“The relationship between compensation committee quality and the voluntary adoption of clawback provisions”

ARTICLE INFO Hui-Wen Hsu, Liu-Ching Tsai, Chaur-Shiuh Young and Chia-Hui Chen (2018). The relationship between compensation committee quality and the voluntary adoption of clawback provisions. Investment Management and Financial Innovations, 15(4), 345-355. doi:10.21511/imfi.15(4).2018.28 DOI http://dx.doi.org/10.21511/imfi.15(4).2018.28 RELEASED ON Friday, 21 December 2018 RECEIVED ON Wednesday, 11 April 2018 ACCEPTED ON Wednesday, 19 December 2018


INTRODUCTION
In recent years, clawback provisions have been increasingly prevalent as a punishment mechanism that links the CEO compensation to their financial reporting behavior (Chan et  . Clawback provisions allow firms to recoup CEO compensation to the extent it is determined that corporate performance goals were not achieved, thereby reducing the incentives of managers to manipulate earnings. Thus, clawback provisions create tension between executives and boards (Scott & Seelig, 2010).
The prior research provides evidence about the consequences of clawback provisions and indicates that managers, analysts (Dehaan et al., 2013), investors (Iskandar-Datta & Jia, 2013), and auditors (Chan et al., 2012) may react to the adoption of clawbacks. Recent research also examines the economic determinants of firms' voluntary adoptions (Addy et al., 2014;Brown et al., 2015;Huang et al., 2015). However, the viewpoint of corporate governance has been less directly examined, with the exception of few studies. Using an index of corporate governance, Addy et al. (2014) find that firms with entrenchment management make clawback provisions less likely, and the compensation committee's social ties with other adopters increase the implementation of clawback provisions. Huang et al. (2015) indicate that firms with more co-opted boards are less likely to have clawback provisions and the relationship is more pronounced when there are co-opted directors on the compensation committee. Chen and Vann (2017) indicate that firms with strong governance are positively related to the adoption of clawback provisions. Compared to the prior literature, which does not consider the role of compensation committee, this paper uses seven measures for compensation committee quality, because the measure of compensation committee quality is more comprehensive.
All the corporate activity is the responsibility of the board of directors; however, compensation-related matters are assigned to compensation committees (Conyon & Peck, 1998;Collins et al., 2009). Because clawbacks concern the CEO's compensation, this task would be delegated to the compensation committee (Huang et al., 2015). Since boards have fiduciary duties to shareholders, the compensation committee may adopt a clawback provision. Adoption of clawback provisions reflects independence and vigilance and illustrates that board interests coincide with those of outsiders. Thus, this paper constructs one index that describes compensation committee quality to examine whether companies with higher compensation committee quality are more likely to adopt clawback provisions. The attributes of compensation committee quality that this study investigates include the degrees of independence and professionalism of the directors. The level of professionalism of committees affects their ability to monitor management and is of particular importance given the current issue. The second purpose of this study is to examine whether the association between compensation committee quality and the voluntary adoption of clawback provisions is affected by the amount of Level 3 fair values. We are interested in the moderating effect of the amount of fair values, because the relation between Level 3 fair values and the clawback provisions is unclear in the literature.
This paper contributes to a better understanding of how compensation committee structure can influence policies to punish management for financial misreporting. The results should help companies make decisions about whether to consider voluntary clawback adoption. Moreover, this study provides practitioners with insights that compensation committees are vital to voluntary clawback adoption. The findings add to the understanding that compensation committees make a valuable addition to the clawback provisions. Finally, this study contributes to the literature by examining the association between fair value reporting and voluntary clawback adoption.
Using a sample drawn from the U.S. firms from 2008 to 2015, the results show that the compensation committee quality is positively related to firm's voluntary adoption of clawback provisions. Additionally, the positive relationship between compensation committee quality and the voluntary adoption of clawback provisions is more pronounced for firms with higher Level 3 fair values.
The remainder of the study is organized as follows: section 1 introduces the literature review and hypotheses development, section 2 describes the sample selection techniques and the variables used in the empirical model, section 3 describes the empirical results, final section concludes the paper.

