Buying Bad Behavior: Tournament Incentives and Securities Class Action Lawsuits

Abstract

Tournament theory suggests that a large gap in pay between CEOs and top managers can provide incentives to perform, but we argue that it can also elicit negative effort and even motivate the kind of behavior that leads to lawsuits. We posit that this negative effort is greater when firms have high levels of unrelated diversification because there is less operational interdependency, so tournament effects are stronger. We also contend that the influence of tournament incentives on behavior leading to lawsuits is weaker when environmental uncertainty is high. We discuss the consequences of these findings for research on fraud and tournament theory as well as the practical repercussions for firms, investors, and policymakers.

Keywords: pay dispersion; securities lawsuits; tournament theory; top management team; organizational misconduct

JEL Classification: G30; J33