A Behavioral Agency Model of Managerial Risk Taking

A Behavioral Agency Model of Managerial Risk TakingAuthor(s): Robert M. Wiseman and Luis R. Gomez-MejiaSource: The Academy of Management Review, Vol. 23, No. 1 (Jan., 1998), pp. 133-153Published by: Academy of ManagementStable URL: http://www.jstor.org/stable/259103Accessed: 01/09/2010 11:01

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g Academy of Management Review 1998, Vol. 23, No. 1, 133-153.

A BEHAVIORAL AGENCY MODEL OF MANAGERIAL RISK TAKING

ROBERT M. WISEMAN LUIS R. GOMEZ-MEJIA

Arizona State University

Building on agency and prospect theory views, we construct, in this article, a behavioral agency model of executive risk taking. In the model we combine elements of internal corporate governance with problem framing to explain executive risk-taking behavior. The model suggests that executive risk taking varies across and within different forms of monitoring and that agents may exhibit risk-seeking as well as risk-averse behaviors. We develop specific propositions that combine monitoring with performance and the framing of strategic problems to explain executive choices of strategic risk. The resulting propositions enhance and extend the agency-based corporate governance literature on executive risk taking.

"Agency theory ... [is characterized] by its em- phasis on the risk attitudes of principals and agents" (Barney & Hesterly, 1996: 124). Specifi- cally, principals are considered risk neutral in their preferences for individual firm actions, since they can diversify their shareholdings across multiple firms. Conversely, since agent employment security and income are inextrica- bly tied to one firm, agents are assumed to exhibit risk aversion in decisions regarding the firm in order to lower risk to personal wealth (Donaldson, 1961; Williamson, 1963). However, agent risk aversion creates opportunity costs for risk-neutral principals who prefer that agents maximize firm returns (Baysinger, Kosnik, & Turk, 1991; Garen, 1994; Hill & Hansen, 1989; Hill, Hitt, & Hoskisson, 1988; Hoskisson, Hitt, & Hill, 1992; Morck, Schleifer, & Vishny, 1988). This "risk differential" (Beatty & Zajac, 1994; Coffee, 1988) between agents and principals creates a "moral hazard" problem in the principal-agent relationship. The challenge of corporate governance is to set up supervisory and incentive alignment mechanisms that alter the risk orientation of agents to align them with the interests of principals (Tosi & Gomez-Mejia, 1989). Despite the fundamental role risk plays in the calculus of agency theory, it is our contention that agency theory's formulation of risk has been too restric-

tive and naive. This narrow view of risk has prevented a fuller understanding of managerial decision making under conditions of dissimilar risk bearing and risk preferences between agents and principals. In this article we attempt to enhance agency theory's treatment of risk by addressing these limitations.

We can challenge agency-based views of risk on several counts. First, risk remains an underdeveloped concept within agency theory. In general, agency-based corporate governance models restrict risk-taking behavior of agents either to risk aversion (preferring lower risk options at the expense of returns) or neutrality (seeking options where risk is compensated), thus tend- ing to neglect the possibility of risk-seeking (cf., Fiegenbaum, 1990; Jegers, 1991; Machina, 1983; Markowitz, 1952; Piron & Smith, 1995; Wiseman & Bromiley, 1996) or risk-"loving" behavior (accepting options where risk is not fully compensated; e.g., Asch & Quandt, 1990; Bulmash & Maherz, 1985; Coffee, 1988; Piron & Smith, 1995). In general, agency scholars consider non-risk-averse preferences outside those induced by the compensation contract as either special cases (Jensen & Meckling, 1976: 338-340) or "uninter- esting" (Arrow, 1971) and, therefore, generally ignore them altogether. In contrast, a large body of knowledge on risk-taking behavior (Bowman, 1980; Bromiley, 1991; Fiegenbaum, 1990; Jegers, 1991; MacCrimmon & Wehrung, 1986; March & Shapira, 1987; Sinha, 1994; Tversky & Kahneman, 1981) has grown independently from the agency literature, challenging the restrictive risk as-

We thank the following individuals for their very helpful comments on earlier drafts of this paper: Philip Bromiley, Dave Balkin, Jeffrey Coles, William Glick, Richard Gooding, Kent Miller, Amy Pablo, and Harry Sapienza.

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134 Academy of Management Review January

sumptions often included in agency-based models. By incorporating this literature into agency- based models of corporate governance, we can relax these assumptions and possibly improve the explanatory power of agency models of corporate governance.

Second, both normative and positivist agency scholars typically assume stable risk preferences (often characterized as a second-order utility curve; e.g., Lambert, 1986; Shavell, 1979) in models explaining changes in organization wealth (e.g., Holmstrom, 1979). This premise con- tradicts behavioral decision theory (Bazerman, 1994; Kahneman & Tversky, 1979; March & Shapira, 1992) and research (Bromiley, 1991; Fiegenbaum, 1990; Jegers, 1991; Kahneman & Lovallo, 1993; Lant, 1992; Wiseman & Catanach, 1997) and ultimately limits agency theory's contribution to explaining how managerial risk taking affects firm performance. In this article we relax the assumption that agents hold consistent risk preferences (e.g., increasing or decreasing risk aversion) and utilize a contingency- based view from behavioral research on risk taking to allow for the possibility of varied risk preferences by the agent in a corporate governance context.

Third, despite considerable theoretical (e.g., Baysinger & Hoskisson, 1990; Coffee, 1988), analytical (e.g., Holmstrom, 1979; Shavell, 1979), and empirical (e.g., Hoskisson et al., 1992) support for a link between governance structure and agent risk choices, the precise relationship remains in question. This suggests that models relying on governance structure alone may be inadequate and that additional factors may influence managerial risk taking. For example, scholars exam- ining managerial risk taking have found that governance factors alone provide insufficient explanations of managerial risk preferences (Catanach & Brody, 1993; Golbe & Shull, 1991). Further, some preliminary evidence suggests that aspects of the decision situation, as captured in "problem framing" and as suggested by prospect theory (Kahneman & Tversky, 1979), add to corporate governance models of managerial choice behavior (Palmer, 1995; Wiseman & Catanach, 1997). We propose here a more comprehensive view of managerial risk taking, formally integrating both the risk and performance attributes of the choice situation as well as the internal governance structure into a synthetic view of managerial risk.

Finally, despite a growing body of research on multiperiod contracts (Elitzur & Yaari, 1995; Holmstrom & Milgrom, 1987; Lambert, 1983), scholars' treatments of agent risk and performance in the corporate governance literature often are linear and recursive. That is, their models of agent behavior tend to predict performance outcomes based on the agent's risk preferences (McGuire, 1988; Rees, 1985), current wealth (Elitzur & Yaari, 1995), and the risk and performance characteristics of available options (Hoskisson et al., 1992; Kerr & Kren, 1992).1 Evidence from outside of the agency stream, however, demonstrates a more complex relation between performance and executive choices of risk (cf., Wiseman & Bromiley, 1996). For example, an executive's current wealth may provide only a point of reference for assessing prospects as opposed to directly influencing the preference for risk (cf., Kahneman & Tversky, 1979), as some agency models contend (Holmstrom & Milgrom, 1987). Further, executives' choices of risk also may be influenced by their prior success at selecting risky alternatives (March & Shapira, 1987; Webber & Milliman, 1997). Taking a more longitudinal and dynamic view of risk and performance may enhance our explanation of agent risk taking and may improve explanations of firm performance resulting from managerial choices.

