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

Abstract:
    



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