How Sarbanes-Oxley Affects Board Changes and CEO Turnover

Following the corporate governance scandals of the early 2000s, the effectiveness of board monitoring came into question. In response, Congress passed the Sarbanes-Oxley Act of 2002 (SOX) in an attempt to increase monitoring and improve corporate governance. In conjunction with SOX, exchange listing requirements required firms to have a majority of independent directors on their boards.  While firms that did not already have such a majority were forced to alter their board structures, SOX may also have prompted other firms to alter the composition of their boards.  In our recent paper, published in the Journal of Banking and Finance, we consider how changes in the boards that already had a majority of independent directors affected the ability of those boards to monitor their firms.

Prior literature shows that the proportion of independent directors was increasing even before the Enron and WorldCom accounting scandals, but that the pace of the increase and the public’s focus on effective monitoring grew after the scandals hit. Therefore, pressure from investors and the public may have prompted board changes at firms that had a majority of independent directors before the listing requirements took effect.  Specifically, those firms may have increased board independence following the corporate scandals and the subsequent independence requirements, even though they were not required to do so.

On the other hand, prior to SOX, the degree of board independence was up to each company. While the new requirements promote the importance of a simple majority of independent directors on the board, they do not necessarily encourage board independence beyond that minimum threshold. Since complying with all SOX provisions increases monitoring costs, some compliant firms may have perceived their higher than required board independence as redundant monitoring. Accordingly, these firms may have chosen to reduce board independence.  Moving toward the minimum required threshold may have held down monitoring costs. Alternatively, since complying with SOX imposes higher monitoring pressure on the executives, some managers may have taken advantage of the redundant monitoring argument in order to reduce board independence and, thus, alleviate the monitoring pressure. That is, knowing that SOX would restrict executives’ control and authority, managers may have taken other measures to boost their power.

We investigate how altering the board structures of complying firms (which represent approximately 80 percent of the firms in our sample) affected the effectiveness of those boards.  Our findings suggest that, following the new legislation, many compliant firms modified their board composition.  The participation of independent directors increased significantly following the passage of SOX as many firms felt pressure to increase monitoring. This increase in independence appears to have come at the expense of insiders, as we show a significant reduction in the participation of inside directors in the post-SOX period.  Of the firms that were already complying, 55.8 percent further increased their levels of independence in the post-SOX era.  However, we find that 26.4 percent of compliant firms actually decreased the level of monitoring by reducing the number of independent directors serving on their boards, suggesting a non-trivial number of firms moved toward the structure prescribed by the regulations.

CEO turnover is often used as a measure of board effectiveness. That is, a higher probability of CEO dismissal due to poor performance signals more efficient monitoring. During the post-SOX period, we find a significant decline in the incidence of CEO turnover for compliant firms.  In addition, our results show that compliant firms that chose to remove an independent director following SOX were less likely to remove a poorly performing CEO, which is consistent with less effective board monitoring.  We find that firms that decreased independent directors the most were the least likely to remove such a CEO.  The only subgroup more likely to jettison a CEO for performance reasons consisted of those firms that added even more independent directors or removed insiders.  While our results are consistent with the notion that independent directors provide monitoring benefits, we suggest that the passage of SOX and the NYSE/NASDAQ independence provisions had unintended consequences not only on board structures but also on board monitoring.  For many compliant firms, SOX had an adverse effect on the internal monitoring.

This post comes to us from Professor Mustafa A. Dah at Lebanese American University, Professor Melissa B. Frye at the University of Central Florida, and Professor Matthew Hurst at Stetson University. It is based on their recent article, “Board Changes and CEO Turnover: The Unanticipated Effects of the Sarbanes-Oxley Act,” available here.