Mandatory Clawback Provisions, Information Disclosure, and the Regulation of Securities Market

The following post comes to us from Diane Denis, Professor of Finance at the University of Pittsburgh.

In the paper, Mandatory Clawback Provisions, Information Disclosure, and the Regulation of Securities Markets, forthcoming in the Journal of Accounting and Economics, I discuss the potential pitfalls of mandating that compensation be recouped from the executives of firms that are found to have engaged in material accounting misstatements. My discussion is motivated by recent evidence in the literature that the voluntary adoption of such clawback provisions by firms is followed by a reduced incidence of accounting restatements, lower auditing fees and a reduced auditing lag, and stronger earnings response coefficients. It is tempting to conclude from this evidence that government attempts to mandate such provisions, most recently through Section 954 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, will increase the accuracy of information disclosure by firms and thereby enhance the integrity of the capital market. I argue that such a conclusion is premature at best.

I provide several possible reasons why the voluntary adoption of clawback provisions by boards of directors might be followed by apparent increases in reporting accuracy, a result that is somewhat surprising given that boards have the power to settle up with errant executives even in the absence of such provisions. One possibility is that boards consider the repayment of ill-gotten gains to be a more appropriate penalty than either renegotiating future compensation or firing executives, and are therefore more likely to impose such a penalty. It is also possible that boards of directors adopt clawback provisions as part of their broader plans to increase the integrity of firms’ reporting. In this scenario, clawback adoption does not necessarily lead to better reporting but rather serves as an external signal of a board’s decision to adopt more careful monitoring overall. Finally, it is also possible that voluntary adoptions of clawback provisions do not, in fact, lead to more accurate financial statements. Rather, it could be that auditors’ erroneous belief that firms that adopt clawback provisions will issue more accurate reports leads them to examine such firms’ financial statements less carefully, thereby reducing the likelihood that they discover material misstatements that require restatement. These various possibilities have quite different implications regarding the precise effect that voluntary clawback provisions have on the accuracy of financial disclosure by executives.

More importantly, whether or not voluntary clawback provisions lead directly to increased financial accuracy, we cannot conclude that government-mandated clawback provisions are necessarily expected to do so. The U.S. government originally mandated clawback provisions in 2002 within Section 304 of the Sarbanes-Oxley Act; however, that mandate has rarely been enforced and is therefore unlikely to have been effective. A purported benefit of the more recently enacted Dodd-Frank Section 954 is that a firm’s board of directors, rather than the overburdened SEC, is responsible for its enforcement. However, it is not at all clear that boards of directors who have not chosen to adopt clawback provisions can be expected to enforce them with the same diligence as would directors who have adopted such provisions voluntarily.

Furthermore, it is important to recognize that any regulation imposes costs as well as benefits. Clearly, an increase in the transparency and integrity of financial information is a benefit to the capital market. However, it is worth considering the potential costs of government-mandated clawback provisions as well. For example, at the margin, Dodd-Frank Section 954 potentially reduces firms’ incentives to make financial restatements, thereby reducing the accuracy of public financial data. More broadly, to the extent that voluntary adoptions of clawback provisions provide useful signals to the market, such information benefits are lost once clawback provisions are mandated for all firms. In addition, at the same time that a government-mandated clawback policy may decrease the information in the market, it could also create an unwarranted illusion of information quality, such that material misstatements become less likely to be discovered. It is also possible that once a misstatement is discovered, a board could default to the government-mandated penalty when it would otherwise have imposed appropriately harsher penalties for a particularly egregious financial misstatement. Finally, one less obvious potential unintended consequence of government regulation arises because mandatory clawback provisions make incentive pay more risky to managers. To the extent that this leads firms to reduce their use of incentive-based compensation and, with it, the incentive-alignment benefits of such compensation, shareholder wealth may be adversely affected.

The basic issues on either side of a debate about the net impact of government imposition of clawback provisions are much the same as those associated with any other attempt to regulate corporate behavior. At one end of the spectrum is the argument that corporations operating in a free and competitive market will adopt contracts that best suit their own complex sets of circumstances. At the other end of the spectrum is the view that frictions in the market are such that corporations cannot be counted upon to do what is best for society or even for their own shareholders. Further evidence and more careful analysis is needed if we are to better understand the impact of mandated clawback provisions in particular and regulation of corporations more generally.

The full paper is available for download here.

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