Article2010

Effects of Litigation Risk on Board Oversight and CEO Incentive Pay

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Corporate Finance and Governance Auditing, Earnings Management, Governance Corporate Governance and Financial Management

Abstract

Various commentators have praised the WorldCom and Enron settlements for holding outside directors personally liable, arguing that heightened director liability will induce greater board oversight. This paper shows that the connection between director liability and board behavior is more subtle, because directors have multiple means to respond to an increase in liability exposure: They can increase oversight to prevent accounting manipulation and/or reduce performance-based CEO pay to mitigate the CEO's ex ante incentive to engage in manipulation. These two decisions are interrelated, implying that the effects of director liability on board oversight and CEO incentive pay are ambiguous. In particular, the model predicts that, for firms in which board oversight is difficult and costly (e.g., large firms with complex business operations), a stricter legal environment for directors leads to a lower level of board oversight, lower CEO incentive pay, and lower shareholder value.

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References

2007A Theory of Friendly Boards 2005Consequences of Financial Reporting Failure for Outside Directors: Evidence from Accounting Restatements and Audit Committee Members 2007Financial fraud, director reputation, and shareholder wealth 1994Performance Measure Congruity and Diversity in Multi-Task Principal/Agent Relations.2005Economic Effects of Tightening Accounting Standards to Restrict Earnings Management 2005Trends in Corporate Governance 2006An equilibrium model of incentive contracts in the presence of information manipulation 2000Reporting Bias

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2017Network connections, CEO compensation and involuntary turnover: The impact of a friend of a friend 2016Blockholders’ Ownership and Audit Fees: The Impact of the Corporate Governance Model 2019Leadership style in a board of directors: implications of involvement in the strategic decision-making process 2017The Effect of CFO Personal Litigation Risk on Firms’ Disclosure and Accounting Choices 2014Litigation risk, financial reporting and auditing: A survey of the literature

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