Not Clawing the Hand that Feeds You

In our paper, Not Clawing the Hand that Feeds You: The Case of Co-opted Boards and Clawbacks, which was recently made publicly available on SSRN, we examine the impact of beholdenness of the directors to the CEO on the adoption and enforcement of clawbacks.

Clawbacks have been increasingly prevalent in recent years, and the aim of such provisions is to provide a punishment mechanism that links an executive’s compensation more closely to his or her financial reporting behavior. Clawbacks typically allow firms to recoup compensation from executives upon the occurrence of accounting restatements. Perhaps not surprisingly, the implementation and enforcement of clawbacks by companies is likely to create tensions between boards and executives because executives are unlikely to want to have a “Sword of Damocles” hanging over the compensation that is already in their pocket and are likely to resist attempts by boards to claw at this compensation when accounting restatements trigger a clawback. Hence, to better understand the use of clawbacks by firms, it is important to understand the type of boards that are more likely to implement clawbacks.

Recent literature has focused on the economic consequences of clawbacks (Chan, Chen, Chen, and Yu, 2012, 2014; Chan, Chen and Chen, 2013; Dehaan, Hodge, and Shevlin, 2013; Iskandar-Datta and Jia, 2013). This literature typically focuses on the fact that clawbacks could have a positive impact on financial reporting ex ante by punishing executives for financial misreporting ex post. This positive impact has been documented to be associated with various positive economic consequences, such as better loan terms and higher firm valuation. The generally positive economic consequences of clawbacks lead one to ask why the boards of all firms do not simply implement clawbacks.

We aim to fill this gap in the literature by focusing on how board co-option influences the use of clawbacks. Board co-option is a relatively new construct in the corporate governance literature that focuses on the beholdenness of the directors to the CEO. Following Coles, Daniel, and Naveen (2014), we define co-opted boards as the fraction of the board comprising directors appointed after the CEO has assumed office. Our focus on co-opted boards is motivated by the fact that in practice, CEOs (and even other top executives) are likely to exert considerable influence on the selection of board members (Coles et al., 2014) and the popular notion that one is unlikely to “bite the hand that feeds him”. Consistent with this notion, we examine the board’s implementation of policies to constrain financial misreporting when the board is beholden to the CEO, after controlling for CEO characteristics, board characteristics, and other firm characteristics.

To examine the relation between board dynamics and clawbacks, we obtain a sample of 2,714 firm-years over the 2007-2010 period and we show that co-opted boards are less likely to have clawbacks. In terms of economic significance, we find that a one-standard-deviation increase in board co-option reduces the probability of clawbacks by approximately 6%. To further identify the causal effect of board co-option on clawbacks, we use the death of directors as an instrument for board co-option; the underlying assumption is that the death of directors allows the CEO to increase the degree of board co-option but that these factors do not have a direct effect on clawbacks. Using two-stage least squares (2SLS) regressions with this instrument, we continue to find that greater board co-option reduces the likelihood of clawbacks.

Next, we examine how board co-option is an underlying mechanism through which CEOs can exert their power to reduce the likelihood of clawbacks. Using CEO tenure as a proxy for CEO power, we find significant evidence that CEO power is associated with higher board co-option, which is in turn associated with a reduced likelihood of clawbacks. We use a Sobel (1982) test to provide further evidence of the statistical significance of board co-option as a mediating mechanism linking CEO power and clawbacks. Interestingly, we do not find that CEO power (or at least CEO tenure) has a direct effect on clawbacks after controlling for board co-option. One possible explanation is that the implementation of a clawback is a board policy and the ability to have “control” the membership of the board is an important mechanism via which a powerful CEO influences board policies.

Finally, we run two sets of cross-sectional analyses to enrich our examination of how the beholdenness of the board to the CEO affects clawback, as well as to provide some supporting identification of the causal effect. First, we rely on the natural assumption that co-opted board directors are more likely to influence the use of a clawback policy if they are on the compensation committee because a clawback policy is essentially part of a firm’s entire remuneration policy. Consistent with our expectations, we find that the negative association between board co-option and clawbacks is more pronounced when at least one co-opted member is present on the compensation committee. Second, we examine how the likelihood of enforcement of clawback provisions moderates the effect of board co-option on clawbacks. We conjecture that co-opted boards are less likely to use clawbacks if there is a higher likelihood that he/she will have to act against the CEO in the future by enforcing clawback provisions. Using material internal control weaknesses and prior restatements to proxy for the need to enforce clawback in the future, we find evidence supporting this conjecture.

The full paper is available for download here.