The fast pace in this changing world as brought about by the rapid technological progress and globalization has made the market for every industry and sector highly competitive. The shift of most economies to the tertiary level of development which emphasizes the knowledge intensive structure means that there is a higher demand for more skilled workers as well as a higher demand for better results to justify the huge capital expenditure related to these developments. This has created pressure on not only companies to increase their productivity by retaining the best managers but also on the managers themselves to increase their productivity. While these adjustments have generated a lot of benefits for most companies, it cannot be argued that there is also a downside to all of this and more specifically agency problems in management have begun to arise.
This is where managerial incentives become relevant. Managerial incentives play an important role in minimising the agency problems. 1In fact many authors emphasised the fact that the increasing incentives in shape of unrestricted stockholdings are the main source of fraud in some cases.
This short discourse therefore seeks to present and discuss what has been written so far concerning the issue of managerial incentives and their role in the corporate fraud. For this purpose, the case study of the pharmaceutical industry has been undertaken. The paper also proposes a methodological approach in order to conduct a research study concerning the issue of managerial incentives and corporate fraud.
2- Literature review
This section will seek to highlight the relevant literature that is important to this topic and present an outline of the flow of the argumentation and presentation that will be used in this discussion.
The first part of the problem lies in identifying the relationship between equity-based compensation and the incentive to commit fraud. As found by many researchers, there exists a significant relationship between equity-based compensation and incentives to commit fraud. 2,3,4,5,6,7 These results have also helped the regulatory bodies develop regulations regarding the managerial incentive issues. This leads to the second portion of the discourse which tackles the issue of how these regulatory bodies are dealing with the problem.
In line with this growing concern of the relationship between equity-based compensation and the incentive to commit fraud, agencies in the United Kingdom have also taken steps to address this issue. The ICAEW (2002) reports the step by step development of Corporate Governance in UK 8, which is also the first step taken towards the process of financial irregularities investigation resulted in shape of Cadbury Report which was published in 1992. The report proposed recommendations such as separation of Chair man and chief executives role and selection of board members. Transparency and fairness in reporting information were also found to be important factors. The report recommended a code of best practise, which were included in the rules recommended by London Stock Exchange.
There are also other reports which show the efforts that have been undertaken to deal with this issue. The Rutteman Report presented in 1994 was the extension of the same effort by working group on Internal Control. Greenbury Report in 1995 addressed the important matters as director’s pay and the share options. The report also recommended a step forward in the disclosure of remuneration in the annual reports. The recommendations proposed by the report were also added in the listing rules of London Stock Exchange. The process was enhanced in 1996 by establishing Hampel Committee, which undertook the inquiry about the implementation of Cadbury and Greenbury Reports. The Committee published a combined code of Governance in 1998. The publication covered the areas concerning the structure and operations of board, director’s remuneration and broadened the area of regulations by addressing the accountability and the relations and responsibility of shareholders. In 2001, the relationship between institutional investors and companies was addressed with the Government commissioned Myners Review. In 2002 the Directors’ Remuneration Report Regulations were introduced to further strengthen the powers of shareholders in relation to directors’ pay; the shape and vesting status of managerial incentive payoffs in providing incentives to commit fraud.
These reports show that there indeed is a growing recognition of the problem in relation to managerial incentives, particularly equity based incentives, and corporate fraud. As will be discussed thoroughly in this report, Different regulatory agencies have already begun taking steps to alleviate this situation.
There are other views however that hypothesize that the relationship between the incidences of corporate fraud in relation to managerial incentives is inverse and will be expected to decrease as ownership stake by the managers of the firm increase. Meckling (1976) predict that the demand for contracting and monitoring aimed at reducing agency problems will decline as managerial ownership increases since, as their stakes rise, managers bear a larger share of these costs and are, therefore, less likely to squander corporate wealth.9 this study is relevant in the discussion because it sheds a different view of the matter by showing that not all managerial incentives lead to corporate fraud and strengthens the argument that maybe what is needed is the implementation of better regulations.
In line with the discussion of showing that the type of managerial incentive being offered may be a factor to inducing corporate fraud, it was found in a study by Johnson et al., in 2006 which was a study on the differences in the levels and sources of managerial incentives across firms that commit fraud and industry and size-matched control firms that after controlling for various firm, governance, and CEO characteristics, the likelihood of fraud is positively related to incentives from unrestricted stockholdings and is unrelated to incentives from restricted stock and unvested and vested options. Moreover, unrestricted stockholdings are the largest source of managerial incentives at fraud firms, whereas vested options are the largest source at control firms. Frauds begin following declines in operating performance, fraud firms earn essentially zero raw stock returns over fraud periods, and stock prices fall by an average 17% on the disclosure of potential fraud, which suggest that frauds are attempts to avoid stock price declines. Executives at fraud firms sell more stock, exercise larger fractions of their options, and receive greater total compensation during the fraud years than the control executives. Collectively, the results emphasise the importance of the shape and vesting status of managerial incentive payoffs in providing incentives to commit fraud. 10
Now that the framework for the discussion has been presented, the next step is to discuss the preliminary portions of this report which will deal with the hypothesis and methodology.
