Do Voluntary Clawback Adoptions Curb Overinvestment?

• Published date: 01 July 2017
• Author: Yu‐Chun Lin
• DOI: http://doi.org/10.1111/corg.12194
• Date: 01 July 2017

ORIGINAL ARTICLE

Do Voluntary Clawback Adoptions Curb Overinvestment?

Yu‐Chun Lin

Finance Shih Hsin University, Taiwan

Correspondence

Yu‐Chun Lin, Department of Finance, Shih

Hsin University, No. 111, Sec. 1, Muzha Rd.,

Wenshan Dist., Taipei City 116, Taiwan

(R.O.C.). Tel.: 886 222368225 Ext. 63433.

Email: tifny@cc.shu.edu.tw

Funding information

Ministry of Science and Technology, Taiwan,

Grant/Award Number: 102‐2410‐H‐128‐036.

Abstract

Manuscript TypeEmpirical

Research Question/IssueThis study tests whether the adoption of clawback provisions

mitigates overinvestment. A clawback provision is a recoupment policy that allows certain

bonuses previously paid to executives to be cancelled or “clawed back”if financial statements

are restated.

Research Findings/InsightsThis study focuses on 1,093 voluntary clawback adopters in

the United States during 2006–2012 and uses propensity score matching to obtain a matched

sample. We then perform a difference‐in‐differences analysis to assess pre‐and post‐adoption

changes in overinvestment. The empirical results show that (i) clawback provisions mitigate over-

investment, and (ii) overinvestment decreases most for those executives identified as overconfi-

dent or receiving higher option compensation.

Theoretical/Academic ImplicationsAgency conflict between shareholders and executives

distorts a firm's investment decisions. According to the agency‐based explanation, better financial

reporting quality decreases information asymmetry. Clawback provisions improve financial

reporting and mitigate potential overinvestment under agency conflict. To the best of our knowl-

edge, no other published study has discussed executives’investment behavior or has reported

that one benefit of clawback provisions is mitigating ex post overinvestment. It is important for

regulators and academics to understand how clawback provisions impact executives’behavior.

Practitioner/Policy ImplicationsThe results of this study provide political implications for

mandatory clawback provisions under Section 954 of the Dodd‐Frank Act after 2016 in the US.

Given that we show that voluntarily adopting clawback provisions curbs overinvestment, it is

important to examine whether this new act should place restrictions on the form of executive

pay.

KEYWORDS

Corporate Governance, Clawback Provisions, Compensation,Overinvestment

1|INTRODUCTION

The information asymmetry existing between shareholders and execu-

tives represents a classic principal–agent problem. According to

agency theory (e.g., Cuevas‐Rodríguez, Gomez‐Mejia, & Wiseman,

2012; Jensen & Meckling, 1976; Marris, 1964; Williamson, 1964),

executives’and shareholders’utility functions diverge: shareholders

want the firm to pursue profit maximization, whereas executives’

interests are more aligned to continual expansion (because growth

reduces managerial risk while increasing managerial compensation;

e.g., Murphy, 1985, 1986). According to the free cash‐flow hypothesis

(e.g., Jensen, 1986) as well as the firm life‐cycle hypothesis (e.g.,

Mueller, 1972), agency problems between shareholders and execu-

tives can lead to the overutilization of managerial discretion, resulting

in overinvestment (Hoskisson & Turk, 1990; Kuo & Hung, 2012).

Moreover, agency conflict can distort a firm's investment decisions,

again leading to a scenario of overinvestment.

The agency cost explanation introduced by Jensen (1986) and

Stulz (1990) suggests that information asymmetry is mitigated by man-

agers producing financial statements. Prior research reveals that higher

quality financial reporting lessens information asymmetry, leading to

decreased agency costs (Gompers, Ishii, & Metrick, 2003).

Received: 26 February 2016Revised: 22 December 2016Accepted: 22 December 2016

DOI: 10.1111/corg.12194

Corp Govern Int Rev. 2017;25:255–270.© 2017 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg255

Furthermore, the reported information is used by shareholders to

monitor managerial investment activities (Biddle, Hilary, & Verdi,

2009; Lambert, 2001). Jensen (1986) and Myers (1977) suggest that

financial reporting quality is negatively associated with investment

among those firms that are more likely to overinvest. While there are

numerous theoretical justifications explaining why high‐quality finan-

cial reporting mitigates overinvestment, there is limited empirical evi-

dence that directly supports this hypothesis.

This study tests whether the adoption of clawback provisions

results in a decrease in executives’overinvestment. Clawback provi-

sions are designed to recover certain bonuses paid to executives in

the event that firms restate their financial statements. Prior literature

suggests that firms adopting clawback provisions have higher quality

earnings (Dehaan, Hodge, & Shevlin, 2013) and generate fewer earn-

ings restatements (Chen, Greene, & Owers, 2015). Higher financial

reporting quality could curb managerial incentives to engage in

value‐destroying activities such as overinvestment. Biddle et al.

