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Does Equity-Based Compensation Really Have a 'Dark Side'? The Influence of Regulatory Discretion

Michael F. Ferguson
University of Cincinnati - Department of Finance - Real Estate

Buhui Qiu
Erasmus University - Rotterdam School of Management

Weihong Song
University of Cincinnati - Department of Finance

January 1, 2011

It is widely believed that equity-based compensation (EBC) has a 'dark side' that incentivizes fraud. The empirical evidence for this claim is mixed. Using a recent sample of firms subject to SEC litigations for fraud over a thirteen-year period and employing a detection-controlled estimation technique, we find that EBC is strongly positively related to both the probability of fraud commission and the probability of being prosecuted by the SEC. However, the magnitude of the effect is greater on detection than commission. That is, there exists a strong link between EBC and fraud commission – evidence supporting the notion that EBC has a ‘dark side’ – but there exists an even stronger link between EBC and the probability of being caught – evidence in favor of the notion that the regulator is strategically allocating resources where fraud is more attractive. Moreover, we find that EBC usage significantly decreased post-Sarbanes-Oxley (SOX), but only in high-growth industries. Finally, we find that post SOX, fraud commission dramatically declined, and this appears to be driven by the increased fraud penalties in SOX. Thus, SOX may have had the intended consequence of deterring fraud.

Keywords: Equity-Based Compensation, Regulatory Discretion, Fraud, Sarbanes-Oxley

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