In sum, agency theory's contribution to corporate governance has been limited by its simplis- tic assumptions of consistent risk aversion among agents, its modeling of a recursive influence from risk choice on performance, and its inability to provide unambiguous predictions of corporate governance's influence on executive behavior. These limitations provide both a challenge and an opportunity for us to improve agency-based models of managerial risk taking. It is our contention that the recent emergence of behavioral decision models of risk can contribute directly to redressing these limitations. Al- though the potential contribution of behavioral decision theory to agency theory has been ac- knowledged (Coffee, 1988; Gomez-Mejia, 1994; Gomez-Mejia & Wiseman, 1997), scholars have not yet formally linked or integrated it with the

1 Multiperiod contract models utilizing utility theory, however, have recognized a role for agent wealth and have argued that, assuming agents are risk averse, preferences for risk aversion may decrease as agent wealth increases.

1998 Wiseman and Gomez-Mejia 135

parallel agency-based literature on the same subject. In this article we integrate behavioral decision theory views on risk with agency relations in a corporate governance context in order to develop a synthetic model of managerial risk taking.

A BEHAVIORAL AGENCY MODEL OF MANAGERIAL RISK TAKING

The behavioral agency model (BAM) we develop here takes a meso-theoretic perspective of corporate governance by integrating complementary views of risk within an agency context. In particular, we argue that prospect and agency theories are complementary so that com- bining them may improve the predictive and explanatory value of agency-based models of executive risk-taking behavior. Since much of the argument underlying BAM builds from agency views of the principal-agent relationship, the model developed here is restricted to settings where the interests of agents and principals differ and, therefore, is primarily concerned with the efficacy of corporate governance mechanisms designed to improve the principal's control over the agent. Further, since corporate governance encompasses a broad realm of factors, we constrain the model to examine key elements of incentive alignment and monitoring control and how the decision and risk-bearing attributes associated with these elements influence executive choices of firm strategy involving risk. This restriction assumes that an agent's (specifically, a senior executive's) risk preferences are displayed through his or her choice behavior on behalf of the firm (i.e., strategic choices) and that these choices hold implications for the firm's performance and the agent's employment and compensation risk (cf., Amihud, Kamin, & Ronen, 1983; Amihud & Lev, 1979). Since this scenario still represents a large proportion of public corporations, we feel the resulting model is sufficiently generalizable to warrant attention by corporate governance scholars.

Problem Framing and Risk

Much of scholars' conceptual and empirical examination of risk outside the agency literature is based on behavioral decision theory and, in particular, prospect theory (Sitkin & Pablo,

1992). Those creating behavioral models of decisions find that risk preferences of decision makers and, thus, their risk-taking behavior change with the framing of problems (Kahneman & Tversky, 1979; Lant, 1992; Sitkin & Weingart, 1995). Agency theorists, in contrast, assume consistent choice behavior across differently framed problems based on normative views of choice behavior (e.g., rational expectations and utility theory) and, therefore, do not consider the importance of problem framing. In behavioral decision models scholars frame problems by comparing anticipated outcomes from available options against a reference point. Positively framed problems occur when available options of varying risk and return generally promise acceptable expected values. Negatively framed problems occur when available options generally promise unacceptable expected values. Thus, problems can be framed as a choice among potential gains or a choice among potential losses. Using current wealth or executive aspirations (cf., March & Shapira, 1992) as the reference points for framing problems as gain or loss, behavioral models predict that decision makers exhibit risk-averse preferences when selecting among positively framed prospects and exhibit risk-seeking preferences when selecting among identical but negatively framed prospects (Kahneman & Tversky, 1979).

Underlying this shift in risk preferences between positively (gain) and negatively (loss) framed problems is the concept of "loss aversion." Loss aversion (see Table 1 for a list of terms and definitions) concerns the avoidance of loss, even if this means accepting higher risk (Tversky & Kahneman, 1986). Hence, loss aversion is not to be confused with the assumption of risk aversion found in most agency formulations. In particular, loss-averse decision makers are more sensitive to losing wealth than to increasing wealth (Tversky & Kahneman, 1986, 1991). Hence, loss aversion explains a preference for riskier actions to avoid an anticipated loss altogether over less risky options to merely minimize the loss (Thaler & Johnson, 1990), which suggests that risk preferences of loss- averse decision makers will vary with the framing of problems in order to prevent or reverse losses and thus preserve their utility (Coffee, 1988). The assumption of risk aversion underlying agency theory, however, suggests that agents will prefer options with the highest ex-


pected value subject to some limit on risk, which, in the case of losses, would mean accepting smaller losses with minimal uncertainty.

Risk bearing. Risk bearing plays an important role in agency models of executive behavior (Beatty & Zajac, 1994; Coffee, 1988). Specifically, normative agency scholars have argued that risk bearing increases risk aversion by aggra- vating the overinvestment problem faced by managers (Amihud & Lev, 1981; Holmstrom, 1979; Holmstrom & Milgrom, 1987; Shavell, 1979). Risk bearing generally occurs by design, through governance mechanisms devised to transfer risk (i.e., risk sharing) from the principal to the agent (thus, placing more of the agent's income at risk), or is inherent in the role of the agent owing to the employment risk that cannot be diversified away. Building on this view, we use "risk bearing" to represent perceived risk to agent wealth that can result from employment risk or other threats to agent wealth. "Risk taking," however, represents the agent's choice of invest-

ment risk from among the firm's investment opportunities.2

While accepting that agents may become more risk averse in response to increased risk bearing, BAM proposes that risk bearing partially mediates the influence of problem framing on risk taking. This view extends Sitkin and Pablo's (1992) argument that "perceived risk" may mediate the influence of problem framing on risk taking. Their reasoning is that, under conditions of gain (positively framed problems),

TABLE 1 Definitions of Key Terms Used

Term Definition

Aspirations Performance or wealth goals used in judging the acceptability of alternatives Behavioral evaluation criteria Means-based evaluation criteria focusing on decisions and other behaviors Compensation mix Proportion of variable pay in the compensation scheme Down-side risk Probability that a loss will result from a given option Employment risk Threat of termination Gain context Anticipating a return in excess of one's reference (e.g., aspirations) for gauging

acceptability Instant endowment Immediately including either just-received or fully anticipated wealth into one's

calculations of personal wealth Layering Adding variable pay to a compensation scheme without changing the amount of base

pay Loss aversion Preferring options that avoid losses altogether over options that limit the size of the

loss Loss context Anticipating a return below one's reference (e.g., aspirations) for gauging acceptability Problem framing Framing a choice situation as a potential loss or a potential gain relative to some

reference point, such as current wealth or aspirations for wealth Restructuring Converting some portion of base pay into an equivalent amount (in expected value

terms) of contingent pay Risk aversion Preferring lower risk options at the expense of returns Risk bearing Perceived risk to agent wealth that can result from employment risk or other threats to

agent wealth Risk neutral Preferring options with the highest expected value and in which the risk is fully

compensated Risk seeking (loving) Accepting options in which the risk is not fully compensated in hopes of realizing the

up-side potential of the option Risk taking Choice of investment risk from among the firm's investment opportunities Target difficulty Probability of not achieving a performance goal

2 Our view of risk bearing differs from standard utility maximization views of risk "shifting," which seek to identify an optimal allocation of risk between the principal and agent and assume that the contract transfers risk from the principal to the agent. Further, not all the value an agent receives because of his or her position is included in the contract. For example, membership on the local arts boards (e.g., museum trustee) may be tied to the agent's position (e.g., CEO). Hence, threats to a variety of intangible items, including one's image, also may be included in risk bearing, but, for purposes of simplicity, we will continue to talk about threats to wealth.


