" Academy of Management Beview

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 behav-
ioral agency model of executive risk taking. In the model we combine elements of
internal corporate governance with problem iraming to explain executive risk-taking
behavior. The model suggests that executive risk taking varies across and within
different forms oi 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 cor-
porate 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 ex-
hibit 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 relation-
ship. 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 prin-
cipals (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-
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.
133
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 under-
developed concept within agency theory. In gen-
eral, agency-based corporate governance mod-
els 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 (accept-
ing options where risk is not fully compensated;
e.g., Asch & Quandt, 1990; Bulmash & Maherz,
1985; Coffee, 1988; Piron & Smith, 1995). In gen-
eral, agency scholars consider non-risk-averse
preferences outside those induced by the com-
pensation 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-
134 Academy of Management Review
sumptions often included in agency-based mod-
els. 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 cor-
porate governance.
Second, both normative and positivist agency
scholars typically assume stable risk prefer-
ences (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 con-
tribution to explaining how managerial risk tak-
ing affects firm performance. In this article we
relax the assumption that agents hold consis-
tent risk preferences (e.g., increasing or decreas-
ing 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 gover-
nance context.
Third, despite considerable theoretical (e.g.,
Baysinger & Hoskisson, 1990; Coffee, 1988), ana-
lytical (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 man-
agerial 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 cap-
tured in "problem framing" and as suggested by
prospect theory (Kahneman & Tversky, 1979),
add to corporate governance models of manage-
rial choice behavior (Palmer, 1995; Wiseman &
Catanach, 1997). We propose here a more com-
prehensive view of managerial risk taking, for-
mally 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.
January
Finally, despite a growing body of research on
multiperiod contracts (Elitzur & Yaari, 1995;
Holmstrom & Milgrom, 1987; Lambert, 1983),
scholars' treatments of agent risk and perfor-
mance in the corporate governance literature
often are linear and recursive. That is, their
models of agent behavior tend to predict perfor-
mance outcomes based on the agent's risk pref-
erences (McGuire, 1988; Rees, 1985), current
wealth (Elitzur & Yaari, 1995), and the risk and
performance characteristics of available op-
tions (Hoskisson et al., 1992; Kerr & Kren, 1992).'
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 exam-
ple, an executive's current wealth may provide
only a point of reference for assessing prospects
as opposed to directly influencing the prefer-
ence 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 suc-
cess 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 explana-
tions of firm performance resulting from mana-
gerial choices.
In sum, agency theory's contribution to corpo-
rate governance has been limited by its simplis-
tic assumptions of consistent risk aversion
among agents, its modeling of a recursive influ-
ence 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 chal-
lenge 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 contrib-
ute 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
' Multiperiod contract models utilizing utility theory, how-
ever, 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
parallel agency-based literature on the same
subject. In this article we integrate behavioral
decision theory views on risk with agency rela-
tions 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 de-
velop here takes a meso-theoretic perspective of
corporate governance by integrating comple-
mentary 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 relation-
ship, the model developed here is restricted to
settings where the interests of agents and prin-
cipals differ and, therefore, is primarily con-
cerned with the efficacy of corporate gover-
nance mechanisms designed to improve the
principal's control over the agent. Further, since lecting among positively framed prospects and
corporate governance encompasses a broad
realm of factors, we constrain the model to ex-
amine key elements of incentive alignment and
monitoring control and how the decision and
risk-bearing attributes associated with these el-
ements influence executive choices of firm strat-
egy 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, are more sensitive to losing wealth than to in-
1979). Since this scenario still represents a large creasing wealth (Tversky & Kahneman, 1986,
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 litera-
ture is based on behavioral decision theory and,
in particular, prospect theory (Sitkin & Pablo,
135
1992). Those creating behavioral models of deci-
sions find that risk preferences of decision mak-
ers 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 con-
sistent 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 gener-
ally promise unacceptable expected values.
Thus, problems can be framed as a choice
among potential gains or a choice among poten-
tial 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 se-
exhibit risk-seeking preferences when selecting
among identical but negatively framed pros-
pects (Kahneman & Tversky, 1979).
Underlying this shift in risk preferences be-
tween positively (gain) and negatively (loss)
framed problems is the concept of "loss aver-
sion." 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 aver-
sion is not to be confused with the assumption of
risk aversion found in most agency formula-
tions. In particular, loss-averse decision makers
1991). Hence, loss aversion explains a prefer-
ence 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 fram-
ing of problems in order to prevent or reverse
losses and thus preserve their utility (Coffee,
1988). The assumption of risk aversion underly-
ing agency theory, however, suggests that
agents will prefer options with the highest ex-
136 Academy of Management Review January

