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Corporate risk-taking after adoption of compensation clawback provisions

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Abstract

The adoption of clawbacks purports to mitigate harmful behavior to firms’ operation, including excessive corporate risk-taking at the expense of investors’ interests and firms’ long-term benefits. This study empirically examines whether corporate risk-taking declines after the adoption of clawback provisions in the compensation contracts of top executives in publicly traded US firms. Using a sample of clawback adopters and non-adopters in the Russell 3000 Index firms during the period 2005–2014, we find that the presence of clawback provisions is significantly associated with a lower level of corporate risk-taking as reflected by firms’ investment strategies and their capital structure. Additional analyses suggest that this association is stronger for small firms and for firms audited by Big 4 auditors. Robustness checks of using alternative measures for corporate risk-taking, controlling for the occurrence of financial restatements, board independence, and internal control quality, and employing a propensity matching score matching sample further support the main results. Overall, the results of this study indicate more conservative corporate risk-taking behavior after the adoption of clawbacks.

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Notes

  1. Some may argue that clawback provisions do not affect managers’ behavior because relatively few managers are caught engaging in financial misreporting by the SEC. However, the frequency with which financial misstatements are exposed does not represent the “true” occurrence of financial misreporting (Chan et al. 2012). Firm-initiated clawback provisions are expected to cause a change in managerial behavior because they authorize board of directors to exercise a private right to enforce the clawbacks, and corporate insiders (such as board of directors) are more likely to detect corporate fraud than the SEC (Dyck et al. 2010; Chan et al. 2012). In other words, the signaling effect from clawback adoption can direct managers to act more cautiously.

  2. Clawback provisions were initiated by Sect. 304 of the Sarbanes–Oxley (thereafter, SOX 304) in 2002. Section 954 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which goes a step further than SOX 304, authorizes corporate boards to recoup the compensation executives gained through their misconduct in financial reporting. Our study examines the impact of the clawback provisions on corporate risk-taking as reflected in managers’ decisions on their firms’ investment and debt policies between 2005 and 2014. All of the years in our sample fall within the post-SOX period. Therefore, all firms in our sample are exposed to an enhanced regulatory environment resulting from a series of risk-reducing provisions in SOX, such as expanding the role of independent directors, increasing director and officer liability, emphasizing internal control quality, etc.

  3. DFA 954 requires all listed US firms to adopt clawback provisions in their executives’ compensation contracts. However, the implementation rules have not been finalized because of certain concerns (Chan et al. 2015). Following the practice of prior studies (e.g., Chan et al. 2012; Dehaan et al. 2013; Iskandar-Datta and Jia 2013; Addy et al. 2014; Chan et al. 2015; Fung et al. 2015), we investigate the impact of the voluntary adoption of clawback provisions on firms’ investment efficiency.

  4. To illustrate this point, let us assume that a CEO can achieve a certain amount of additional benefit by choosing a riskier investment policy over a less risky one. Any extra benefit would be discounted by the possible incremental costs imposed by clawback provisions, which mandate the recoupment of the CEO’s compensation if restatements occur. Therefore, in clawback firms, the anticipated incremental net benefits from pursuing riskier policies (the difference between the incremental benefits of pursuing riskier policies and the incremental costs of provoking clawback provisions) are less than in non-clawback firms, because the latter do not have the increment costs of clawbacks.

  5. Although we hand-collect data on clawback adoption, our data are generally comparable with those of prior studies that use the Corporate Library dataset (e.g., Chan et al. 2012; Chan et al. 2015).

