The Impact of Shareholder Litigation Risk on Equity Incentives: Evidence from a Natural Experiment

Abstract

While prior studies generally support that equity-based compensation induces CEOs to manipulate financial reporting, there is little direct empirical evidence on how concerns regarding financial misreporting affect compensation design. Exploiting the exogenous reduction in litigation threat brought about by a 1999 ruling of the U.S. Ninth Circuit Court of Appeals, we examine how the weakened litigation environment affected CEOs’ compensation design. Consistent with the theoretical prediction that concerns regarding misreporting prevent companies from providing more powerful incentive pay that is otherwise optimal, we find that firms headquartered in Ninth Circuit Court states decreased CEOs’ equity portfolio vega after the ruling. We also show that the reduction was more pronounced for firms with higher litigation risk and for firms with lower institutional ownership.

Keywords: Ninth Circuit Court ruling; Litigation risk; CEO incentives; Misreporting

JEL Classification: J33, K22, M52