In our paper, Director Ownership, Governance, and Performance, forthcoming in the Journal of Financial and Quantitative Analysis, we study the impact of SOX on the relationship between corporate governance and company performance. A significant part of SOX and other exchange requirements increase the role of independent board members. Given that prior academic research suggests there is no positive relationship between board independence and firm performance, the above regulatory efforts are especially notable.
We find a shift in the relationship between board independence and firm performance after 2002. Prior to 2002, we document a negative relationship between board independence and operating performance. After 2002, we find a positive relationship between independence and operating performance. We find this result is driven by firms that increase their number of independent directors. An event study provides independent evidence supportive of the above results – specifically, when a company goes from being non-compliant to being compliant with SOX’s board independence requirement, the market response is significantly positive. Why might SOX be related to this positive performance? SOX and the listing standards impose new responsibilities on firms’ directors, such as regular meetings of the independent directors, approval of director nominations by independent directors, and approval of CEO compensation by independent directors. As a consequence of these policies boards began including more independent directors, and, perhaps the independent directors became more engaged in the firm’s governance processes. For example, we find that firms with greater board independence (and stock ownership of board members) are less likely to engage in a value-destroying activity, namely, acquisitions.
In addition to studying the changing nature of corporate governance across the pre-2002 and post-2002 sub-periods, we make four additional contributions to the literature. First, consistent with the Efficient Market Hypothesis, we show that none of the governance measures are correlated with current or future stock market performance, in contrast to the claims in papers such as Gompers, Ishii and Metrick (GIM, 2003). Second, we find that given poor firm performance, the probability of disciplinary management turnover is positively correlated with stock ownership of board members and board independence. However, given poor firm performance, the probability of disciplinary management turnover is negatively correlated with better governance measures as proposed by GIM. In other words, so called “better governed firms” as measured by the GIM index are less likely to experience disciplinary management turnover in spite of their poor performance. Third, we find that firms with greater stock ownership of board members (and board independence) are less likely to engage in a value-destroying activity, namely, acquisitions. On the other hand, better governed firms as measured by the GIM index are more likely to engage in acquisitions.
The most important contribution of this paper is a new measure of corporate governance, namely – dollar ownership of the board members. On average, the median director’s stock ownership is 45 percent greater in 2003-2007 than it was in 1998-2001 – and the relationship between director ownership and firm performance is consistently positive for both sub-periods; this relationship is robust to a battery of specification tests. Furthermore, the governance measure proposed here, namely – dollar ownership of the board members – is simple, intuitive, less prone to measurement error, and not subject to the problem of weighting a multitude of governance provisions in constructing a governance index. Consideration of this governance measure by future researchers would enhance the comparability of research findings with more robust progress in governance research.
The full paper is available for download here.