Clawback - Explained
What is a Clawback?
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What is a Clawback?
Clawback describes when an employer recovers already disbursed money from an employee, likely with an additional penalty. There are federal laws enacted and proposed which provide for clawbacks associated with executive compensation coming from accounting errors or fraud. Employee contracts provided by companies may include clawback provisions, regardless if laws are requiring there to be such provisions, which allow employers to take back any bonuses they have previously paid out.
How Does Clawback Work?
Clawbacks are specific clauses in contracts regarding money that's offered for services that are given back contingent on circumstances outlined in the agreement. The provisions are made so as to prevent the use of incorrect information by an individual. For example, in the financial industry a clawback is to avert the misapplication of accounting details. Clawbacks put a balance between community or economic progress and corporate advantage. Before 2005, clawback provisions were less than three percent for Fortune 500 companies. They rose nearly 82 percent by 2010. Clawback is a term found in other settings as well. When it is used in private equity, it alludes to the right of limited partners to recover a portion of the general partners carried interest, which is a reserved incentive for the management of the firm or an investing venture capitalist, in situations when the resultant losses mean the general partners get paid excess compensation. A clawback is determined at the time a fund is liquidated. Medicaid can clawback, from deceased patients estates, costs of care. A case when clawbacks don't involve money would be when an attorney clawbacks confidential documents unintentionally turned over during electronic discovery. The Sarbanes-Oxley Act of 2002 was the first federal statute to approve clawbacks of executive pay. In the event of company misconduct, not necessarily committed by executives, that leads to the restatement of the firm's financial performance, the statute provides for clawbacks of incentive-based compensation, such as bonuses, paid to CFOs and CEOs. In 2008, the Emergency Economic Stabilization Act, which was amended the following year, allowed for incentive-based compensation paid to an executive or the next 20 employees paid the highest. The laws are only applicable to organizations that get TARP (Troubled Asset Relief Program) funds. Regardless of misconduct, this law applies when financial outcomes are found to be inaccurate. In 2015, an SEC (Securities and Exchange Commission) rule was proposed associated with 2010's Dodd-Frank Act that would let companies clawback incentive-based pay to executives in cases of an accounting restatement. The limitations of the clawback are only the excess of what would have been paid based on the restated results. The rule would mean stock exchanges had to prohibit companies from being listed if they did not have such clawback provisions detailed in their contracts. Clawbacks can be found in the areas of government contracts, dividends under specific circumstances, and life insurance.
Academic Research on Clawbacks
- The effects of firm-initiated clawback provisions on earnings quality and auditor behavior, Chan, L. H., Chen, K. C., Chen, T. Y., & Yu, Y. (2012). Journal of Accounting and Economics, 54(2-3), 180-196. Despite the popularity of clawbacks and the enactment of the Dodd-Frank Act, little is known about the effectiveness of the provisions. The authors find that cases of accounting restatements reduction after including such provisions. They show how auditors and investors consider having clawback provisions in place is a sign of increased accounting quality and lowered audit risk. The adoption of provisions has shown to improve a companys earnings response coefficients. Auditors will issue audit reports with shorter lag and charge lower audit fees if firms adopt clawbacks.
- Does voluntary adoption of a clawback provision improve financial reporting quality?, Dehaan, E., Hodge, F., & Shevlin, T. (2013). Contemporary Accounting Research, 30(3), 1027-1062.Shevlin examines the financial reporting quality of a firm that adopts compensation clawback provisions. Following the Sarbanes-Oxley Act of 2002, clawbacks became increasingly more prominent as a direct link of executive's compensation to behavior. It is a governance mechanism used to deter various trigger events, ranging from ethical misconduct to executive fraud. There has been academic research which connects stock-based compensation and accounting restatements. The author believes such payment, whether stock-based or performance-based encourages the manager to alter accounting details to maximize their pay.
- Substitution between real and accruals-based earnings management after voluntary adoption of compensation clawback provisions, Chan, L. H., Chen, K. C., Chen, T. Y., & Yu, Y. (2014). The Accounting Review, 90(1), 147-174. Although clawbacks reduce financial misstatements and increase the confidence investors have on earning information, the authors show that the benefits come with the accidental consequence of some companies exchanging accruals management with the management of real transactions. Therefore, the full amount of earnings management does not lessen along with clawback adoption. The authors show how actual transactions management for a period increases the stock performance and short-term profitability of firms that adopt clawbacks but reverses following three years. It is believed that for companies with managers who pressured to meet earning goals have unexpected effects from clawbacks.
