The influence of Sarbanes–Oxley Act on CEO turnover.
Student name: Diejue Wang Student number: 11376848 Supervisor: Dr Sikalidis
Date: 25/07/2017
Word count： 12857
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam
Statement of Originality
This document is written by student Diejue Wang who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract
Boards of directors bring advantages to companies via monitoring and corporate governance because they play a vital part in employing and removing top management. Specifically, outside directors are more responsible for assessing top management and replacing them if their performance are bad, many studies support this view by showing that the high CEO turnover rate is relevant to bad performance and high proportion of outside directors in a firm. From this point of view, outside directors can improve the overall level of monitoring of management in a firm. Consequently, after the exposure of financial and accounting scandals in 2002, such as Enron and WorldCom, SOX(Sarbanes–Oxley Act) forced firms to have a majority of independent directors serving on the boards to enhance firm’s independence. Reinforced corporate independence leads to greater monitoring of CEOs and better decision-making. Greater monitoring of CEOs leads to high turnover rate for incompetent CEOs, which is associated with CEO turnover. In addition, firms that were already compliant with the regulations are also provided motivation to alter their board structure by the board independence requirements enacted in concomitant with the SOX. So in my paper, I explore the change of correlation between CEO turnover and outside directors after SOX, more specifically, whether outside directors replace CEOs because of poor performance in ROA and EBIT.
Contents 1 Introduction...4 2 Literature Review...9 3 Hypothesis development... 13 4 Data... 15 4.1 Sample selection...15 4.2 Variable definition ... 16 4.3 Methodology ...18 5 Empirical Finding...20 5.1 Descriptive data...20
5.2 Board composition pre-and post-SOX... 21
5.3 Wall street journal for CEO resignation ... 26
5.4 Correlation between CEO turnover and outside directors Pre-and Post-SOX ...29
5.5 Logistic regression for turnover performance sensitivity ...31
6 Conclusion...37
1. Introduction
In this study, I investigate whether SOX has positive influence on relationship between CEO turnover and outside directors by testing correlations between CEO turnover and outside directors pre-and post SOX. I further examine what factors influence the probability of CEO turnover by using logistic regression model. Specifically, I examine if outside directors dismiss incompetent CEOs because of bad performance in EBIT and ROA.
A board of directors is a group of people who are responsible for supervising activities of a company. Typical responsibilities of boards of directors include building up organization policies and setting strategic objectives to regulate the organization, setting salaries, compensation and rewards for top management, assessing, reviewing and rejecting performance of the chief executives. It is widely believed that the most important duty for board of directors is to monitor top management. If top management are unable to perform well, board of directors are responsible for replacing them. More specifically, there is a difference in monitoring between outside directors and inside directors. Inside directors are those who are employees, officers, chief executives or someone similarly related to the firm. Inside directors are representatives of the interests of firms’ stakeholders and have special information of the firms’ internal workings as well as financial and market position. Outside directors are those who are not full-time employees of the firm or not related to the firm in any other way. They are also called independent directors. As for the identification of independent directors, I follow Chhaochharia and Grinstein (2009) and use RiskMetrics to identify independent directors. NYSE states that a director is regarded as outside director only if the board of directors positively considers that the director has no direct, significant relationship with the listed firm, for example, the director is not a partner, shareholder or officer of an organization. The definition of independent director determined by NYSE and NASDAQ categorize a former employee of the firm as outside director if his/her employment terminated at least more than three years. However RiskMetrics, never categorizes a former employee as independent. RiskMetrics may categorize former employees and directors with
unimportant business transactions as linked even if they might be independent according to the NYSE and NASDAQ.
In general, it is universally acknowledges that outside directors are more responsible for monitoring CEOs than inside directors, inside directors can do very little to improve monitoring. Jensen(1993) demonstrates that inside directors cannot improve and may even have negative influences on monitoring. Fama(1980) suggests that outside directors are professional referees who can stimulate and supervise top management. So the job of removing incumbent CEOs is mainly fall on outside directors because outside directors can develop reputations in the process of monitoring, if firms they monitor are running effectively, they can prove that they are competent to the market and can be employed with higher salaries and reward. In contrast, inside directors do not have such incentives to remove incumbent CEOs, because inside directors are potential future CEOs, their careers are associated with CEOs, they are unwilling and even unable to take place bad-performance CEOs. Just as Geneen(1984)suggests, it is unlikely that inside director would drastically challenge his superior in the firm. Since outside directors have more incentives to remove incumbent CEOs, more outside directors in the board lead to better monitoring of firm, better monitoring leads to higher turnover rate for incompetent CEO. So it is widely believed that if firms are outsider-dominated, then they are more likely to remove incumbent CEOs than firms that are insider dominated. CEO removal is not the only way in which outside directors govern CEOs, there are many other ways in which CEO’s action is governed by outside directors. For example, outside directors can govern CEOs through accounting policies. CEO has discretion on earning management for his own benefit, board of directors has authority to make decisions about the amount of discretion the CEO can take.
There is evidence that poor performance raise probability of CEO turnover. CEO turnover performance sensitivity is how an organization’s CEO turnover frequency responds to different level of CEO performance. Lord & Benoit Report (2006) study about 2,500 companies and find that firms whose internal control
systems had few significant defects often enjoyed much greater increase in share prices than firms with significant defects. Warner, Watts, and Wruck (1988) implies that bad stock performance precede CEO resignation. Prior literature usually uses three methodologies to measure CEO performance(Weisbach,1987): earnings before interest and tax(EBIT), return on assets(ROA) and stock returns. EBIT is a representative of a company's profitability, it is counted as revenue subtracts expenses(tax and interest are not included). EBIT is also termed as operating earnings. ROA is a profitability ratio that measures the net income produced by total assets by comparing net income to the average total assets. ROA gives an idea as to the efficiency of management to use its assets to generate earnings. ROA is calculated as divide a firm's annual earnings by its total assets and manifested as a percentage. ROA is also termed as return on investment. The stock return formula is calculated by dividing the initial price of the stock by the appreciation in the price plus any dividends paid. The source of stock income is appreciation in stock value and stock dividends. Fisher and McGowan(1983) find that CEO resignation can be predicted through accounting earnings data such as EBIT and ROA , CEO turnover is often followed by poor performance in EBIT and ROA. According to Weisbach(1987), using accounting earning data to measure performance is better than stock performance measure. Because stock price represents the present discount value of future cash flow, which is an estimation and is not accurate. Another reason is that stock price is affected by various external factors such as market’s estimate of the possibility of CEO turnover. Hence, if I use stock price to measure performance, the result will underestimate the monitoring effect of outside directors.
