Corporate Governance Principal-Agent Problem: The Equity Cost of Independent Directors

Abstract

The classic question in corporate governance is how to manage the conflicts-of-interest that arise from fundamental principal-agent problems. One of the most popular methods of solving the problem is by separating ownership and management. Since 2002, the Sarbanes-Oxley Act has set new standards for board composition by using independent directors, especially for audit committees. This article analyzes the impact of board composition, related to a majority of independent directors, on returns. For this purpose we construct a panel dataset of 2919 stocks over a 10 year period. We find that a majority of independent directors on the board has an overall negative effect on stock returns. We also use our panel data set to show the consequences of the Sarbanes-Oxley Act on the defense or offense mechanisms that companies might pursue over their lifespan.