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

Abstract

Proposals after the last financial crisis in 2008 call for an extension of the scope of clawback provisions in compensation contracts beyond what is commonly legally required. Under such an extended scope, managers would be held accountable for losses. The reason for such an extended scope is to counter incentives for excessive risk-taking that are currently present in many bonus contracts. We argue that such a call for an extended scope of clawback provisions ignores implications from prospect theory and motivated reasoning. We propose that holding managers accountable under an extended clawback regime may backfire and lead to additional risk-taking if risk-taking is a means for avoiding personal liability. This is specifically the case when managers make an investment decision in a loss state, where an investment alters only the size of a loss. We argue that additional accountability in such a setting leads to a motivated reasoning process. Managers overweigh positive project success factors and underestimate risk. We further propose that this effect occurs despite a higher risk tolerance, as suggested by prospect theory. Using an experiment, we find empirical evidence that is consistent with our predictions. Our findings contribute to the debate of extending the scope of clawback provisions in management compensation contracts. We also expand the research on prospect theory by showing that motivated reasoning processes occur even when prospect theory implies a higher risk tolerance, which conceptually should negate the need for motivated reasoning.