Disciplining Entrenched Managers Through Corporate Governance Reform: Implications for Risk-Taking Behavior

Abstract

Research Question/Issue: This paper examines how enhanced monitoring by corporate boards following the passage of the Sarbanes-Oxley Act of 2002 and concurrent reforms to stock exchange rules (SOX) mitigated risk-related agency conflicts prevalent in entrenched firms. Research Findings/Insights: Post SOX, entrenched firms increased risky and value-enhancing investments. These investments were financed by reductions in financial slack and dividend payouts, and by lower cost of debt. The specific mechanism driving the positive changes in corporate policies of entrenched firms is the SOX requirement of an independent compensation committee. Managers of entrenched firms previously non-compliant with this requirement are rewarded with more equity-based pay after SOX, which strengthened their incentives to pursue value-creating riskier investments. Only firms with low information asymmetry benefit from this requirement. Theoretical/Academic Implications: The paper provides evidence of a disciplining effect of the critically important governance legislation on firms with entrenched management. The findings suggest that, by imposing an additional layer of discipline on managers, SOX increased managers' willingness to take on riskier, but more value-enhancing projects that were previously stifled in entrenched firms. The paper underscores the roles of an independent compensation committee and information cost in alleviating managerial risk avoidance. Practitioner/Policy Implications: The paper has implications for the ongoing debate among policy-makers and legislators on the costs and benefits of SOX and for future governance reforms. Legal enforcement of stricter board requirements can realign investment policies with shareholders' interests even in the presence of value-reducing firm-specific arrangements that entrench managers. However, majority independent board and fully independent audit and compensation committees do not rein in CEO's risk aversion. It is a fully independent compensation committee that is instrumental in incentivizing CEOs to pursue risky projects that also add value. Firms and policy-makers need to be aware that the effectiveness of the independent compensation committee in designing optimal pay policies depends on the access to timely and accurate information. Other mechanisms need to be considered to enhance risk-taking in entrenched firms operating in high cost information environment.