The Sarbanes–Oxley Act was issued by the U.S. Congress in July 2002 as an anti-fraud measure in response to a great deal of significant financial and accounting scandals, such as Enron and WorldCom. The Sarbanes–Oxley Act concentrates on corporate governance and the duties of board of directors in corporate governance. For example, SOX forced firms to have a majority of outside directors serving on the boards to enhance firm’s independence. Consequently, SOX may change the
relationship between outside directors and CEO, and thereby influence the rate of CEO turnover indirectly. To be more special, the change brought by SOX may be different between compliant and non-compliant firms. Guo and Masulis (2012) suggest that for firms who were already compliant with independence requirement before SOX, SOX had little influence on them since they were not forced to change composition of boards. But according to Zingales (2000), firms’ corporate
governance is largely influenced by public opinion and pressure. So even through those firms were compliant with independence requirement, they might still be affected by external pressure and change their board structure. On the contrary, non-compliant firms were required to increase the proportions of independent directors serving on boards to compliant with independence requirement, as a result non-compliant firms would subject to greater changes in board structures and corresponding change in CEO turnovers.
The implementation of Sarbanes–Oxley Act of 2002 has both benefits and costs. It has been debated for several years whether the costs outweigh their benefits. Obviously, greater transparency and accountability of financial reports, lower risk from fraud and theft will benefit investors, creditors and lenders. Institute of Internal Auditors (2005) suggests that firms have built up quality of internal control systems and that the financial statements become more transparent after SOX. SOX primarily aims at enhancing the transparency and reliability of financial reporting and increasing directors’ duty for inaccurate and fraud reporting. The section of bills enacted plenty of relevant provisions to undertake reliable and transparent financial reporting. Prior research suggest that a firm is more likely to report its true financial situation to investors and financial report users if the firm increases presence of outside directors and experts. Outside directors produce professional and independent monitoring to firm that may also help decrease the possibility that CEOs perform poorly or manage earnings for their own benefits. However firms will spend more money on internal control as well as corporate governance because of SOX . Foley & Lardner (2007) finds that changes in the total costs were dramatically influenced by
SOX in U.S. public company. Costs such as insurance fees, external auditor fees, compensation fees, legal fees, and lost productivity increased dramatically between year 2001 and 2006. These benefits and costs also influence CEOs directly and indirectly. Prior literature that focus on the relationship of SOX and CEO mainly focus on the SOX influence on CEO pay, CEO turnover or CEO certification. My paper is aimed to research whether the Sarbanes-Oxley Act influence the number of CEO resignation in public firms.
In my paper, I focus on the change of relationship between outside director and CEO turnover before and after SOX, I also investigate and compare CEO turnover performance sensitivity in firms that increase, decrease, or maintain independence after SOX. I use sample of North America from the years 1999-2005, spanning 3 years prior and post the adoption of SOX in 2002. To test the change of relationship between outside director and CEO turnover after SOX, I use Pearson correlation to compare and analyze correlations before and after SOX. In order to test CEO turnover performance sensitivity after SOX, I choose EBIT and ROA as performance measurements and use logistic regression model to test what factors influence the probability of CEO turnover rate and whether CEOs are more probable to be removed due to bad performance in firms who increase outside directors than firms who decease or remain independence after SOX.
Based on my sample of CEO turnover from years 1999 to year 2005, I conclude that almost all non-compliant firms choose to increase outside directors after SOX to satisfy independence requirement of SOX. Compliant firms are also influenced by SOX and alter their board composition, it is strange that some of them choose to decrease outside directors, this phenomenon is consistent with Choi et al. (2008), who suggests that some firms view SOX as an opportunity to decrease redundant monitoring and save money. Also, SOX has positive influence on the relationship between outside directors and CEO turnover, because the number of compliant firms increase after SOX, more outside directors lead to more CEO turnovers. In addition, I find that CEO turnover is related to ROA rather than EBIT. Compared to firms who are insider-dominated, firms who have majority of outside directors present higher
correlation between performance measures and CEO turnover. In the post-SOX period, increased outside directors are less acceptable of bad performance, resulting in higher turnover rate.
I make two contributions to current research on CEO turnover. Firstly, as far as I know, few studies has been done on CEO turnover and outside director in the background of SOX. Prior literature that focus on the relationship of SOX and CEO mainly focus on the SOX influence on CEO pay, CEO turnover or CEO certification. My paper is aimed to research whether the Sarbanes-Oxley Act influence the number of CEO resignation in public firms. Even through SOX may not have direct influence on CEO turnover, it affects CEO turnover indirectly because of the forcible independence requirement. Secondly, current research on CEO turnover is related to CEO tenure, compensation, and risk aversion. In my study, I investigate turnover performance sensitivity to explore relationship between CEO turnover and firms’ EBIT and ROA. Moreover, I have three control groups, that is, firms who increase, decrease, and do not change independence after SOX. As a result, my study should provide a more holistic picture about CEO turnover performance sensitivity.
I structure the rest of the paper as follows. Section 2 reviews the studies about duties of board of directors, reasons for CEO resignation as well as influenced of SOX to firms. Section 3 develops hypothesis about change of correlation after SOX and CEO turnover performance sensitivity. Section 4 presents variables and provides descriptive data. Section 5 provides empirical results which are designed to test my hypothesis. Section 6 provides a conclusion, lists limitations of this paper and proposes suggestions for further research.
2. Literature review
In order to investigate the change of relationship between outside directors and CEO turnover after SOX. It’s important to learn about responsibility of outside directors, influence of SOX and CEO resignation. I classify prior literature into three categories: literature concerning the role of outside directors, literature about the reason of CEO resignation and literature explore firms’ transformation before and
after SOX.
It is widely believed that outside directors play a larger role in monitoring CEOs based on their performance than inside directors do. Fama(1980) argues that outside directors are responsible for stimulating and supervising the performance among the company’s top management. Increased outside directors in a firm can lower probability of CEO colluding and shirk. The task of replacing CEO is mainly fall on outside directors because outside directors have incentive to do so. Fich and Shivdasani (2007) suggest that accounting fraud scandals have negative effects on board directors, they find that after the exposure of a financial fraud event, outside directors are less likely to get other board appointments because financial fraud event is signal that the outside directors are inefficient. Boards who have more outside directors are more likely to replace incumbent CEOs for their own reputation. Fama and Jensen(1983) suggest that outside directors have incentive to supervise managers, because being board members of efficient firms indicates that they are compete to the market. On contrast, insider directors make bad monitors, they do not have this incentive and make little contribution in monitoring. Michael, C. (1993) suggests that corporate internal control systems have failed to deal effectively with bad-performance CEOs. Robert, P. and Kenneth A, B. (1996) suggest that the proportion of outside directors is positively related to the frequency of CEO turnover. Borokhovich et al. (1996) indicates a strong correlation between outside directors and the probability of removing an incumbent CEO. Moreover, Perry (2000) suggests a positive correlation between outside directors and efficient board monitoring. Easterbrook (1984) conducts an meaningful research to explore whether the capability of CEOs to manage earnings differs systematically based on the type of board. In firms who have more outside directors, CEOs have less opportunities to manipulate accruals due to strict corporate governance.
