paid to executive ofﬁcers who committed wrongdoing. Whilethe SEC has not yet ﬁnalized
this rule, many companieshave adopted their own clawback polices.
By allowing ﬁrms to recoup compensation from executives in case of a breach of their
ﬁduciary duty to the ﬁrm, clawbacks providea form of discipline that is likely to reduce the
likelihood of wrongdoing by corporate managers. While compensation clawbacks provide
an ex-ante form of discipline, the legal and ﬁnancial systems provide several ex-post
disciplinary mechanisms. Amongthose, corporate litigation is one of the most common and
costly. In the wake of the ﬁnancial crisis, ﬁnancialﬁrms along with other corporations have
been sued numeroustimes and, in many cases, have paid multibillion-dollar settlements.
We study the relation between compensation clawbacks and lawsuits and analyze how
these two corporate disciplinary forces interact over time. We ﬁrst ask whether litigation
risk affects a ﬁrm’s decision to adopt a clawback provision. We then examine whether
clawback adoption discourages future lawsuits or diminishes the severity of lawsuits
(measured by both the dismissal likelihood and the eventual settlement amount). Prior
literature on litigation riskand corporate lawsuits has found that the threat of litigation and
actual lawsuits can motivate a ﬁrm’s decision to improve corporate governance practices
(Humphery-Jenner, 2012;Ferris et al.,2007;Marciukaityte et al.,2006; and Farber, 2005).
Thus, we hypothesize that ﬁrms with higher litigation risk are likely to improve their
governance by adopting clawback policies. Furthermore, prior work on clawbacks shows
that adopting compensation clawbackpolicies affects subsequent corporate activities (Chan
et al., 2012;Iskandar-Datta and Jia, 2013; and Babenko et al., 2017). We contend that
companies experience a decline in litigation risk after the implementation of clawback
provisions and that lawsuits ﬁled against ﬁrms with clawbacks are less severe, are more
likely to be dismissedor are associated with lower settlement costs.
Using a sample of S&P 1500 ﬁrms from 2007 to 2014, we ﬁnd that ﬁrms exposed to
higher litigation riskare more likely to adopt clawback provisions. Furthermore,our results
show that after the adoption of clawbacks, litigation risk declines signiﬁcantly, supporting
our hypothesis that clawback policies are effective in reducing the likelihood of corporate
lawsuits. Speciﬁcally, we ﬁnd that after clawback adoption, on average, ﬁrms experience 1
per cent lower risk of being sued in the next three years. We also ﬁnd that when lawsuits
occur, ﬁrms with clawback policies are more likely to have such lawsuits dismissed or
settled for a lower amount compared to other ﬁrms. Speciﬁcally, ﬁrms with clawback
policies have 51 per cent higher probability of a lawsuit being dismissedand 12-14 per cent
lower settlement costs. Clawbacks, therefore, reduce bothlitigation risk and litigation costs.
Overall, our ﬁndings suggest thatcompanies strategically adopt clawback provisions as an
internal disciplinary mechanism to effectively reduce the incidence of costlier ex-post
disciplinary forcessuch as lawsuits.
Our paper contributes to both the extensive literature on executive compensation
regulations and the growing bodyof research on corporate litigation. As a major innovation
in contracting between the ﬁrms and the CEOs, clawbacks have attracted signiﬁcant
interest from academics. Recent work has focused on the causes and consequences of
adopting compensationclawback policies. However, the effectiveness of clawback policiesis
unclear. We are the ﬁrst to analyze the relation between clawbacks and corporate litigation
and show how clawback policies couldbe effective. Furthermore, our ﬁndings have practical
implications, as they suggest that the SEC rule, if implemented, could signiﬁcantly reduce
overall corporatelitigation risk.
The remainder of the paper proceeds as follows. Section 2 includesa brief review of the
literature and motivates our hypotheses. Section 3 provides description of our sample and