Executive Summary

This submission aims to provide recommendations for APRA to consider regarding their proposal that significant financial institutions “must allow for variable remuneration to be recoverable for at least two years after the end of the deferral period, and a further two years where an individual’s circumstances are under investigation” (APRA 2019). This report will look at how well mandatory clawback provisions have worked in other countries that have implemented such provisions.

It was found that managers in countries without clawback provisions used alternate methods to conceal bad news. Activities‐based earnings management such as earnings smoothing to reduce the effect of significant events on their financial performance is one of the main ways this was done, this was usually legal and thus the auditors were unlikely to question it. Another way bad news was concealed is by reducing the readability of the financial reports. This is likely to work well with significant financial institutions as often investors buy their shares for the stable dividends and disregard most other information about the business. Therefore, they pay little attention to the financial statements and if the media is unable to interpret them and bring this to the investors’ attention, they are unlikely to notice bad events. These methods lead to an increase in the crash risk of the firm, compared to firms in countries that do not have mandatory clawback provisions.

Clawback provisions are also likely to reduce the risk appetite of the managers. This could be a problem as investors are likely to have their wealth invested in various companies, making their overall portfolio less volatile and thus many of them would prefer the firm to invest in more risky projects, provided it offered a satisfactory risk-adjusted return.

An alarming finding is that CEO’s of companies with clawback provisions in their contracts are likely to have higher pay and lower ownership. This is likely to be a major problem as agency theory suggests that the best way to get the CEO to act in the best interests of shareholders is to make sure their interests aligned. This is unlikely to be the case if management, particularly the CEO does not have a significant portion of their wealth invested in the company. A possible reason for this may be due to CEO’s preferring to invest in firms with a higher risk appetite, thus increasing their average returns.

Due to clawback provisions of 2-4 years being unlikely to stop bad behaviour it is recommended that the APRA does not implement mandatory clawback provisions in their current form.  Instead, an alternative APRA should consider is having equity incentive as a mandatory part of the renumeration package of significant financial institutions, with the possibility of expanding this to all listed companies. This is likely to help better align the CEO’s interest with shareholders. In addition, APRA should also consider introducing harsher penalties for CEO’s that do not act in the best interest of the shareholders, including jail sentences for major cases of misconduct as this is likely to be much more effective than a monetary penalty.

Introduction

This submission aims to provide recommendations for APRA to consider regarding their proposal that significant financial institutions “must allow for variable remuneration to be recoverable for at least two years after the end of the deferral period, and a further two years where an individual’s circumstances are under investigation” (APRA 2019). Clawback provisions are “a contractual provision whereby money already paid to an employee must be returned” (Kentin 2019).

Agency theory states that “while the agent (CEO) has a legal and fiduciary duty to act in the best interests of the principle (shareholders) … both parties are utility maximisers” so “the agent won’t always at in the best interests of the principle if it does not coincide with their own interests” (Rankin et al. 2018).

The APRA’s report is an example of the regulatory bushfire theory as they are proposing to implement legislation to fix failures of regulatory processes regarding the renumeration of CEO’s.

Risk of Managers Using Alternative Channels to Conceal Bad News

Bao Fung & Su (2018) explored the behaviour of managers in countries with and without clawback related laws and they found that in many cases managers used different methods to conceal bad news and thus listed companies were more likely to experience a share price crash than in countries without these provisions if the incentives were strong or monitoring is week. For the purpose of their report crash risk is defined as the “likelihood of an extreme negative firm‐specific return”.

After analysing the quantitative data of the listed companies in various different countries, Bao Fung & Su (2018) were able to conclude that “that adopters (countries with mandatory clawback provisions) experience an increase in crash risk in the post‐adoption period relative to non‐adopters” and that “such provisions do not prevent managers from hiding bad news, and the net effect of adoption from an investor perspective is negative in the context of stock price crash risk”.

There are two common ways that bad news can be concealed. “Real activities‐based earnings management” (Bao Fung & Su 2018) uses allowed accounting/tax rules to manipulate earnings such as inflating and/or smoothing the profit of the firm. This can often be identified by sophisticated investors who compare the cash flow statement with other financial statements to identify inconsistencies, but this is often missed by many other investors. Enron is an example of a company who used this strategy and they went bankrupt in 2001. The other way Bao Fung & Su (2018) identified is by “managing readability of financial reports” (by making their reports hard to read and understand), many investors and the media will be unable to identify the bad events. This is consistent with Dechow, Ge, & Schrand, (2010) as quoted by Chen & Vann (2017) where they found that firms are more likely to “engage in earnings management to reduce the volatility of earnings” if clawback provisions are used.

This is an example of agency theory as even though the board members (including the CEO) are hired by the shareholders of the company to act in their best interests, they are acting in their own best interests to increase their variable renumeration which is likely performance based.

This indicates that APRA’s proposal of introducing mandatory clawback provisions for adjustment of the variable renumeration outcomes of CEO’s of significant financial institutions would be ineffective and could lead to higher compliance costs (as increased regulation often does) and lead to a higher crash risk due to other methods of hiding bad news being used.