However, inside directors also bring benefits to firms. Inside directors play a monitoring and advising role in corporate governance. Baldenius et al. (2010) indicate that inside directors have better knowledge and more specific information about the firm, as a result, they are better at making decisions concerning the firm. On the
contrary, outside directors do not have enough firm-specific information, it’s costly to transform their knowledge and experience to fit a certain firm. In addition, Masulis and Mobbs (2011) suggest that inside directors can better serve shareholders if they are well informed. Coles et al. (2008) suggest that firms who have greater growth opportunity need more inside directors to provide more advising role. In such a case, merely increase outside directors while overlook the role of inside directors might not be optimal for the firm. Firms should also take care of inside directors to prevent strengthening corporate governance at the expense of losing advising function.
It’s a commonly-held belief that CEO gets fired because of poor performance. Firms provide fat salary for CEOs to prompt economic growth, if CEOs fail to deliver good results and harm shareholder’s benefits, directors will force them to leave. Michael, W. (1998) suggests that companies who have more outside directors are more likely to replace CEOs based on prior performance than companies who have more inside directors. Sanjai, B. and Brian, B. (2008) suggests that Increase outside directors in board members can improve corporate governance, tightening corporate governance can discipline management of poorly poor performance. It should be stressed that the main duty for independent directors is to supervise CEOs of badly performing companies rather than improve firms’ performance. In other words, CEOs are removed because they perform badly rather than for improving performance. According to Nikos, Bozionelos and Sumona Mukhuty(2015), a common view is that CEOs are replaced because of lower-than expected performance. Lower-than expected performance is a signal of low ability or low effort of CEOs. Low ability CEOs’ compensations do not match their contributions to firms. Consequently, directors will force those bad CEOs to leave.
Some literature also suggests that the frequency of CEO turnover is also influenced by organizational investors and the financial media. Parrino, Sias, and Starks (2003) notes that organizational investors are inclined to step in CEO activities to prevent shareholder’ interest being harmed. Erkens, Hung, and Matos (2009) find that the likelihood of CEO turnover increases if firms with high institutional ownership suffered large loss. The financial press also affect CEO turnover. Joe, Louis, and
Robinson (2009) show that the frequency of CEO turnover grows following the negative news reported by financial press. Farrell and Whidbee (2002) state that there is an evident relation between negative news on bad firm performance and the possibility of CEO turnover.
After the exposure of accounting scandals of Enron and WorldCom and the decreased investors confidence. SOX was adopted to enhance monitoring of corporate governance via increasing the proportion of outside directors in board members. Generally speaking, SOX bring three main changes to corporate governance: Firstly, it increase the presence of outside directors serving on the board. Chhaochharia and Grinstein (2009) and Guo and Masulis (2012) find a steady increase in the proportion of complying firms following SOX. Linck et al. (2009) find that the number of outside directors increased after SOX as a result monitoring function of corporate boards become stronger. SOX requires not only more outside directors, it also requires firms to increase audit committees meetings as well as financial professionals and board meetings. SOX empowers audit committee to oversight performance of registered public accounting firms, it also requires public firms to report directly to the audit committee. More board meetings will lead to more effective monitors. Gordon (2007) shows that even through firms had been increasing outside directors before SOX, they accelerate the increase of independent directors following the adoption of SOX. Linck et al. (2009) find that SOX not only significantly increase outside directors, it also increases audit committee meetings, Secondly, SOX has positive influnce on the relation between outside directors and CEO turnover. Dahya et al. (2002 ） suggest that more CEOs are removed and the correlation between poorly performance and CEO turnover becomes stronger after the adoption the Code of Best Practice. Thirdly, firms who increase outside directors after SOX have greater CEO turnover performance sensitivity. Because they are less tolerant of bad performance. Dah and Frye(2014) note that increased outside directors can enhance effectiveness and efficiency of monitoring, resulting in less power in the hands of incumbent CEOs and increasing likelihood of CEO turnover following poor performance.
3. Hypothesis development
SOX is known as an anti-fraud measure in response to plenty of significant financial and accounting scandals. The primary goal of SOX is to enhance the correctness and faithful presentation of financial reporting and require CEO to be more responsible for inappropriate reporting. SOX incorporates a number of provisions to ensure reliability and relevance of financial reports. Prior research suggest that accurate and objective financial reporting could be achieved by independent and expert monitoring. Independent and expert monitoring can be achieved by increasing the coverage of outside directors on the board. If SOX has had its intended fact, a firm should faithfully present its complete and objective financial reporting to investors and regulators. Meanwhile board of directors will become stricter to CEOs, many actions will be regarded as unacceptable and not allowed. Hence, outside directors would be more likely to replace incompetent directors based on poor performance.
Not only board of directors is better at removing incumbent CEOs after SOX. In addition, the stronger function of board of directors is strengthened by external pressure and institutional investors. Researchers have noted that firms’ investors and the financial media affect decisions made to CEO removal. Investors play an significant role in removing incumbent CEOs, because they can either directly intervened and get involved in CEO activities or exert influence on board of directors. Financial media also play an significant role in CEO turnover, because financial press is also a kind of monitoring, especially after the exposure of scandals, the press put more attention on the action of firms. Firms value their reputation a lot and try to avoid bad news spread in public. As a result, outside directors would be more alert to CEO’s poor performance and replace CEOs due to negative news coverage(Farrell and Whidbee, 2002). So my first hypothesis is based on the effect of more tightening monitoring:
after SOX
I use correlation analysis to test hypothesis 1. I compare correlations before and after SOX, I also compare correlations between CEO turnover and outside directors. If the result is as expected, the correlation between CEO turnover and outside directors should be higher after SOX, since more outside directors are introduced to increase board independence. Meanwhile, the correlation between CEO turnover and outside directors should be higher than correlation between CEO turnover and inside directors.
