Executive Pay-Performance-Sensitivity and Litigation
University of Texas at Dallas - School of Management
Harvard Business School - Finance Unit
Cheung Kong Graduate School of Business
December 17, 2010
Contemporary Accounting Research, Forthcoming
Although the standard principal-agent model predicts a negative relation between incentive strength (i.e., pay-performance-sensitivity or PPS) and firm risk, the empirical evidence is mixed (Prendergast, 2002). This study revisits this prediction. Using carefully selected litigation events to conduct a comparative static analysis, we show that firm risk, post lawsuit filing, increases by about 11% for our sample. We then document that the incremental PPS (measured by the correlation between executive’s annual compensation and shareholders’ wealth) drops after the company is sued, although the total value of compensation remains relatively unchanged. Once a lawsuit case is closed, we find that both firm risk and the incremental PPS revert back (risk goes down and incremental PPS goes up). Finally, we use the instrumental variable approach to test the relation between PPS level (measured by the sensitivity between executive’s wealth and shareholders’ wealth) and firm risk directly, and again find that, cross-sectionally, firm risk is negatively correlated with PPS level. Our evidences suggest that the standard principal-agent model prediction holds well and that executive’s incentives are indeed negatively related to firm risk.
Keywords: executive compensation, pay-performance-sensitivity, risk, litigation event
JEL Classification: G30, M41
Date posted: February 17, 2011 ; Last revised: January 21, 2013
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