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ABSTRACT
Title of Dissertation: FIRM-INITIATED CLAWBACK
PROVISIONS: REAL ACTIVITIES
EARNINGS MANAGEMENT, ANALYST
COVERAGE, AND INNOVATION
Henry Kimani Mburu, Ph. D. May 2015
Dissertation chair: Alex P. Tang, Ph. D.
Accounting and Finance Department
“Clawback Provisions” have been defined as corporate governance mechanisms
intended to reduce executive risk-taking and opportunistic behavior. Although firm-
initiated clawback provisions have been associated with several positive
consequences in extant literature, there is little empirical evidence of their having a
diminishing effect on executive risk-taking and opportunistic behavior. Additionally,
there is a need to better understand the consequences of voluntary clawback adoption
as the debate on mandatory clawback provisions for all publicly traded companies in
the U.S. rages on. In this study, I focus on restatement triggered clawback provisions,
and examine two research questions: whether clawback adoption influences the
executive risk-taking behavior, and whether clawback adoption impacts the firm’s
information environment and innovation output. I use the difference-in-difference
research design on a propensity score-matched sample of 418 firms for the period
2010-2013. I find that despite the increase in manipulation of operational cash flows
to increase short-term earnings, which is a documented adverse consequence of
clawback adoption, executives significantly reduce manipulation of discretionary
expenses. In addition, executives in clawback firms earn higher total compensation,
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earn lower proportion of bonuses to total compensation, exercise more in-the-money
exercisable options as a proportion of total compensation, and have lower Vega
overall. These findings suggest that executives of clawback firms are more risk-
averse than those in non-clawback firms. I also find that clawback firms have higher
analyst following and more accurate analyst forecasts, implying better information
environments, and have lower output from innovative activities compared to non-
clawback firms. I, therefore, make several contributions to the literature on voluntary
clawback adoption. I add to the list of the consequences of voluntary clawback
adoption, document evidence of the change in executive risk-taking behavior upon the
clawback adoption, and the impact of clawback adoption on a specific firm activity,
innovation. I also provide empirical evidence that adoption of voluntary clawback
provisions is better explained by the causal hypothesis than by the signaling
hypothesis. Overall, my study significantly adds to the on-going debate on whether to
require mandatory clawback adoption for all publicly traded firms in the U.S.
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FIRM-INITIATED CLAWBACK PROVISIONS: REAL ACTIVITIES EARNINGS
MANAGEMENT, ANALYST COVERAGE, AND INNOVATION
By
Henry Kimani Mburu
A Dissertation Submitted in Partial Fulfilment of the Requirements for the Degree
Doctor of Philosophy
MORGAN STATE UNIVERSITY
May 2015
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UMI Number: 3707686
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FIRM-INITIATED CLAWBACK PROVISIONS: REAL ACTIVITIES EARNINGS
MANAGEMENT, ANALYST COVERAGE, AND INNOVATION
by
Henry Kimani Mburu
has been approved
March 2015
DISSERTATION COMMITTEE APPROVAL:
, Chair
Alex P. Tang, Ph. D.
Dina El-Mahdy, Ph. D.
Huey-Lian Sun, Ph. D.
Phyllis Keys, Ph. D
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Dedication
To my late father George M. Mbũgũa and my mother Julia W. Mbũr ũ who
taught me the virtue of hard work and inculcated in me the importance of education.
And to my wife Alice Njoki and our children for their tremendous sacrifices to have
me go back to school when they most needed my presence.
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iv
Acknowledgments
I express my heartfelt gratitude to my committee chair Dr. Alex Tang and the
committee members: Dr. Dina El-Mahdy, Dr. Huey-Lian Sun, and Dr. Phyllis Keys
for their remarkable advising, guidance, professionalism, and impeccable supervision
during the entire dissertation process. I thank the Dean of the School of Business and
Management Dr. Fikru Boghossian, the chair of the Accounting and Finance
department, Dr. Sharon Finney, the Ph. D. program director, Dr. Leyland Lucas, and
the accounting Ph. D. advisor, Dr. Huey-Lian Sun for providing me with awesome
administrative support to successfully complete my doctoral studies. I am grateful for
their kindness and selflessness. I also recognize Dr. Frank Manu, Dr. Victor Teye,
Dr. Gazie Okpara, Dr. Nathan Austin, Dr. Jasper Imungi, Rev. Dr. John Maviiri, Rev.
Dr. Peter Gichure, and Br. Dr. Celestine Kakooza who directed me in the preparations
to go back to graduate school. I thank them for their encouragement and mentorship.
I also gladly appreciate family members and friends especially: Njoki, Chege,
Wambũi, G ĩ tuto, Mũmbi, Mbũr ũ, Mbũgua, Angelica, Kabat ĩ , Daniel, Geoffrey,
Gladys, Robert, Amos, Isaac, Kamande, K ĩ miti, K ĩ nyua, Mũtũra, Njũũgũ, Teresa
Ir ũngũ, Kobina Ghansah, Fr. Akesseh, the community of St. Matthew’s, and all the
Faculty and staff in the School of Business and Management for their wonderful
support during the entire period of my studies. I thank Dr. Monique Akassi, the
director of the Writing Center, for her highly professional direction in writing.
I also acknowledge with gratitude the financial support from The Catholic
University of Eastern Africa and Morgan State University. Specifically, I benefited
from the Class of 1957 Scholarship and the Business School Scholarship through the
Morgan State Foundation, without which I would not have completed the program.
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Table of Contents
Dedication .................................................................................................................... iii
Acknowledgments......................................................................................................... iv
Table of Contents ........................................................................................................... v
List of Tables ...............................................................................................................vii
List of Figures ............................................................................................................ viii
INTRODUCTION ......................................................................................................... 1
LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT............................ 9
Clawback Provisions .................................................................................................. 9
Clawback Provisions and Corporate Governance .................................................... 15
Adoption of Firm-initiated Restatement Triggered Clawback Provisions ............... 17
Firm-initiated Clawback Adoption and Information Environment .......................... 27
Firm-initiated Clawback Adoption and Analyst Coverage ...................................... 32
Firm-initiated Clawback Adoption and Innovation ................................................. 33
Summary of the Related Literature and the Conceptual Model ............................... 36
RESEARCH DESIGN AND METHODOLOGY ....................................................... 38
Data Sources ............................................................................................................. 38
Sample Construction ................................................................................................ 38
Propensity-Score Matching Model ....................................................................... 41
Final Sample Distribution .................................................................................... 44
Research Design ....................................................................................................... 48
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Real Activities Earnings Management and Clawback Adoption .......................... 49
Executive Compensation Structure and Clawback Adoption ............................... 54
Information Environment of Clawback Adopting Firms ...................................... 56
Analyst Following and Clawback Adopting Firms............................................... 60
Innovation and Clawback Adopting Firms........................................................... 63
EMPIRICAL RESULTS AND DISCUSSION ........................................................... 65
Univariate Analysis .................................................................................................. 65
Test of Differences in Means and Medians .......................................................... 65
Pearson’s Correlation Analysis............................................................................ 70
Multivariate Analysis ............................................................................................... 75
Clawback Adoption and Real Activities Earnings Management .......................... 76
Clawback Adoption and Executive Compensation Structure ............................... 83
Clawback Adoption and Firm Information Environment ..................................... 87
Clawback Adoption and Analyst Following ......................................................... 89
Clawback Adoption and Innovation Output ......................................................... 92
Additional Analysis .................................................................................................. 94
CONCLUSIONS.......................................................................................................... 98
References .................................................................................................................. 103
Appendices ................................................................................................................. 114
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vii
List of Tables
Table 1: Sample selection procedure ........................................................................... 39
Table 2: Binary logistic regression for propensity score matching ............................. 42
Table 3: Distribution of the propensity scores ............................................................. 43
Table 4: Distribution of the sample firms .................................................................... 45
Table 5: Descriptive statistics of the sample firms ...................................................... 47
Table 6: Test of differences in the dependent variables .............................................. 66
Table 7: Pearson’s correlation coefficients .................................................................. 72
Table 8: Clawback adoption and real activities earnings management ....................... 77
Table 9: Clawback adoption and executive Vega ........................................................ 82
Table 10: Clawback adoption and executive compensation structure ......................... 84
Table 11: Clawback adoption and analyst forecasts’ accuracy ................................... 87
Table 12: Clawback adoption and analyst following ................................................... 89
Table 13: Clawback adoption and patent applications ................................................ 92
Table 14: Test statistics for equality of coefficients .................................................... 96
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viii
List of Figures
Figure 1: Conceptual framework of the study ............................................................. 36
Figure 2: Summary of extant literature related to the study and hypotheses ............... 37
Figure 3: Trend of adoption of firm-initiated clawback provisions, 2007-2013 ......... 40
Figure 4: Population propensity scores compared with Dehaan et al..’s (2013) ......... 44
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INTRODUCTION
In this study, I extend the growing research on firm-initiated restatement
triggered clawback provisions in executive compensation. Specifically, I examine the
impact of firm-initiated, or voluntary restatement triggered clawback adoption on the
risk-taking behavior of executives. I focus on the executives’ engagement in real
activities earnings management and changes in their compensation structure.1 I also
examine the impact of firm-initiated restatement triggered clawback adoption on the
firm’s information environment, financial analyst following, and the output from the
firm’s innovative activities.
