CHAPTER 1 INTRODUCTION
1.3 The Interaction of Equity-based Compensation and Clawback Provisions
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voluntary adoptions (e.g., Gao et al. 2010). A well-crafted clawback policy can enhance a firm’s overall compensation strategy by establishing a viable disincentive against fraud, misconduct, and excessively risky or otherwise harmful acts. Other regulatory agencies and the press explicitly recognize clawbacks as one of the tools a firm can use to manage compensation related risks (e.g., Leaders’ statement 2009; Scott et al. 2010).
The firms voluntarily adopt clawback provisions by showing clawback information in the disclosure in firms’ Compensation Discussion and Analysis (CDA), a portion of firms’ definitive proxy statement (Form 14A-DEF). The clawback provisions are generally applied to all executives and board members. Since Caskey et al. (2010) points out that audit committees’ penalties for not diligently collect information during their oversight process are too low, it is reasonable to expect that clawback provisions shall constitute a form of monetary penalty that may affect audit committees’ ex ante effort in monitoring firms’ financial reporting.
1.3 The Interaction of Equity-based Compensation and Clawback Provisions
Equity-based compensation and clawback provisions create two counterbalancing forces on audit committees’ oversight effectiveness. On the one hand, prior auditing studies show that stock options could potentially weakens audit committee independence, leading to oversight failurs reported in restatements, internal control weakness and earnings management (e.g., Archambeault et al. 2008; Bédard et al. 2004; Cullinan et al. 2010). On the other hand, clawback provisions create one form of monetary penalties on audit committees’ oversight failures (e.g., Caskey et al. 2010).7 Therefore, whether firms’ clawback provisions mitigate the adverse influence of equity-based compensation on audit committees’ effectiveness is an empirical question and deserves more in-depth examination.8 Currently, such evidence is rare, if exists.
7While Caskey et al. (2010) concluded that audit committee parameters affect not just the ex post reporting process, but also the ex ante information-collection process, I extend this notion to suggest that misreporting penalties (i.e., clawback provisions) affect audit committees’ ex ante effort on collecting due-diligence information.
8This empirical question seems to the second-order effect of clawback provisions. Although the first-order effect (i.e., the association clawback provisions and financial reporting quality) is tested in prior literature, I attempt to consider the role of audit committees on financial reporting process by showing the second-order effects. Considering audit committees and CEOs can help understand how clawback provisions affect firm participants’ quality, leading to high financial reporting quality.
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Using all S&P 500 firms and controlling for endogenous biases, I find that clawback provisions significantly mitigate the adverse effects of equity-based compensation on audit committees’ oversight effectiveness. These findings enrich the growing literature that examines the association between equity-based compensation and audit committees’ effectiveness (e.g., Archambeault et al. 2008; Bédard et al. 2004; Cullinan et al. 2010). To the best of my knowledge, my study is the first one that investigates the issue of whether firms’ voluntary adoption of clawback provisions mitigates the unfavorable effects of the use of equity-based compensation for their audit committees.
Because a observed decrease in audit committees’ oversight failure could be driven by the decreased CEO manipulation in reported earnings, I thus control for CEO compensation by classifying all sample into two subsamples: high and low CEO equity-based compensation groups.
Desai et al. (2006) finds that, if managers understand that their fraudulent behavior will be penalized ex post, they should have less incentive to engage in earnings manipulation ex ante. The control for this possibility does not affect my empirical results notably, and clawback provisions themselves mitigates the adverse effects of the equity-based compensation for their audit committees, no matter what type of firms’ CEO compensation.
While the content of clawback provisions may vary widely with the language of any particular contract, Chrry and Wong (2009) suggests that clawback provisions could be triggered under three circumstances: misconduct or fraud, the restatement of financial results, or the event of employees’
bad faith. I use Chrry and Wong’s (2009) categorization to analyze the possibly differential influences of these three triggers. Since regulators require firms to adopt recoupment policy on firms’ compensation agreement from 2012, the evidence of differential trigger effects from voluntary clawback adoption provides implications for the mandatory clawback provisions.
I find that clawback provisions strengthen audit committees’ oversight effectiveness, especially when firms use bad faith events as the trigger. This finding makes three contributions to the literature and the practice. First, Caskey et al. (2010) models a financial reporting process to define
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audit committees’ ex ante information-collection process. However, it is hard to observe audit committees’ diligence during the financial reporting monitoring. I extend Caskey et al. (2010) by providing empirical evidence of the association between clawback provisions and the monitoring outcome of audit committees. Second, I show the differential effects of ckawback triggers.
Although prior literature suggests that clawback provisions have a beneficial impact on financial reporting quality (e.g., Chan et al. 2012a; DeHaan et al. 2011), the diversity of clawback provision has not been discussed. The result in this paper indicates that the benefits of clawback provisions are driven by specific “bad faith” triggers. Third, my empirical results are expected to have useful implications for the mandatory clawbacks that will become effective in July 2012. Under Section 954 of the Dodd-Frank Act, clawback provisions will be triggered only when firms incur restatements. I find no significant association between restatement triggers and audit committees’
effectiveness. Since CEOs and directors could engage in bad faith actions which probably do not cause restatements, regulators shall impose extra restrictions on the triggers of clawback provisions to increase the recoupment effects.
The remainder of this dissertation is organized as follows. Section 2 discusses the background, relevant literature and hypothesis development. Section 3 describes the sample selection procedure and research design. Section 4 reports the descriptive statistics and empirical results. Section 5 contains summary and conclusion.
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CHAPTER 2 BACKGROUND, LITERATURE AND HYPOTHESIS DEVELOPMENT