Clawback provision adoption, corporate governance, and investment decisions

• Published date: 01 October 2017
• Author: Carol E. Vann,Yu Chen
• Date: 01 October 2017
• DOI: http://doi.org/10.1111/jbfa.12259

DOI: 10.1111/jbfa.12259

Clawback provision adoption, corporate

governance, and investment decisions

Yu Ch en 1Carol E. Vann2

1Departmentof Accounting, Shanghai Jiao Tong

University,Antai College of Economics and

Management,Shanghai, China

2Departmentof Accounting, University of South

Alabama,Mitchell College of Business, Mobile, AL

36688-0002,United States

Correspondence

YuChen, Department of Accounting, Shanghai

JiaoTong University,Antai College of Economics

andManagement, Shanghai, 200030, China.

Email:yu_chen@sjtu.edu.cn

Fundinginformation

ShanghaiPujiang Program, Grant/Award Num-

ber:16PJC049

Abstract

We examine the effect of corporate governanceon the likelihood of

clawback provision adoption, and its consequences in terms of cor-

porate investment practices and risk-taking behavior.We find that

firms with strong governance (as proxied by board independence,

diligence, and size) are positively associated with the firm’s adop-

tion of a clawback provision; whereas firms with weak governance

(as proxied by management entrenchment, i.e., CEO duality status

and tenure) are negatively associated with clawbackprovision adop-

tion. Using the propensity-score matching, difference-in-differences

research design, and inverseMills ratio to mitigate omitted variables

and self-selection biases, we find that after adopting a clawback pro-

vision, firms’ abnormal investment decreases and the firms’ invest-

ments are less risky.

KEYWORDS

abnormal investment, clawback provision, corporate governance,

risk-taking

1INTRODUCTION

Clawback provisions in executivecompensation contracts are important corporate governance measures intended to

better align management interests with shareholders’ interests. Recent years haveseen an increasing number of firms

voluntarily adopting clawback provisions in their executivecompensation contracts. However, questions remain as to

the rationale for the growing popularity of clawback adoptions, and extantresearch provides mixed results (see litera-

ture review in Section 2). We argue that the decision to adopt, or not to adopt, clawback provisions is likelyrelated to

two considerations, which are often intertwined: (1) the strength of existing corporate governancemeasures, and (2)

the potential consequences (costs and benefits) of clawback adoption. For example,if strong corporate governance is

already in place and the clawback provisions will only bring in minimal benefits, or if the costs outweigh the benefits,

then a firm may not want to adopt clawback provisions.1This study examinesthese two issues and provides evidence

for a better understanding of clawback provision adoptions.

1Even if the firm uses adoption of clawback provisions as a signal to the market, theywill likely consider the two issues mentioned above. For example, if

clawbackleads to significant negative effects as a side-effect, then the signaling may not be worthwhile. Similarly, if the firm’s governanceis already sufficiently

strong,the incremental effect of signaling by clawback adoption may be minimal.

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2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2017;44:1370–1397.

CHEN ANDVA NN 1371

Regarding the first issue, corporate governance measures do not work in isolation, but interact with each other in

potentially important ways (Brown, Beekes, & Verhoeven,2011b; Cohen, Krishnamoorthy, & Wright, 2004). A com-

prehensive review of accounting and finance research on corporate governance by Brown et al. (2011b) shows that

various corporate governance practices substitute for each other or are complements.2Agrawal and Knoeber (1996)

and Rediker and Seth (1995) find evidence that firms choose the most efficient combination of governance mecha-

nisms to achieve equifinality. In particular, Denis (2012, p. 200) argues that various governance mechanisms, includ-

ing clawback provisions, interact in potentially important ways, and we have much left to learn about the specifics

of these interactions. A firm without clawback provisions does not necessarily mean that its corporate governance

is weak; it could simply be that other corporate governance measures are strong enough, and therefore clawback

provisions are not necessary. For example,in the absence of clawback provisions, a board can renegotiate the com-

pensation contracts and such longer-term compensation changes seem to have greater consequences compared with

clawback provisions (Denis, 2012, p. 198). Therefore, a more complete understanding of clawback adoptions would

require a consideration of other existing corporate governance measures. However, extant research has not, to our

knowledge, fully examined the relations between clawback provisions and other governance measures. We examine

this important issue, and find that clawbacks are more likely to be adopted by a firm when its corporate governance

is stronger as proxied by board independence, diligence, and size; whereas when corporate governance is weakeras

proxied by management entrenchment (CEO duality status and tenure), the firm is less likely to adopt a clawback

provision.

Regarding the second issue (i.e., the potential consequences of clawback adoption), we examine the effect of

clawback adoption on firms’ investment decisions, which is motivated by two reasons. First, a firm’s profitability and

sustainability ultimately depend on sound investmentdecisions. Therefore, the potential effect of clawback provisions

on investment decisions are of great interest to investors and other stakeholders.Second, firms adopt clawback pro-

visions based on cost–benefit analyses. Although a few studies find that clawback adoptions result in higher financial

reporting quality (e.g., Chan, Chen, Chen, & Yu, 2012; deHaan, Hodge, & Shevlin, 2012), others find negative conse-

quences of clawback adoptions. For example, Chan, Chen, Chen, and Yu (2015)find that clawback adopters substi-

tute accruals earnings management with real earnings management, and the total amount of earnings management

does not decrease subsequent to clawback adoption. They call for research on substantive effects of clawback adop-

tions, such as whether managers’ investment behavior or risk-taking is affected by clawback adoption. This study is a

response to that call.

We makecontributions to the literature in the following ways. First, we contribute to the corporate governance lit-

erature by examining the relationship between clawback adoption and other corporategovernance mechanisms. It is

not obvious apriorithatfirms with strong corporate governance will adopt clawback provisions because all corporate

governance measures come with a cost, and other corporate governance measures may be substitutes or may work

even better. Forexample, the board of directors may renegotiate the compensation contract when there is financial

restatement or fraud. This provides more flexibilityand potentially more severe penalties to management. In addition,

firms with weak governance may adopt clawback provisions as a (false)signal of strong governance to avoid penalties

imposed by capital markets and investors. In this case, clawback adoptions mightnot be related to the firms’ existing

corporate governance.Extant literature has not fully examined the relationship between clawback adoption and other

governancemechanisms. Therefore, the mixed results of extant clawback studies may be due to relationships between

clawback adoption and other corporategovernance measures that are not included in the model. We provide evidence

on this issue and enhance our understanding of determinants of clawback adoptions. Our results show that firms with

strong corporate governanceare more likely to adopt clawback provisions, suggesting that boards perceive that exist-

ing governance measures are not complete substitutes for clawback provisions.

Second, we contribute to the clawback literature by documenting empirical evidence on the effects of clawback

adoptions on firms’ investment decisions.Although extant clawback literature generally finds that clawback adoptions

2Althoughthey reviewed about 370 papers, Brown et al. (2011b) do not cover any clawback provisions research.