This paper not only sheds light on relationship between outside directors and CEO turnover, it also takes into account the relationship between corporate governance and performance. The changes in board composition resulted from SOX also has influence on the CEO turnover performance sensitivity. The relative power of the outside directors is changed by modification in the composition of board. Elimination of outside directors will compromise efficiency and effectiveness of board monitoring, incumbent CEOs are not afraid to be constrained by independent directors. Consequently, the likelihood of turnover following poor performance decreases. Conversely, elimination of inside directors will improve efficiency and effectiveness of board monitoring, CEOs are supervised and evaluated by outside directors, if CEOs fail to achieve good results, outside directors will replace them. More specifically, when board of directors are making removal decision, outside directors’ reliance on performance is more than that of inside directors. The possible explanation is that outside directors have more incentive to remove poor-performance CEOs, because outside directors have to make sure that the firm is running effectively to signal themselves as competent board members. While inside directors always do not have the power or are not willing to offend CEOs, since CEOs are their superiors who decide their job promotion. So my second hypothesis is based on CEO turnover performance sensitivity:
increase outside directors than firms who decease or remain independence after SOX. The hypothesis 2 is tested using logistic regression model. This model is designed to explore factors that influence the probability of CEO turnover. I use EBIT and ROA as performance measure and exclude stock return. Prior research has viewed stork return as an ineffective and inaccurate way in measuring performance. Bhagat and Bolton(2008) suggest that almost no governance measure is related to stock market performance in the future. If hypothesis is true, the regression coefficient should be higher in firms who increase independent directors.
4. Data
4.1. Sample selection
The data includes 368 board members from 39 companies of North America and are collected from Risk Metrics, Execucomp and Compustat(company data with the same ticker number are chosen from each database). I chose data from America because SOX sets requirement for all U.S. Public companies, although SOX has world-wide influence, I believe America is the most typical and representative one. The period of the sample is from 1999 to 2005, I choose the 7-year sample because this period allows my reseach to have an equal length of time for pre- and post-SOX periods(SOX was adopted in 2002), so I can make an impartial comparison for events occurred before and after SOX. Due to Execucomp database, there are three reasons for CEO turnover: death, retirement and resignation. I delete turnovers due to death and retirement and focus on forced turnover in this paper.
The definition of independence defined by NYSE and NASDAQ stock exchange standards are similar. Both NYSE and NASDAQ require that a majority of the board of directors of a listed company be independent. If a firm has more than 50% of independent directors, then the firm is said to be complying with the board composition requirement, and we call it compliant firm. On the contrary, a non-compliant firm is a firm whose independent directors are less than 50% of total directors. Generally speaking, an Independent director (also sometimes called outside
director) is a board member who does not have a significant correlation with firm or related people. There are some difference between Risk Metrics and NYSE and NASDAQ for the definition of independent directors. A former employee would be classified as an independent directors if at least three years has passed since their employment ended in NYSE and NASDAQ. However, a former employee can never be independent in the classification of Risk Metrics.
4.2. Variable definition 4.2.1. Dependent variable
4.2.1.1. CEO turnover: This is a dummy variable that equals to one if it is a forced
turnover. A turnover is voluntary if a CEO retires or died. Forced turnover occurs when a CEO quit his/her job because of poor firm performance or strategic divergence with the board. In my thesis I focus on forced turnover so I delete turnovers due to death and retirement.
4.2.2. Independent variable:
4.2.2.1. SOX: This is a dummy variable. If the announcement of turnover occurred
after 2002, I code Post-SOX dummy as 1 and 0 otherwise.
4.2.2.2. Independent directors: Since I use Risk Metrics as database, a former
employee is never classified as independent. Risk Metrics may classify former employees and directors with insignificant business transactions as linked even though they might be independent according to the NYSE and NASDAQ.
4.2.2.3. Compliant firm: is a dummy variable equals to 1 if the firm’s board includes at least 50% outside directors. This variable is used to test whether high level of independent directors influence CEO turnover or not.
4.2.2.4. Non-compliant firm: is a dummy variables equals to 1 if the firm’s board
level of independent directors influence CEO turnover or not. It is also used as a comparison group for compliant firm. If independent directors truly play a role in taking place of bad-performance CEOs, then these two groups should show opposite result.
4.2.2.5. ROA (return on assets): ROA is used as a measure for performance, it is
calculated as net income divided by end of year total assets. I use ROA at year-1 relative to the turnover announcement date to measure a firm’s performance, because poor performance in this year may trigger the replacement of a CEO in the subsequent year.
4.2.2.6. EBIT (earnings before interest and tax): EBIT is used as a measure for
performance, it is calculated as (EBIT-t1—EBITt2)/Total Assets. Some literature use stock price to measure performance of CEO. But in this paper I use EBIT, reasons are as follows: EBIT reflect short-term profits while stock price is an indicator of present discounted value of the expected future cash flows. The stock price reflects the market’s estimate of the possibility that an incumbent CEO will be removed. Hence the stock price of companies with incumbent CEOs is higher compared to CEOs who have lifetime job guarantee. So the monitoring effect of outsiders may be underestimated if stock price are used as measure of performance. Using EBIT can be used to prevent and avoid influence of change or capital structures difference or tax treatments.
4.2.3. control variable:
4.2.3.1. CEO age: According to Bhagat (2008), CEOs of different age may have
diverse equity ownership and different characteristic even they have same years of tenure. CEOs of 65 are likely to have different quality, incentive, and working concerns. Gibbons and Murphy (1992) provide evidence on this. Therefore, CEO age is controlled for CEO quality.
If the total number of directors of firms, including both insiders and outsiders, varies to a large extent, the result may be biased. Large boards and small boards have different characteristics. A larger size provides enough people to more easily manage the workload of firm. Heavy work load of small boards may create burnout. And the influence of SOX is entirely different on large firm and small firm. As a result, board size should be controlled so the result would be more objective.
4.2.3.3. Audit committee size: The total number of audit committee members. Audit
committee size is important governance mechanism that affects companies. If a company has a good governance mechanism, bad-performance CEOs would be fewer than company who has a lower degree of governance mechanism. So audit committee has the same function as independent directors as audit committee helps replace bad-performance CEOs. Consequently, the effect of independent directors is more obvious in firms with smaller audit committee size.
4.3. Methodology
For Descriptive data and major comparisons of my paper. I divide my sample into pre-SOX and post-SOX periods and compare CEO turnovers, change of independent directors, percentage of compliant firms each year, performance of firms and other firm characteristics between these two periods.
To test the strength of relationship between CEO turnover and independent directors pre and post- SOX, I use correlation analysis. A large coefficient indicates CEO turnover and independent directors are highly correlated, while a small coefficient means these two variables are hardly related. If hypothesis 1 is correct, I expect that the correlation between these two variables would be stronger after SOX, since higher level of independent directors are required after SOX.
