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E-MailWeiqiang Tan is an Associate Professor of Finance at The Education University of Hong Kong. This post is based on an article forthcoming in the Journal of Accounting and Public Policy by Professor Tan, Professor Yuting Qian, Professor Bo Qin, Professor Daifei Troy Yao, and is part of the Delaware law series; links to other posts in the series are available here.
Stock price crashes—sudden and extreme negative movements in share prices—pose serious threats to shareholder value and corporate reputations. While these events often appear unpredictable, a growing body of research links them to weak corporate governance, especially the failure to disclose bad news in a timely manner. Our recent study, Skin in the Game, sheds light on the role of outside directors in mitigating such crash risk—and how their equity-based compensation (DEC) might provide the right incentives to enhance oversight.
Drawing on a comprehensive dataset of U.S. public firms between 2008 and 2021, we investigate whether awarding equity pay to outside directors strengthens their monitoring role or compromises their independence. The key question is whether this form of compensation induces or mitigates stock price crash risk.
Two Competing Theories: Monitoring vs. Collusion
There are two theoretical camps on how equity pay affects the behavior of outside directors:
- The Enhanced Monitoring Hypothesis suggests that when directors have “skin in the game,” they are more motivated to protect long-term shareholder interests. This includes being more vigilant in overseeing management, promoting transparency, and deterring opportunistic behaviors such as over-investment or financial misreporting.
- The Management Collusion Hypothesis argues the opposite. High equity stakes might compromise director independence by making them more aligned with management than with shareholders. Such directors may become reluctant to challenge executives or disclose bad news that could damage the firm’s stock price—and, by extension, their own compensation.
Our study empirically tests which of these opposing effects dominates in practice.
A Closer Look at the Evidence
We construct a firm-year panel of 5,026 observations from 2008 to 2021, using director compensation data from BoardEx, stock return data from CRSP, and financials from Compustat. We measure stock price crash risk using two standard metrics in the literature: NCSKEW (negative skewness of firm-specific returns) and DUVOL (down-to-up volatility).
Our key variable of interest—DEC—is calculated as the proportion of total outside director compensation paid in equity (stocks and options).
Our baseline findings are striking: a one standard deviation increase in DEC is associated with a 26%–28% reduction in crash risk, holding all else equal. This relationship remains statistically and economically significant across model specifications, even after controlling for firm size, profitability, market-to-book ratio, leverage, return volatility, and a host of governance and board structure variables.
Critically, we find no evidence that the relationship is non-linear (e.g., turning positive at very high levels of DEC), suggesting that equity incentives have consistently beneficial effects within the observed range.
How Does DEC Reduce Crash Risk? Unpacking the Channels
To explore why equity pay helps reduce crash risk, we examine three specific channels:
1. Over-Investment
Prior studies have linked over-investment—particularly in low-return projects—to crash risk. When directors are inattentive, managers may engage in empire building or value-destroying acquisitions. We find that higher DEC is associated with significantly lower levels of abnormal investment, consistent with enhanced board oversight discouraging inefficient capital allocation.
2. Financial Misreporting
We use future financial restatements flagged as fraudulent (from the WRDS non-reliance dataset) as an indicator of opaque reporting. Firms with more equity-compensated directors are significantly less likely to restate their financials due to fraud, suggesting improved monitoring of accounting practices.
3. Bad News Hoarding
Delayed disclosure of adverse information is a central cause of crash risk. Using a standard event-study approach, we find that cumulative abnormal returns around earnings announcements are more negative when firms report bad news—especially when DEC is low. However, this stock price decline is significantly muted in firms with high DEC, indicating that bad news is more likely to be released in a timely and incremental fashion, rather than building up and triggering a crash.
Collectively, these findings support the enhanced monitoring view: DEC reduces managerial opportunism and strengthens governance.
Addressing Causality: A Quasi-Natural Experiment
To strengthen causal inference, we exploit a Delaware court ruling in 2012 (Seinfeld v. Slager) that increased legal scrutiny of director compensation. This ruling required companies to demonstrate that director pay was “entirely fair” to shareholders. We hypothesize that this regulatory shock would lead Delaware-incorporated firms to reconsider and potentially redesign director compensation structures.
Using a difference-in-differences (DiD) approach, we show that, post-ruling, Delaware firms did increase equity-based pay to directors—and, importantly, experienced greater reductions in crash risk compared to non-Delaware firms. This quasi-experimental design supports the idea that DEC has a causal effect on improving board oversight and reducing crash risk.
Who Benefits Most? Boundary Conditions
Our study also examines when DEC is most effective. The crash risk–reducing effect of DEC is more pronounced in firms with:
- High information asymmetry, where monitoring is inherently more difficult
- Greater agency costs, such as those with entrenched management
- Higher audit risk, suggesting a more opaque financial reporting environment
- Transient institutional ownership, where investor monitoring is weaker
Director characteristics also play a role. The effect is stronger when boards have:
- Less busy directors, who are better able to focus on their oversight duties
- Greater gender diversity, which has been linked to improved board effectiveness
- “Quad-qualified” directors, defined as those with independence, expertise, bandwidth, and incentive alignment
These findings suggest that the effectiveness of DEC is contingent on firm context and director quality—one size does not fit all.
Policy and Governance Implications
Our findings carry important implications for boards, investors, regulators, and proxy advisors:
- Boards should consider linking a greater portion of outside director pay to equity, especially in firms with weak internal controls or high agency conflicts.
- Regulators and governance advocates should re-evaluate blanket restrictions on director equity pay, such as those found in the UK Corporate Governance Code, which discourage performance-based pay for non-executives.
- Investors and proxy firms should look beyond CEO pay and evaluate director incentives as a core part of governance analysis.
Equity pay is not a silver bullet, but when thoughtfully designed, it can strengthen directors’ commitment to long-term shareholder value and improve governance outcomes.
Concluding Thoughts
In an era where investors increasingly demand accountability and transparency, our study underscores the critical role of director incentives. Outside directors are expected to serve as independent monitors, yet their effectiveness depends on the structure of their compensation.
Our evidence suggests that equity-based pay—often criticized for potential conflicts—can actually serve as a governance-enhancing tool when properly calibrated. By giving directors “skin in the game,” firms can empower them to be better stewards of shareholder value—and reduce the risk of catastrophic stock price declines.
For those seeking to understand or reform corporate boards, how directors are paid may be just as important as who they are.