Executive compensation and its accompanying effects on managerial risk-
taking behavior has been an issue of great concern to researchers (Coles, Daniel, and
Naveen 2006; Cohen, Dey, and Lys 2013), market regulators and participants, and
legal and corporate governance practitioners among other interested constituencies.
At the heart of this issue is corporate governance, the mechanisms put in place by
boards of directors to reduce agency problems in firm management. Major scandals
and market failures have partly been blamed on problems associated with corporate
governance (Agrawal and Chandha 2005). The assumption is that existing
governance mechanisms failed to adequately deal with the attendant principal-agent
relationship problems.
Regulators have responded to these problems by enacting laws to ensure good
governance and disclosure. The Sarbanes-Oxley Act of 2002 (SOX) introduced many
regulations to enhance corporate governance. Additionally, the SOX introduced
1 Clawback adoption in this study refers to voluntary or firm-initiated adoption of restatement triggered
clawback provisions unless otherwise indicated. Furthermore, the terms voluntary and firm-initiated
are used interchangeably.
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regulations in relation to executive compensation under Section 304. These
regulations are commonly referred to as clawback provisions. Also, the Dodd-Frank
Wall Street Reform and Consumer Protection Act (simply referred to as the Dodd-
Frank Act) which was enacted in 2010 made various recommendations that were
meant to enhance corporate governance and provide guidelines on executive
compensation in listed companies in the U.S.
Section 954 of the Dodd-Frank Act of 2010 makes further recommendations
as to how clawback provisions should be implemented. The Act recommends that the
Securities Exchange Commission (SEC) should provide implementation guidelines on
mandatory clawback provisions for all listed firms in the U.S. These guidelines have
not yet been made available at the time of this study. Although all financial firms
under the Troubled Assets Recovery Program (TARP) are required by law to adopt
clawback provisions, other firms are not yet mandated to adopt clawback provisions.
Nonetheless, many non-financial firms continue to voluntarily adopt clawback
provisions. In addition, under the amended regulation S-K of 2006, the SEC requires
all filers to make disclosure regarding such clawback provisions. Practitioners
continue to engage with the SEC and the Financial Accounting Standards Board
(FASB) as they look forward to guidelines as recommended by the Dodd-Frank Act
of 2010 (Burkholder 2013; Whitehouse 2013).
In the existing literature, researchers use two hypotheses to explain voluntary
clawback adoption, the causal hypothesis (Chan, Chen, Chen, and Yu 2012) and the
signaling hypothesis (Chan et al. 2012; Dehaan, Hodge, and Shelvin 2013; Iskandar-
Datta and Jia 2013). On the one hand, the causal hypothesis argues that clawback
adoption would lead to changes in executive behavior resulting in certain positive
outcomes as mentioned hereunder. On the other hand, the signaling hypothesis argues
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that clawback adoption may be used either to signal the market about the high quality
corporate governance, or to manage the impression of management to outsiders.
Neither of these two reasons would be expected to lead to behavior change of the
executives.
Prior studies have documented that clawback adoption is associated with
positive outcomes including: higher earnings quality, reduction in restatements
(Dehaan et al. 2013), perception of lower audit risk (Chan et al. 2012), and better
quality corporate governance (Iskandar-Datta and Jia 2013). Other studies also find
that managers of clawback-adopting firms use less accruals earnings management, but
more real activities earnings management (Chan, Chen, and Yu 2013; Yu 2013; Chan,
Chen, and Yu 2014).
I extend this growing research by investigating two research questions. First, I
examine whether firm-initiated clawback adoption is associated with changes in
executive risk-taking behavior. Second, I examine whether firm-initiated restatement
triggered clawback adoption has an impact on the firm’s information environment,
and how that affects analyst coverage and investment in innovative activities. These
research questions shed light on voluntary clawback adoption from two perspectives,
that of the executives and that of the users of financial information. Prior research has
examined the association between earnings quality and two variables that are of
interest to my study: earnings management (Dechow, Ge, and Schrand 2010) and
clawback adoption (Chan et al. 2013; Dehaan et al. 2013). My study builds on this
research by examining the association between clawback adoption and executive risk-
taking behavior.
The first research question examines whether clawback adoption has an
impact on risk-taking behavior of executives. Assuming the causal hypothesis of
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clawback adoption, change in the executives’ risk-taking behavior would be a
reasonable expectation. Specifically, I conjecture that in the presence of clawback
provisions, executives would engage less in real activities earnings management and
accept higher total compensation, but with lower stock options and bonus
components. My argument is motivated by the Prospect Theory (Kahneman and
Tversky 1979; Tversky and Kahneman 1986) and the Behavioral Agency Theory
(Wiseman and Gomez-Mejia 1998). These theories explain agents’ behavior when
governance mechanisms shift risk to the agent as in the case of restatement triggered
clawback provisions. I use real activities earnings management as a proxy for risk-
taking behavior. Moreover, I also use Vega, which is a more specific measure of
executive risk-taking (Coles et al. 2006; Low 2009), in additional analysis.
Executives with higher Vega are known to undertake higher risk policy decisions
(Coles et al. 2006). This provides additional evidence about the consequences of
voluntary clawback adoption.
Prior studies document conflicting findings in regard to total Chief Executive
Officer (CEO) compensation after clawback adoption (Dehaan et al. 2013; Iskandar-
Datta and Jia 2013). In spite of the conflicting findings, none of these studies have
focused on stock option and bonus components of executive compensation. Stock
options and bonus components would capture changes in executive risk-taking
behavior in the presence of restatement triggered clawback provisions which may not
be captured by total compensation.
Two recent studies (Yu 2013; Chan et al. 2014) have examined real activities
earnings management in clawback adopting firms from the perspective of substitution
with accruals earnings management. My study is similar to these studies to the extent
that I focus on the consequences of clawback adoption and examine real activities
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earnings management. My study, however, differs from these studies in three major
aspects. First, I focus on real activities earnings management as a measure of
executive changing risk-taking behavior. Second, I examine information
environment, analyst following, and impact of innovative activities in addition to real
activities earnings management. Third, I focus on restatement triggered firm-initiated
clawback provisions. Therefore, the focus on these three aspects separates my study
from prior research studies which have examined real activities earnings management
in clawback firms.
Informed by the Prospect Theory and the Behavioral Agency Theory of
principal-agent relationship, I predict that the executives in clawback firms will be
more risk-averse and more concerned with the prospect of losing wealth in case of
restatement or any other behavior that would result in misleading investors, 2
compared to executives in non-clawback firms. In addition, clawback provisions
would increase the executives’ risk -bearing. The executives in clawback firms will,
therefore, engage less in real activities earnings management, prefer less bonuses, and
exercise more of the exercisable in-the-money stock options compared to the
executives in non-clawback adopting firms.