My hypothesis 2 states that CEOs are more likely to be removed due to bad performance in firms who increase outside directors than firms who decease or remain independence after SOX. To test hypothesis 2 I use logistic model to examine CEO turnover performance sensitivity. Many prior literature choose this model to study
resignation problems. Several other research also use a probit model to study the influence of outside directors on the frequency of CEO turnover. The difference between logistic model and probit model is that the logistic regression model assumes that the error term follows a logistic distribution, while the probit model suggests that the error term follows a normal distribution. I choose logistic model because the independent variables in logistic model do not need to be interval, normally distributed or linearly related, the nature of the independent variables is consistent with CEO turnover data. A logistic regression model is the standard method used to evaluate CEO turnover. Since my dependent variable has more than two outcome categories, I use multinomial logistic regression to analyze my data. If possibility of CEO turnover is stronger related to bad performance for firms who have more outside directors than for firms who have more inside directors, it would be evidence thatthat outside directors are more responsible for monitoring management.
I find that there is a debate on the methodology used to evaluate CEO turnover. While most literature use logistic model some research papers also use a probit model to study the influence of independent directors on the turnover-performance sensitivity. According to Hurst and B. Frye(2014), logistic is much better as it assumes that the error term follows a logistic distribution, while the probit model follows a normal distribution. Furthermore the independent variables do not need to be interval, normally distributed, linearly related, or of equal variance within each group. For these reasons, I believe logistic model is the most suitable one. The logistic approach assumes that:
Pr(CEO turnover)=F(xβ)=exp(xβ)/(1+exp(xβ))
X is a vector of variables that may affect the probability that CEO lose his job, such as the influence of SOX, percentage of outside directors in a firm, firm performance(EBIT or ROA). β is a parameter vector. The logistic model use maximum likelihood to estimate the parameters. The regression equation takes the form:
CEO turnover=β0+β1Performance1+β2SOX+β3Performance2+β4Outsiders+γ
CEO turnover is a dummy variable that takes the value of one if it’s a forced turnover. In order to measure firm performance to test CEO turnover performance sensitivity, I use two methods. The first measure is EBIT and the second is ROA. As defined earlier, EBIT is calculated as (EBIT-t1—EBITt2)/Total Assets. ROA is calculated as net income divided by end of year total assets.γ represents set of control variables, as I mentioned earlier, control variables includes CEO age, audit committee size, board size. The percentage of outsiders is also an important factor influence CEO turnover.
5. Empirical Findings
5.1. Descriptive data
Table 1 summarizes the corporate governance characteristics of a firm in the pre-SOX period(Panel A) and in the post-SOX period(Panel B). In the aspect of performance, the mean value for EBIT decreases slightly after SOX while ROA is 1% higher that ROA before SOX. And the maximum value of ROA reaches 1.25. Compliant firms increase after SOX given the forcible changes in corporate governance. Because of the strict and compulsive independence requirement, in my sample, no non-compliant firms exist after SOX anymore. This is a good prelude that firms’ financial reports will be more faithfully represented, more reliable and objective under the supervisory of outside directors. The table also shows that the average audit committee increases after SOX. SOX gives audit committee the right to appoint, compensate, and oversight the performance of any registered public accounting companies hired by a company. Inclusion of audit committee can help better detect financial frauds, which is the aim of SOX.
As expected, the mean value for outside directors increase after SOX while the maximum value of outside directors is lower. The possible explanation is that firms increase outside directors to satisfy independence requirement, at the same time, firms avoid having too many outside directors since higher than required levels of
independence is costly and redundant. On the contrary, the average inside directors that the firms hire decrease to 2 after SOX. Firms do not eliminate all inside directors because it may not be ideal if the board of directors is composed entirely of outside directors. Although outside directors are more responsible for judging CEOs and remove them once they perform poorly, inside directors have other functions that bring benefits to firms. Generally, inclusion of inside directors in a firm has two advantages. Firstly Inside board members are potential CEOs in the future. Being an inside director in a firm gives inside directors experience that are required in becoming a professional CEO. Secondly, in order to help outside directors to make accurate and reliable decisions regarding who have the ability to become a CEO, firms have to include inside directors to give outside opportunities to evaluate potential CEO candidates. So even though outside directors play a more important role in corporate governance, it is widely believed that boards of directors who combine inside and outside directors usually perform better in removing incumbent CEOs since this kind of board possesses perfect discipline of the inside directors and outside directors can better evaluate them in this context.
5.2. board composition pre-and post-SOX
Different board compositions represent different firm characteristics. In general, outside directors can help firm better improve its monitoring mainly by replacing ineffective CEOs, so there is a relationship between CEO turnover and outside directors. Especially after SOX, which required higher level of monitoring. In order to meet the requirement, firms have to increase the percentage of outsiders. So it is relevant to study the change of board composition before and after SOX.
While the descriptive data in prior section provides information of corporate governance for each firm, table 2 provides a more holistic picture of board composition on an overall level, that is, the data are summarized for all companies not a single company. Panel A shows the number of inside and outside directors and their growth rate each year. From this table we can notice that the percentage of outside director increases continuously even prior to SOX because companies have to include
enough outside directors who provide independent and objective work to ensure effective running of firm. From panel A, we can notice that after SOX the number of outside directors is 252. This is not the maximum value for outside directors from 1999 to 2005. Because when some firms were increasing outside directors, some firms chose to decrease outside directors to the minimum level to reduce cost. In order to evaluate the changing trend for outside directors, it’s better to look at the growth rate, which reflects the percentage of increase in each year. More specifically, in 2003, the year immediately after the SOX, the growth rate of outside directors shoots up to 3.12% and hits to the peak, this is an obvious surge compared to 2001 whose growth
Table 1. Descriptive statistics Panel A: Descriptive data for sample prior to SOX
Variables Median Mean Maximum Minimum St.dev
EBIT 0.170 0.333 2.090 -0.530 0.435 ROA 0.170 0.147 1.140 -1.670 0.336 Outside directors 7 7 19 1 2.921 Inside directors 2 3 5 1 1.043 Compliant firm 27 28 32 29 1.411 Non-compliant firm 5 3 5 2 1.500 Board Size 7 8.805 20 3 2.699 Audit Committee 3 3 7 2 1.042 Age 59 59.193 80 44 8.037
Panel B: Descriptive data subsequent to SOX
Variables Median Mean Maximum Minimum St.dev
EBIT 0.330 0.290 2.290 0.170 0.414
ROA 0.130 0.156 1.250 -0.260 0.225
Outside directors 8 8 14 3 2.384
Compliant firm 31 31 32 30 1.000
Non-compliant firm 0 0 0 0 0.000
Board Size 8 9.303 16 5 2.347
Audit Committee 4 4 6 2 0.994
Age 61 59.892 81 37 8.335
Notes: This table provides summary statistics for the main variables for corporate governance characteristic from fiscal year 1999-2005. It includes 368 board members from 39 companies of North America. Panel A reports summary statistics for the main variables for corporate governance characteristics prior SOX. Panel B reports summary statistics for the main variables for corporate governance characteristic after SOX. The corresponding variables in panel A and panel B compare to each other to evaluate the change of corporate governance characteristics before and after SOX. All numbers are rounded up to third decimal place. Variable definitions are shown in section 4.
rate equals 1.8% and 2002 whose growth rate equals 2.4%. This trend is also in sharp contrast to the trend of inside directors who went down during 1999 to 2003. After SOX, both the number and growth rate of decrease to the lowest level.