  6. Throughout all regression analyses, R&D is set equal to zero if R&D is missing in Compustat over the testing period.

  7. Even though R&D expenditures are expensed in the investment as required by GAAP, which has been reflected in the CEO’s same-year performance-based compensation that is contingent on earnings performance, clawback provisions can still have a significant influence on the CEO’s decisions regarding R&D investments. The inferior performance of an R&D investment will not result in write-offs; however, the CEO can anticipate the future growth brought by R&D investments and the resulting positive impacts on his/her financial interests when making R&D decisions. When anticipated growth is not realized or the situation becomes worse, managers may resort to earnings manipulation (Dechow et al. 2011). When clawback provisions are in place, CEOs are held financially liable for losses due to financial misstatements induced by management misdeeds. If there are any financial restatements in the future, CEOs may incur “double” losses (the compensation retrieved due to the clawback provisions and the “loss” of their compensation in the year when the R&D expenditures were expensed). This can be an important reason for CEOs to be cautious when making R&D investment decisions.

  8. We employ book leverage instead of market leverage because the change of market leverage may be driven primarily by the stock price rather than the underlying managerial choice (Welch 2004).

  9. All three models control for industry fixed effects using two-digit SIC codes (IndustryFE) and the Dodd-Frank time effect (DoddFrank).

  10. After we delete observations with missing values in total assets, the overall sample size for this set of analyses is 25,856 firm-year observations.

  11. The probability of violating GAAP could theoretically be reduced to zero because of the strong monitoring of Big 4 auditors. As a result, there would be no restatements and therefore no need for clawbacks. However, such cases are rare and extreme. Furthermore, prior literature substantiates that strong corporate governance and strong auditing appear to be complements rather than substitutes (e.g., Lee et al. 2004; Chen and Zhou 2007; Lennox and Park 2007; Bronson et al. 2009; Carcello et al. 2011). Therefore, the effects exerted by clawback provisions are unlikely to be replaced by strong auditing.

  12. We use the propensity score matching (PSM) sample we constructed to report the statistics and execute the difference tests. Please refer to Sect. 6.3 for a detailed introduction to the construction of the PSM sample. In short, we assign each control firm (non-adopter) an artificial adoption year equal to its matched clawback adopter’s adoption year, even though the control firm never adopted clawbacks.

  13. We also tried including the three risk-taking proxies as additional controls in this analysis, and the results (untabulated) were consistent.

  14. Alternatively, we included the estimated probability of restatements as a control variable. The probability of restatement was estimated through a logic model with the occurrence of restatements in the current year as the dependent variable and the occurrence of restatements in prior years, firm size, leverage, losses, ROA, market-to-book ratio, external auditor, board size, board independence, CEO duality and accrual quality as independent variables, following prior literature (e.g., Chan et al. 2012; Dehaan et al. 2013; Hollie et al. 2012; Stanley and Sharma 2011; Abbott et al. 2004; Dechow and Dichev 2002; Cao et al. 2015; Nicholls 2016). However, we did not find significant results using the estimated probability of restatement. It is possible that the estimated probability of restatement from the logic model is unable to fully capture the probability of the occurrence of restatements.

  15. The estimated coefficients of the independent variables in the first-stage selection model are generally consistent with the results of Chan et al. (2012) and Chan et al. (2015). Further, the mean difference tests (untabulated) show that the determinants of the probit model reveal no significant differences in means for the predictors between clawback adopters and non-adopters, which indicates that the PSM procedure mitigates observable differences across the subsamples.

  16. As discussed earlier, because the control firms (non-adopters) selected by propensity score matching also have an artificial adoption year, we modify the main models by including the After variable in the regression analysis.

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Authors and Affiliations

  1. School of Business and Management, State University of New York College at Brockport, Brockport, NY, USA

    Yin Liu

  2. Manning School of Business, University of Massachusetts Lowell, Lowell, MA, USA

    Huiqi Gan & Khondkar Karim

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  1. Yin Liu
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  2. Huiqi Gan
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  3. Khondkar Karim
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Correspondence to Yin Liu.