The second research question examines whether clawback adoption leads to
improvement in the firm’s information environment. Prior studies have documented
improvement in financial reporting quality (Dehaan et al. 2013), reduced audit risk
(Chan et al. 2012), and higher quality corporate governance (Iskandar-Datta and Jia
2013). Taken together, these findings suggest that clawback adoption is associated
2 The SEC emphasizes this point, “The SOX "clawback" provision deprives corporate executives of
money that they earned while their companies were misleading investors.” From Press Release 2009 -
167 available from http://www.sec.gov/news/press/2009/2009-167.htm.
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with better corporate governance, and better corporate governance is also associated
with better information environment (Byard, Li, and Weintrop 2006; Armstrong,
Balakrishnan, and Cohen 2012). Two recent studies (Dehaan et al. 2013; Iskandar-
Datta and Jia 2013) have examined the information environment of clawback
adopting firms. Dehaan et al. (2013) find lower analyst forecast dispersion after
clawback adoption, suggesting an improved information environment. Iskandar-Datta
and Jia (2013) find lower bid-ask spread, a measure of liquidity, for restating
clawback firms compared to non-restating clawback firms. Dehaan et al.’s result is,
nonetheless, subject to an alternative interpretation. This is because differences in
dispersion may be due to other factors besides information availability, such as the
forecasting models employed. In addition, Sheng and Thevenot (2012) point to
econometric issues attendant to using the dispersion as a measure of information
environment. In times of economic shocks, dispersion will be understated, being
erroneously interpreted as improved information environment.3
My study builds on the findings of Dehaan et al. (2013) and Iskandar-Datta
and Jia (2013). However, it differs from both studies because I examine the
information environment of clawback adopting firms by investigating the extent of
financial analyst following and the accuracy of analysts’ forecasts. These direct
measures of information environment in clawback adopting firms have not been
examined in prior studies. Answering this question from an analyst’s perspective,
also affords me an opportunity to directly examine the management’s commitment to
3 Dehaan et al. (2013) use data for period 2005-2010. There is possibility that this result is partly driven
by effects of 2008-2009 economic meltdown.
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implement voluntarily adopted clawback provisions. Moreover, this allows me to
directly examine the signaling hypothesis of clawback adoption.
I further investigate whether clawback adoption influences firm management
investment decisions in innovative activities. There are two reasons why it is
important to examine this question. One, prior research (Yu 2008) finds that analysts
can exert pressure on management, leading to emphasis on meeting short-term targets
and to myopic management decisions. To the extent that clawback adoption impacts
analyst following, this stifles management’s long-term investment decision making
resulting in a decline in innovative activities. In addition, Derrien and Kecskes (2013)
provide empirical evidence on the causal relationship between analyst following and
firm investment decisions. Two, assuming the causal hypothesis of clawback
adoption, it is possible that the executives would make changes to the corporate risk
policy in line with their own individual risk-taking behavior. This question also
indirectly tests the information environment of the clawback firms, because it assumes
the higher analyst following. This question has not been examined in prior clawback
studies.
My study contributes to the nascent but growing literature on voluntary
clawback adoption in several ways. First, it further informs our understanding of the
consequences of voluntary clawback adoption. Second, because financial analysts are
considered key and sophisticated users of financial information, this study provides
valuable insights into clawback adoption not previously examined. I use the
difference-in-difference research design to test for causal relationships between
clawback adoption and each of the five dependent variables: a.) real activities
earnings management, b.) analyst forecast accuracy, c.) analyst following, d.)
executive compensation, and e.) innovative output. This provides additional evidence
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of the consequences of clawback adoption. The study also contributes to the debate
about the consequences of clawback adoption. Furthermore, the study contributes by
directly testing the reduction of managerial opportunistic behavior alluded to by
Iskandar-Datta and Jia (2013).
Third, my study adds to the on-going debate among stakeholders including the
SEC and the FASB on whether clawback provisions should be made mandatory for
all listed firms in the U.S. as recommended by the Dodd-Frank Act of 2010. It is not
possible to generalize findings from this study to mandatory clawback adoption,
nevertheless, more information is always advantageous.
Fourth, this study makes a contribution by examining the link between
clawback adoption and a specific firm activity, innovation, a link not previously
focused on. Fifth, my study makes a further contribution by examining the impact of
clawback adoption on executive risk-taking behavior. This is important because as
Cohen et al. (2013) indicate, there is a need to assess to what extent corporate
governance regulations impact operation and investment strategy through interaction
with the executives’ incentives. Although Dehaan et al. (2013) indicate that clawback
provisions are meant to discourage executive risk-taking, to date, there is little direct
empirical evidence to support this claim.
Sixth, I also contribute to the extant literature by directly testing the two
hypotheses of voluntary clawback adoption, the causal and the signaling hypotheses.
While prior studies have made inferences to these hypotheses from their findings, my
research design tests directly the plausibility of each hypothesis in explaining
clawback adoption.
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LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT
Clawback Provisions
Clawback provisions, also referred to as recoupment clauses or simply
clawbacks, have been used in executive compensation for a long time (Langevoort
2007). Clawback provisions are the rights of a firm to recoup from an executive of
the firm benefits already earned and paid following a predetermined triggering event
(Earlie and Wilkerson 2012). Such triggering events include: misconduct, breach of
restrictive covenants such as (e.g., non-competition and non-solicitation agreements),
influence on employees, termination of employment due to unethical behavior, and
financial statement restatement.4
The U.S. Securities and Exchange Commission (SEC, 2003) describes the
adoption of clawback provisions through enactment of the Sarbanes-Oxley Act (SOX)
Section 304 as an action to improve the “tone at the top.” According to Robert
Khuzami, Director of the SEC’s Division of Enforcement, clawback provisions are:
“An important incentive for senior executives to be vigilant in preventing misconduct
and ensuring that companies comply with financial reporting requirements.”5
Earlie and Wilkerson (2012) identify three main purposes of clawback
provisions: limiting the risk of manipulation, penalizing bad behavior, and preventing
windfall earnings.6 In addition, Earlie and Wilkerson (2012) indicate that, broadly
speaking, clawback provisions permit recovery of compensation regardless of
4 Each of the two examples of clawback provision clauses given in the next page have differenttriggers.5 The Director was commenting on the clawback enforcement case of Heazer Homes USA (seeAppendix C). Press Release 2011-61 available at http://www.sec.gov/news/press/2011/2011-61.htm.6 Emphasizing this point, Robert Khuzami, director of the SEC’s Division of Enforcement said, "The
personal compensation received by CEOs . . . can be clawed back. The costs of such misconduct neednot be borne by shareholders alone." In addition, a quote from filing DEF 14A of Mineral Technologies
Inc. dated 04/03/2013, “. . . ensure that our executives do not retain undeserved windfalls . . .”illustrates this point too.
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misconduct on the part of the executive. Dehaan et al. (2013) add that clawback
provisions are corporate governance mechanisms meant to deter executives from risk-
taking behavior that would result in restatements, and at the same time penalize the
executives if they engage in such behavior. Furthermore, Iskandar-Datta and Jia
(2013) add that the key benefits of clawback adoption are reduction of managerial
opportunistic behavior and assurance of high quality financial reporting. Below are
two examples of clawback clauses extracted from the SEC DEF 14A filings:
We maintain clawback provisions relating to stock options, restricted stock units,
performance share units and market share units. Under these clawback provisions,
executives that violate non-competition or non-solicitation agreements, or otherwise
act in a manner detrimental to our interests, forfeit any outstanding awards, and any
accrued and unpaid dividend equivalents underlying these awards, as of the date such
violation is discovered and have to return any gains realized in the twelve months
prior to the violation. These provisions serve to protect our intellectual property and
human capital, and help ensure that executives act in the best interest of BMS and our
stockholders.7
Although the applicable rules have not yet been adopted, in February 2013 the Boardadopted a clawback policy under which the Board, or a committee of the Board, will
have the right to cause the reimbursement by an executive officer of the Company(including the NEOs) of all or a portion of certain incentive compensation if:
the compensation was predicated upon the achievement of certain financialresults that were subsequently the subject of a required restatement of theCompany’s financial statements,
the compensation was predicated upon the achievement of certain financialresults that were subsequently the subject of a required restatement of theCompany’s financial statements,
the executive officer engaged in fraudulent or intentional illegal conduct thatcaused the need for the restatement, and
a lower payment would have been made to the executive officer based upon therestated financial results.