decision makers perceive more risk to wealth since they now have something to lose- namely, the anticipated gains to wealth. Con- versely, when facing a loss condition, decision makers perceive less risk to wealth, since the wealth is effectively already lost. This argument presents a cognitive explanation for why decision makers act conservatively when facing gains (the award of anticipated wealth is still at risk) but take greater risks when facing a loss (there is nothing to lose here but the loss itself). Their definition of perceived risk as threats to wealth (cf., Sitkin & Pablo, 1992: 14) conforms nicely with the notion of risk bearing we use here. Thus, adapting their argument to reflect a principal-agent setting, we assume that prospects for future firm performance impact the wealth of executives. That is, when forecasts of firm performance are satisfactory (a gain situation), executives anticipate positive gains to personal wealth (e.g., bonuses, normal raises, and so forth) and act conservatively. Conversely, when forecasted performance is unsatisfactory, executives may anticipate losses to wealth (e.g., raises may be withheld, the value of stock options may fall, and so forth) and therefore enter- tain greater strategic risks on behalf of the firm. Thus, to the extent that executive wealth is im- pacted by firm performance, executives are likely to perceive more risk to personal wealth (i.e., risk bearing) under conditions of gain but less risk to that wealth under conditions of loss. This counterintuitive argument provides a cognitive explanation for why the framing of problems as losses or gains may influence a decision maker's risk preferences.

Based on this argument, we predict that risk bearing partially mediates the link between problem framing and risk taking.3 Recognizing a mediating role for risk bearing between problem framing and risk taking represents a critical, though missing, link in agency-based formulations as well as behavioral models of executive risk, because it allows us to make differential predictions as to how monitoring

and incentive alignment affect managerial decisions under particular decision contexts.4 These arguments lead to our first proposition:

Proposition 1: To the degree that executive wealth is tied to firm performance, risk bearing partially mediates the influence of problem framing on risk-taking behavior so that positively framed problems increase risk bearing, and risk bearing, in turn, exhibits a negative influence on risk taking.

Performance history. Operating from an assumption that sunk costs (and gains) are irrele- vant to choices of future investment options, cre- ators of agency-based models generally have assumed a recursive relation in which risk choice influences performance. When these scholars have considered the influence of performance on risk preferences (e.g., multiperiod models), they have generally looked at how the agent's current wealth may influence agent preferences for risk as modeled along a quad- ratic utility function for the agent (often specified as decreasing risk aversion; e.g., Lambert, 1986).

Prospect theorists and the related work of others on the behavioral theory of the firm (e.g., Cyert & March, 1992; March & Shapira, 1987, 1992) challenge this view by suggesting that the results of previous strategic choices (past and current performance) also may influence risk bearing and, ultimately, risk taking through its effect on the reference point used in framing problems (e.g., Bromiley, 1991). Thaler (1980) makes the point explicitly by arguing that sunk costs (and, presumably, sunk gains) matter in choice behavior. Indeed, it is the influence of prior performance on choice behavior that clearly distinguishes behavioral models from rational expectation views of decision, such as those captured in traditional agency models (Tversky & Kahneman, 1986). This perspective, graphically shown in Figure 1 and captured in our second proposition, argues for a dynamic

'Although Sitkin and Pablo (1992) propose a fully mediating role for perceived risk, preliminary empirical evidence supports only a partially mediating influence (Sitkin & Weingart, 1995). Further, both the behavioral theory of the firm and prospect theory predict a direct effect from problem framing on risk taking. A partially mediating role best ac- commodates these arguments.

4 It is also possible that risk bearing moderates the relation between problem framing and risk taking so that greater risk bearing increases risk aversion in gain situations. However, it is not clear how risk bearing would moderate the relation in loss situations. (We thank an anonymous reviewer for this suggestion.)


relation between risk and prior performance so that rising performance should raise the reference point used in framing a problem as gain or loss and, consequently, decrease the probability of a gain context.

Proposition 2: Rising firm performance over time elevates agent aspirations for future firm performance and thus decreases the probability of a gain context.

Incentive Alignment and Risk

In agency-based models incentive alignment as a control mechanism is achieved by making some portion of agent compensation contingent upon satisfying performance targets specified in the contract (Welbourne, Balkin, & Gomez- Mejia, 1995). As such, incentive alignment generally involves four issues: (1) the allocation of compensation between base (i.e., any contractually guaranteed pay, such as salary) and variable (i.e., any nonrecurrent and/or contingent pay, such as a performance bonus) forms, (2) the design of variable pay forms of compensation (e.g., stock options), (3) the setting of perfor-

mance targets for the awarding of variable pay, and (4) the selection of measures used in evaluating performance (Gomez-Mejia & Balkin, 1992). In this section we examine the effects of each of these elements separately in order to under- stand each element's influence independent of assumed interrelations. This approach relaxes assumptions of correspondence and internal consistency among these elements and, we believe, enhances the generalizability of our model to a broader set of compensation arrange- ments, and it allows us to explore factors not generally present in such contracts as direct supervision and the use of behavioral criteria.

Compensation mix. One major issue in the design of compensation schemes concerns the allocation of pay between variable and base forms (Harris & Raviv, 1979). This issue relates to the debate in the corporate governance literature over the ultimate influence of incentive alignment schemes on agent risk taking (Gomez-Mejia, 1994). At the heart of this debate is a controversy over the relative importance of the incentive and risk-bearing properties of variable pay (Beatty & Zajac, 1994). In one argument performance-based pay schemes that link

FIGURE 1 A Behavioral Agency Model of Managerial Risk Taking

Internal/external Compensation Stock Behavioral performance mix options evaluation

indicators design criteria

P 4b P 5a, 5b

7a, 7b P 9 P 3a, 3b, 4a

Performance P 2 Problem P 1 Risk P 1 Risk history * framing > bearing taking

| 6a, 6b P1

Direct P 8a, 8b, Target supervision ' difficulty


a portion of compensation to firm performance "reduce a risk-averse manager's natural ten- dency to reject variance increasing projects" (Larcker, 1983: 10). According to this view, agents are motivated to improve personal wealth, and when that wealth is strongly linked to the wealth of firm owners, executives will exhibit risk preferences similar to those of principals by selecting riskier strategic options (Coffee, 1988; Mehran, 1995). Conversely, when executive compensation is insulated from firm performance, no incentive exists to accept risk, and executives should exhibit risk aversion when selecting among strategic options (Bulmash & Maherz, 1985; Hill et al., 1988; Hill & Snell, 1989). Under this argument pay incentives in the form of contingent pay contractually promote agent self- regulation (in lieu of direct supervision), to the benefit of the principal (Welbourne et al., 1995). Findings by Larcker (1983) and others (Hill & Hansen, 1989; Hoskisson et al., 1992) suggest that managers receiving contingent pay do increase capital investment and R&D spending, which presumably implies that higher variance (i.e., riskier; cf., Mansfield, 1969) projects are now be- ing pursued.

In contrast, a normative agency argument recognizes that when managers bear too much risk, they become increasingly risk averse (Holm- strom, 1979; Holmstrom & Milgrom, 1987; Shavell, 1979). This view argues that owing to noise in the relation between agent actions and firm performance, managers seek to reduce uncertainty in firm performance when their compensation is closely linked to that performance (Amihud & Lev, 1981; Coffee, 1988; Kroll, Simmons, & Wright, 1990; Lewellen, Loderer, & Marktin, 1987; Sloan, 1993; Walsh & Seward, 1990). Cannella and Gray (1992) indirectly support this argument by noting that in high-risk situations, firm performance is unrelated to executive pay, indicating that risk is compensated, whereas under conditions of low risk, firm performance is closely related to pay (cf., Garen, 1994).