- Valuation consequences of clawback provisions, Iskandar-Datta, M., & Jia, Y. (2012). The Accounting Review, 88(1), 171-198. The authors investigate the extent of clawback provisions as an effective governance mechanism. They expect it to be beneficial because it gets rid of risks in financial reporting. Shareholders of companies that have adopted clawbacks have positive stock-valuations. The clawback policy curtails incentives for compensation manipulation. The authors do not find any evidence supporting the belief that clawback provisions include higher CEO compensation nor that adopting clawbacks effects the contractual design.
- The effects of firm-initiated clawback provisions on bank loan contracting, Chan, L. H., Chen, K. C., & Chen, T. Y. (2013). Journal of Financial Economics, 110(3), 659-679. Clawbacks lower the instances of accounting manipulation but cause managers to participate in less than great activities to reach earnings goals. The authors examine the effectiveness of clawback provisions from the point of view of debtholders. After companies start clawbacks, banks add more financial stipulations and provisional performance pricing in their loan agreements and lower interest rates. The authors find that when a firm initiates clawback provisions, it removes ambiguity debtholders come up against and improves accounting reporting quality.
- The Clawback Provision of Sarbanes-Oxley: An Underutilized Incentive to Keep the Corporate House Clean, Schwartz, R. E. (2008). The Business Lawyer, 1-35.
- Mandatory clawback provisions, information disclosure, and the regulation of securities markets, Denis, D. K. (2012). Journal of Accounting and Economics, 54(2-3), 197-200. Studies show that by voluntarily adopting clawback provisions there will follow less financial restatements, fewer reports by auditors revealing weaknesses of material internal control, reduced auditing fees and lags, and higher compensation response cooperatives. The conclusion from the research suggests that increased financial integrity is the result of voluntary adoption of clawback clauses. The author presents alternative explanations to those results and discusses the problems with government-mandated clawback provisions.
- A corporate bond innovation of the 90s: The clawback provision in high-yield debt, Goyal, V. K., Gollapudi, N., & Ogden, J. P. (1998).Journal of Corporate Finance, 4(4), 301-320. The authors believe that bond issuers use clawback provisions to diminish wealth losses that would occur in another way when new equity is presented. Clawback provisions are likely to be in bond offerings from private issuers with more intangible assets and are unregulated. The authors estimate the yield of clawback provisions on bonds to be on average 86 basis points more than what they would be without the rules.
- Voluntary adoption of clawback provisions, corporate governance, and interlock effects, Addy, N., Chu, X., & Yoder, T. (2014). Journal of Accounting and Public Policy, 33(2), 167-189. The authors investigate the correlation between a firm's administrative structure and the early adoption of clawbacks. They build an index of whether the regulation was more for relative management breach versus observing and discovering that the alleged management breach made clawbacks less likely. The authors look at if social networks of the compensation board with other companies who adopted clawbacks had any effect on whether a firm included the provisions. They believe that companies with clawbacks fashioned after the Sarbanes-Oxley Act connected with monitoring-oriented administration and social networks with other clawback adopters because Dodd-Frank did not exist yet.
- Italian IPOs: Allocations and claw back clauses, Boreiko, D., & Lombardo, S. (2011). Journal of International Financial Markets, Institutions and Money, 21(1), 127-143. The authors examine share allocation methods in Italian initial public offerings (IPOs) which run for retail investors who present binding orders and for institutional investors who only offer an inkling of interest. The clawback provisions which are a familiar thing with Italian IPOs allow the organization discretion based on actuality rather than a forecast for the retail to the institutional offering. Reputable underwriters in IPOs that have lower institutional demand offer more retail offering.
- The costs and benefits of clawback provisions in CEO compensation, Chen, M. A., Greene, D. T., & Owers, J. E. (2014). The Review of Corporate Finance Studies, 4(1), 108-154. The authors discover that misreporting is curbed and incentives have extended boundaries with clawback clauses. However, having the provision adds discord to the fundamental performance standard, lowers effort on the part of management and reduces firm value. The authors record how clawback clauses link with better reporting quality, increased CEO pay-for-performance responsiveness and higher CEO pay.