As expected, the trend for the outside director in panel A is decidedly upwards, since after SOX companies have to substantially increase proportion of outside directors to meet the more strict independent requirement. A probable explanation would be that firms increase outside directors serving on boards at the expense of inside directors. This finding is consistent with the findings of Linck et al. (2009), who suggest an increase of outside directors and decrease of inside directors after SOX.
Panel B provides information on compliant and non-compliant firms before and after SOX. As I mentioned earlier, a firm is a compliant firm if it has more than 50% independent directors, otherwise, it’s a non-compliant one. Because of the more strict board independence requirement after SOX, many firms hire more outside directors to meet the requirement. So it is not hard to find that the percentage of complaint firms increases to 100% following SOX. Conversely, the percentage of non-compliant firm deceases to 0. This can be explained by more severe punishment for illegal financial activities, for example, the punishment can be up to $5,000,000 penalty or imprisoned
not more than 20 years. All of these bring powerful impact on firms and force firms to comply with SOX.
Panel C provides cross section data which reports more detailed information on firms’ board change. I classify change of inside directors or outside directors into three categories: increase, no change, or decrease. So there are nine combinations for changes of board structure. Firms whose board structure remain unchanged occupy the largest proportion, 33.33% firms neither increase outside directors nor decrease inside directors. This situation may arise because these firms have already compliant with board independence requirements and operate effectively before SOX, so these firms do not have to increase extra outside directors to meet the requirement or improve efficiency of financial performance. For most of firms, higher than required levels of independence is costly and redundant monitoring. Hence, Firms whose inside directors and outside directors corporate well and reach a balance do not have to make any change.
Surprisingly, some firms choose to decrease outside directors, this situation may arise because those firms already have too many outside directors before SOX, and these firms consider payments for outside directors are too expensive that they cannot afford. The costs related to coordination, information asymmetry, and free-rider problems will increase following the increase in outside directors on boards. Consequently, these firms view SOX as an opportunity to reduce costly monitoring that results from excessive board independence. Nearly half of the firms(43.33%) choose to increase participation of outside directors on their boards because they have to increase board independence and monitoring to meet requirements by SOX. Even though some firms have already compliant with independence requirement, after the exposure of financial scandal, they may feel the need to strength monitoring to prevent financial fraud and loss. This suggests that the pressure to increase board independence and monitoring may have been felt by plenty of companies, no matter compliant or non-compliant firms. Maybe the most unique board structure change during SOX is decreasing outside directors while increasing inside directors.The more effective monitoring role of outside directors does not mean inside directors are
useless and inefficient. Inside participation on the board make larger contributions in other functions such as help better make decisions about who the successor should be. A board who contains too many outside directors or contain no inside director is unlikely to be more efficient than a board who combines both inside and outside directors. That is why some firms choose to increase inside directors.
In conclusion, table 2 provide detailed information on board composition before and after SOX. From this table we find that outside directors increase significantly at the expense of inside directors after SOX. All firms are compliant with independence requirement after SOX to avoid severe punishment for illegal financial activities. Not all firms choose to increase outside directors and decrease inside directors. Some firms also choose to decrease outside directors to avoid costly and redundant monitoring or increase inside directors to achieve a more balanced structure of board of directors.
Table 2. Statistics for board composition Year Panel A: data for insider and outsider by
year.
Panel B: data for compliant and non-compliant by year.
Insider Outsider Compliant firm Non-compliant firm
1999 57 - 227 - 30 0.857 5 0.142 2000 46 -0.172 231 0.043 29 0.853 5 0.147 2001 45 -0.090 253 0.018 32 0.914 3 0.085 2002 37 -0.137 247 0.024 29 0.935 2 0.064 2003 29 -0.208 252 0.031 31 1.000 0 0.000 2004 32 0.119 245 -0.013 30 1.000 0 0.000 2005 33 -0.041 266 0.005 32 1.000 0 0.000
5.3. wall street journal for CEO resignation
Table 3 is designed to explore CEO turnover before and after SOX. Panel A summarizes reasons for CEO turnover while panel B summarizes the turnover rate from 1999-2005.
Reasons for CEO turnover is worthy of study since I expect that CEO is replaced because of poor performance in EBIT an ROA. Table 3 represents reasons for CEO resignation provided by the Wall Street Journal. The most common reasons for CEO turnover are retirement, death, and personal reasons, which are excluded from my data for CEO resignation because they are irrelevant to my research. The fifth highest percentage for reasons of CEO turnover lies in performance, that is, 3.15% CEOs are replaced due to bad performance, which proves that poor performance does precede CEO resignation.
From panel A we can notice that the age of CEO is also highly correlated to the frequency of CEO turnover. These turnovers are unrelated to performance but will influence CEO turnover on a large degree. Gibbons and Murphy (1992) suggest that CEOs of different age have different reputation,incentives, and career experience. For Panel C: Cross section of changes in board structure.
Inside directors
Increase No change Decrease
Outside directors
Increase 0.0667 0.2333 0.1333
No change 0 0.3333 0
decrease 0.1 0.1333 0
Notes: This table provides summary statistics for board composition and types of firm in the period from 1999 to 2005. Panel A reports summary statistics for the total number of inside directors and outside directors and their growth rate, the left column shows the numbers and the right column shows the growth rate. Panel B reports summary statistics for the total number of compliant and non-compliant firms and their percentage by year, the left column shows the numbers and the right column shows the percentage. Panel C reports summary statistics for the frequency and percentage of firms for each of the nine possible combinations of changes in board structure after SOX.
example, it is likely that the ability and equity ownership of a CEO at age 70 are different from that of a CEO at age 50. So I included CEO age as my control variable in later section.