One resolution to this debate recasts the problem of compensation design as a situation in which agents must choose between different forms of pay (base and variable) having different risk and payoff characteristics. Specifically, BAM suggests that when a compensation scheme includes both base pay and ex ante contingent pay (variable pay that is contractually linked to risky firm performance targets)

and that pursuit of these targets jeopardizes future base pay (e.g., augments the chances of executive dismissal), agents essentially are faced with a choice between safeguarding future base pay (i.e., reducing employment risk), with conservative firm strategies that smooth income streams, create firm growth at the expense of profitability, hoard cash, and so forth (Baumol, 1959; Marris, 1964; Williamson, 1963), or pursuing contingent pay with riskier firm strategies that promise better firm performance (and, therefore, contingent pay awards) but that also raise the probability that the target will not be met and thereby increase employment insecu- rity for the executive (Donaldson, 1984; Hoskis- son et al., 1991, 1992). As we noted earlier, this argument assumes that the pursuit of riskier strategies designed to achieve performance targets linked to the award of contingent pay also places future employment at risk should those strategies fail (Walsh & Seward, 1990). However, we argue that if executives count future base pay in perceived wealth, then loss-averse agents may seek to protect future base pay by opting for lower strategic risk on behalf of the firm, which, in turn, constrains firm performance. Recasting the problem of compensation design in this way allows us to develop a model of agent risk preferences under differing compensation designs using prospect theory predictions of choice behavior under uncertainty.

BAM asserts that executives make a distinction between base pay and ex ante contingent forms of variable compensation. Consider a basic compensation scheme that includes ex ante contingent pay,5 which is tied to the achievement of specified performance targets, and base pay and adjustments (i.e., salary and normal market adjustments) that are fixed over the life of the compensation agreement. Consistent with normative agency views, contingent pay is distinguished from base pay by the degree of uncertainty associated with each so that increases in the proportion of contingent pay increases

5Ex ante contingency compensation differs from ex post variable compensation in that the targets and rewards for achieving those targets are specified in the contract prior to executive action, whereas ex post variable compensation (discussed later, under "Monitoring and Risk") represents a "settling up" process whereby boards determine bonus awards and other pay following executive actions (Finkel- stein & Hambrick, 1996; Gomez-Mejia, 1994).


"compensation risk" (Holmstrom, 1979; Holm- strom & Milgrom, 1987; Shavell, 1979). In our example executives know with certainty the amount of salary they will receive in each year of their contract since it is specified, but they cannot predict the amount of contingent pay they may receive in each year, since the amount depends on a variety of unpredictable market and economic factors. Thus, contingent pay con- tains greater uncertainty for the agent than base pay since the latter is fixed over the period of the contract, whereas the awarding of contingent pay is not.

The distinction we make above suggests that executives may view future base pay much like a renewable annuity and therefore include it in calculations of perceived current wealth. This assumption builds on the concept of instant endowment (Thaler, 1980), which recognizes that decision makers immediately include into calculations of personal wealth money just received (Franciosi, Kujal, Michelitsch, Smith, & Deng, 1996; Thaler & Johnson, 1990). This argument is reasonable if we recognize that pur- chases involving multiyear loans (e.g., homes and cars) are made on the premise, by both the buyer and lender, that the buyer's current base pay will continue indefinitely into the future. Hence, future base pay is instantly endowed into calculations of perceived current wealth.6 However, true ex ante contingency pay is not as likely to be included in this calculation since it is far less certain. Executives may receive large amounts in some years (Comp flash, 1995; Rainie, Loftus, & Madden, 1996) and none in other years owing to changing firm fortunes and economic conditions. Thus, an executive's reference point for gauging compensation prospects depends largely on anticipated base pay, since this pay is counted in calculations of perceived current wealth.

A variety of empirical evidence provides indi- rect support for this argument. For example, several scholars have noted that people treat regular income differently from how they treat unexpected windfalls (O'Curry & Lovallo, 1992;

Shefrin & Thaler, 1988; Thaler, 1985, 1990). Ex- panding on this theme, Strahilevitz (1992) argues that regular pay may be used primarily for re- current consumption expenses (e.g., rent, food, utilities, and so forth), whereas uncertain pay (e.g., unanticipated bonuses) is more likely to be used for nonessential expenses and savings (see also research by Arkes, Joyner, & Stone, 1994; Henderson & Peterson, 1992; Rucker, 1984). These findings indicate that employees tend to spend assured income on practical necessities linked to their standard of living (houses, cars, and so forth) but prefer nonessential items (va- cations or luxuries) when spending unexpected or highly uncertain income. Essentially, base pay is tied directly to an executive's customary standard of living, whereas variable pay is less so since it is an unreliable source of income. Indeed, Balkin and Banister (1993) have noted that most executives attach little security to variable forms of compensation, suggesting that its loss represents less risk to wealth. Hence, threats to future base pay and its value (e.g., losing cost-of-living or market adjustments) would seem more salient than threats to variable pay, since losses associated with future base pay pose a significant threat to an executive's perceived wealth, future earnings potential, and, ultimately, to his or her standard of living. Loss of true variable pay (i.e., nonrecurrent contingent compensation) poses a less severe loss because it is normally used for discre- tionary consumption expenses and savings that can be deferred more easily into the future or, perhaps, foregone altogether (Arkes et al., 1994; Strahilevitz, 1992).

If we count base pay in perceived current wealth-and do not count ex ante contingent pay-we reduce the prospects facing the agent to protecting perceived current wealth (i.e., reducing employment risk, protecting normal adjustments to base pay, and ensuring future earnings potential) or to risking that wealth in pursuit of variable pay. By assuming that they are loss averse and not risk averse, BAM holds that agents are indifferent toward uncertainty (Shapira, 1995) but hold clear preferences regarding loss (Tversky & Kahneman, 1991). In other words, agents are more concerned with avoiding loss to perceived wealth than to attracting additional wealth (loss avoiders rather than wealth maximizers). Hence, compensation risk bearing results primarily from threats to

6 It is also possible that agents may include future market adjustments to base pay (e.g., normal raises) and future earnings potential in calculations of perceived wealth. If this is true, threats to these forms of wealth occur as relative deprivation (lagging the market) and declines in the executive's market value (Fama, 1980).


wealth in the form of base pay. As a corollary, we observe that if future base pay is insulated from threats arising from pursuit of variable pay, then risk bearing is reduced, allowing variable pay to provide incentives for agents to select riskier strategic options.

Proposition 3a: Risk bearing results from threats to future base pay and anticipated adjustments to that pay.

Proposition 3b: To the extent that future base pay is insulated from the threat of loss, agent risk bearing is reduced and agents may therefore be more willing to pursue contingent pay through riskier strategic choices.

Clearly, BAM's perspective of risk bearing differs from traditional agency views. Building on utility theory arguments regarding risk (cf., Markowitz, 1952), developers of traditional agency models view compensation risk as the proportion of compensation that is variable, and they see this measure as a proxy for risk bearing (cf., Beatty & Zajac, 1994; Gray & Cannella, in press). This has led agency scholars to view risk and, indeed, risk bearing in terms of uncertainty. It follows from this view that if agents are risk averse, they are averse to uncertainty and thus prefer higher proportions of certain compensation over uncertain (variable) compensation.

In contrast, as discussed earlier, we assume agents are loss averse-not risk averse. Hence, we argue that the amount of contingent pay in the compensation package design has little effect on agent risk bearing when simply added to a compensation scheme (i.e., "layering"), since its loss is not likely to pose a threat to perceived wealth. That is, adding more contingent pay to a given compensation design has no effect on agent risk bearing since risk bearing results from the threat to base pay engendered from pursuit of contingent pay. Alternatively, "restructuring" compensation schemes, whereby some portion of base pay is converted into variable pay, creates a loss condition for the agent. This conversion of "certain" pay into "uncertain" pay induces this loss condition for the agent since the future pay that was counted in perceived wealth (and possibly allocated to paying for a long-lived asset) has now been taken away

and offered back as a gamble. These arguments underlie the following two BAM propositions:

Proposition 4a: Increasing the amount of contingent pay in total compensation through layering has no effect on risk bearing.

