Executive pay, earnings manipulation and shareholder litigation

The paper examines the role of executive compensation in inducing management behavior that triggers private securities litigation. Incentive pay in the form of options is found to increase the probability of securities class action lawsuits, holding constant a wide range of other firm characteristics. In contrast, base pay levels and share ownership do not have a significant impact on lawsuit incidence. Our results suggest that option-based compensation may give executives too strong an incentive to target the short term share price, which may be harmful to long term shareholder value. We further identify earnings manipulation as an important channel linking compensation and litigation: incentive pay has a significant impact on earnings manipulation, which in turn significantly affects the probability of litigation. However, our accrual-based measure of manipulation does not capture the full impact of compensation on litigation, suggesting other channels are important. JEL classification: G30, G34, J33, K22, M41