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E-MailGary C. Biddle is Professor of Financial Accounting at the University of Melbourne; Lilian H. Chan is Associate Professor of Accounting at the University of Hong Kong; and Jeong Hwan Joo is Assistant Professor of Accounting at the University of Hong Kong. This post is based on a recent paper by Professors Biddle, Chan, and Joo. Related research from the Program on Corporate Governance includes Rationalizing the Dodd–Frank Clawback by Jesse Fried (discussed on the Forum here).
This study presents evidence that capital investment choices are influenced by voluntary adoptions of clawback provisions that authorize boards of directors to recoup executive compensation based on financial results that are later restated. Restitutive clawbacks were sanctioned by Sarbanes-Oxley Act Section 304 in response to allegations in the early 2000s that executive compensation was boosted by financial misreporting. Despite lax enforcement by the U.S. Securities and Exchange Commission (SEC), U.S. listed firms voluntarily adopting clawback clauses rose from 19 in 2005 to 1,032 in 2012. Similar allegations arising during the 2008-2009 financial crisis motivated Dodd-Frank Act Section 954 to bar U.S. exchange listings by companies lacking clawback policies. A pending SEC rule to implement DFA 954 observes that “while these incentives could result in high-quality financial reporting that would benefit investors, they may also alter operating decisions of executive officers.” It also requests “comment on any effect the proposed requirements may have on efficiency, competition and capital formation (SEC 2015, 103-104).”
Consistent with their purported benefits, prior research finds clawbacks to enhance financial reporting quality as evidenced by fewer restatements, larger earnings response coefficients, fewer reported internal control weaknesses, lower audit fees, quicker audit reporting, lower borrowing costs, reduced loan collateral, longer loan terms, positive stock price reactions, and higher sensitivity of chief executive officer (CEO) annual pay to reported earnings (Babenko, Bennette, Bizak, and Coles 2015; Chan, Chen, Chen, and Yu 2012; Chan, Chen, and Chen 2013; Chen, Green, and Owers 2014; Dehaan, Hodge, and Shevlin 2013; Iskandar-Datta and Jia 2013). Related findings indicate that enhanced financial reporting quality increases capital investment efficiency, suggesting a substantive potential clawback benefit (e.g., Biddle and Hilary 2006; Biddle, Hilary, and Verdi 2009; McNichols and Stubben 2008), yet no direct evidence exists. Pertinently, Chan, Chen, Chen, and Yu (2015) report that clawback adoptions induce managers to engage in real transactions manipulation (e.g., cutting research and development expenses) to preserve expected compensation. Because R&D expenses are synonymous with R&D investments (hereafter R&D), these findings raise questions of how clawbacks affect capital investment mix choices and how they affect capital investment efficiency.
Prior analytical research suggests possible relations among clawback adoptions, performance-based compensation, earnings management, and capital investment choices. Benmelech, Kandel, and Veronesi (2010) show for a setting in which executives possess private information regarding investment opportunities, boards and market participants rely on earnings to evaluate them, and executives receive stock-based compensation (including annual equity grants, changes in the value of equity holdings, stock-price-linked dismissal), there arise incentives to manage earnings. In particular, executives of firms with high growth opportunities have incentives to exploit growth options and if growth slows, to manage earnings and even forego R&D projects to maintain a pretence of high earnings growth. Kedia and Philippon (2009) show that executives with stock-based compensation not only manage earnings but also hire and invest to mask a decline in investment opportunities. By mitigating incentives to boost pay using overstated earnings that might later be restated (Chen et al. 2014; Benmelech et al. 2010), clawback provision adoptions provide executives with incentives to rely more on other means to preserve expected compensation (Ewert and Wagenhofer 2005; Chan et al. 2015). Recent evidence by Chan et al. (2015) that firms adopting clawback provisions reduce R&D expenses and thus expenditures, while consistent with incentives to preserve earning-linked compensation, begs whether executives thereby lower total capital investment and longer-term value, or rather shift capital investment mix so as to better preserve longer-run profitability and firm value.
