The Banking Benefits of Clawback Provisions

Executive compensation is often closely linked to firm performance, and therein lies a temptation for managers to manipulate financial reports in their favour. To deter this behaviour, the US has moved towards requiring firms to have clawback provisions that authorise boards to recover compensation paid to executives if the company has to restate its financial report. A number of firms have already started adopting these provisions voluntarily. So just how effective are they?

Studies looking at the question from the perspective of equity holders have come up with inconsistent results. But research by Lilian H Chan, Kevin CW Chen and Tai-Yuan Chen takes a different tack by focusing on debtholders instead. Their findings clearly show that clawback provisions can bring benefits to both the debtholder and the firm.

Their focus is banks which, as debtholders who have a special relationship with firms, are in a good position to understand the quality of financial reports and firm dynamics.

“Banks have more proprietary firm-specific information, including information on management integrity and ability, than other creditors,” the authors said. “We expect banks are better able to determine the effects of clawback adoption than other creditors and hence are likely to respond favourably to clawback adoption only when such provisions are able to reduce the information uncertainty they face.”

Bank loans are a useful vehicle for exploring these questions because they are directly affected by improvements to financial reporting quality. If lenders feel clawback provisions are effective in reducing their information uncertainty, then loan contracts should contain more financial covenants and performance-pricing provisions.

Similarly, since lenders use financial reports to assess credit risk, then interest rates should be lower and other credit terms loosened, such as maturity and collateral requirements, if clawback adoption increases lenders’ confidence in the reliability of these reports.

The authors tested these propositions on a sample of 147 matched firms of clawback adopters and non-adopters, which were issued a total of 1,566 loan facilities from 2000-09. They found strong evidence that debtors regarded the clawback provisions favourably.

For firms that adopted clawbacks, banks used more financial covenants in loan contracts than before, as well as more accounting-based performance-pricing provisions; interest rates were 33 basis points lower post-adoption, representing a 24 per cent decrease in the cost of debt capital; and bank loans had a longer maturity and were less likely to be collateralised. The effects were stronger among firms that had had a higher risk of restatement of their financial reports prior to clawback adoption.

The authors were able to rule out that the effects were driven by improvements to corporate governance or to trends happening before the clawback adoption.

“The results suggest that banks perceive firm-initiated clawbacks as effective in promoting financial reporting integrity, and so seek less protection following clawback adoption,” they said.

“Since the majority of prior research on clawbacks has been based largely on equity investors who have less access to a firm’s private information than banks, our study provides stronger evidence on the usefulness of clawback policies for users of financial information.”

CHEN, Kevin C W

Chair Professor

CHEN, Tai Yuan

Associate Dean (MBA Programs), Professor