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

pected value subject to some limit on risk,
which, in the case of losses, would mean ac-
cepting smaller losses with minimal uncer-
tainty.
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 diversi-
fied 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.^
While accepting that agents may become
more risk averse in response to increased risk
bearing, BAM proposes that risk bearing par-
tially 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).
^ Our view oi 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.
1998 Wiseman and Gomez-Mejia
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 deci-
sion 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 pros-
pects for future firm performance impact the
wealth of executives. That is, when forecasts of
firm performance are satisfactory (a gain situa-
tion), executives anticipate positive gains to per-
sonal 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 op-
tions 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 risic 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 cog-
nitive explanation for why the framing of prob-
lems as losses or gains may influence a deci-
sion maker's risk preferences.
Based on this argument, we predict that risk
bearing partially mediates the link between
problem framing and risk taking.^ Recognizing a
mediating role for risk bearing between prob-
lem framing and risk taking represents a criti-
cal, though missing, link in agency-based for-
mulations as well as behavioral models of
executive risk, because it allows us to make
differential predictions as to how monitoring
' Although Sitkin and Pablo (1992) propose a fully medi-
ating 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.
137
and incentive alignment affect managerial de-
cisions under particular decision contexts.^
These arguments lead to our first proposition:
Proposifion 1: To the degree that exec-
utive wealth is tied to firm perfor-
mance, risk bearing partially medi-
ates the influence of problem framing
on risk-taking behavior so that posi-
tively framed problems increase risk
bearing, and risk bearing, in turn,
exhibits a negative influence on risk
taking.
Performance history. Operating from an as-
sumption 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 per-
formance 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 speci-
fied as decreasing risk aversion; e.g., Lambert,
1986).
Prospect theorists and the related work of oth-
ers 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
•* It is also possible that risk bearing moderates the rela-
tion between problem framing and risk taking so that
greater risk bearing increases risk aversion in gain situa-
tions. However, it is not clear how risk bearing would mod-
erate the relation in loss situations. (We thank an anony-
mous reviewer for this suggestion.)
138 Academy of Management Review January