The policy is applicable to the performance units and annual cash bonusescommencing with the year the policy was adopted, and provides for a look-back period of up to three years.8
Regulation concerning clawback provisions came into effect following the
enactment of the SOX Act in 2002. Under Section 304 ( Forfeiture of Certain Bonuses
7 Extract from Bristol Myers Squibb Co. filing DEF 14A dated 03/21/2013.8
Extract from Pioneer Natural Resources Co. filing DEF 14A dated 04/11/2013.
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and Profits) of the Act, Chief Executive Officers (CEOs) and Chief Finance Officers
(CFOs) are required to repay back bonuses and profits deemed to have been earned
from misstated accounting numbers arising from culpable misconduct resulting in the
restatement of financial statements. Specifically, the onus of enforcing the Act is on
the SEC; it does not matter whether the firm has adopted clawback provisions or not
for the SEC to enforce clawback provisions (see Appendix A).
Appendix A lists five cases of clawback enforcement by the SEC under
Section 304. It is apparent from the concluded clawback cases that under Section 304
of the SOX Act, CEOs and CFOs do not have to be involved in misconduct
themselves;9 the only requirement is that they received incentive compensation at a
time when the firm restated earnings or misled investors. In cases in which they are
directly involved, the provisions equally apply.10
Following the 2008 economic meltdown, another Act, The Dodd-Frank Wall
Street Reform and Consumer Protection Act (simply referred to as the Dodd-Frank
Act), was signed into law on July 21, 2010. This Act recommends a new environment
under which clawback provisions would operate. Clawback provisions under Section
954 of the Dodd-Frank Act differ from those under the SOX Section 304 in three
aspects (Sharp 2012).
9
"CEOs should know that they can be deprived of bonuses or stock profits they received whileaccounting fraud was occurring on their watch," said Robert Khuzami, Director of the SEC's Divisionof Enforcement (available at http://www.sec.gov/news/press/2011/2011-243.htm). "Jenkins wascaptain of the ship and profited during the time that CSK was misleading investors about the company'sfinancial health," said Rosalind R. Tyson, Director of the SEC's Los Angeles Regional Office. Quotesare in reference to former CEO of CSK Auto, Mr. Maynard L. Jenkins available at
http://www.sec.gov/news/press/2009/2009-167.htm.
10 "Whenever a corporate officer misleads investors about a company's performance by secretly backdating stock options, the integrity of our markets is undermined," said SEC Chairman ChristopherCox. "As demonstrated in this case, the SEC is committed to holding corporate officers accountable forillegally backdating stock options and will seek the return of undeserved compensation." In referenceto the case of former UnitedHealth Group CEO William. W. McGuire, available at
http://www.sec.gov/news/press/2007/2007-255.htm.
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First, while Section 304 only applies to CEOs and CFOs, Section 954 applies
to all current and former executive officers. Second, Section 304 requires material
noncompliance arising from misconduct, but Section 954 does not require
misconduct. Third, Section 304 requires a one-year look-back period while Section
954 requires a three-year look-back period.11 These differences have been deemed
potential improvements in clawback provisions (Chan et al. 2012). Moreover, the
board of directors rather than the SEC is the enforcer of clawback provisions under
the Dodd-Frank Act 2010. Appendix B lists one case of clawback enforcement by the
board of directors. The board of directors can only enforce clawback provisions if the
firm has adopted clawback provisions and incorporated them in the executive
compensation plan.
Due to the aforementioned differences and improvements, Chan et al. (2012)
posit that voluntary clawback provisions are stronger than those under the SOX
Section 304 but weaker than those under the Dodd-Frank Act Section 954.12
Furthermore, London, Zwick, and Witkowski (2011) argue that the Dodd-Frank Act
envisages broader requirements of clawback provisions compared to the SOX. These
differences between the two Acts have led to the contention that clawback provisions
under the two Acts may possibly result to different governance regimes (Addy, Chu,
and Yoder 2014). In addition, the Dodd-Frank Act recommends that clawback
provisions be made mandatory for all publicly traded firms in the U.S.
11 For example, the clawback provisions for Bristol Myers Squibb Co. have a one-year look back while
those for Pioneer Natural Resources Co. have a three-year look back period (see extracts for footnote 7
and footnote 8).12 In line with this argument, there has also been a felt need for an in-house clawback provision that
board of directors can use (Iskandar-Datta & Jia 2013, 175) when the SEC does not get to enforce all
cases that need recoupment. This need is also well articulated in some companies’ proxy statements,
e.g., “We have a formal “clawback” . . . that is broader in its reach than that imposed by Section 304 . .
. “(Quote from DEF 14A filing dated 01/17/2014 by Nordson Corp.)
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The guidelines for implementing the mandatory clawback provisions are to be
provided by the SEC as envisaged in the Dodd-Frank Act (Dehaan et al. 2013). The
SEC is yet to provide those guidelines for the implementation of the Act (Whitehouse
2013). Stakeholders have also requested from the FASB accounting guidelines for
issues surrounding clawback provisions like the grant date for stock compensation
awards. The FASB has so far declined to take up this issue (Whitehouse 2013).
Thomas Linsmeier, the FASB chair explained that any rule on the clawback issue
would lead to unwarranted divergence from IFRS (Burkholder 2013).
Clawback provisions have thus created a growing interest in both research and
practitioner publications in accounting, law, and corporate governance in recent years.
This points to how critical clawback provisions are considered to be in executive
compensation today. A stream of accounting research has been evolving to better
understand both determinants (Brown, Davis-Friday, and Guler 2011; Addy et al.
2014; Brown, Davis-Friday, and Guler 2014) and consequences (Chan et al. 2012;
Chan et al. 2013; Dehaan et al. 2013; Iskandar-Datta and Jia 2013; Mariola and Ryan
2013; Chan et al. 2014) of voluntary or firm-initiated clawback provisions.
The majority of these studies have documented positive consequences of
clawback adoption. These include higher financial reporting quality and reduced
analysts’ forecast dispersion (Dehaan et al. 2013), positive stock-valuation effects
(Iskandar-Datta and Jia 2013), decline in restatements, and a perception of lower audit
risk (Chan et al. 2012). Furthermore, firms whose management has a monitoring
orientation are more likely to adopt clawback provisions compared to those whose
management has an entrenchment orientation (Addy et al. 2014). Adoption of
clawback provisions also results in an oversight impression and could reduce the cost
of recovery of paid compensation from errant executives (Addy et al. 2014). Beck
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(2012) finds that, conditional on the quality of corporate governance, firms which
adopt clawback provisions are associated with lower income-increasing accrual
earnings management. She further argues that clawback adoption may be viewed as a
strong governance mechanism.
A few studies, though, have documented negative or undesired consequences
of voluntary clawback adoption. Though clawback adopting firms engage less in
accruals earnings management they engage more in real activities earnings
management (Chan et al. 2013; Chan et al. 2014). These results, nevertheless,
contradict prior findings that clawback adopters have higher actual and perceived
earnings quality (Dehaan et al. 2013), are perceived to have lower audit risk (Chan et
al. 2012), and are received positively by the market (Dehaan et al. 2013).
