Incentive-based compensation lies at the heart of good corporate governance. A corporation’s board of directors needs to ensure that executive compensation is enough to attract and retain talented managers, that compensation packages serve to align the interests of managers with shareholders, and that managers are not overpaid.

The empirical evidence indicates that in practice, executive compensation displays too little variability in respect to pay for performance, insufficient dismissal, and excessive payment for executives. Directors’ own comments reveal that the members of corporate boards have been overconfident in their ability to structure incentives appropriately without overpaying executives. Directors also suggest that their tasks are made that much more difficult by overconfidence on the part of executives.

In traditional theory, employee stock options are used to align the risk attitudes of managers and shareholders. In the traditional approach, the inability of managers to diversify their portfolios as well as shareholders leads managers to be more risk averse than shareholders. However, managers who behave in accordance with prospect theory might find the risk characteristics of stock options attractive because of its casino effect. In this respect, stock options might also induce risk-seeking behavior because of the tendency to overweight low probabilities. Moreover, firms appear to pay their employees in options when the latter are inclined to overvalue those options.

The combination of aversion to a sure loss and overconfidence can also induce ambitious, unethical managers to manipulate accounting information in order to exercise their stock options when the stock is overpriced. In this respect, a combination of behavioral phenomena and agency conflicts affected some accounting firms. Those events were the catalyst for the passage of the Sarbanes-Oxley Act.