Do Voluntary Clawback Adoptions Curb Overinvestment?

Abstract

Manuscript Type EmpiricalResearch Question/Issue This study tests whether the adoption of clawback provisions mitigates overinvestment. A clawback provision is a recoupment policy that allows certain bonuses previously paid to executives to be cancelled or "clawed back" if financial statements are restated.Research Findings/Insights This study focuses on 1,093 voluntary clawback adopters in the United States during 2006-2012 and uses propensity score matching to obtain a matched sample. We then perform a difference-in-differences analysis to assess pre-and post-adoption changes in overinvestment. The empirical results show that (i) clawback provisions mitigate overinvestment, and (ii) overinvestment decreases most for those executives identified as overconfident or receiving higher option compensation.Theoretical/Academic Implications Agency conflict between shareholders and executives distorts a firm's investment decisions. According to the agency-based explanation, better financial reporting quality decreases information asymmetry. Clawback provisions improve financial reporting and mitigate potential overinvestment under agency conflict. To the best of our knowledge, no other published study has discussed executives' investment behavior or has reported that one benefit of clawback provisions is mitigating ex post overinvestment. It is important for regulators and academics to understand how clawback provisions impact executives' behavior.Practitioner/Policy Implications The results of this study provide political implications for mandatory clawback provisions under Section 954 of the Dodd-Frank Act after 2016 in the US.Given that we show that voluntarily adopting clawback provisions curbs overinvestment, it is important to examine whether this new act should place restrictions on the form of executive pay.

Determinants and consequences of clawback provisions in management compensation contracts: a structured literature review on empirical evidence

“…Neoclassical principal agent theory (Ross 1973;Jensen and Meckling 1976;Tirole 1986;Eisenhardt 1989) is the most popular theoretical foundation in clawback research (e.g., Lin 2017;Erkens et al 2018;Liu et al 2020;Natarajan and Zheng 2019). Agency theory focuses on maximizing firm value (Jensen and Meckling 1976) based on the residual claim of principals' stocks and the assumption of homogeneous shareholder preferences (Fama and Jensen 1983).…”

“…Most of the included studies examine abnormal investments or overinvestment behavior and related measures (e.g., investment mix or investment efficiency). It is assumed that clawback adoption will lead to lower abnormal investments/overinvestments due to better incentive alignment between management and shareholders (Chen and Vann 2017;Lin 2017). Usually, abnormal investments are approximated by the degree of capital expenditures and R&D expenditures (Liu et al 2018).…”

“…Corporate finance: most included studies found that clawback adoption has a negative impact on overinvestments or abnormal investments (Babenko et al 2019;Lin 2017;Chen and Vann 2017;Liu et al 2020;2018). Biddle et al (2018), however, found a positive effect.…”

“…Corporate governance: other management compensation variables have been included as main significant moderators in prior research. Lin (2017) stressed that the negative impact of clawbacks on overinvestment is strengthened by optionbased compensation. According to Biddle et al (2018), investments shift away from research and development (R&D) to capital expenditures due to higher performance-linked annual pay in the context of clawbacks.…”

“…According to Natarajan and Zheng (2019), powerful CEOs receive higher salaries, which are not subject to the SOX's mandatory clawback provisions. Lin (2017) stressed that the negative impact of clawbacks on overinvestments is strengthened by executive overconfidence. Moreover, according to Remesal (2018), the positive link between clawback adoption and sensitivity of unvested (long-term) compensation was mitigated by pre-adoption board independence.…”