FIGURE 1
A Behavioral Agency Model of Managerial Risk Taking

Internal/external Compensation Stock Behavioral

performance mix options evaluation
indicators design criteria

P4b

7a, 7b

Performance 2 Problem p Risk

history ^ ^ framing taking

P 6a, 6b

Direct P8a,8b>, Target

supervision difficulity

relation between risk and prior performance so
that rising performance should raise the refer-
ence 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 gen-
erally involves four issues: (1) the allocation of
compensation between base (i.e., any contractu-
ally guaranteed pay, such as salary) and vari-
able (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 evalu-
ating 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 be-
lieve, 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 litera-
ture 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 argu-
ment performance-based pay schemes that link
1998 Wiseman and Gomez-Mejia
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 com-
pensation 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 con-
tingent 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 rec-
ognizes 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 per-
formance, 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 prob-
lem of compensation design as a situation in
which agents must choose between different
forms of pay (base and variable) having differ-
ent 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 contractu-
ally linked to risky firm performance targets)
139
and that pursuit of these targets jeopardizes fu-
ture base pay (e.g., augments the chances of
executive dismissal), agents essentially are
faced with a choice between safeguarding fu-
ture base pay (i.e., reducing employment risk),
with conservative firm strategies that smooth
income streams, create firm growth at the ex-
pense of profitability, hoard cash, and so forth
(Baumol, 1959; Marris, 1964; Williamson, 1963), or
pursuing contingent pay with riskier firm strat-
egies 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 tar-
gets 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 perfor-
mance. Recasting the problem of compensation
design in this way allows us to develop a model
of agent risk preferences under differing com-
pensation designs using prospect theory predic-
tions of choice behavior under uncertainty.
BAM asserts that executives make a distinc-
tion between base pay and ex ante contingent
forms of variable compensation. Consider a ba-
sic compensation scheme that includes ex ante
contingent pay,^ which is tied to the achieve-
ment 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 dis-
tinguished from base pay by the degree of un-
certainty associated with each so that increases
in the proportion of contingent pay increases
' Ex 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).
140 Academy of Management Review
"compensation risk" (Holmstrom, 1979; Holm-
strom & Milgrom, 1987; Shavell, 1979). In our ex-
ample 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 en-
dowment (Thaler, 1980), which recognizes that
decision makers immediately include into cal-
culations of personal wealth money just re-
ceived (Franciosi, Kujal, Michelitsch, Smith, &
Deng, 1996; Thaler & Johnson, 1990). This argu-
ment 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.^
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 (Compflash, 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, sev-
eral scholars have noted that people treat regu-
lar income differently from how they treat
unexpected windfalls (O'Curry & Lovallo, 1992;
^ 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 execu-
tive's market value (Fama, 1980).
January
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 vari-
able pay, since losses associated with future
base pay pose a significant threat to an execu-
tive's perceived wealth, future earnings poten-
tial, and, ultimately, to his or her standard of
living. Loss of true variable pay (i.e., nonrecur-
rent contingent compensation) poses a less se-
vere 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., re-
ducing employment risk, protecting normal ad-
justments to base pay, and ensuring future earn-
ings 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 re-
garding loss (Tversky & Kahneman, 1991). In
other words, agents are more concerned with
avoiding loss to perceived wealth than to at-
tracting additional wealth (loss avoiders rather
than wealth maximizers). Hence, compensation
risk bearing results primarily from threats to
1998 Wiseman and Gomez-Me;'ia
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 vari-
able pay to provide incentives for agents to se-
lect riskier strategic options.
Proposifion 3a: Risk bearing results
from threats to future base pay and
anticipated adjustments to that pay.
Proposition 3b: To the extent that fu-
ture 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 dif-
fers 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 un-
certainty. It follows from this view that if
agents are risk averse, they are averse to un-
certainty and thus prefer higher proportions of
certain compensation over uncertain (vari-
able) 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 ef-
fect 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, "re-
structuring" compensation schemes, whereby
some portion of base pay is converted into vari-
able 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 per-
ceived wealth (and possibly allocated to paying
for a long-lived asset) has now been taken away
141
and offered back as a gamble. These arguments
underlie the following two BAM propositions:
Proposifion 4a: Increasing the amount
of contingent pay in total compensa-
tion through layering has no effect on
risk bearing.
Proposition 4b: Restructuring base pay
into contingent pay creates a per-
ceived 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 influ-
ence executive risk taking. Again, building on the
concept of insfanf endowment (Thaler, 1980; Thaler
& Johnson, 1990), we suggest that stock option
schemes may increase risk bearing of the execu-
tive (and, thus, increase risk aversion) rather than
decrease risk aversion, as suggested by those ar-
guing incentive alignment (cf., Pavlik & Belkaoui,
1991). Our view argues that if, like base pay, pre-
viously awarded (though not exercised) options
become part of perceived current wealth (i.e., are
instantly endowed), then, consistent with the no-