Hypotheses development
All corporate activity is the responsibility of the board of directors; however, compensation-related matters are assigned to compensation committees (Conyon & Peck, 1998;Collins et al., 2009). Thus, the use of clawbacks would most likely be delegated to the compensation committee (Huang et al., 2015). An optimal contract is designed to maximize the net expected economic value to shareholders after transaction costs and payments to employees (Core et al., 2003). Under this viewpoint, compensation committees set executive incentive to minimize agency costs resulting from information asymmetry between shareholders and managers. Since boards have fiduciary duties to shareholders, the compensation committee may adopt a clawback provision. Adopting clawback provisions reflects independence and vigilance, illustrating that board interests coincide with the interests of outsiders.
The optimal contracting view posits that the board, working in the interests of the shareholders, provides the optimal incentives to align the interests of managers with those of the shareholders. However, Bebchuk and Fried (2003) suggest that directors' behaviors are also subject to an agency problem, which may undermine the effectiveness of incentive design. As such, a number of studies examine the effect of governance quality on different aspects of compensation design and provide evidence that it is at least partially supportive of this effect (e.g., Core Vafeas (2003) in-dicates that directors with more reputation are less likely to collude with management when designing CEO compensation. Therefore, the reputation capital of the compensation committee provides strong incentives for the members to effectively monitor managers. Accordingly, this paper expects that firms with higher compensation committee quality are more likely to adopt a clawback provision. Therefore, the first hypothesis is formulated in alternate form: H1: Ceteris paribus, there exists a positive relationship between the compensation committee quality and the voluntary adoption of clawback provisions.
Lev and Zhou (2009)  Those literatures provide evidence that Level 3 inputs are the most problematic among the three tiers of fair value inputs. Because the measurement of Level 3 fair values is based on models with unobservable market inputs, the resulting fair values are difficult for outsiders to verify (Ryan, 2008). When fair value inputs become less observable, the degree of managerial discretion and uncertainty for fair value estimates is higher, and, in turn, the unreliability becomes more severe. Therefore, this paper expects that the positive relationship between compensation committee quality and the voluntary adoption of clawback provisions is positively affected by the degree of Level 3 fair values. Therefore, the second hypothesis is presented: H2: The positive relationship between compensation committee quality and the voluntary adoption of clawback provisions is more pronounced for firms with higher Level 3 fair values.

RESEARCH DESIGN
The variable of interest in Hypothesis 1 is CCQ, which represents the degree of compensation committee quality. If the coefficient is positive, then, Hypothesis 1 is supported.

Test of Hypothesis 2
Hypothesis 2 states that the positive relationship between compensation committee quality and the voluntary adoption of clawback provisions is more pronounced for firms with higher fair value assets. In order to test Hypothesis 2, we modify equation (1) to form the second model as follows: The variable of interest in Hypothesis 2 is the interaction term 3, CCQ LEVFVA ⋅ which captures the differential impact for firms with more fair value assets. If the coefficient is positive, then, Hypothesis 2 is supported.

Dependent variable
According to Brown et al. (2015), the probability of the existence of a clawback (CL AW BACK ) is a dummy variable that equal to one if firm has voluntarily adopted a clawback policy in year t and zero otherwise; t denotes the year of adoption.

Independent variable -compensation committee quality (CCQ)
This , whether a financial expert sits on the compensation committee (FINEXPERT), the proportion of directors on the committee with 10 or more years of board service (SENIOR), the proportion of CEO appointed directors on the compensation committee (APPOINT), the proportion of directors with three or more additional board seats on the compensation committee (BUSYDIR), and the proportion of CEOs from other firms on the committee (CEODIR). These proxies measure the independence, expertise, experience, and effectiveness of the compensation committee. The seven measures are converted to percentile scores from which an index, CCQ, is then constructed to capture the combined effect of these factors. CCQ equals the average of these seven percentile values.

Independent variable -Level 3 fair values (LEVFVA3)
L E V FAV 3 is the fair value of Level 3 fair assets divided by total assets in fiscal year t-1.