3- Reasons for Choosing this topic
The fundamental reason for choosing this topic is that having searched literature I found that very few works have been conducted concerning the role of managerial incentives in corporate frauds. The possible reason might be that the research undertaken in the field is being undertaken by the corporate governance specialists and gurus, who are somehow the part of those pressure groups which constitute the management of most corporations. This has urged me to conduct this study in order to show the importance of risk disclosure for shareholders. Finally having examined a considerable number of companies’ annual reports I found that they tend not to disclose the level of risk associated with investment to their shareholders.
The aim of this research is to examine the impact of managerial incentives on the chances of corporate fraud.
H1: Does the existence of Managerial incentives, in the form of equity-based incentives, in companies have a positive relationship with the incidences of fraud?
H2: Is there a relationship between the structure of the managerial incentive that a company utilizes and the incidence of fraud? Does an incentive structure that allows for greater chances of managerial ownership relate to a greater incentive to commit corporate fraud?
H3: Does the fact that the pharmaceutical industry remains one of the most lucrative enterprises today have any bearing on the incentive to commit corporate fraud?
The data relating all the firms included in ExecuComp database that are the subjects of Securities and Exchange Commission’s (SEC) Accounting and Auditing Enforcement Releases (AAERs) from 2000-2005 will be taken as sample.
To arrive at a better understanding of the problem and to support the theory that the type of managerial incentive that is to be provided is directly related to the incidence of fraud, a simple linear regression model will be utilized to show the direct correlation between different types of managerial incentive programs and the reported incidences of corporate fraud in the firm.
The survey that will be conducted will provide relevant insight as to other factors that may induce the occurrence of corporate fraud that are not captured by the variables in the simple regression model that will be used. The survey will try to find out if there are other factors that may contribute to corporate fraud such as weak system of checks and balances, auditing, corporate culture and competitiveness of the industry. This will also act a guide for other matters that may be used to properly understand the relationship between different forms of managerial incentives and the occurrence of corporate fraud in the pharmaceutical industry.
Final document proposal:
The research study and statistical implications will then be developed for the final research document arrangement.
The outline for the final research document arrangement is as follows:
Nature and scope
Methodology and Activities
Chapter 2—Problem Statement
Objective of the Study
Chapter 3—Review of Literature
History (Who has done this before, what were their results?)
Elative to the fraud habits of managers.
Chapter 4—Methodologies and Procedures Used in the Study
Questionnaire process and development
Procedure of deployment
Based on the research proposal.
Factual and objective results of the study and statistical analysis.
Tables and figures.
Correlations, Hypothesis proof or disproof.
Statistical inferences: Who, What, Why
Chapter 6—Discussion, Conclusions, Recommendations
Recommendations for Action based on the study and marketing capability.
Recommendations for Dissemination assign the actions to be implemented by and methods of implementations.
Recommendation for Additional Research and Study
In conclusion, the research proposal hopes to define managerial incentive patterns, which lead to corporate fraud. In addition to this, this discourse will also seek to identify which managerial incentive structures are less susceptible to corporate fraud. This research proposal is feasible because of the low cost associated with the development and deployment of the survey as well as the metrics the questionnaire is geared towards defining. When attempting to send questionnaires to management, it might be difficult to access companies’ management in order to send them these questionnaires.
The study will be undertaken according to the following Gantt Chart
Results and Conclusion
1. Agrawal and G. N. Mandelker. “Managerial Incentives and Corporate Investment and Financing Decisions.” The Journal of Finance, September 1987, Vol. 42(4), pp. 823-837.
2. Bar-Gill, O., and L. Bebchuk, 2003a, Misreporting corporate governance, unpublished working paper, Harvard University.
3.Bar-Gill, O., and L. Bebchuk, 2003b, The costs of permitting managers to sell shares, unpublished working paper, Harvard University.
4. Bebchuk, L. and J. Fried, 2003, Executive compensation as an agency problem, Journal of Economic Perspectives 17, 71-92.
5. Goldman, E., and S. Slezak, 2006, An Equilibrium Model of Incentive Contracts in the Presence of Information Manipulation”, Journal of Financial Economics 80, 603-626.
6. Robison, H., and R. Santore, 2004, Managerial incentives, fraud, and firm value, Unpublished working paper, LaSalle University.
7. Chesney, M., and R. Gibson-Asner, 2004, Stock options and managers’ incentives to cheat, University of Zurich working paper.
8. ICAEW, (2002). Corporate governance developments in the UK, Institute ofChartered Accountants in England and Wales, Available from <http://www.icaew.co.uk/index.cfm?AUB=TB2I_78921|MNXI_78921&route=11295|P|47492|47496|78921>
9. Jensen, Michael C. and William H. Meckling, 1976, Theory of the Firm: Managerial Behaviour, Agency Costs, and Ownership Structure, Journal of Financial Economics 3, pp. 395-360.
10.Johnson, Shane A., Ryan, Harley E. and Tian, Yisong S., “Managerial Incentives and Corporate Fraud: The Sources of Incentives Matter” (November 2, 2006). EFA 2006 Zurich Meetings Available at SSRN: http://ssrn.com/abstract=395960