CEO turnover frequencies are one of the most significant study object in this paper. Panel B provide information on CEO replacements in compliant and non-compliant firms before and post SOX. Before SOX the turnover rate for compliant firm is obviously higher than that of non-complaint firm. The most typical data is in year 2002, the turnover rate of compliant firms equals 0.027 while that of non-compliant firms equals zero, in other words, no CEO was replaced in non-compliant firm in 2002. The reason is that compliant firms have more outside directors who are responsible for replacing incumbent CEOs.
Panel B shows a significant reduction in CEO turnover of compliant firms after SOX, which is not consistent with my expectation that CEO turnover should increase after SOX because of higher proportion of outside directors. There are two reasons for this reduction. Firstly, the reduction is a total number for all compliant companies, the reduction does not represent that CEO turnover decreased in all compliant companies, the true meaning behind the reduction is that the degree of decrease is higher than increase. To be more specific, the percentage of compliant firms whose CEO turnover decreased is more than that of firms whose CEO turnover increased. This could be interpreted as more compliant firms choose to decrease redundant monitoring. The second reason is that firms that were already compliant with independence requirement before SOX always keep high-quality monitoring, as a result few bad-performance CEOs exist in compliant firms so those firms do not have to remove a mass of CEOs after SOX.
However panel B dose not show change of turnover rate in non-compliant firms after SOX because no non-compliant firm exist in my sample anymore. The 0% dose not represent no CEO was removed after SOX, it means that no non-compliant firms exist, as a result, the CEO turnover rate is 0. It’s reasonable since no firm want to be punished or suffer reputation and finance damage. Panel B only shows information about CEO turnover, it does not clearly address the turnover performance sensitivity,
the monitoring efficacy of the board will be explored in later in the later part.
In conclusion, Panel A provides clear evidence that poor performance is related to CEO turnover, which supports my hypothesis 2 that outside directors replace incumbent CEOs because of bad performance. Panel B shows that the CEO turnover rate is higher in compliant firms than in non-compliant firms, this can be interpreted as compliant firms have more outside directors who have incentive to replace incumbent CEOs. Panel B also shows that after SOX, CEO turnover rate decrease in compliant firms, because most of compliant firms do not have to increase outside directors to meet independence requirement, they are more willing to eliminate redundant monitoring to save money.
Table 3. Statistics for CEO turnover after SOX Panel A: Reasons for CEO turnover from Wall Street Journal
Reason for resignation Percentage of resignation
Retirement 48.25%
Personal reasons 5.94%
Death 4.20%
Normal succession procedure 3.85%
Illness 3.15%
Performance mentioned 3.15%
Policy or personality disagreement 2.80% Take prestigious appointment elsewhere 1.75%
Followed by takeover 1.40%
Scandal 1.40%
Company policy to retire at 60 1.05%
Merge 0.70%
CEO purchased a subsidiary and will run it 0.35%
No reason given 24.61%
Year Compliant firm Non-compliant firm 1999 0.044 0.006 2000 0.042 0.000 2001 0.027 0.003 2002(SOX) 0.101 0.013 2003 0.064 0.000 2004 0.054 0.000 2005 0.062 0.000
Notes: This table provide summary statistics for CEO turnovers from fiscal year 1999-2005. Panel A reports summary statistics for reasons and their proportions for CEO turnover. Panel B reports summary statistics for the average turnover rate in compliant and non-compliant firms before and after SOX. Panel A suggests that poor performance is one of the turnover reasons. Panel B compares different figures in different type of firm by year to demonstrate the relationship between board structure and turnover. All numbers are rounded up to third decimal place.
5.4 correlation between CEO turnover and outside directors Pre-and Post-SOX
In this section, I investigate whether SOX has positive influence on relationship between CEO turnover and outside directors. This can be tested by Pearson correlation analysis, if relationship between these two variables is stronger after SOX than that before SOX, then SOX truly has positive influence because of increased board independence, in other words, more outside directors are responsible for replacing CEOs after SOX.
Table 4 shows the result of Pearson correlation analysis on CEO turnover and outside director as well as relevant variables before SOX(panel A) and after(SOX). From panel we can notice that the coefficient between CEO turnover and outside directors equals 0.567, while in panel B equals 0.850. The positive and significant coefficient demonstrates a positive correlation before these two variables, to be more specifically, the number of CEO turnover increases with the number of outside directors. The coefficient for post-SOX period is much higher than that for Pre-SOX period, reaching 0.850. Higher coefficient represents stronger relationship between
these two variables. The higher correlation coefficient may result from increase of outside directors after SOX, since outside directors play an important role in replacing CEOs, increased outside directors will lead to increased CEO turnover. This result reveals that outside directors play an important role in CEO turnover frequencies by improving the effectiveness of monitoring. Especially after SOX, because of increased number of outside directors, the responsibility of outside directors become more evident.
It’s also interesting to look at the correlation between outside directors and financial performance. Both panel A and panel B show a positive correlation between these two variables. The results is easy to understand, more outside directors construct a more effective corporate governance system, CEOs work harder to avoid being replaced, ROA and EBIT become higher because of good performance of CEO. And the bigger coefficient of 0.51 in ROA in panel B suggests that this correlation become stronger after SOX. The reason is the same as before, higher level of monitoring helps better governs a firm. We can also notice that after SOX there is a positive and significant coefficient between outside directors and audit committee. Because SOX not only increase independence requirement, it also empowers audit committee with more authority. Just as outside directors, audit committee play a more important role in controlling board of directors, such as appoint, supervise, and compensate the work of any registered public accounting firms hired by a company.
CEO turnover is negatively related to ROA. As I just mentioned earlier, incumbent CEOs are removed because of poor performance, so if the firm runs effectively and ROA is high, it signals that CEOs do a good job. Outside directors have no reason and no need to replace them. Since both EBIT and ROA are regarded as measures to evaluate firms’ performance, it’s not difficult to understand their relationship, a firm who performs well in EBIT can not suffer a significant loss in ROA. These two measures can reflect a firm’s capability to earn profit and gain advantage in financial market.
In conclusion, table 4 suggests that the relationship between CEO turnover and outside directors becomes stronger after SOX because of a more strict independent
requirement, which supports my hypothesis 1 that SOX has positive influence on CEOs.
5.5 Logistic regression for turnover performance sensitivity
In this section, I investigate whether outside directors are responsible for replacing bad-performance CEOs. I use EBIT and ROA as performance measures. I expect that increase of outside directors will improve the efficiency and effectiveness of firms’ monitoring. Especially after SOX, outside directors are more responsible for replacing poor-performance CEOs because of a more strict requirement by SOX. In contrast, if a firm decreases outside directors, the likelihood of turnover following bad performance will decrease. This section will provide support for my hypothesis 2 which states that outside directors are more responsible for replacing under-performing CEOs.
