Academic journal article Journal of Business and Accounting

Clawback Provisions, Firm Performance, and Risk Shifting

Academic journal article Journal of Business and Accounting

Clawback Provisions, Firm Performance, and Risk Shifting

Article excerpt

ABSTRACT

The number of publicly-traded firms that have voluntarily adopted clawback provisions in executive compensation packages has grown significantly since 2005. Section 304 of the Sarbanes-Oxley Act (2002) gives the SEC the power to recover certain executive compensation on behalf of the issuer, if the issuer is required to restate its financial statements when there is a suspicion of corporate misconduct, even when the affected executives are not personally guilty of misconduct. The Act is an attempt to increase management accountability by requiring the CEO and CFO to repay the firm for 'any bonus or other incentive-based or equity-based compensation' as well as any profits from the sale of securities during the 12-month period following the period being restated even if the misconduct was by another employee. In this study, we examine the impact of clawback provisions on firm performance and risk posture. Specifically, we focus on firms' earnings and leverage during the preand post-Sarbanes-Oxley periods and the period before and after clawback provisions adoption, to determine if there are any differences in performance or any evidence of risk shifting. The results indicate an increase in leverage following a clawback provisions adoption, consistent with risk shifting. Our hypothesis of an increase in firm performance was not supported.

INTRODUCTION

Section 304 of the Sarbanes-Oxley Act (2002) which was passed in response to the accounting scandals that occurred in the early 2000s, empowered companies to "claw back" certain executive bonuses and stock profits under the following conditions:

"If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for-

1. any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and

2. any profits realized from the sale of securities of the issuer during that 12-month period."

Although the regulation has been in effect since 2002, only 29% of the S&P 500 companies had adopted a clawback provision as of 2008 (Addy and Yoder, 2011). To encourage companies to adopt and disclose these provisions, the SEC altered section 402(b)(2)(iii) of Regulation S-K in 2006 in response to a recommendation by the Council of Institutional Investors requesting companies to disclose any "clawback" provisions in their Compensation Discussion and Analysis of the proxy statement. If a company does not have such a policy, it has to disclose the fact along with the reasons for the absence of such a policy. Companies therefore need not adopt "clawback" provisions, but if they decide to do so, they have to disclose them.1 Fewer than 30 percent of the S&P 500 companies had a "clawback" provision in place by 2008 with the majority found in the materials and telecommunications sectors and the lowest percentage found in the consumer staples sector (Addy and Yoder, 2011).

The board of directors of each company must decide if they want to adopt the clawback provisions. If they do adopt the provisions, the company must disclose the individuals to whom the provisions must apply, the types of awards to be affected, the circumstances that would trigger the clawback provisions (material restatement or any error in financial information), the type of conduct that would trigger the clawback provision (including misconduct by a particular individual from whom the firm decides to recover excess compensation, or misconduct by any employee), and how far back the clawback provision must reach (Goodman, 2008). …

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