tion of loss aversion, choices between preserving
this wealth and earning new options should result
in a conservative risk-averse posture. Hence, op-
tions awarded annually in a multiyear contract
may serve to increase risk aversion over time.
Specifically, positively valued stock options cre-
ate risk bearing when executives anticipate the
returns from exercising those options in the future.
Loss-averse managers respond to this risk by pre-
ferring 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.^ The resulting BAM propositions are as
follows:
' An 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).
142 Academy of Management Review
Proposifion 5a: Unexercised, posi-
tively valued stock options create risk
bearing for the agent, which ulti-
mately increases executive risk aver-
sion.
Proposition 5b: Stock options do not
create risk bearing for the agent when
the down-side risk of stock options is
set fo 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 ef-
fect of high or low targets on risk-taking behav-
ior. 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 in-
crease risk taking, whereas lower (easier) per-
formance targets reduce risk taking. Follow-
ing arguments by Payne, Laughhunn, and
Crum (1980), we argue that the performance
targets (used in awarding variable pay) influ-
ence the location of the reference point to the
extent that executive aspirations are influ-
enced by the performance targets specified in
their compensation agreement. Although other
factors also may influence executive aspira-
tions for firm performance and thus the loca-
tion 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 set-
ting this reference point, which suggests that
executives frame strategic problems as poten-
tial gains or losses by comparing forecasts of
firm performance against the performance tar-
gets specified in their compensation agree-
ment. Thus, high, variable-pay performance
targets relative to performance forecasts cor-
respond to loss contexts (ultimately increasing
agent risk-iaking behavior), and vice versa. As
January
a corollary, targets must continually adjust
with performance trends (within the con-
straints of industry norms for executive con-
tracts) if a loss context is to be maintained and
risk aversion discouraged. This leads to the
next BAM propositions:
Proposifion 6a: A high, variable-pay
target increases the probability that
executives will face a loss decision
context and ultimately leads to an in-
crease in executive risk taking.
Proposition 6b: Variable-pay targets
must adjust with performance to en-
sure that executives face loss decision
contexts.
Performance measures. The fourth issue in the
design of incentive alignment mechanisms con-
cerns the choice of outcome measures used in
evaluating executive performance. Corporate
governance scholars long have argued the rel-
ative merits of accounting (or internal) versus
market-based (or external) measures for evalu-
ating 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 un-
ambiguous guidance in the selection of outcome
criteria. The argument centers on the informa-
tional 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 shar-
ing" (1993: 61), and "the relative weights place[d]
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 perfor-
mance 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..
1998 Wiseman and Gomez-Mejia
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 behav-
ioral 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 indi-
cates that agents exhibit a preference for account-
ing-based performance measures, whereas prin-
cipals 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 mar-
ket-based measures, because they can alter ex-
penses, reallocate capital or cash flow, change
accounting procedures, and so forth (Dyl, 1989;
Hunt, 1985; Varrecchia, 1986); market value, how-
ever, 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- (ex-
ternal) based outcome measures, it seems rea-
sonable 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 perfor-
mance relative to aspirations when accounting-
based measures are used but will forecast lower
performance relative to aspirations when mar-
ket-based measures are used. This prediction
assumes that the selection of performance mea-
sures influences expectations for performance
but not aspirations, since performance forecasts
(i.e., expectations) are controlled by the execu-
tive, whereas aspirations are largely influenced
by the design of the corporate governance (e.g.,
performance targets specified in the contract)
143
and other exogenous factors (e.g., peer perfor-
mance). 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 rel-
ative to aspirations, thus increasing the proba-
bility of a loss context and risk taking.^
We observe that considerable empirical evi-
dence supports BAM's prediction. For example,
R&D spending is lower among firms using ac-
counting measures than among firms using
market-based measures (Coughlan & Schmidt,
1985; Jensen & Murphy, 1990b). Meanwhile, oth-
ers suggest that market-based measures corre-
spond to higher levels of risk taking (Paul, 1992;
Rappaport, 1986). Thus, BAM's prediction corre-
sponds to standard agency expectations regard-
ing 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 indi-
rectly—through its effect on the executive's
framing of problems. Thus, to the extent that
performance targets are independent of perfor-
mance measures, we expect the selection of per-
formance measures to influence the probability
of each decision context. These arguments lead
to the next BAM propositions:
Proposifion 7a: Reliance on market-
based (external) outcome performance
criteria increases the probability of a
loss context.
Proposition 7b: Reliance on account-
ing-based (internal) outcome perfor-
mance criteria increases the probabil-
ity 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-
* 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.)
144 Academy of Management Review
hardt, 1989; Gomez-Mejia & Balkin, 1992; Tosi &
Gomez-Mejia, 1989). Whereas incentive align-
ment contractually links performance outcomes
to agent compensation through ex ante contin-
gent pay (Finkelstein & Hambrick, 1996; Gomez-
Mejia, 1994), monitoring concerns an ex post "set-
tling up" process whereby monitors directly
observe and evaluate either the agent's behav-
iors, 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 mecha-
