Manipulation and Equity-Based Compensation

This paper models optimal executive compensation in a setting where managers are in a position to influence the public perception of their company, and thus the short-term stock price. Stock prices take the possibility of manipulation into account but fail to fully back it out, the degree of manipulation, due to investors’ uncertainty about managers’ ability to manipulate effectively. An novel property of our specification is that it is the elasticity of managers' wealth to firm value, not the sensitivity, that determines effort. We show that manipulation costs result in an optimal contract that has a lower equilibrium choice of effort, even though the elasticity of pay with respect to the stock price may be higher if there is uncertainty about the degree of manipulation. We conclude by discussing possible extensions to the model and policy implications.