Executive Stock Options : The Effects of Manipulation on Risk Taking

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. 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. 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. 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. 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