Compensating for Executive Compensation: The Case for Gatekeeper Incentive Pay

Financial markets are in crisis again and quite certainly on their way to an added layer of regulation. Only a few years ago, at the start of the twenty-first century, a massive wave of corporate fraud revealed the failure of corporate gatekeepers. The Sarbanes-Oxley legislation accordingly targeted gatekeepers, primarily auditors, with strict regulation and enhanced independence guidelines. This legislative remedy has proven to be of disputable benefit while its costs have been huge. This paper argues that a certain type of auditor incentive compensation could work better than regulation. Under the proposed alternative scheme, auditors would defer a portion of the payment they receive from the client firm, which would be used to purchase shares in the client once their tenure as auditors has ended. Instead of making them simply independent, this compensation structure would cause auditors to guard against inflated share prices. This type of auditor compensation could serve to counterbalance recent trends in executive compensation that cause managers to overstate earnings. Modern accounting standards that broaden management’s scope of discretion add to the benefits of this compensation scheme. Thus, the paper calls for the Securities and Exchange Commission to promulgate a safe harbor that would facilitate such schemes, which current independence guidelines do not allow.