The Impact of Shareholder Litigation Risk on Equity Incentives: Evidence from a Quasi-Natural Experiment

31 Dec 2019


YANG, Jingyu; YU, Yangxin; ZHENG, Liu

The Accounting Review, forthcoming

The use of stock- and option-based compensation has increased dramatically over the past three decades. Proponents argue that this shift in compensation structure helps align the interests of managers with those of shareholders, which contributes to value creation. But critics argue that equity-based compensation also motivates managers to conceal bad news and manipulate financial reporting to inflate current share prices, significantly threatening the existence and efficiency of capital markets. Should compensation be designed differently in firms with high misreporting risk versus those with low misreporting risk? Do board members take into consideration the incentive of misreporting in the design of incentive-compensation contracts?  

 New research by Dr Liu Zheng and Professor Yangxin Yu at the Department of Accounting, finds that when financial misreporting risks are heightened in a less litigious environment, boards make adjustments to CEOs’ equity compensation to counter-balance those risks. The research, coauthored with Dr Jingyu Yang, Assistant Professor from Shenzhen University, was recently accepted for publication in The Accounting Review. 

 Dating back to 1999, the U.S. Ninth Circuit Court of Appeals issued a ruling Re: Silicon Graphics. The ruling requires plaintiffs to provide strong evidence that defendants were “deliberately reckless” in making the alleged misstatement or omitting material information while providing mere recklessness would be sufficient in the other circuits. The ruling disproportionally lowered litigation threat against firms headquartered in the nine states of Ninth Circuit Court. A reduction in the litigation risk creates an opportunity for managers to misreport without fear of shareholder lawsuits. For researchers, the change of litigious environment creates an ideal setting to examine how increased misreporting concerns influence firms’ compensation design. 

 Consistent with the theoretical prediction that misreporting concerns prevent companies from providing more powerful incentive pay, Zheng and Yu find that firms headquartered in Ninth Circuit states decreased risk-taking incentive in CEOs’ equity portfolio after the ruling. The findings suggest the boards take preemptive actions to adjust equity-based compensation when misreporting concerns are high.