Proposition 4b: Restructuring base pay into contingent pay creates a perceived loss for the agent.

Stock options design. BAM also differs from typ- ical agency views in predicting how a popular form of variable pay-stock options-may influence executive risk taking. Again, building on the concept of instant endowment (Thaler, 1980; Thaler & Johnson, 1990), we suggest that stock option schemes may increase risk bearing of the executive (and, thus, increase risk aversion) rather than decrease risk aversion, as suggested by those arguing incentive alignment (cf., Pavlik & Belkaoui, 1991). Our view argues that if, like base pay, previously awarded (though not exercised) options become part of perceived current wealth (i.e., are instantly endowed), then, consistent with the notion of loss aversion, choices between preserving this wealth and earning new options should result in a conservative risk-averse posture. Hence, options awarded annually in a multiyear contract may serve to increase risk aversion over time. Specifically, positively valued stock options create risk bearing when executives anticipate the returns from exercising those options in the future. Loss-averse managers respond to this risk by preferring actions that preserve this anticipated value over actions that enhance the value. Corre- spondingly undiversified equity holdings in the employing firm (from employee stock option plans, exercised options, and so forth) would act in a manner similar to options having a positive down-side risk. However, if the down-side risk of options is set to zero (i.e., the stock option value is insulated from any adverse consequences of risk taking), then option awards may not result in risk aversion.7 The resulting BAM propositions are as follows:

7An important limitation to these arguments concerns the horizon of investment payoffs relative to the realization of stock awards. If, for example, stock holdings or options can be converted to cash at market value in the near future, executives may select investment options designed to raise the near-term market value of the company at the expense of the long-term value (Bizjak, Brickley, & Coles, 1993).


Proposition 5a: Unexercised, positively valued stock options create risk bearing for the agent, which ultimately increases executive risk aversion.

Proposition 5b: Stock options do not create risk bearing for the agent when the down-side risk of stock options is set to zero.

Target setting. A third issue in the design of an incentive alignment control system concerns the attainability of performance targets used in awarding variable pay. Target attainability, as well as the specific targets employed, varies considerably across compensation agreements (Gomez-Mejia & Balkin, 1992). The question of target attainability ultimately concerns the effect of high or low targets on risk-taking behavior. Agency-based corporate governance models are relatively silent on this issue, even though it appears to be a crucial element in governance design.

Several behavioral views (e.g., Kahneman & Tversky, 1979; March, 1988; March & Shapira, 1987) provide guidance by suggesting that, holding other factors constant, higher (more difficult) performance targets ultimately increase risk taking, whereas lower (easier) performance targets reduce risk taking. Follow- ing arguments by Payne, Laughhunn, and Crum (1980), we argue that the performance targets (used in awarding variable pay) influence the location of the reference point to the extent that executive aspirations are influenced by the performance targets specified in their compensation agreement. Although other factors also may influence executive aspirations for firm performance and thus the location of this reference (including performance history, peer performance, market conditions, and so on), it seems clear that the explicit performance targets in the compensation agreement must play a significant role in setting this reference point, which suggests that executives frame strategic problems as potential gains or losses by comparing forecasts of firm performance against the performance targets specified in their compensation agreement. Thus, high, variable-pay performance targets relative to performance forecasts cor- respond to loss contexts (ultimately increasing agent risk-Laking behavior), and vice versa. As

a corollary, targets must continually adjust with performance trends (within the constraints of industry norms for executive contracts) if a loss context is to be maintained and risk aversion discouraged. This leads to the next BAM propositions:

Proposition 6a: A high, variable-pay target increases the probability that executives will face a loss decision context and ultimately leads to an increase in executive risk taking.

Proposition 6b: Variable-pay targets must adjust with performance to ensure that executives face loss decision contexts.

Performance measures. The fourth issue in the design of incentive alignment mechanisms concerns the choice of outcome measures used in evaluating executive performance. Corporate governance scholars long have argued the relative merits of accounting (or internal) versus market-based (or external) measures for evaluating agent performance (e.g., see reviews by Gomez-Mejia, 1994; Gomez-Mejia & Balkin, 1992; Lambert & Larcker, 1985a,b; Sloan, 1993). How- ever, their discussion has failed to provide unambiguous guidance in the selection of outcome criteria. The argument centers on the informational properties of the two measures, as well as their effects on incentive alignment. As Sloan notes: "[T]he optimal contract involves a trade- off between incentive alignment and risk sharing" (1993: 61), and "the relative weights placed] on the two performance measures [earnings and stock price] ... are chosen to minimize the amount of noise to which the CEO is exposed" (1993: 62-63). Thus, one agency argument con- centrates on the effects of a measure's "noise" on agent risk bearing and suggests that market- based measures may increase the risk borne by executives (requiring that a risk premium be paid to the agent), since they measure performance largely outside the manager's control (Lambert, 1993). A counterargument focuses on the link between principal and agent interests and proposes that awarding incentives through the use of market-based criteria increases the likelihood that executives will exhibit behavior consistent with the interests of principals (i.e.,


risk-neutral behavior; Finkelstein & Hambrick, 1989; Jensen & Murphy, 1990a; Rappaport, 1986). This latter argument focuses more on the moti- vational than the informational properties of the two performance measures. Neither argument, however, recognizes behavioral processes that might drive executive behavior, but each rests instead on an assumption of agent risk aversion, which, as we argued previously, can result in contradictory predictions of executive behavior. In contrast, prospect theory provides a behavioral foundation for guiding this debate and for instructing future research on this question by replacing the assumption of agent risk aversion with an assumption of loss aversion.

The executive compensation literature indicates that agents exhibit a preference for accounting-based performance measures, whereas principals prefer market-based measures (see Gomez-Mejia & Balkin, 1992: 204-205, and Go- mez-Mejia, Tosi, & Hinkin, 1987, for discussions). Managers find internal or accounting-based measures easier to control than external or market-based measures, because they can alter expenses, reallocate capital or cash flow, change accounting procedures, and so forth (Dyl, 1989; Hunt, 1985; Varrecchia, 1986); market value, however, is more subject to exogenous economic factors (Elitzur & Yaari, 1995). Thus, managers may feel more secure in achieving targets based on accounting measures. But principals clearly prefer market-based measures because they are less susceptible to manipulation and are more closely aligned with their personal wealth (Jensen & Murphy, 1990a). Given this distinction between accounting- (internal) and market- (external) based outcome measures, it seems reasonable to argue that the use of accounting- based measures should increase the perceived probability of achieving target performance over that of using market-based measures. Thus, executives should expect higher performance relative to aspirations when accounting- based measures are used but will forecast lower performance relative to aspirations when market-based measures are used. This prediction assumes that the selection of performance measures influences expectations for performance but not aspirations, since performance forecasts (i.e., expectations) are controlled by the executive, whereas aspirations are largely influenced by the design of the corporate governance (e.g., performance targets specified in the contract)

and other exogenous factors (e.g., peer performance). This leads us to predict that the use of (internal) accounting measures leads to higher forecasted performance relative to performance aspirations, thereby increasing the probability of a gain context and thus risk aversion, whereas the use of (external) market-based measures lowers performance expectations relative to aspirations, thus increasing the probability of a loss context and risk taking.8

We observe that considerable empirical evidence supports BAM's prediction. For example, R&D spending is lower among firms using accounting measures than among firms using market-based measures (Coughlan & Schmidt, 1985; Jensen & Murphy, 1990b). Meanwhile, others suggest that market-based measures corre- spond to higher levels of risk taking (Paul, 1992; Rappaport, 1986). Thus, BAM's prediction corresponds to standard agency expectations regarding the influence of measurement criteria on agent risk taking. However, BAM differs in its explanation by suggesting that the influence of measurement criteria on risk taking occurs indirectly-through its effect on the executive's framing of problems. Thus, to the extent that performance targets are independent of performance measures, we expect the selection of performance measures to influence the probability of each decision context. These arguments lead to the next BAM propositions:

Proposition 7a: Reliance on market- based (external) outcome performance criteria increases the probability of a loss context.

