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Equity Incentives Weaken Corporate Governance

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A September 30th post on the Harvard Law School Forum on Corporate Governance and Financial Regulation argues that while corporate gatekeepers (also called executive gatekeepers) do reduce governance failures, the reduction in corporate governance failures provided by gatekeepers drops off significantly if/when the gatekeepers are given equity incentives as compensation.

Most well-educated American adults will not be at all surprised at the results of this study. It seems obvious that those responsible for oversight of the behaviors of others would at the very least “lose focus” on their duties if they receive a financial incentive to do so. In fact, most thoughtful, morally-focused Americans would say “what the hell were you thinking” to the idea of giving gatekeepers equity incentives. Giving them stock in the company financially incents gatekeepers to let questionable things go so the stock price rises, and by the same token, incents them to not object to questionable management practices as that might hurt the stock price. To any reasonable person equity incentives for gatekeepers are an obvious recipe for disaster and should never have even been considered, never mind implemented on a large scale as is the case in corporate America today.

Corporate governance: Internal gatekeeping a dubious proposition in the first place

Coffee (2006) and other scholars argue it is not clear that effective internal gatekeeping is even possible. The Harvard blog points out that internal gatekeepers are not independent, and they are paid by those who they are supposed to gatekeep. The blog also notes that “…internal gatekeeping has crept further and further into everyday corporate decision-making as a reaction to a series of pressures—the hostile takeovers of the 1980s, the scandals and subsequent Sarbanes-Oxley legislation of the 2000s, Dodd-Frank, and now shareholder activism.”

Corporate gatekeeping can help corporate governance, but equity incentives decrease effectiveness

In his blog, R. Christopher Small points out that their study showed that the presence of executive gatekeepers significantly decreases a number of types of fraud. For example, regulatory compliance failures (AAER frauds and insider trading) decline notably. Frauds scores, (the least evidence-driven measure of fraud monitoring among the measures used in the study) are also down 9%. Securities class action suits, which are typically a mixture of compliance and verbal misrepresentation or omission of information, are also down 43%.

The study also shows that compensating gatekeepers via equity incentives, however, clearly decreases the effectiveness of gatekeepers. Small notes: “…we find equity incentives increase the likelihood of class action lawsuits, uncaught fraud, and option backdating. In particular, a one standard deviation increase in the sensitivity of general counsel’s wealth to a one percent change in stock price (the compensation “delta”) unwinds 82 percent of the governance improvements in terms of avoiding securities fraud associated with hiring an executive gatekeeper. In terms of uncaught financial misrepresentation, we find that the gatekeeper unwinds 18 percent of governance improvements. We also find evidence that equity incentives hinder backdating prevention.”

The full study can be found here

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