Compensation clawback policies and corporate lawsuits

Author:Matteo P. Arena, Nga Q. Nguyen
Position:Marquette University, Milwaukee, Wisconsin, USA
Pages:70-85
SUMMARY

Purpose The purpose of this paper is to study the relation between compensation clawbacks and lawsuits and analyze how these two corporate disciplinary forces interact. This paper hypothesizes that by allowing firms to recoup compensation from managers who breach their fiduciary duty, clawbacks provide a form of discipline that potentially reduces the likelihood of managerial wrongdoing,... (see full summary)

 
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Compensation clawback policies
and corporate lawsuits
Matteo P. Arena and Nga Q. Nguyen
Marquette University, Milwaukee, Wisconsin, USA
Abstract
Purpose The purpose ofthis paper is to study the relation between compensationclawbacks and lawsuits
and analyze how these two corporatedisciplinary forces interact. This paper hypothesizes that by allowing
rms to recoup compensation from managers who breach their duciaryduty, clawbacks provide a form of
discipline that potentiallyreduces the likelihood of managerial wrongdoing, which, in turn, lowersthe risk of
corporatelawsuits.
Design/methodology/approach This paper identieswhether or not a company in the S&P 1500 had
a clawback policy between2007 and 2014 by searching the company lings and press releases. The authors
also construct differentproxies for litigation risk and lawsuit outcomes using the Audit Analytics Database.
They then perform a variety of empiricaltests to examine the association between clawbacks and litigation
risk and the associationbetween clawbacks and litigation outcomes.
Findings This paper ndsthat rms with higher litigation risk are more likely to adopta clawbackpolicy.
In addition, after the adoption of clawback provisions, litigation risk signicantly declines, suggesting that
clawback policies are effective in reducing the likelihood of corporate lawsuits. Furthermore, rms with
clawback policies are approximately 50 per cent more likely to have lawsuits against them dismissed or
settledfor lower amounts(approximately 12 per cent lower).
Practical implications The ndings of thispaper provide insights to the efcacy of a current change in
compensationregulation, the mandatory clawback adoption requirementby the DoddFrank Act of 2010.
Originality/value This paper contributes to the literature on both clawbacks and litigation,as it is the
rst to analyze the relationbetween the two.
Keywords Risk management, Executive compensation, Litigation risk,
Clawback corporate lawsuits, Corporate litigation
Paper type Research paper
1. Introduction
Excessive risk-taking, negligence and wrongdoing by nancial executives in the past
decade contributed to the 2008 US nancial crisis, which culminated in a deep global
recession. As a response to this crisis,in 2010, congress passed the DoddFrank Wall Street
Reform and Consumer Protection Act (DoddFrank)which requires numerous government
bodies to institute several reforms with the goal of increasing nancial stability. One
important change related to executive pay is the mandatory adoption of clawback
provisions. On July 1, 2015, the Securities and Exchange Commission(SEC) proposed rules
that would require listedcompanies to claw back all or part of the undeserved compensation
JEL classication G30, G34, G38, K20, K22
The authors would like to thank two anonymous referees, John Ashton (the editor), Patty Bick and
participants of the 2017 Annual Meeting of the Financial Management Association for helpful
comments and suggestions. They thank Victoria Fasi for valuable research assistance. This research
was supported in part by the Marquette University Miles grant.
JFRC
27,1
70
Journalof Financial Regulation
andCompliance
Vol.27 No. 1, 2019
pp. 70-85
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-10-2017-0081
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
paid to executive ofcers who committed wrongdoing. Whilethe SEC has not yet nalized
this rule, many companieshave adopted their own clawback polices[1].
By allowing rms to recoup compensation from executives in case of a breach of their
duciary duty to the rm, 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 nancial systems provide several ex-post
disciplinary mechanisms. Amongthose, corporate litigation is one of the most common and
costly. In the wake of the nancial crisis, nancialrms 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 rst ask whether litigation
risk affects a rms 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 rms decision to improve corporate governance practices
(Humphery-Jenner, 2012;Ferris et al.,2007;Marciukaityte et al.,2006; and Farber, 2005).
Thus, we hypothesize that rms 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)[2]. We contend that
companies experience a decline in litigation risk after the implementation of clawback
provisions and that lawsuits led against rms with clawbacks are less severe, are more
likely to be dismissedor are associated with lower settlement costs.
Using a sample of S&P 1500 rms from 2007 to 2014, we nd that rms exposed to
higher litigation riskare more likely to adopt clawback provisions. Furthermore,our results
show that after the adoption of clawbacks, litigation risk declines signicantly, supporting
our hypothesis that clawback policies are effective in reducing the likelihood of corporate
lawsuits. Specically, we nd that after clawback adoption, on average, rms experience 1
per cent lower risk of being sued in the next three years. We also nd that when lawsuits
occur, rms with clawback policies are more likely to have such lawsuits dismissed or
settled for a lower amount compared to other rms. Specically, rms 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 ndings 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 rms and the CEOs, clawbacks have attracted signicant
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 rst to analyze the relation between clawbacks and corporate litigation
and show how clawback policies couldbe effective. Furthermore, our ndings have practical
implications, as they suggest that the SEC rule, if implemented, could signicantly 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
Compensation
clawback
policies
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