The Relative Efficiency of Clawback Provisions in Compensation Contracts

Abstract

Clawbacks are retractions of previously-awarded bonuses. In our model, the manager takes a first-period effort that stochastically determines a first-period signal and a second-period cash flow. Both the cash flow and the signal are noisy indicators of effort. The agent can manipulate the signal, i.e., manage earnings. The no-clawback contract pays the agent in the first period for a good signal. The clawback contract also rewards the good signal, but the payment is in the second period and may be lower if the cash realization is low. The agent is impatient and prefers a first-period payment. We find that the no-clawback contract dominates the clawback contract if the cash realization is relatively noisy, earnings management is difficult, or the agent is very impatient. Earnings management may be optimal even though the actual cash realization is contractible. A contract involving restricted stock is always dominated by the clawback contract. The results demonstrate that the optimal ex ante alignment of manager and shareholder interests does not imply perfect ex post alignment of manager and shareholder payoffs.

Keywords: executive compensation, earnings management, clawback

JEL Classification: M40, J33