Abstract
We examine the impact of incentive compensation on the riskiness of acquisition decisions before and after the passage of the Sarbanes–Oxley Act (SOX). Before SOX, equity-based compensation was positively related to changes in risk around acquisition decisions, but this relationship weakened after the introduction of SOX. The drop in post-SOX acquisition-related risk stems from how managers respond to compensation-based incentives in the new regulatory environment. We show that executive stock options and pay-risk sensitivity drive post-SOX managerial responsiveness to risk-taking incentives. We also document a post-SOX value-enhancing effect on long-term stock-price performance and total factor productivity through these same incentive compensation mechanisms. The results are robust to selection bias, simultaneity, measurements of risk, and the definition of incentive compensation.
Highlights
The Sarbanes–Oxley Act (SOX), enacted July 30, 2002, imposed the requirement that both Chief Executive and Chief Financial Officer certify the accuracy of financial statements (SOX, Section 302) and provide information on the adequacy of their internal controls (SOX, Section 404)
Executive compensation plays an important role in mitigating managerial risk aversion in the pre-SOX period, which stems from the convex nature of payoffs from executive stock options
The properties of restricted stock grants, which are more closely related to the compensation characteristics captured by directly analyze the underlying pay-performance (Delta), cannot explain changes in acquisition risk surrounding the passage of SOX
Summary
The Sarbanes–Oxley Act (SOX), enacted July 30, 2002, imposed the requirement that both Chief Executive and Chief Financial Officer certify the accuracy of financial statements (SOX, Section 302) and provide information on the adequacy of their internal controls (SOX, Section 404). For the pre-SOX period, we find a positive relation between managerial compensation incentives and post-acquisition changes in risk This is consistent with earlier research that shows executive stock options incentivize managers to make riskier M&A decisions (Datta et al 2001) by increasing the convexity of managerial payoffs (Agrawal and Mandelker 1987; Coles et al 2006). We show that the change in responsiveness of acquiring managers to risk-taking incentives has a value-enhancing effect on long-run total factor productivity and shareholder wealth, primarily through the managerial option portfolio. These findings indicate the prevalence of a potentially excessive level of risk-taking before SOX with the mitigating impact of the Act on managerial risk appetite being beneficial to shareholders.
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