Proposition 7b: Reliance on accounting-based (internal) outcome performance criteria increases the probability of a gain context.

Monitoring and Risk

Monitoring generally provides an alternative mechanism to incentive alignment for control- ling agent activities (Beatty & Zajac, 1994; Eisen-

8 If aspirations adjust with the selection of performance measures, then the predicted influence may be nullified. Hence, this prediction is dependent upon the independence of the selection of the performance measure and the deter- mination of target difficulty or performance aspirations. (We thank an anonymous reviewer for this point.)


hard, 1989; Gomez-Mejia & Balkin, 1992; Tosi & Gomez-Mejia, 1989). Whereas incentive alignment contractually links performance outcomes to agent compensation through ex ante contingent pay (Finkelstein & Hambrick, 1996; Gomez- Mejia, 1994), monitoring concerns an ex post "settling up" process whereby monitors directly observe and evaluate either the agent's behaviors, outcomes, or both and then determine compensation awards. Monitoring, therefore, involves the use of behavioral criteria and direct supervision. Unlike some agency theorists' exam- inations of monitoring, we examine the mechanism of supervision separately from the behavioral evaluation criteria normally employed.

Direct supervision. Although some have criti- cized agency-based models of corporate governance for generally ignoring direct supervision (Hirsch, Friedman, & Koza, 1990; Perrow, 1986), there are models that have included it (e.g., Beatty & Zajac, 1994; Hoskisson & Turk, 1990). One criticism of these models is that they have confounded the mechanism of control (in this case, supervision) with the criteria of evaluation (agent behavior vis-d-vis outcomes; see Ouchi & Maguire, 1975; cf., Eisenhardt, 1985). That is, when supervision is considered in agency formulations, it is generally thought of as focusing on agent behavior, since outcomes are more ef- ficiently captured in contractually based incentive alignment mechanisms. This suggests that agency views of supervision within the governance literature may be underdeveloped regarding its ultimate influence on agent behavior (Westphal & Zajac, 1995).

At a minimum, direct supervision would seem to involve setting and communicating performance standards to the agent (Mitnick, 1994). It also seems reasonable for us to assume that, within the constraints set by industry practice and the market for executives, these standards are strongly related to the principals' (and, hence, monitors') preferences. In a BAM perspective board supervision then establishes the standards for executive success. Unambiguous communication of these standards results in clear performance targets for the executive, which, as argued previously, should influence an agent's aspirations or reference point for success. If principals are vigilant in their role, we would expect that the standards they set should be higher than the standards set by the agent. Conversely, in the absence of vigilant supervi-

sion, standards (such as performance targets) should be lower, reflecting the agent's desire to establish accessible goals that reduce employment risk and ensure contingent pay. The vigilance of monitoring, therefore, should relate to the difficulty of performance targets and, thus, to the executive's reference point for success. Formally stated:

Proposition 8a: Strong supervision of an executive by the board corresponds to more difficult performance targets.

Proposition 8b: Weak supervision of an executive by the board corresponds to easier performance targets.

Behavioral evaluation criteria. Monitoring control with behavioral criteria also may influence risk bearing and, subsequently, risk taking. Some agency arguments suggest that focusing on executive behavior may decrease executive risk aversion by allowing owners to punish observed instances of risk aversion directly, while rewarding risk-neutral behaviors. Baysinger and Hoskisson (1990) provide a ratio- nale for this relation by arguing that replacing incentive alignment (compensation linked to performance criteria) with direct supervision translates into replacing financial controls (outcome performance) with strategic controls (agent behavior; cf., Ouchi & Maguire, 1975). Their argument goes on to suggest that the use of strategic controls lowers risk sharing by managers, since it relieves managers of achieving outcomes they can only partly influence, and instead focuses evaluation on means, which are assumed to be objectively and accurately assessed. Though compelling, Baysinger and Hoskisson's argument assumes that monitors utilize accurate and unbiased information about strategic behavior in evaluating executive actions. This implies that strategic behaviors can be assessed relatively unambiguously by inside directors intimately familiar with the business. In contrast, we argue that because of the inherent ambiguity of the appraisal criteria used in the evaluation of senior executives (Ferris & King, 1992; Kanter, 1977), and because of the necessity of reaching consensus over those criteria among a diverse and varying set of monitors, the use of behavioral criteria is likely to increase agent risk bearing, resulting in greater preferences for lower risk strategic options.


Prospect theory proponents (Tversky & Kahne- man, 1981, 1986) and others, going back to Simon (1947; March & Simon, 1958) and, more recently, within the governance literature itself (Walsh & Seward, 1990), have challenged assumptions of rational decision making requiring accurate and unbiased information. These challengers point out that behavior is, in itself, equivocal and subject to unique interpretation that is experience dependent (Weick, 1970). Performance appraisal, in particular, has been shown to be heavily influenced by the evaluator (Becker & Cardy, 1986). Thus, monitors with diverse backgrounds may individually frame responses differently, according to idiosyncratic schematic processing and prioritization (Waller, Huber, & Glick, 1995), which can result in unique perceptions, interpretations, and prioritizations of agent behaviors by monitors (Fiske & Taylor, 1984). Further, a host of biases can influence performance evaluation significantly (Bernadin & Beatty, 1984; Bernardin & Buckley, 1981; Cardy & Dobbins, 1994; Murphy & Cleveland, 1991). These biases are compounded by the fact that relevant aspects of performance often are ambiguous and are left to be determined by individual evaluators (Murphy & Cleveland, 1991). Without a common frame of reference, some monitors may be severe and others lenient in their evaluations of a given behavior. All this suggests that even insiders may not agree on the appropriateness of a given strategy.

Exaggerating monitor biases in performance appraisal is the ex post specification of behavioral criteria. Unlike financial outcome criteria, which generally are specified in advance, behavioral criteria are not fully specified in advance but are determined at the time of evaluation, following the observation of agent behavior. This clearly creates the potential for uncertainty in how monitors will perceive and interpret a given behavior. For example, negative information has been shown to carry more weight than positive information (Edder & Fer- ris, 1989); therefore, the interpretation of behavior using post hoc criteria is subject to the framing of information received (Kameda & Davis, 1990), so monitors view a given behavior more favorably when outcomes are acceptable than when outcomes are unacceptable (Becker & Cardy, 1986). As Walsh and Seward (1990) point out, boards make performance attributions to managers largely because they lack better in-

formation upon which to make more "rational" judgments. This occurs because it is difficult for principals to disentangle the role of potential agent incompetence from unfortunate circum- stances. Therefore, if agents, in good faith, took risks desired by principals, they could increase the probability of an unfavorable evaluation, to the extent that the outcomes from those risks were not acceptable to the monitors.

