Can Clawback Provisions in Management Incentive Contracts Backfire and Lead to More Risk Taking?

• In Event: Managerial Contracts

Abstract

Executive compensation contracts commonly use bonus provisions to align the interest of managers with the interest of shareholders. However bonus provisions create an asymmetry in risk sharing between a company and managers because managers only share in profits, but do not participate equivalently in any losses that a company incurs. This asymmetry has been criticized for leading to excessive risk taking as demonstrated in the financial crisis in 2008. As a potential remedy for excessive managerial risk taking institutional investors, such as CalPERS, have propagated an expansion of clawback provisions beyond the scope required by SOX and Dodd-Frank. Such an expansion of the use of clawback provisions would in the extreme case require managers to return part of their compensation when the company incurs a loss. We argue that such calls should be made with caution. We propose that clawback provisions have the unintended effect of leading to more managerial risk taking when a company incurs losses and the impact of an investment only changes the size of the loss. We further propose that the risk of having to forfeit compensation leads to a motivated reasoning process whereby managers are not aware of making a risky investment. Instead those managers assess the outcome more favorable. In an experimental study we find empirical evidence for our predictions. This means if a company is incurring a loss then clawback provisions expose a company to greater risk at a time when a company is least likely to be able to withstand the consequences of a negative outcome of a risky investment. We contribute to the debate on clawback provisions by showing unintended consequences of clawback provisions in form of more risk taking.

Authors

• Bernhard E. Reichert, Drexel University

• Matthias Sohn, Bundeswehr University Munich