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Appendix: Variable definitions

Appendix: Variable definitions

Variable

Description

R&D

Research and development expenditure to assets

CAPEX

Net capital expenditure to assets

BookLeverage

Book debt to total assets

Clfirm

Indicator variable that takes the value of one if the firm is the clawback adopter, and zero otherwise

Aftercl

Indicator variable that takes the value of one if the firm is the clawback adopter in those years in which the clawback provision is implemented, and zero otherwise

After

Indicator variable that takes the value of one for firm-years in which clawback adopters and control firms have clawback provisions in place, and zero otherwise (each control firms is assigned an artificial adoption year even though it has never initiated clawbacks)

Log(Sales)

Logarithm of a firm’s sales

M/B

The market value of total assets to the book value of total assets (market to book ratio)

SurplusCash

Cash from assets-in-place to total assets

SalesGrowth

Log (Salest/Salest−1)

StockReturn

Annual return over the fiscal year

ROA

Return on total assets

NetPPE

Net property, plant, and equipment to total assets

DoddFrank

Indicator variable that takes the value of one if it is during the Post-Dodd-Frank period, and zero otherwise

Big4

Indicator variable that takes the value of one if the auditor is a Big 4 auditor or successor, and zero otherwise

Future volatility growth1-year (2-year)

The return volatility in the year of clawback adoption (the year after clawback adoption) minus the return volatility in the year before clawback adoption, all divided by the return volatility in the year before clawback adoption

Future R&D growth 1-year (2-year)

R&D expenditures divided by total assets in the year of clawback adoption (the year after clawback adoption) minus R&D expenditures divided by total assets in the year before clawback adoption, all divided by R&D expenditures divided by total assets in the year before clawback adoption

Future cash/assets

The firm’s cash reserves in the year after clawback adoption divided by total assets

Firm Size

Natural logarithm of a firm’s total assets

Tobi’s Q

Book value of long-term debt and debt in current liabilities plus the market capitalization of the firm divided by total assets

R&D intensity

Indicator variable that takes the value of one if R&D expenditures are positive, and zero otherwise

Cash flow/assets

Earnings before extraordinary items divided by total assets

Past stock return volatility

Annualized standard deviation of daily returns over the fiscal year

Past stock return

Stock return of the firm during the previous year

Market leverage

Long-term debt and debt in current liabilities divided by the book value of debt and market capitalization of the firm

Cash/assets

Cash reserves divided by total assets

Capital expenditures/assets

Capital expenditures divided by total assets

Restate

Indicator variable that takes the value of one for firm-years in which firm’s reported earnings are restated, and zero otherwise

PriorRestate

Indicator variable that takes the value of one for firm with any earnings being restated during prior three years, and zero otherwise

Lev

Long-term debt divided by total assets

Loss

Indicator variable that takes the value of one if net loss is reported, and zero otherwise

Foreign

Indicator variable that takes the value of one if firm reports foreign exchange income/loss, and zero otherwise

Merger

Indicator variable that takes the value of one if firm is involved in a merger or acquisition, and zero otherwise

Restructure

Indicator variable that takes the value of one if firm takes a restructuring charge, and zero otherwise

BDIndep

The number of independent directors divided by the total number of directors on the board

AudComSize

The number of directors in the audit committee

LnMV

The natural log of market value

LnRev

The natural log of sales revenue

SaleG

One-year sales growth

BDSize

The number of directors on the board

MW

Indicator variable that takes the value of one for firms disclosing a material weakness, and zero otherwise

Tenure

The natural log of CEO tenure. Set equal to zero if missing

CEOpay

The percentage CEO’s total pay to the aggregate total pay of the firm’s top five executives, computed by Execucomp’s variable: TDC1. Set equal to zero if missing

Execucomp_dum

An indicator variable that takes the value of one if a firm is non-missing in Execucomp and zero otherwise

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Liu, Y., Gan, H. & Karim, K. Corporate risk-taking after adoption of compensation clawback provisions. Rev Quant Finan Acc 54, 617–649 (2020). https://doi.org/10.1007/s11156-019-00801-y

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