Additionally, Pyzoha (2014) argues that reduction in restatements in clawback
adopting firms may be due to executives refusing to amend prior financial statements
when they have a higher proportion of incentive-based pay.13
Along the same line of research, Chan et al. (2013) find that voluntary
clawback adoption may have undesired consequences notwithstanding the reported
higher earnings quality. Furthermore, in an earlier study Davis-Friday, Fried, and
Jenkins (2011) find no improvement in the financial reporting quality of mandatory
clawback adopting firms and indicate that clawback provisions may have unintended
consequences.
Research findings, nevertheless, generally concur that adoption of clawback
provisions influence activities of managers, analysts, investors, and auditors (Chan et
13 Iskandar-Datta and Jia (2013) also document reduction in restatements, but do not examine reasons
for the reduction. Nevertheless, they interpret this finding to suggest that clawback adoption leads to
reduction in incentives for earnings management.
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al. 2012; Dehaan et al. 2013; Iskandar-Datta and Jia 2013) and have positive
consequences.
Clawback Provisions and Corporate Governance
Corporate governance is an important aspect of this study. This is because
clawback provisions have been referred to as corporate governance mechanisms (SEC
2003; Beck 2012; Sharp 2012; Dehaan et al. 2013; Iskandar-Datta and Jia 2013).
Dehaan et al. (2013) define clawback provisions as corporate governance mechanisms
meant to deter executives from risk-taking behavior. The SEC (2003) puts it that
clawback provisions improve the tone at the top. In addition, Beck (2012) argues that
clawback adoption may be viewed as a strong governance mechanism. Iskandar-
Datta and Jia (2013) add that this governance mechanism may signal the
determination of the management to address any past reporting failures. 14 In general,
research findings associate adoption of clawback provisions with better corporate
governance. This may partly be due to the improved perceived and actual financial
reporting quality associated with clawback adoption (Dehaan et al. 2013), and the
reduced likelihood of restatement (Chan et al. 2012). Prior research also views
earnings quality as a critical product of good governance (Srinidhi, Gul, and Tsui
2011).
Addy et al. (2014) document findings in support of this argument that
clawback adopters have a govenance tilt towards monitoring but away from
entrenchment. In other jurisdictions, clawback adoption is recommended as part of
governance best practice, for example, the Office of the Superintendent of Financial
14 The fact that some firms adopted clawback provisions after the SEC enforcement of clawback
provisions gives credence to this claim (see Appendix C).
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Institutions (OSFI), which regulates financial institutions in Canada (Dehaan et al.
2013). In a similar vein, Iskandar-Datta and Jia (2013) argue that the threat of
clawback provisions can prompt managers to institute strong financial controls.
There is also anecdotal evidence that the corporate world views the adoption
of clawback provisions as part of the best-practices in corporate governance. The
following extract from a proxy statement supports this view.
In 2013, we decided to formalize and clarify our best practices in relation to our boardof directors and executive officers in a director policy and executive officer policyeffective as of the annual meeting including the following:
A Recoupment/Clawback Provision. The Company's executives will be required to pay back incentive awards erroneously awarded to them on the basis of restated financial
statements, if they participated in fraud or misconduct leading to the restated financialstatements.15
Corporate governance refers to the controls and procedures applied to ensure
that managers act in the interest of the shareholders (Kanagaretnam, Lobo, and
Whalen 2007). Further, corporate governance has also been defined as the set of
mechanisms that protect outside investors against expropriation by insiders (Hab,
Vergauwe, and Zhang 2014). Corporate governance affects the flow of information
from firm insiders to outsiders and may, therefore, reduce the firm’s agency costs
(Armstrong et al. 2012). Firms with high quality corporate governance are associated
with lower earnings management (Dechow, Sloan, and Sweeney 1996). In addition,
corporate governance mechanisms can be classified as an internal mechanism
(including board structure, debt financing, and percentage of outside directors) or an
external mechanism (including effective takeover market and legal infrastructure)
15 This extract is from the proxy statement of Ethan Allen Interiors Inc. filed on October 25th 2013.
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(Hab et al. 2014). In this classification, clawback provisions would be considered an
internal corporate governance mechanism.
Contemporaneous research focusing on voluntary clawback adoption suggests
that clawback adopters have better corporate governance compared to non-adopters.
For example Chan et al. (2012) find that managers of clawback adopters have superior
internal controls thus pointing to improved governance. Yu (2013) argues that
adoption of clawback provisions may signal improved corporate governance. Addy et
al. (2014) examine the relationship between a firm’s governance structure and the
adoption of clawback provisions, and argue that directors are interested in those
activities that portray them as having better governance. Dehaan et al. (2013) show
that adoption of clawback provisions leads to improved corporate governance and
better perceived and actual financial reporting quality. Furthermore, Hunton, Hoitash,
and Thibodeau (2011) find that firms with higher quality boards are associated with a
better perception of tone at the top and actual higher earnings quality.16
Adoption of Firm-initiated Restatement Triggered Clawback Provisions
Although clawback provisions are currently mandatory for all financial firms
under the Troubled Assets Relief Program (TARP) following enactment of the
Emergency Economic Stabilization Act of 2008, it is not so for other publicly traded
firms. Non-financial publicly traded firms may exercise discretion on whether to
adopt clawback provisions in their compensation contracts or not. The number of
non-financial firms that voluntarily adopt clawback provisions has been on the rise
since 2006 partly due to the SEC’s requirement of disclosure of such provisions
16 The SEC considers Section 304 as an action towards ‘improving the “tone at the top.”’ From Press
Release 2003-89a available at http://www.sec.gov/news/press/2003-89a.htm.
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(Chan et al. 2012).17 Notwithstanding this increase, only a few enforcement cases
appear in literature.18
Fried and Shilon (2011) attribute this dearth of enforcement to the limited
resources available to the SEC. Furthermore, Dechow et al. (2010) argue that due to
lack of resources, the SEC only gets to charge the most egregious violators in court.
Another reason that has been floated for this small number of enforcement cases is
that courts have interpreted Section 304 as only applicable to the government (Addy
et al. 2014).
Firm-initiated clawback provisions have many different triggers, including but
not limited to: restatements, breach of non-solicitation and non-competition
covenants, termination for cause, resignation, change of control, intentional
misconduct, fraud, negligence, and breach of fiduciary duty. In this study, I focus
only on restatement triggered clawback provisions, which are the subject of the SOX
Section 304 and Section 954 of the Dodd-Frank Act.
Extant literature presents two competing hypotheses to explain the voluntary
adoption of clawback provisions; the causal hypothesis and the signaling hypothesis.19
The causal hypothesis contends that voluntary adoption of clawback provisions can
17 The SEC altered Section 402(b) (2) (iii) of Regulation S-K in 2006 following recommendations from
Council of Institutional Investors and required disclosure of clawback provisions. This encouraged
firms to adopt and disclose clawback provisions (Mariola and Ryan 2013).
18 For example Addy et al. (2014) observe that in 2007 four firms were charged by the SEC under
Section 304 among other violations following restatements due to option backdating (also see the cases
of CEO/CFO clawback enforcement appearing in the SEC website in Appendix C).19 Dehaan et al. (2013, 1031) argue that signaling in the context of clawback adoption would be to
make market participants aware of the quality and reliability of the firm’s financial statements.
Similarly, Iskandar-Datta and Jia (2013, 173) use the term signaling to refer to the board’s commitment
to address past failures and improve financial reporting. Hence the term signaling in this context seems
to take a different meaning from the conventional meaning in Watts and Zimmerman (1986, 166-167)
where firms incur costs to reduce information asymmetry between insiders and outsiders as part of
corporate disclosure.
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change management behavior, leading to observable consequences. On the other
hand, the signaling hypothesis argues that firms with superior reporting indicators can
use clawback adoption to provide such information to investors without necessarily
changing the management behavior (Chan et al. 2012). Largely, prior research
findings support more the causal hypothesis rather than the signaling hypothesis.
Still, whichever hypothesis explains voluntary clawback adoption, sophisticated users
of financial information, like financial analysts, would respond favorably to clawback
adoption. This is true so long as the management is committed to the implementation
of clawback provisions.
