Self-Enforcing Clawback Provisions in Executive Compensation

There has been widespread public debate over the effectiveness of corporate governance practices in firms. One of the main concerns is that CEOs take advantage of accounting discretion to misreport financial information and to extract excess compensation (rents) from shareholders. Thus, the connection between CEO compensation and financial misstatements has received considerable attention. Due to these concerns, Section 304 of the Sarbanes-Oxley Act of 2002 (hereafter SOX) called for clawback provisions, which requires public company CEOs and CFOs to disgorge incentive-based compensation in the event of material noncompliance with financial reporting requirements. More recently, the U.S. Securities and Exchange Commission (SEC) changed Regulation S-K Item 402 (b) to require that compensation committees disclose their policies regarding bonus recovery in the event of errant financial statements. In response to Section 304 of the SOX, some, but not all, companies have voluntarily developed policies to incorporate clawback provisions in compensation contracts. Anecdotal evidence suggests that the introduction of clawback provisions has profound influence on corporate governance practices in several aspects. Regulators maintain that clawback provisions may mitigate the incentive of misreporting financial statements, thereby resulting in higher shareholders’ value. Opponents, in contrast, argue that provisions could make compensation contracts with clawback provisions less attractive and thus hiring and retaining managers more costly. In addition, clawback provisions would have unintended consequences: firms could try to circumvent clawback provisions by increasing base salaries, rather than tightening the links between pay and performance.