When the Enron debacle and similar cases filled headlines in the early 2000s and the Bush administration announced an “aggressive agenda” against corporate fraud, many analysts decried the longstanding practice of providing managers with stock options, blaming it for increasing the likelihood of fraud.

J. Shane Johnson
Johnson

This was a judgment error, says Shane Johnson, Wells Fargo/Peters/Nelson/Heep Foundation Professor of Finance. When he recently compared a set of fraud firms to control firms during the 1991-2002 period, he found the opposite of analysts’ opinion was true: firms under the leadership of managers with greater stock holdings rather than options were more likely to experience fraud.

Johnson and colleagues looked at 87 sets of firms over the 12-year period, matching by industry and size. They found that, contrary to stereotype, the firms that experienced accounting fraud generally weren’t causing their stock prices to soar; rather, they held prices steady when similar stocks were falling. This is significant as stock option values fall at a slower rate than stock holdings.

Managers in that instance have a greater incentive to cheat when they have stock holdings, not options; they lose money faster on stock holdings if they accurately report earnings.

Johnson's research found that while providing stock holdings and options as part of a compensation package to align managers' interests with that of the shareholders, it also creates incentive for fraud.
Johnson’s research found that while providing stock holdings and options as part of a compensation package to align managers’ interests with that of the shareholders, it also creates incentive for fraud.

Another finding is that, as one might expect, the greater the level of corporate governance, the lower the likelihood of fraud. Johnson says these findings are consistent with the economics of crime: criminals act when the benefits outweigh the risks. When looking at the pairs of fraud and control firms in the study, Johnson says it was obvious that in fraud firms there was a greater incentive to cheat, as there was less governance and managers faced losses of personal wealth in the form of stock holdings.

Simply put, Johnson says that firms that commit fraud have a greater incentive to do so. While popular media has encouraged companies to limit stock options in compensation packages in favor of holdings, the research shows this is counterproductive to limiting fraud.

The takeaway for shareholders is realizing that while providing stock holdings and options as part of a compensation package to align managers’ interests with that of the shareholders, it also creates incentive for fraud. Based on other research he is conducting, Johnson recommends that one way to limit fraud risk would be to increase the vesting period for managers’ stock holdings. This forces them to commit fraud over a longer period before seeing rewards, which is harder to accomplish without detection. When managers face short vesting horizons, they are more likely to manage earnings in that period. He also noted that insiders in a firm where fraud has been committed tended to sell much more stock during the fraud period than did their counterparts at a non-fraud firm.

For more information

For further information, contact Shane Johnson. His paper, “Managerial Incentives and Corporate Fraud: The Sources of the Incentives Matter,” created with colleagues Harley Ryan and Yisong Tian was published in Review of Finance in 2009.