By this reasoning, we posit that managers respond to clawback provision adoptions by shifting their capital investment mix away from R&D as previously found, and toward property, plant, and equipment (hereafter capex) and also acquisitions conditional on enabling liquidity, with the effects of clawback adoptions on total capital investment an open empirical question. Our reasoning reflects that R&D investments reduce earnings immediately with generally delayed and less certain paybacks (Bhagat and Welch 1995; Kothari, Laguerre, and Leone 2002; Coles, Daniel, and Naveen 2006). By comparison, capex expenditures generate formulaic amortization and depreciation charges and nearer-term profits from generally extant business contexts. While acquisition investments can immediately enhance and may never reduce earnings, they also require enabling liquidity, integration with existing operations, and can often require lead-times to execute. The increased proportion of performance-based pay associated with clawback adoptions documented in prior studies is consistent with both enhanced precision in earnings measurement and earnings and risk offsets for managers and provides added incentive to shift investment mix.
We test these propositions using a propensity-matched sample of 4,200 firm-years for 463 voluntary clawback adoptions between 2005 and 2012 inclusive. Our findings are consistent with clawback adoptions inducing capital investment mix shifts from R&D to capex expenditures, and to acquisition expenditures for firms with enabling liquidity. Increased capital expenditures by clawback adopters are positively associated with the likelihood of overinvestment in property, plant, and equipment beyond a level supported by investment opportunities, consistent with an induced investment shift. Corroborative sub-sample tests confirm significant reductions in R&D investments and significant increases in capital expenditures for firms with higher proportions of performance-based pay, and for firms with higher market-perceived growth opportunities, thus lending support to the effects of clawback adoptions operating via compensation incentives. A sub-sample test also confirms that clawback adoptions are positively associated with the likelihood of overinvestment in property, plant, and equipment and in total capital assets for firms with higher proportions of performance-based pay. The shift in capital investment mix and capital overinvestment remain identical after controlling for the risk-toleration incentives related to executive equity portfolio, indicating that the ex post settling up mechanism introduced by clawback adoptions has a significant incremental effect on capital investment mix.
Our findings contribute to prior research in several ways. First, we extend prior evidence regarding the effects of clawback adoptions to reveal that the R&D reductions documented in Chan et al. (2015) comprise part of a broader capital investment mix shift away from R&D and toward capex and acquisitions investments conditional on enabling liquidity. Second, we show that this shift in capital investment mix results in overinvestment in capital assets. Combined, these findings suggest an unintended consequence of clawback provisions that can help inform a pending proposal for clawback provisions to be a listing pre-condition for U.S. exchanges. Third, our findings contribute insights regarding the relation between financial reporting quality and capital investment efficiency. Whereas prior studies document that higher financial reporting quality can enhance capital investment efficiency by mitigating capital underinvestment associated with financial constraints and capital over-investment associated with free cash flows by enhancing transparency (e.g., Biddle and Hilary 2006; McNichols and Stubben 2008; Hope and Thomas 2008; Biddle et al. 2009; Chen, Hope, Li, and Wang 2011; Cheng, Dhaliwal, and Zhang 2013; Chen, Young, and Zhuang 2013; Lo 2015; Biddle, Callahan, Hong, Knowles 2016), our findings indicate that countervailing actions taken by executives to clawback adoptions can decrease, rather than increase, capital investment efficiency even when financial reporting quality is enhanced by clawback provision adoptions. Finally, the increased likelihood of capital overinvestment associated with clawback adoptions differs from the well-documented empire-building proclivity in the sense that the former stems from a shift in capital investment mix that attempts to preserve incentive-based compensation whereas the latter is motivated by executives’ direct preference for a larger salary associated with firm size irrespective of incentive alignment (Jensen 1986).
The complete paper is available for download here.
