More Long Term Compensation and... More Fraud?

Abstract

I show that heeding recent calls to reduce agency costs and managerial short-termism may, in fact, lead to more fraud but better welfare outcomes. In the model, shareholders choose the manager's compensation in light of the manager's dual roles of exerting eort and making disclosures regarding the …rm's value. A measure of agency cost is provided by the manager's relatively shorter time horizon. Where agency costs are small, shareholders award equity compensation, leading to both eort and some level of fraud. Where agency costs are large, shareholders will be unwilling to award performance-based compensation due to the high level of fraud that managers would undertake. The principal …ndings are (1) fraud can be a sign of relative economic health, in that it is more likely to occur when eort is exerted and returns to eort are higher, (2) the incidence of fraud-inducing compensation increases as agency costs decrease, and (3) when agency costs are high, reductions in agency costs actually increase the incidence of fraud. Regulatory implications include that deterring fraud, even absent adjudicatory error, may be socially ine¢ cient; rather, policy should be oriented toward internalizing costs of fraud onto shareholders and enhancing freedom of contract.