Control variables
Following

Sample selection and data sources
Firms are required to provide the Level 3 fair value hierarchy disclosure for the fiscal years beginning after November 15, 2007. We thus initially identify nonfinancial firms that adopted clawback provisions during the period 2008-2015 from the MSCI ESG research database. We limit our sample to nonfinancial firms because the majority of firms in the financial sector are subject to the mandatory adoption of clawback provision during the financial cri-sis in 2008 and 2009. We also require data availability on executive characteristics, financial variables, compensation committee characteristics and stock returns. These screening procedures make our final sample consisting of 4,098 firm-years for the sample period going from 2008 to 2015.
We obtain executive characteristics from the ExecuComp database; financial information from the Compustat database; compensation committee characteristics from the RiskMetrics database; annual reports from the Edgar Online database and stock returns from the CRSP database. CLAWBACK is an indicator variable that is equal to one if firm i has voluntarily adopted a clawback policy in year t and zero otherwise; CCQ is firm's average score of compensation committee quality; CMSIZE is the number of directors on the committee; SHARE is the aggregate directors' shareholding; FIN_EXPERT is an indicator variable that equals one when there is a financial expert on the compensation committee, zero otherwise; SENIOR is the proportion of directors on the committee with 10 or more years of board service time; CEOAPP is the proportion of CEO appointed directors on the compensation committee; BUSYDIR is the proportion of directors with three or more additional board seats on the compensation committee; CEODIR is the proportion of the CEOs of other firms on the committee; LEVFVA3 is the Level 3 fair value of assets divided by total assets for fiscal year t-1; FSIZE is the logarithm of total assets of firm i in year t-1; PROFIT is measured as net income divided by the market value of equity in year t-1; MB is the market-to-book ratio for year t-1.; RISK is the standard deviation of daily stock returns for year t-1; LEV is the ratio of total liabilities to total assets at the end of year t-1; REST is a dummy variable equal to 1 if the company had a restatement due to irregularities in the last five years; REST_IRR is an indicator variable equal to one if firm i had a restatement in years t-5 through t-1 that is classified as intentional, and zero otherwise; DUALITY is an indicator variable that is equal to one if the CEO is the chair of the board at the end of year t-1, and zero otherwise; TENURE is the number of years the CEO has served of the end of year t-1; BONUS is the amount of bonus paid to the CEO at the end of year t-1, divided by the cash compensation of the CEO at the end of year t-1; SEG is the number of segments in year t-1.   Table 1 for variable definitions. 4. ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.  Table 2 provides the results of the correlations among variables, with some coefficients warranting particular attention. Overall, the correlations are relatively small, and the low inter-correlations among all independent variables indicate that multi-collinearity does not appear to be a problem in the regression model. Table 3 reports the results for the hypothesis one and hypothesis two. Hypothesis one states that there exists a positive relationship between the compensation committee quality and the voluntary adoption of clawback provisions. The results show that the coefficient of compensation committee quality (CCQ) is significantly positive. Therefore, Hypothesis 1 is supported. This result is similar to the findings of prior literature, which showed that firms with strong governance are positively associated with the firm's adoption of a clawback provisions (Chen & Vann, 2017). Compared with their research, this paper focuses on the role of compensation committee. The result shows that high-quality compensation committees can design CEO compensation that will reduce the ability of CEOs to extract rents. The results support that the due to the information risk, inherent estimation errors, and possible reporting bias. Thus, Hypothesis 2 is supported.

CONCLUSION
This paper examines how compensation committee quality affects the adoption of clawback provision. Additionally, this paper investigates whether the relationship varies with the Level 3 fair values. Using a sample drawn from the U.S. firms from 2008 to 2015, the results of the regression test show that there exists a positive relationship between the compensation committee quality and the voluntary adoption of clawback provisions. Additionally, the positive relationship between compensation committee quality and the voluntary adoption of clawback provisions is more pronounced for firms with higher Level 3 fair values. This paper contributes to a better understanding of how compensation committee structure can influence policies to punish management for financial misreporting. Moreover, this study provides practitioners with insights that compensation committees are vital to the voluntary clawback adoption. Finally, this study contributes to the literature by examining the association between fair value reporting and voluntary clawback adoption.