(2009) document a negative association between financial reporting

quality (i.e., accrual quality) and investment levels for firms operating

in settings more prone to overinvestment. The prior literature does

not clearly establish that executives who confront governance mecha-

nisms to improve earnings quality carry out less overinvestment. Given

the improved financial reporting quality after the adoption of clawback

provisions (e.g., Chan, Chen, Chen, & Yu, 2012; Dehaan et al., 2013),

we predict that overinvestment will decrease after firms voluntarily

adopt clawback provisions.

We further examine whether clawback provisions can mitigate

overinvestment in the case of overconfident executives. Prior litera-

ture suggests that executive overconfidence affects corporate invest-

ment, financing, and dividend policies (e.g., Cordeiro, 2009;

Deshmukh, Goel, & Howe, 2013; Hirshleifer, Low, & Teoh, 2012;

Malmendier & Tate, 2008; Malmendier, Tate, & Yan, 2011). An

agency‐based explanation suggests a positive relation between execu-

tive overconfidence and overinvestment (Biddle & Hilary, 2006; Hope

& Thomas, 2008; McNichols & Stubben, 2008). When executives are

too optimistic about their ability to generate future value, they are

more likely to pursue innovation. Babenko, Bennett, Bizjak, and Coles

(2015) suggest that clawback provisions potentially reduce firm risk

taking, as manifested in lower stock return volatility, lower R&D

expenditures, and fewer patent applications. Therefore, whether

clawback provisions influence overconfident executives is an open

empirical question. Babenko et al. (2015) do not provide direct

evidence on the relationship between clawback provisions, CEO

overconfidence, and overinvestment. We use the interactions in our

regression model to examine the effects of clawback provisions on

overinvestment when executives are overconfident.

Prior studies provide some evidence that options compensation

can induce opportunistic behavior among executives (Bebchuk & Stole,

1993; Carpenter, Indro, Miller, & Richards, 2010; Stein, 1989;

Yermack, 1997). Other studies find that compensation through stock

options can motivate executives to make riskier investments

(Carpenter et al., 2010; Efendi, Srivastava, & Swanson, 2007; Morgan

& Poulsen, 2001; Smith & Stulz, 1985). The adoption of clawback pro-

visions has already been shown to improve financial reporting quality

(Dehaan et al., 2013) and make executives averse to taking risks

(Babenko et al., 2015), so we will further examine whether these pro-

visions mitigate overinvestment among those executives receiving

options compensation.

The period of this study is from 2006 to 2012. We collect data for

clawback adopters from the LexisNexis academic database. We utilize

propensity scores to find a matched sample and use a difference‐in‐

differences design to analyze changes in overinvestment before and

after clawback adoption. Following D’Mello and Miranda (2010) and

Richardson (2006), we use two measures as proxies for overinvest-

ment: (i) a capital expenditure ratio above the industry median and (ii)

abnormal investment. Dummy variables for overinvestment are used

in a logistical regression model.

1

Consistent with the agency cost

explanation, the empirical results show that firms experience a

decrease in the likelihood of overinvestment after the adoption of

clawback provisions. We also find that clawback provisions curb exec-

utive overinvestment for those executives identified as overconfident

or receiving compensation through options.

The empirical results contribute to the literature in many ways.

First, prior studies do not clearly establish whether clawback provi-

sions mitigate information asymmetry in the agency conflict and thus

lead to decreased overinvestment. No other published study has

reported that a benefit of clawback provisions is mitigating ex post

overinvestment. Prior studies investigated the impact of firms’volun-

tary adoption of clawback provisions on their financial reporting qual-

ity and the market's reaction to these voluntary adoptions (e.g., Brown,

Davis‐Friday, Guler, & Marquardt, 2015; Cashman, Harrison, &

Panasian, 2016; Chan et al., 2012; Dehaan et al., 2013; Iskandar‐Datta

& Jia, 2013; Pyzoha, 2015). However, little is known about whether

clawback provisions affect executives’investment behavior.

Second, our findings contribute to a growing body of literature

that studies relations between financial reporting quality and invest-

ment (e.g., Bens & Monahan, 2004; Biddle & Hilary, 2006; Hope &

Thomas, 2008; McNichols & Stubben, 2008). Biddle and Hilary

(2006) find that firms with higher quality financial reporting exhibit

higher investment efficiency. We further suggest that clawback provi-

sions, which serve as a tool to improve financial reporting quality, mit-

igate the overinvestment resulting from information asymmetry driven

by principal–agent problems.

The remainder of this study is organized as follows. The next sec-

tion discusses the background, relevant literature, and hypothesis

development. The third section describes the sample selection proce-

dure and research design. The fourth section reports the empirical

results. The final section presents our conclusion and contributions.

2|LITERATURE REVIEW AND HYPOTHESIS

DEVELOPMENT

2.1 |Institutional Background

Section 304 of the Sarbanes‐Oxley Act of 2002 (SOX) authorizes the

Securities and Exchange Commission (SEC) to recoup certain execu-

tives’bonuses when firms restate their financial statements because

of material noncompliance or misconduct. The SEC rarely enforces this

provision (Chan, Chen, Chen, & Yu, 2015). In 2015, UnitedHealth

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