially large for those firms that were both SOX noncompliant and supply constrained in local director labor markets at the time the reforms were enacted. Moreover, firms with larger SOX-related losses of director proximity experienced significantly greater post-SOX declines in earnings quality. Our findings therefore suggest that, for some firms, the director independence mandates had unintended consequences for financial reporting quality. Data are available at https://doi.org/10.1287/mnsc.2017.2736. This paper was accepted by Wei Jiang, finance.

Pay for Outsiders: Compensation Incentives for Nonfamily Executives in Family Firms

We examine how the unique contracting environment with modified agency conflicts in family firms influences compensation incentives for nonfamily executives. Nonfamily executives receive weaker pay-for-performance incentives as family monitoring reduces the need to use costly performance-based incentives. Family firms offer nonfamily executives weaker risk-taking incentives to protect family’s concentrated wealth and private benefits of control. The CEO-VP pay gap in family firms does not include tournament incentives when there are family vice-presidents as potential heirs and thus, is not related to firm performance in these firms. Nonfamily executives receive higher fixed pay in exchange for a lower upside potential in promotion and pay. Family influence on incentives depends on both the founding family ownership and founding family involvement in management. The effect of family ownership is significantly stronger than that of nonfamily blockholders, which suggests that family influence goes beyond concentrated ownership.

Compensation Incentives for Nonfamily Executives in Family Firms

We examine how the unique agency environment in founding family firms influences compensation incentives for executives that are not family members. Nonfamily executives receive weaker pay-for-performance incentives when family members serve as executives or board chair and weaker risk-taking incentives if there are family executives. Family firms do not structure compensation to include tournament incentives when there are family heirs. Family ownership exerts a greater influence on compensation incentives than nonfamily blockholders, which suggest that family ownership is different than other concentrated ownership. Altogether, the results suggest that compensation structure reflects a tradeoff between shareholder-manager conflicts and family-nonfamily shareholder conflicts.