Finally, it is important to recognize that evaluation of executive behavior is done collectively by a group of monitors (i.e., the board of directors) having different backgrounds, experience, and frames of reference, but who must reach consensus over the executive's performance. Changes in group membership may affect the group's power structure and, thus, the selection and prioritization of the evaluation criteria employed. This further raises ambiguity in the evaluation process, since it creates uncertainty about what criteria this group may deem relevant. Unlike financial controls, where agents may estimate the probability of achieving a specified performance target in advance of performance, behavioral control prevents this esti- mation, since the target is unknown until after performance. The uncertainty surrounding the selection of specific criteria adds to the ambiguity agents face when monitors employ behavioral criteria.

In sum, if an agent has reason to suspect that taking risks may lead to negative evaluations because the appraisal criteria and performance targets are ill defined until after the actions are taken-and are thus subject to a wide range of hindsight interpretation-then the agent subject to behavioral criteria should frame the situation as riskier and should reduce risk taking. There- fore, we predict that executives subject to behavioral criteria by the board of directors are less able to discern how monitors will evaluate their performance than when assessment is based on more objectively and unambiguously defined (financial) criteria. This leads to the last BAM proposition:

Proposition 9: The use of behavioral criteria by the board creates uncertainty for the executive over how performance will be evaluated, increases agent risk bearing, and ultimately reduces agent risk taking.


IMPLICATIONS AND EXTENSIONS

In order to focus attention on how behavioral theory may inform agency models of corporate governance, our development of BAM has been centered on selected elements of internal corporate governance design. We have chosen these elements to highlight and then examine key biases regarding risk within agency theory that have limited its contribution to models of corporate governance. In this section we extend BAM by exploring additional issues that may help distinguish BAM's contribution to corporate governance. Implications from this discussion may provide the basis for future conceptual development and offer guidance for empirical research.

One major contribution of BAM is the replace- ment of an assumption of risk aversion with an assumption of loss aversion in models of corporate governance. By assuming loss aversion, we portray agent self-interest in a manner that differs from the "wealth maximizing" view generally implied in agency formulations. Drawing from behavioral decision theory (Tversky & Kahneman, 1986), we argue that self-interested individuals are less concerned with maximizing future wealth than minimizing losses to present wealth. Reframing the problem of corporate governance in this way has implications for a variety of issues, including explanations for R&D investments (e.g., Hill & Snell, 1989), for diversification decisions (e.g., Amihud & Lev, 1981; Kroll et al., 1990; Kroll, Wright, Toombs, & Leavell, 1997), for the use of "poison pills" (e.g., Kosnick, 1987), and for investments in capital intensity (e.g., Hill & Snell, 1989). For instance, it seems that loss minimization provides a more parsimo- nious and accurate explanation for executive preferences for poison pills, "golden parachutes," and diversification than does wealth maximization, since these decisions generally seek to limit losses to wealth while incurring opportunity costs (i.e., sacrificing some portion of uncertain wealth prospects). Indeed, if agents are more concerned about protecting current wealth than attracting additional wealth (or even minimizing uncertainty), then compensation designs that simultaneously protect the present and future base pay of agents (through poison pills, golden parachutes, and so forth) and that provide agents with strong variable- pay incentives may be in the principals' best interests, since these designs will provide in-

centives f or the agent that are tied to firm performance, without the threat of loss that pursuing higher return projects could entail (cf., Arrow, 1996).

Compensation Design

Within the context of incentive alignment, we might also consider implications from recognizing the opportunity costs and sanctions in compensation design. Opportunity costs penalize premature turnover by delaying the realization of some portion of compensation into the future (stock options awarded that cannot be exercised for several years). The effect of this scheme on agent risk-taking behavior seems to depend on whether the value of that compensation is tied to the outcome of current strategic choices, as well as to the extent that this delayed compensation will be awarded if the executive was ter- minated prematurely. We suggest that "golden handcuffs" and other forms of opportunity costs may create risk-averse behavior in the same manner as base pay. This view assumes that delayed compensation is subject to instant endowment effects and thus becomes part of perceived personal wealth. Actions that threaten this wealth (i.e., pursuing risky options) would then be eschewed in favor of risk-averse choices.

Sanctions represent another extension of BAM. Agency-based corporate governance models tend to focus on rewarding behavior rather than on imposing sanctions, yet loss of anticipated gains (i.e., lack of cost-of-living adjustments or market adjustment raises) is an important part of compensation. One avenue for investigating the effects of sanctions emerges from Thaler's (1985) examination of coding mixed gains and losses. His work suggests that individuals prefer to integrate mixed gains and losses when the net outcome is a gain but prefer to segregate gains from losses when the net outcome is a loss. The precise role of these processes in compensation design raises questions about how and whether variable pay can sub- stitute for apparent sanctions to base pay resulting from a lack of increases in base pay. Further, Thaler's argument has implications for how dis- tinct compensation decisions (e.g., for different forms of raises and bonuses) be communicated and paid to executives (cf., Lippert & Moore, 1994). Are choices that threaten losses viewed in


isolation, or are they pooled with choices that promise gains in strategic choice opportunities? Although financial theorists (Cardoza & Smith, 1983; Sharpe, 1964) suggest a portfolio view, whereby choices are pooled so that independent risks are balanced against one another to minimize the overall risk of the portfolio, behavior decision theorists suggest a sequential approach in which down-side risk may be minimized for each individual choice (Kahneman & Lovalo, 1993). This view has special application to multiyear contracts, where choices of risk may be pooled or viewed sequentially across the years of the contract. How sanctions are treated when mixed with gains represents an important avenue for future research that could have major implications for compensation design.

Performance Measures and Targets

BAM predicts that the performance target used in compensation design to award variable pay will positively influence the aspirations used by executives to frame problems as positive (gain) or negative (loss). This view can be extended in two ways: (1) by asking if limits exist to this monotonic relation and (2) by recognizing multiple performance targets in contract design. Evidence from goal-setting theory (e.g., Bandura, 1986; Locke & Latham, 1990) suggests a nonlinear relationship between goal difficulty and effort. That is, as targets become more difficult, their influence on behavior lessens, since the targets become increasingly perceived as impossible. This argues for a limit to the influence of performance targets where this influence on executive aspirations may be margin- ally decreasing with the difficulty of the target. Correspondingly, goal time horizons also may influence perceptions of goal achievability (Bandura, 1986). It seems likely that the further targets extend into the future, the less likely they will influence executive aspirations. The precise relationship between specified performance targets and a decision maker's reference point remains an avenue for future exploration. Further, formally incorporating goal-setting theory into agency models of compensation design may provide new ways of viewing the criteria used in awarding variable pay.

Contracts generally contain multiple performance targets with graduated variable-pay awards that have different probabilities of

achievement corresponding to the difficulty of the targets. Recognizing multiple targets of graduated difficulty greatly complicates the relationship among performance target difficulty, executive aspirations, and behavior. Multiple performance targets potentially provide executives with multiple reference points for success. How executives select from among those targets may depend on the range of difficulty the targets represent and the independence of the targets. For example, if independent targets vary in difficulty, executives may endow into calculations of personal wealth bonuses associated with easy targets; this would affect the incentive value of more difficult performance targets, es- pecially if progressively higher targets required progressively riskier investments containing potential losses large enough to eliminate the gains from prior target achievement.

Consistent with traditional agency views, the previous argument clearly suggests that as target difficulty increases, the variable-pay awards attached to the target must increase pro- portionately. However, rather than basing the size of the award on the uncertainty of target achievement, we believe that the award must compensate for the potential loss of variable pay already "earned" (from reaching the easier targets) but not yet awarded. That is, executives may evaluate the rewards of pursuing the next more difficult target relative to the loss of both base and anticipated bonus pay. Even if the probabilities of reaching each target are identical but their outcomes are interdependent (losses in one negatively affect gains in another), awards must become progressively larger to at- tract agent interest in their pursuit, since each variable-pay award must compensate for the more heavily valued loss of anticipated variable-pay awards as well as future base pay. Estimating the weighting of losses relative to gains and how executives calculate current wealth represents two important research issues for guiding compensation design.