Pertaining to the signaling hypothesis research findings are scanty, but a study
by Iskandar-Datta and Jia (2013) find a positive and significant market reaction to
voluntary clawback adoption.20 In addition, Yu (2013) examines the effect of
voluntary adoption of clawback provisions on accrual based and real activities
earnings management strategies. Yu (2013) finds that adoption of clawback
provisions may signal management’s commitment to improve financial reporting.
She documents results consistent with the signaling hypothesis, but also supports the
argument that the adoption of clawback provisions decreases managerial opportunistic
behavior. Furthermore, Addy et al. (2014) argue that adoption of a governance
mechanism, like clawback provision, is different from its implementation. Addy et
al. (2014) cite prior literature that supports the possibility for managers to develop and
20This result has to be interpreted with caution. This is because capital market research finds that
market reaction may be due to two categories of investors: sophisticated and naïve (Lakonishok,
Shleifer and Vishny 1994). I use financial analysts who, being sophisticated users of financial
information, avail a unique interpretation of findings.
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disclose governance features as part of image management without imposing any
actual consequences.
In support of this latter argument, Elsbach, Sutton, and Principe (1998), argue
that management has salient image concerns and managers can take actions to manage
their impression to external stakeholders. In this connection, adoption of clawback
provisions would reflect independence and portray a picture of concurrence between
the board and outsider interests. Chan et al. (2012), however, find that clawback
adoption does lead to improved reporting integrity besides simply serving as a signal.
Prior research documents a decline in restatements, reduced likelihood to
report internal material control weaknesses, lower audit fees, and a shorter audit
report issuing lag (Chan et al. 2012) following the voluntary clawback adoption.
Furthermore, adopters of clawback provisions are associated with reduced meet-or-
beat behavior and unexplained audit fees, increase in ERC, and decrease in analyst
forecast dispersion compared to non-adopters, as well as increase in CEO cash
compensation responsiveness to accounting performance measures (Dehaan et al.
2013). Taken together, these research findings support the contention that the
adoption of clawback provisions has an effect on executive behavior. This in turn
affects the perception of financial reporting by investors and analysts.
A behavioral approach to clawback adoption may help to extend the causal
hypothesis and directly link it to executive risk-taking behavior. According to the
Prospect Theory (Kahneman and Tversky 1979), there exists decision choices that
violate the expected utility theory, which is the dominant theory applied in the
analysis of decision making under uncertainty. Specifically, the Prospect Theory
identifies two phases in the process of decision making (Tversky and Kahneman
1986) whose outcomes are expressed as positive (gains) or negative (losses) based on
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a neutral reference outcome assigned the value of zero. Thus, according to the
Prospect Theory, agents behave differently depending on whether their prospects are
gains when they are said to be in a loss domain, or losses when they are said to be in a
gain domain. Accordingly, agents’ risk -taking behavior does not remain constant
with changing prospects as would be predicted by the expected utility theory. Agents
are risk-averse in the gain domain and risk-seeking in the loss domain according to
the Prospect Theory.
The Prospect Theory underlies the Behavioral Agency Theory that better
predicts executive risk-taking behavior in agency relationships outlined in Jensen and
Meckling (1976). According to the Behavioral Agency Theory (Wiseman and
Gomez-Mejia 1998), executives will avoid risky activities that potentially threaten
their endowed wealth and will make a choice of activities depending on the contract
framing. Wiseman and Gomez-Mejia (1998) explain that contracts are positively
framed when the available options generally promise desirable outcomes and are
negatively framed when the options generally promise undesirable outcomes.
Executives can, therefore, exhibit both risk-seeking and risk-averse behavior
depending on whether the contracts are positively or negatively framed.
Restatement triggered clawback provisions introduce negative framing in
executive compensation contracts, placing managers in a gain domain according to
the Prospect Theory (Tversky and Kahneman 1986). Restatement triggered clawback
provisions also increase the executives’ risk-bearing. Risk-bearing results when
corporate governance mechanisms transfer risks to the agent and places part of the
agent’s income at risk (Wiseman and Gomez-Mejia 1998). Agents with high risk-
bearing would be more risk-averse.
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Accordingly, from a behavioral perspective, executives in restatement
triggered clawback adopting firms would be expected to change their risk-taking
behavior. This is because restatement triggered clawback provisions effectively place
the executives in a gain domain exposing them to the risk of losing their endowed
wealth. Such executives would, therefore, behave in such a manner to protect their
potentially endowed wealth and general welfare. This argument is consistent with
Tversky and Kahneman (1986) who indicate that risk-averse agents are more sensitive
to losing than to gaining wealth. Hence the adoption of restatement triggered
clawback provisions would directly affect the executive risk-taking behavior
consistent with the causal hypothesis of voluntary clawback adoption. Specifically, I
conjecture an attenuation in earnings management.
Earnings management is a risk-taking behavior as it can lead to an executive’s
loss of wealth and reputational capital (Chan et al. 2012). Furthermore, earnings
management can lead to firm overvaluation. To sustain this overvaluation some firms
engage in non-GAAP reporting (Badertscher 2011). Badertscher (2011) finds that
managers of overvalued firms first engage in accruals-based earnings management,
then proceed on to real activities earnings management which in turn segues to non-
GAAP manipulation. Engagement in earnings management, therefore, always has the
potential of triggering clawback provisions. Clawback provisions may be triggered
either because of the ensuing restatement or because of misleading investors.
Furthermore, earnings management is likely to lead to SEC investigation and
enforcement action. Prior research also finds empirical evidence for the fact that
executives are incentivized to engage in earnings management by high proportions of
stock options in their compensation (Cheng and Warfield 2005; Cheng and Farber
2008). And therefore, because benefits earned from exercising stock options increase
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the risk of triggering clawback provisions, earnings management behavior would
most likely be affected.
Prior research documents two causes of restatements: one, fraudulent
accounting due to the use of non-GAAP reporting, and two, non-fraudulent
accounting. In addition, restatements due to non-fraudulent accounting may be due to
either unintentional or intentional errors that may mislead investors (Plumlee and
Yohn 2010). Ettredge, Scholtz, Smith, and Sun (2010) further document empirical
evidence to show that the non-fraudulent restatements may also result from
purposeful accruals or real activities earnings management.
Ettredge et al. (2010) also find empirical evidence to show that purposeful
income-increasing earnings management is achieved by use of real economic
activities that affect core earnings accounts including sales, cost of sales, and
operating expenses. According to Ettredge et al. (2010), firms may, therefore, file
non-fraudulent financial statements, but still end up restating. This finding lends
credence to the argument that real activities earnings management can lead to
restatements and, therefore, trigger clawback provisions.21 Notwithstanding this
possibility, clawback provisions may also be triggered by the mere fact of misleading
investors. Real activities manipulation misleads investors about the real position of
the firm as regards future earnings expectations.
Extant literature also documents that in the post-SOX era managers use both
accruals and real activities to manage accounting numbers (Cohen and Zarowin 2010;
21 Clawback provisions impose additional penalties on the CEOs and the CFOs who engage in
activities that may lead to earnings manipulation (Ettredge et al. 2010, 182). In addition, if fraud or
activities that mislead investors occur on their watch, even if they were not involved, clawback
provisions would be triggered; hence under Section 304, CEOs and CFOs are culpable for other
officers’ engagement in such activities.
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Badertscher 2011; Zang 2012) but more of real activies in the post-SOX period
(Cohen Dey, and Lys 2008). The literature also documents that accruals earnings
management is easily detected by auditors and is reversible after year-end.
Conversely, real activities earnings management is less likely to be detected by
auditors, cannot be reversed, and has a long term effect on the firm-value (Cohen and
Zarowin 2010).