Natarajan & Zheng (2019) explored the impact of the mandatory clawback provisions in the United States and compared it to before it was implemented. Their findings contradict with the findings of Bao Fung & Su (2018), finding that CEO’s were less likely to have misrepresentations in their financial reports following the introduction of the clawback provisions, however the chances did increase if the CEO also served as a board chair.

Impact on Investment Decisions

Chen & Vann (2017) explore the impact of clawback provisions in terms of “corporate investment practices and risk-taking behaviour”. One of their main findings is that “clawback adoption leads to less abnormal investment”. This indicates that the boards interests may be becoming more aligned with shareholders as they are likely to be doing more research when selecting new investment opportunities.

However, Chen & Vann (2017) also found that “after adopting clawback provisions, the firm’s investments are less risky, compared with those of the matched non-clawback firms”. This could be a problem as investors are likely to have their wealth invested in various companies, making their overall portfolio less volatile and thus many of them would prefer the firm to invest in more risky projects, provided it offered a satisfactory risk-adjusted return. This is a clear conflict of interest that can be explained by the agency theory. The Board of Directors / CEO don’t want to harm their reputation by investing in high risk activities which are more likely to fail as it could damage their reputation (and thus future job prospects), but many of the shareholders are likely to want them to if it provides a satisfactory risk-adjusted return.

Impact on Governance and Insider Ownership

Chen & Vann (2017) found that firms with “strong governance are more likely to adopt (voluntary) clawback provisions”. This could be seen as a problem, as firms with strong governance are less likely to have an event that leads to the clawback being used, and thus is likely to be used only to provide assurance to shareholders that they are attempting to act within their best interest. This problem is likely to be solved if mandatory clawback provisions are implemented.

They also found that “CEOs of clawback firms have higher pay slice but lower ownership”. This should be incredibly concerning to APRA, as the best way to ensure that CEO’s interests are aligned with the shareholders interest is if they have a considerable amount of their wealth invested in the company, which makes them less likely to be motivated by short term incentives such as bonuses as they are likely to have an insignificant effect on their wealth compared to a share price crash. The agency theory can then be applied as it makes their own interests aligned with shareholders due to them being a shareholder themselves.

Conclusion

The findings in this report demonstrate that clawback provisions have both positive and negative effects. Positive effects include the decrease in the likelihood of the CEO misrepresenting the position of the company in the financial reports & could lead to them being more selective when searching for investment opportunities. Negative effects include the increased renumeration on average, alternative but legal methods being used to conceal bad news (such as earnings smoothing strategies to reduce the impact of bad news), increased compliance costs and a reduction in the risk appetite of the firm.

Due to clawback provisions of 2-4 years being unlikely to stop bad behaviour (due to them only needing to be undetected for a short period of time), APRA should consider not introducing clawback provisions as they are currently proposed.  This problem could be partially mitigated by significantly increasing the time period to 10 years after the deferral period ends for both CEO’s under and not under investigation, but this is still not ideal. Instead, an alternative APRA should consider is having equity incentives (primarily the issue of ordinary shares) as a mandatory part of the renumeration package (about 10% of the total renumeration is likely to be enough) of significant financial institutions, with the possibility of expanding this to all listed companies, as this is likely to better align the CEO’s interest with shareholders. In addition, APRA should also consider having harsher penalties for CEO’s that do not act in the best interest of the shareholders, including jail sentences as this is likely to be much more effective than a monetary penalty.

References

• Australian Prudential Regulation Authority (APRA). Strengthening Prudential Requirements for Remuneration. (23 July 2019).
  (URL: https://www.apra.gov.au/sites/default/files/discussion_paper_strengthening_prudential_requirements_for_remuneration_july_2019_v1.pdf)
• Bao, D, Fung, SYK & Su, L (Nancy) 2018, ‘Can Shareholders Be at Rest after Adopting Clawback Provisions? Evidence from Stock Price Crash Risk’, Contemporary Accounting Research, vol. 35, no. 3, pp. 1578–1615, viewed 18 October 2019
• , ‘Clawback provision adoption, corporate governance, and investment decisions’, Journal of Business Finance & Accounting, vol. 44, no. 9/10, pp. 1370–1397, viewed 18 October 2019
• Deegan, C. (2014) Financial Accounting Theory. McGraw Hill. Australia
• Kenton, W. (2019). Clawback. [online] Investopedia. Available at: https://www.investopedia.com/terms/c/clawback.asp [Accessed 20 Oct. 2019].
• Natarajan, R & Zheng, K 2019, ‘Clawback Provision of SOX, Financial Misstatements, and CEO Compensation Contracts’, Journal of Accounting, Auditing & Finance, vol. 34, no. 1, pp. 74–98, viewed 19 October 2019
• Rankin, M., Ferlauto, K., McGowan, S. & Stanton, P. (2018) Contemporary Issues in Accounting. 2 nd Ed. Wiley. Australia.