Related to performance target difficulty is the question of measurement. A considerable num- ber of studies on performance measures have focused on capturing and compensating for the noise within various performance measures. This research has sought to find performance measures, individual or in combination (e.g., Sloan, 1993), that provide unambiguous signals of agent effort and risk preferences. Despite con-


siderable empirical and analytical attention, this research has yet to provide clear direction (Lambert, 1993; Moody, 1992). Taking a different view, BAM acknowledges that different performance measures contain different forms of noise and examines the effects of these different forms on problem framing. Noise created by factors outside the executive's control creates the potential for loss contexts, whereas noise engi- neered by executives to obscure effort levels creates gain contexts. Looking at noise in this way helps us avoid some of the measurement problems of extant research (Lambert, 1993). Fur- ther, it suggests new research into the effects of ambiguity on aspirations independent of performance effects. That is, executive aspirations traditionally have been modeled on relatively unambiguous signals of performance (e.g., his- torical and peer performance; Lant, 1992). This leaves open the question of how ambiguity in performance signals may moderate their influence on executive aspirations.

Monitoring

Our view of monitoring draws a strong distinction between the mechanisms of control (direct supervision) and the criteria of control (behavior). We believe that failure to recognize this distinction has confounded prior examination of monitoring. In particular, we argue that the use of behavioral evaluation criteria ultimately increases agent risk aversion by increasing agent risk bearing. Increased risk bearing occurs because behavioral evaluation criteria are more subjective and subject to ad hoc interpretation, which can create ambiguity about what criteria may be utilized and, ultimately, uncertainty over the eventual outcome of the evaluation. Further, the use of direct supervision in an agency context is subject to the same behavioral issues attending other elements of interpersonal relations, such as perceptual bias (Cardy & Dob- bins, 1994; Weick, 1970) and trust (Mitnick, 1994). These factors seem to increase agent risk bearing by tying future compensation, and even employment, to ex post evaluation of performance. Yet modeling these factors in agent settings has been obscured by a focus on information avail- ability (Eisenhardt, 1985). BAM underscores the importance of this line of research by providing a mechanism for understanding the general relations among these factors and by analytically

distinguishing between the mechanism and criteria for monitoring. For example, although explicit risk sharing is not evident in supervision (compensation may not be tied to uncontrollable performance factors), situational risk may ex- ceed that of an incentive alignment mechanism. Clearly, investigations of differences in perceived risk under these two systems seem warranted.

We have omitted from BAM any recognition that executives may engage in upward influence. However, Westphal and Zajac (1995; Zajac & Westphal, 1995) provide evidence that executives may manage board control through ingra- tiation and other tactics designed to induce board member acquiescence to executive pro- posals. Extending the model to recognize executive upward influence tactics would add mod- erating influences on two relationships. First, upward influence may act as a deterrent to board vigilance; second, it may decrease the ambiguity and, thus, risk bearing associated with behavioral criteria. For example, a primary motivation for executive upward influence would be limiting negative performance ap- praisals and ensuring executive discretion, which may be accomplished by gaining preliminary acceptance (i.e., "buy-in") from board members for strategic choices, thereby increasing board member reluctance to criticize those choices later. This action ultimately reduces the ambiguity associated with the use of behavioral evaluation criteria, since boards would have ex- pressed commitment to specific behaviors in advance. Hence, we could extend BAM by introduc- ing executive upward influence as a moderator of the relation between behavioral evaluation criteria and risk bearing. Executive upward influence also may moderate the influence of supervision on target difficulty. This would occur if executives reduce board member anxiety over executive decisions though tactics designed to create trust, strengthen the monitor's confidence in the executive, and enhance monitor perceptions of executive stature and competence (Westphal & Zajac, 1995; Zajac & Westphal, 1995).

Market Factors

Finally, BAM can be extended by looking outside the framework of internal corporate governance factors and recognizing a role for market factors in the model of executive risk choice. In


particular, rising peer compensation relative to the executive's compensation may influence the framing of the compensation problem facing the executive and, therefore, his or her risk choices. This argument builds on equity theory, which, when applied to executives, suggests that executive perceptions of compensation given a level of effort are tied to perceptions of peer wealth/ effort ratios (Wallace & Fay, 1992). Within BAM, peer salary levels would influence executive aspirations for compensation (i.e., a compensation reference point, which should be distinguished from the reference used in evaluating strategic choices) so that rising peer salaries (and, presumably, wealth/effort ratios) should positively influence executive aspirations for compensation. Rising aspirations relative to current compensation therefore would result in a loss context (i.e., relative deprivation), which could trigger changes in executive risk preferences and behavior. Although these behaviors might include pursuing firm strategies for raising firm performance (and, presumably, compensation levels), they may also include entering the executive employment market.

Fama (1980) has suggested a market disciplin- ary role that also could be included in BAM. He argues for the existence of a market for executives that disciplines executives into behaving consistently with the preferences of principals. Specifically, Fama's argument suggests that if executives fail to perform adequately for their firms, or worse (e.g., they are associated with performance declines), their future market value suffers, thus lowering their future earning potential and even limiting their ability to find future employment (Agrawal & Walking, 1994). This argument raises another threat to executive wealth-the threat to future earning potential-that also may result from selecting risky firm strategies that the market may judge faulty (cf., Cannella, Fraser, & Lee, 1995). Thus, the presence of an executive market aggravates the link between strategic choices involving risk for the firm and the executive's own risk bearing.

Conclusions

Models are inherently incomplete depictions of the empirical world. The meso-theoretic perspective we develop here combines behavioral decision theory with agency theory in order to reexamine the influence of various designs of

internal corporate governance on executive risk bearing and risk taking. By necessity, our exploration narrowly frames the setting and issues that we consider and leads us to overlook some potentially important and relevant relations and issues. For instance, we explicitly focus on only two theoretical perspectives and thus ignore other theories that may also contribute useful explanatory power to a model of executive behavior. By focusing on internal corporate governance, we ignore the potential role that external market factors may play in limiting our arguments. Conversely, it is possible that our arguments extend beyond the corporate governance setting examined here. For example, our argument concerning the influence of internal and external performance measures on risk bearing could be extended to consider the locus of control influences on reward designs in general. Finally, we place certain restrictive assumptions on the model that should be given explicit attention in the future. In particular, we assume that executives use and therefore perceive base pay differently from variable pay. We can easily envision compensation designs where this distinction may be lost because of a heavy reliance on variable pay in the form of commissions. We also assume shareholders are consistently risk neutral, even though we relax assumptions of consistent risk preferences by agents. Accom- modating variable risk preferences on the part of diverse principals represents a further avenue for extending BAM. Ultimately, these limits to the model present opportunities for further extensions and refinements, which we hope provide a stimulus for extending corporate governance research and more broadly agency-based views of governance.

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Robert M. Wiseman is an assistant professor of strategic management in the Depart- ment of Management at Arizona State University. He received his Ph.D. in strategic management from the University of Minnesota. His current research interests include modeling decision behavior under uncertainty and the role of risk in corporate governance and decision making.

Luis R. Gomez-Mejia is the Dean's Council of 100 Distinguished Scholar and Professor at the Arizona State University College of Business. He received his Ph.D. from the University of Minnesota. His research interests are macro compensation issues, including executive compensation and compensation strategy.

A Behavioral Agency Model of Managerial Risk Taking

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