It is, therefore, reasonable to argue that keeping accruals-based earnings
management constant, executives of clawback firms are less likely to use real
activities earnings management compared to non-clawback firms. This is because
real activities earnings management, which requires a longer time horizon compared
to accruals manipulation, cannot easily be detected and yet results in overvaluation,
misleads investors, and potentially ends in misstatement. This view finds support in
the related literature (Ettredge et al. 2010; Plumlee and Yohn 2010; Badertscher 2011;
Presley and Abbott 2013) and is consistent with improved earnings quality by
clawback adopting firms.
Furthermore, Ettredge et al. (2010) find empirical evidence that real activities
earnings management would result in restatement within a period of three years even
in the absence of non-GAAP manipulation. In the same vein, Plumlee and Yohn
(2010) and Presley and Abbott (2013) document empirical evidence suggesting that
most of the restating firms usually do not have internal material control weaknesses
that would provide opportunity for fraudulent reporting. Moreover, executives have
huge incentives to deliver earnings that maintain or increase their stock prices
(Graham, Harvey, and Rajgopal 2005; Lefebvre and Vieider 2014). As executives’
risk-taking behavior changes, there would be declining use of real activities
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manipulation to avoid overvaluation. Therefore, I state my first hypothesis as
follows:
H1: All else being equal, clawback firms are less likely to engage in real
activities earnings management compared to non-clawback firms.
The causal hypothesis of clawback adoption envisages a change in executives’
behavior. Such a change would most likely result in a change in the executive risk-
taking. I, therefore, contend that CEOs’ and CFOs’ Vega, a measure of executives’
risk-taking, would also change. Hence, to further examine the association between
executive risk-taking behavior and clawback adoption, I test for the association
between clawback adoption and Vega.
Besides changing the earnings management behavior, executives of clawback
firms are also likely to adopt other risk-decreasing behaviors. These executives, being
risk-averse, would not easily accept compensation contracts with clawback provisions
due to their high risk-bearing nature (Wiseman and Gomez-Mejia 1998). The board
compensation committee would, therefore, be more likely to make higher pay offers
for the executives. Alternatively, the executives would bargain for higher pay
themselves.
Contemporary research documents conflicting findings concerning the CEO
compensation in clawback adopting firms compared to that in non-adopting firms.
Overall, executive compensation of clawback adopters compared to non-adopters,
therefore, remains an open empirical question.
On the one hand, Dehaan et al. (2013) predict that to encourage CEOs to
accept the additional risks attached to clawback provisions, CEOs are likely to
demand additional pay to compensate for the increased risk. Consistent with their
prediction, Dehaan et al. (2013) find an increase in CEO compensation after clawback
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adoption. This finding supports the view that CEOs of clawback firms have a higher
risk-bearing compared to those in non-clawback firms.
On the other hand, Iskandar-Datta and Jia (2013) predict differences in
compensation from another perspective. They argue that voluntary clawback
adoption involves costs and can only be value-enhancing if it results in higher
benefits. Iskandar-Datta and Jia (2013) further argue that firms voluntarily adopting
clawback provisions would find it harder to retain high quality and reputable
executives due to the perceived risk engendered by clawback provisions. To counter
this potential loss of executives, firms may resort to higher CEO compensation.
However, in their study Iskandar-Datta and Jia (2013) do not find significant
differences in CEO compensation between clawback adopters and non-adopters.
It is not clear from the arguments or research designs why the aforementioned
studies find conflicting results. Nevertheless, I conjecture two possible reasons for
the conflicting findings. One, while Iskandar-Datta and Jia (2013) construct their
study (control) sample on the basis of a propensity score and with restating (non-
restating) firms, Dehaan et al.’s (2013) sample does not specifically focus on restating
firms. Focusing on restating firms may be one reason for the conflict, given that
restating firms are associated with weaker boards (Presley and Abbott 2013) who can
easily acquiesce to CEO higher pay demands. Two, it is not clear whether both studies
use similar models for computing the matching propensity-scores, which is another
factor that would confound the results. This leads to the first part of my second
hypothesis:
H2a: All else being equal, CEOs and CFOs in clawback firms are more likely
to have higher total compensation compared to those in non-clawback firms.
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Accounting research has also examined components of executive
compensation in relation to executive risk-taking behavior. Results show that
executives who have higher stock option components in their compensation have
higher incentives to engage in earnings management. Cheng and Warfield (2005) and
Bergstresser and Philippon (2006) find a positive and significant association between
executive stock options and earnings management. In addition, finance research
documents that rational risk-averse executives exercise more in-the-money stock
options earlier than the risk-seeking executives (Huddart 1994; Hall and Murphy
2002; Brisley 2006). Hence, for the risk-averse executives who sign compensation
contracts with clawback provisions, reasonable strategies of lowering risk would be to
reduce the proportion of stock options and bonus components of their compensation
and exercise more of the exercisable in-the-money stock options at the earliest
opportunity. This meaningfully protects their endowed wealth according to the
Behavioral Agency Theory and reduces their risks consistent with their risk-
averseness. Prior research also finds that executive behavior is affected by contract
framing (Christ, Sedatole, and Towry 2012). Executive compensation contracts in
clawback firms are negatively framed. This leads to part two of my second
hypothesis:
H2b: All else being equal, CEOs and CFOs in clawback firms are more likely
to have lower proportion of stock option and bonus components to totalcompensation compared to those in non-clawback firms.
Firm-initiated Clawback Adoption and Information Environment
Many financial reporting scandals in the U.S. have largely been traced to poor
corporate governance (Agrawal and Chandha 2005). Regulators and stock exchanges
have responded to this situation by requiring mandatory corporate governance
mechanisms and disclosures. For example, the SEC and major stock exchanges
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require majority independent directors on the board and independent board members
in audit and compensation committees.22 Furthermore, the SOX Section 404 requires
attestation and disclosure of internal control weaknesses, and the Dodd-Frank Act
recommends mandatory clawback provisions for all publicly traded companies.
The assumption underlying these regulatory changes and recommendations is
that improved corporate governance results in better information environment. The
better information environment in turn leads to better quality information for users of
financial reports, including investors and financial analysts. Overall, financial
scandals in recent years have led to more focus on corporate governance solutions for
improved financial reporting quality (Iskandar-Datta and Jia 2013).
Prior literature documents that higher quality corporate governance is
associated with a better information environment. Good corporate governance is also
associated with better monitoring and lower information asymmetry (Srinidhi et al.
2011). The association between corporate governance and a firm’s information
environment has been of interest to policy makers, regulators, and academic
researchers (Armstrong et al. 2012). Therefore, it is important to understand the
extent to which adoption of clawback provisions is associated with improved
information environment. Furthermore, clawback provisions will only be valuable to
investors if they lead to an improvement in the quality of information available to
them.
22 For example, Rule 4350(c) (5) of the NASDAQ Marketplace Rules require majority a of independent
directors on the board, compensation, and nominating committees consisting of solely independent
directors and audit committees of not less than three directors all of whom should be independent.
Similarly the AMEX company guide requires a majority independent directors on the board, and the
NYSE company guidelines and listing standards (Section 303A.01) require that a majority of board
members be independent. Controlled companies are, nonetheless, exempted from these rules (NYSE
Rule 303A) except for entirely independent directors on the audit committee.
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Kanagaretnam et al. (2007) find that firms with higher quality of corporate
governance have lower information asymmetry around quarterly earnings
announcements. In addition, Kanagaretnam et al. (2007) explain that better corporate
governance quality has a significant influence on both quantity and quality of
corporate disclosures. Furthermore, Richardson (2000) examines the association
between information asymmetry and earnings management and finds empirical
evidence that the presence of information asymmetry is a necessary condition for
earnings management.
Firms with better information environment are associated with lower earnings
management (Jo and Kim 2007). Given that clawback adopters are associated with
higher earnings quality, it is to be expected that they engage less in earnings
management and thus have a better information environment. Iskandar-Datta and Jia
(2013) examine the association between voluntary adoption of clawback provisions
and the firms’ information environment from the market perspective using the bid-ask
spread. Iskandar-Datta and Jia (2013) find empirical support consistent with
voluntary clawback adoption being associated with better information environment.