nism of supervision separately from the behav-
ioral evaluation criteria normally employed.
Direct supervision. Although some have criti-
cized agency-based models of corporate gover-
nance 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-a-vis outcomes; see Ouchi &
Maguire, 1975; cf., Eisenhardt, 1985). That is,
when supervision is considered in agency for-
mulations, it is generally thought of as focusing
on agent behavior, since outcomes are more ef-
ficiently captured in contractually based incen-
tive alignment mechanisms. This suggests that
agency views of supervision within the gover-
nance literature may be underdeveloped re-
garding its ultimate influence on agent behav-
ior (Westphal & Zajac, 1995).
At a minimum, direct supervision would seem
to involve setting and communicating perfor-
mance 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 perspec-
tive 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 suc-
cess. 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-
January
sion, standards (such as performance targets)
should be lower, reflecting the agent's desire to
establish accessible goals that reduce employ-
ment risk and ensure contingent pay. The vigi-
lance 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 influ-
ence risk bearing and, subsequently, risk tak-
ing. Some agency arguments suggest that focus-
ing on executive behavior may decrease
executive risk aversion by allowing owners to
punish observed instances of risk aversion di-
rectly, 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 man-
agers, 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 as-
sessed. Though compelling, Baysinger and
Hoskisson's argument assumes that monitors
utilize accurate and unbiased information about
strategic behavior in evaluating executive ac-
tions. 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 inher-
ent ambiguity of the appraisal criteria used in
the evaluation of senior executives (Ferris &
King, 1992; Kanter, 1977), and because of the ne-
cessity of reaching consensus over those criteria
among a diverse and varying set of monitors,
the use of behavioral criteria is likely to in-
crease agent risk bearing, resulting in greater
preferences for lower risk strategic options.
1998 Wiseman and Gomez-Mejia
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 ex-
perience dependent (Weick, 1970). Performance
appraisal, in particular, has been shown to be
heavily influenced by the evaluator (Becker &
Cardy, 1986). Thus, monitors with diverse back-
grounds may individually frame responses dif-
ferently, according to idiosyncratic schematic
processing and prioritization (Waller, Huber, &
Glick, 1995), which can result in unique percep-
tions, 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 am-
biguous and are left to be determined by indi-
vidual 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 behav-
ioral criteria. Unlike financial outcome criteria,
which generally are specified in advance, be-
havioral criteria are not fully specified in
advance but are determined at the time of eval-
uation, following the observation of agent be-
havior. This clearly creates the potential for un-
certainty in how monitors will perceive and
interpret a given behavior. For example, nega-
tive information has been shown to carry more
weight than positive information (Edder & Fer-
ris, 1989); therefore, the interpretation of behav-
ior using post hoc criteria is subject to the fram-
ing 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-
145
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 eval-
uation of executive behavior is done collectively
by a group of monitors (i.e., the board of direc-
tors) 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 em-
ployed. This further raises ambiguity in the
evaluation process, since it creates uncertainty
about what criteria this group may deem rele-
vant. Unlike financial controls, where agents
may estimate the probability of achieving a
specified performance target in advance of per-
formance, 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 ambigu-
ity agents face when monitors employ behav-
ioral 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 be-
havioral 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:
Proposifion 9; The use of behavioral
criteria by the board creates uncer-
tainty for the executive over how per-
formance will be evaluated, increases
agent risk bearing, and ultimately re-
duces agent risk taking.
146 Academy of Management Review
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 corpo-
rate governance design. We have chosen these
elements to highlight and then examine key bi-
ases regarding risk within agency theory that
have limited its contribution to models of corpo-
rate governance. In this section we extend BAM
by exploring additional issues that may help
distinguish BAM's contribution to corporate gov-
ernance. Implications from this discussion may
provide the basis for future conceptual develop-
ment 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 corpo-
rate governance. By assuming loss aversion, we
portray agent self-interest in a manner that dif-
fers from the "wealth maximizing" view gener-
ally 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 gov-
ernance in this way has implications for a vari-
ety of issues, including explanations for R&D
investments (e.g.. Hill & Snell, 1989), for diversi-
fication 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 para-
chutes," 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 compensa-
tion 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-
January
centives for the agent that are tied to firm per-
formance, without the threat of loss that pursu-
ing higher return projects could entail (cf..
Arrow, 1996).
Compensation Design
Within the context of incentive alignment, we
might also consider implications from recogniz-
ing the opportunity costs and sanctions in com-
pensation 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 compen-
sation 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 en-
dowment effects and thus becomes part of per-
ceived 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 mod-
els tend to focus on rewarding behavior rather
than on imposing sanctions, yet loss of antici-
pated gains (i.e., lack of cost-of-living adjust-
ments or market adjustment raises) is an impor-
tant 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 pro-
cesses in compensation design raises questions
