The Rise and Fall of Managerial Adaptive Responses to Incentive Pay

Sharon Hannes, Tel Aviv University

Abstract

A commonly-voiced argument ties the current financial crisis to prevailing executive compensation practices. Huge stock-option packages and annual bonuses, the claim goes, caused managers to concentrate on the short-run and overlook the downside of risk-taking. But why did crisis emerge only recently, even though such incentive pay schemes are hardly a new phenomenon? This paper argues that for a long period of time, from the beginning of the 1990s until the beginning of the twenty-first century, managers employed a variety of adaptive tactics in response to option-based compensation and other risk-inducing pay schemes. These practices enabled executives to enrich themselves with option-based pay without much need for raising corporate risk-taking to extreme levels.

Option-dating games, the ability to manipulate and whitewash financial disclosures, option repricing, and many other common practices had just this effect. While corporations were mounting options and short term bonuses, the adaptive responses dulled the edge of their risk inducing potential. Managers thus could receive hefty options packages and annual bonuses without actually being driven to taking much additional risk. That is to say, one unnoticed effect of these otherwise troubling practices was to repress the risk-taking that incentive compensation would, under different circumstances, have produced.

However, at the beginning of the twenty-first century, a combination of new regulation, stock-exchange listing requirements, and intensified market attention inhibited most of the risk-mitigating practices. An amendment to the federal securities regulation made option backdating almost impossible; the accounting profession underwent a major overhaul, leaving less leeway for management to manipulate favorable disclosures; and stock exchanges’ listing requirements made option repricing unfeasible. This was also the fate of many other practices that enabled managers to conceal substantial portions of non-incentive-based compensation, such as stealth compensation and spinning. This new market reality thus set the stage for what became all but the only way for managers to make a lot of money through their compensation packages: by adding risk. It seems that the market tried to adapt to the new reality by gradually reducing the use of stock options. However, certain industries, primarily the financial industry, are able to increase their risk profile rather rapidly. And with the heightened incentive to add on risk, it is no wonder that the financial industry brought the economy to a boiling point.