Tournament Incentives and Corporate Fraud (Digest Summary)

At larger firms, tournament incentives, such as increased compensation and potential promotion, can meaningfully affect the conduct of vice presidents aspiring to be CEO. People at this level of senior management may demonstrate a greater proclivity to commit fraud.

Financial misconduct can extend to the vice presidential level on the corporate ladder. Monetary incentives to become CEO may increase firm output but may also provoke misconduct. This phenomenon of misconduct seems prevalent at firms in which strong tournament incentives prevail, as demonstrated by a significant difference in median pay between vice presidents and CEOs. Although such incentives could enhance firm value and functions, they can also motivate fraud through such dysfunctional behavior as the assumption of outsized risk and manipulation of performance in the quest for a promotion.

The authors parse a dataset to find numerous fraudulent firms over a 10-year period that meet various criteria for inclusion in their research. Their investigation reveals that companies with larger disparities between CEO compensation and median vice president compensation are more prone to commit fraud and display a misalignment of incentives between the interests of shareholders and the vice presidents. Unlike CEOs, vice presidents may respond to both performance-based incentives and the opportunity for promotion—but not always in ways that benefit the company and its owners. Additionally, the authors’ findings are robust to different measures of gaps in remuneration between the CEO and vice presidential posts.

This study will interest corporate finance analysts and corporate board members. Security analysts and portfolio managers also may gain further insight into a possibly overlooked determinant of stock price behavior.

Both mainstream media and academic research have focused on the connection between fraudulent conduct and managerial compensation. Theory and practice have informed the authors’ thinking and their hypothesis. They suggest a positive correlation between a tendency to commit fraud and larger pay gaps between the CEO and vice presidential levels, despite the good intentions of tournament incentives to motivate greater productivity through better performance and the possibility of a promotion to the top post.

The authors start with the Stanford Law School Securities Class Action Clearinghouse dataset to identify fraud cases that involve US firms subject to a class action lawsuit under the Securities Act of 1933 and Securities Exchange Act of 1934 for the 1994–2004 period. Approximately three-quarters of the allegations entail accounting-based fraud. The authors exclude firms with multiple fraud occurrences as well as those not covered in ExecuComp, and the final sample of 111 firms has sufficient data from both ExecuComp and Compustat. Almost half of the observations come from 1999–2001, the period when the dot-com bubble and subsequent market crash occurred. There do not appear to be any meaningful patterns of misconduct by industry.

Using a probit model, the authors examine the link between tournament incentives and the possibility of fraud. The greater the gap between total CEO compensation and total median vice president compensation, the stronger the firm’s tournament incentives. The authors include several control variables related to the propensity for fraud and litigation risk. These include controls for market-linked incentives; firm size and age; sales growth, which relates to financing needs; firm performance expressed through return-on-assets and book-to-market ratios; leverage, receivables, inventory, and intangibles; the need for external financing; and capital intensity.

Firms that are more likely to commit fraud have a greater pay gap between the CEO and the vice presidential levels. Such firms, on average, are larger, older, and more leveraged and have higher sales growth rates, more receivables, and greater financing needs. Further, the book-to-market ratio (shareholders’ equity divided by market equity) tends to be significantly negatively related to the propensity to commit fraud. The findings are confirmed when subjected to three models that the authors use for robustness checks. The tests compare initial results with different types of matching, and the results hold up to different research designs and alternative controls (e.g., vice president ability, non-CEO skills, and equity compensation). Examination and testing of alternative fraud samples produces similar results.

Greater tournament incentives can lead to a misalignment of interests. The often great divide between CEO and vice presidential remuneration can be a powerful motivator to commit misdeeds in pursuit of the corner office. How this phenomenon plays out in other corporate cultures in both developed countries and emerging market countries could be a research effort worth pursuing.