about how and whether variable pay can sub-
stitute for apparent sanctions to base pay result-
ing 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
1998 Wiseman and Gomez-Mejia
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 mini-
mize the overall risk of the portfolio, behavior de-
cision 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 con-
tracts, where choices of risk may be pooled or
viewed sequentially across the years of the con-
tract. 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 posi-
tive (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 recog-
nizing 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 dif-
ficult, their influence on behavior lessens, since
the targets become increasingly perceived as
impossible. This argues for a limit to the influ-
ence of performance targets where this influ-
ence 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 perfor-
mance targets and a decision maker's reference
point remains an avenue for future exploration.
Further, formally incorporating goal-setting the-
ory into agency models of compensation design
may provide new ways of viewing the criteria
used in awarding variable pay.
Contracts generally contain multiple perfor-
mance targets with graduated variable-pay
awards that have different probabilities of
147
achievement corresponding to the difficulty of
the targets. Recognizing multiple targets of
graduated difficulty greatly complicates the re-
lationship among performance target difficulty,
executive aspirations, and behavior. Multiple
performance targets potentially provide execu-
tives with multiple reference points for success.
How executives select from among those targets
may depend on the range of difficulty the tar-
gets represent and the independence of the tar-
gets. For example, if independent targets vary in
difficulty, executives may endow into calcula-
tions 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 po-
tential 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 identi-
cal but their outcomes are interdependent (loss-
es 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 vari-
able-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 is-
sues 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-
148 Academy of Management Review
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 perfor-
mance measures contain different forms of
noise and examines the effects of these different
forms on problem framing. Noise created by fac-
tors 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 perfor-
mance 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 influ-
ence on executive aspirations.
Monitoring
Our view of monitoring draws a strong dis-
tinction between the mechanisms of control (di-
rect supervision) and the criteria of control (be-
havior). 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 in-
creases agent risk aversion by increasing agent
risk bearing. Increased risk bearing occurs be-
cause 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 bear-
ing by tying future compensation, and even em-
ployment, 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 re-
lations among these factors and by analytically
January
distinguishing between the mechanism and cri-
teria for monitoring. For example, although ex-
plicit 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 per-
ceived risk under these two systems seem
warranted.
We have omitted from BAM any recognition
that executives may engage in upward influ-
ence. However, Westphal and Zajac (1995; Zajac
& Westphal, 1995) provide evidence that execu-
tives 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 exec-
utive 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 prelim-
inary acceptance (i.e., "buy-in") from board
members for strategic choices, thereby increas-
ing 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 ad-
vance. 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 in-
fluence also may moderate the influence of su-
pervision 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 percep-
tions of executive stature and competence
(Westphal & Zajac, 1995; Zajac & Westphal, 1995).
Market Factors
Finally, BAM can be extended by looking out-
side the framework of internal corporate gover-
nance factors and recognizing a role for market
factors in the model of executive risk choice. In
1998 Wiseman and Gomez-Mejia
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 exec-
utive 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 as-
pirations 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, pre-
sumably, wealth/effort ratios) should positively
influence executive aspirations for compensa-
tion. 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 ex-
ecutive 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 execu-
tives 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 po-
tential and even limiting their ability to find
future employment (Agrawal & Walking, 1994).
This argument raises another threat to execu-
tive wealth—the threat to future earning poten-
tial—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 per-
spective we develop here combines behavioral
decision theory with agency theory in order to
reexamine the influence of various designs of
149
internal corporate governance on executive risk
bearing and risk taking. By necessity, our explo-
ration 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 be-
havior. By focusing on internal corporate gover-
nance, we ignore the potential role that external
market factors may play in limiting our argu-
ments. Conversely, it is possible that our argu-
ments extend beyond the corporate governance
setting examined here. For example, our argu-
ment concerning the influence of internal and
external performance measures on risk bearing
could be extended to consider the locus of con-
trol influences on reward designs in general.
Finally, we place certain restrictive assump-
tions 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 dis-
tinction 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 ave-
nue for extending BAM. Ultimately, these limits
to the model present opportunities for further
extensions and refinements, which we hope pro-
vide a stimulus for extending corporate gover-
nance 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 gov-
ernance 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, in-
cluding executive compensation and compensation strategy.