Examining the properties of financial analyst coverage is another perspective
from which to better understand a firm’s information environment. This perspective
is aligned with the FASB’s view that financial reporting has a decision usefulness role
to users. Several studies have used financial analyst properties to examine the
information environment of a firm. For example, Byard et al. (2006) examine the
relationship between corporate governance and quality of information available from
financial analysts. Byard et al. (2006) find that better governed firms have higher
quality information environment.
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Furthermore, Lang and Lundholm (1996) find that firms with higher
information disclosure policies are associated with higher analyst following, more
accurate analyst forecasts, and lower analyst dispersions. Similarly, Hab et al. (2014)
use analyst following as a proxy for information environment and find empirical
evidence that firms with better corporate governance have larger analyst following
and more accurate forecasts. In addition, Barron, Kim, Lim, and Stevens (1998)
present a model associating the properties of a firm’s analyst forecasts and their
information environment. Bansal, Seetharaman, and Wang (2013) also find that
executive compensation can influence non-GAAP disclosure incentives which affect
the firm’s information environment. Taken together, this stream of research suggests
that improvement in governance and information environment can attract higher
financial analyst following and is associated with more accurate analyst forecasts.
Some studies have, however, documented conflicting results. Frankel and Li
(2004) find that firms with less value-relevant earnings numbers are associated with
higher analyst following. Frankel and Li (2004) argue that if financial statements have
low usefulness, that should increase the cost of information processing and hence lead
to a low analyst information supply.
Notwithstanding the above conflicting results, contemporaneous research
largely suggests that clawback adopters have better quality corporate governance.
Clawback adopters would, therefore, be expected to have better information
environment. Firms with better information environment are associated with
decreased analyst forecast errors (Armstrong et al. 2012). Xu and Tang (2012) also
find that firms with poor governance are associated with lower analyst forecast
accuracy.
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Because information provided by firms is a critical input to financial analyst
models, analyst accuracy would be expected to respond to the quality of corporate
governance and information environment. Like Iskandar-Datta and Jia (2013), I
argue that higher information quality associated with clawback adoption should lead
to lower information asymmetry and better information environment. Iskandar-Datta
and Jia (2013) examine the firm’s information environment from the perspective of
liquidity, measured by the bid-ask spread. I examine the information environment
from the perspective of financial analysts. I measure analyst forecast accuracy using
two different models: the Byard et al. (2006) model, which uses forecast errors, and
the Sheng and Thevenot (2012) model, which uses a combined measure that is a sum
of conditional forecast error variances and forecast dispersions.
I contend that analysts following clawback firms would make more accurate
forecasts compared to those following non-clawback firms. Additionally, corporate
governance affects earnings quality, which is important for analyst forecasts, and
current accounting numbers have persistence if they are of high quality. Furthermore,
the superior quality of financial information already documented to be associated with
clawback adopters should affect all users (Irani and Karamanou 2003) and especially
sophisticated users like financial analysts.
Dehaan et al. (2013) find that clawback adopting firms are associated with
lower analyst forecast dispersion and they interpret this as an improvement in the
information environment. Nevertheless, Dehaan et al.’s (2013) result may have
alternative interpretations because the change in dispersion may be due to such other
factors as differences in forecasting models (Lang and Lundholm 1996). Therefore,
in my study, I use a more apt proxy, that of analyst forecast accuracy. Iskandar-Datta
and Jia (2013) examine the bid-ask spread of restating firms after clawback adoption;
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they find evidence for improved information environment for restating clawback
firms but not for non-restating clawback adopters.
I build on the above studies. I conjecture that clawback firms are more likely
to be associated with a better information environment compared to non-clawback
firms for two reasons. One, there is both empirical and anecdotal evidence that firms
which voluntarily adopt clawback provisions are associated with better corporate
governance. Two, extant literature documents that firms which voluntarily adopt
clawback provisions have higher earnings quality compared to those firms which do
not (Chen et al. 2012; Dehaan et al. 2013). Addy et al. (2014) also document that
managers of firms that voluntarily adopt clawback provisions are more oriented
towards monitoring than towards entrenchment contradicting the impression
management view of clawback adoption. Moreover, prior research finds a positive
association between quality of corporate governance and information environment.
This leads to my third hypothesis:
H3: All else being equal, clawback adoption would more likely be associated
with more accurate analyst forecasts.
Firm-initiated Clawback Adoption and Analyst Coverage
Current literature documents that financial analysts are attracted to higher
earnings quality firms (Lang, Lins, and Miller 2003; Byard et al. 2006) and firms with
better information environment (Anantharaman and Zhang 2011). Furthermore, a
superior information environment is better for financial analysts due to the integrity of
ensuing disclosures, and the reduction of uncertainty in a firm’s future performance
(Bhat, Hope, and Kang 2006). However, Dehaan et al. (2013 p.1032) argue that if
investors and analysts do not view clawback provisions as a credible signal, then they
will not change their views about the firm’s financial reporting quality.
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If clawback provisions are not credible signs, or are used for impression
management, I would expect sophisticated users, like financial analysts, to see
through it and hence not respond to clawback adoption. However, if management is
committed to clawback implementation, and wishes to convey certain internal
information to outsiders, financial analysts would respond favorably to clawback
adoption with higher following. This would hold notwithstanding any changes in
executive behavior as predicted by the causal hypothesis of voluntary clawback
adoption.
Prior research has used the level of analyst following as a measure of
corporate disclosure (Bowen, Chen and Cheng 2008) and analysts’ information
environment (Barron et al. 1998). The existing literature also documents that analysts
seek to make accurate reports by relying on firm-provided disclosures (Byard et al.
2006). Research findings further show that more informative disclosures are more
likely from firms with better governance (Chang and Sun 2010). Furthermore, firms
with superior corporate governance have been reported to have more credible
disclosures. These disclosures result in higher analyst following and higher analyst
forecast accuracy (Lang and Lundholm 1996). I contend that clawback adopters will
attract higher analyst following due to their documented better financial reporting
quality and corporate governance. I, therefore, state my fourth hypothesis as follows:
H4: All else being equal, clawback adoption would more likely be associated
with increased financial analyst following.
Firm-initiated Clawback Adoption and Innovation
Adoption of firm-initiated restatement triggered clawback provisions has the
potential to impact a firm’s investment in innovative activities in a number of ways.
First, prior studies find an association between analyst coverage and innovative
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activities (He and Tian 2013). Second, prior research also finds that clawback
adoption can influence managerial behavior (Iskandar-Datta and Jia 2013). This
influence may result in alteration of corporate risk policy leading to variations in
investment decisions. Third, Cohen et al. (2013) find an association between
corporate governance mechanisms, investment decisions, and risk-taking. Together,
these findings point to a potential impact of voluntary clawback adoption on
innovative activities through one or more mechanisms.
In regard to analyst coverage, Yu (2008) finds an association between analyst
coverage and managerial behavior. He applies two hypotheses to explain this
association, a monitoring hypothesis and a pressure hypothesis. Under the monitoring
hypothesis, financial analysts who are considered as key sophisticated users of
financial information, with expert training in accounting and finance, and who interact
with management on a continuous basis, act as external monitors. On the other hand,
the pressure hypothesis holds that financial analysts create excessive pressure on
managers due to their targets and recommendations resulting in myopic behavior and
earnings management. According to the pressure hypothesis, managers would be
interested more in meeting analysts’ targets than in investing in long-term innovative
projects.
He and Tian (2013) examine and establish causality between financial analysts
and firm innovation output. They find that firms with larger analyst following have
lower innovation output measured by the number of patent application filings and
patent citations compared to those with smaller analyst following. These results are
consistent with the pressure hypothesis of analyst following. Furthermore, Derrien
and Kecskes (2013) document empirical evidence to support the view that financial
analyst coverage can influence the choice of policies that managers make, for
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example in regard to investment in research and development. Hence, if v