Table 4. Correlation analysis on CEO turnover and outside director Panel A: Correlation analysis for pre-SOX statistics
Outside Director
Turnover EBIT ROA Board
Size Audit Committee Age Outside Director 1 0.567 0.321 0.307 0.132 -0.081 -0.088 0.045** 0.670 0.001 0.155 0.386 0.382 Turnover 0.567 1 -0.315 -0.216 -0.091 0.038 -0.014 0.045** 0.012** 0.088* 0.476 0.769 0.916 EBIT 0.321 -0.315 1 0.095 -0.023 0.224 -0.057 0.670 0.012** 0.005*** 0.804 0.014** 0.551 ROA 0.307 -0.216 0.095 1 0.023 0.212 0.38 0.001 0.088* 0.005*** 0.808 0.021** 0.690 Board Size 0.132 -0.091 -0.023 0.023 1 -0.015 -0.175 0.155 0.476 0.804 0.808 0.871 0.81 Audit Committee -0.081 0.038 0.224 0.212 -0.015 1 0.089 0.386 0.769 0.014** 0.021** 0.871 0.376
Age -0.088 -0.014 -0.057 0.38 -0.175 0.089 1
0.382 0.916 0.551 0.690 0.81 0.376
Panel B: Correlation analysis for post-SOX statistics Outside
Director
Turnover EBIT ROA Board
Size Audit Committee Age Outside Director 1 .85 0.226 0.510 0.161 0.800 -0.048 0.047** 0.010*** 0.083* 0.067* 0.010*** 0.590 Turnover 0.850 1 0.022 -0.615 0.032 0.000 -0.056 0.047** 0.885 0.045** 0.836 0.997 0.715 EBIT 0.226 0.022 1 0.532 -0.065 0.144 -0.076 0.010*** 0.885 0.000*** 0.46 0.102 0.389 ROA 0.510 -0.615 0.532 1 0.102 0.119 -0.002 0.083* 0.045** 0.000*** 0.247 0.179 0.981 Board Size 0.161 0.032 -0.065 0.102 1 0.144 0.050 0.067* 0.836 0.46 0.247 0.102 0.562 Audit Committee 0.800 0.000 -0.06 0.119 0.144 1 -0.067 0.010*** 0.997 0.495 0.179 0.102 0.449 Age -0.048 -0.056 -0.076 -0.002 0.050 -0.067 1 0.590 0.715 0.389 0.981 0.562 0.449
This table displays the correlation coefficients mainly for outside directors and CEO turnover before and after SOX. Panel A provides correlation analysis for pre-SOX statistics while panel B provides correlation analysis for post-SOX statistics. The Pearson correlation coefficients are above the diagonal and the significant coefficients are below the diagonal. Significant coefficients at the 1%, 5%, and 10% levels are noted by ⁎⁎⁎, ⁎⁎ and ⁎, respectively.
I use logistic regression to study turnover performance sensitivity, I divide my data into three parts: companies who decrease the proportion of outside directors after SOX, companies remain unchanged, and companies who increase the proportion of outside directors after SOX. In these three kinds of companies, I test relationships between turnover and firm performance, percentage of outside directors as well as
SOX separately so as to reveal the influence of outside directors on the CEO turnover performance sensitivity.
From table 5 we can notice that for firms who decrease the percentage of outside directors, the significance level for SOX is high, indicating that SOX truly influences turnover in this kind of firm. I have mentioned earlier why this kind of firm choose to decrease outside directors after SOX, SOX and listing requirement changes may have provided motivation and incentives to firms that were already compliant before SOX to alter their board structures even though they were not required to do so. These companies view SOX as an opportunity to reduce costly board independence, some of them may even move toward the minimum independence requirement to save money. The unintended consequence of SOX on this kind of firm suggests that compliant firms did react to SOX with unusual reduction in monitoring since they perceived their higher than required levels of independence would result in costly or redundant monitoring.
The significance level for outside directors and ROA in the first kind of firm also show my model is meaningful. The negative coefficient for outside directors indicates that increase in outside directors lead to decrease in CEO turnover. Because redundant outside directors are eliminated, hence unnecessary CEO removals decrease. As for turnover performance sensitivity, it seems like that EBIT has noting to do with turnover rate, namely, CEOs leave their jobs not because low EBIT, instead, they are replaced because of poor performance in ROA. This is consistent with findings of Dah et al which suggest that the firms that decreased monitoring, do not exhibit sensitivity to EBIT but do show negative and significant sensitivity to ROA. In table 5, both coefficient for ROA is negative, this is consistent with the notion that better performance leads to less turnover likelihood, poor performance is perceived as inability or indolence. In firms who decrease outside directors, the decreased level of monitoring following the decease of outside directors result in lower efficiency and effectiveness of removing bad-performance CEOs. Consequently, bad management lead to lower ROA. Lower ROA lead to more CEO turnovers.
figure does not mean the firm is non-compliant, those firms are usually compliant firms who already had enough outside directors before SOX. Their monitoring intensity is already adequate, they decrease outside directors in order to save money rather than decrease level of corporate monitoring, increase audit committee is redundant and can not help remove bad-performance CEOs.
For firms who remain unchanged, after SOX their board structure is the same as that before. SOX has little influence on them, they neither increase outside directors nor decrease outside directors because they have adequate level of monitoring and they do not view this kind of monitoring as costly expense. Consequently, turnovers are not influenced by SOX. The negative coefficient for outside directors indicate that increase in outside directors lead to decrease in CEO turnover, this can be explained by the fact that, since firms’ monitoring has already been saturated, improvement in monitoring do not help much in CEO turnovers, bad-performance CEOs had already been replaced before SOX, so there is no need for firms to increase replacement of CEOs after SOX. The negative coefficient for ROA indicated that for firms that are not required to increase board independence, higher ROA also helps reduce the likelihood that CEOs are replaced because higher ROA is a signal that CEO is capable of doing his work effectively. In this kind of firms, EBIT still has little influence on CEO turnover.
Unlike the first type of firm, firms who remain unchanged has a positive coefficient for audit committee, which suggests that increase in audit committee would lead to increase in CEO turnover. The registered public accounting firms are required by SOX to report directly to the audit committee, and the audit committee also has the authority to participate in independent counsel and other advising to accomplish its duties. Since firms do not change board independence, compared to previous year, audit committees play a larger role in corporate governance than outside directors.
As for firms who increase their board independence after SOX, the influence of SOX on them is the most obvious. Because SOX puts forward a more strict independence requirement, firms have to increase the presence of independent
directors on board to comply with the requirement. From column 3 we find that the coefficient for SOX is significant and positive, the coefficient for SOX equals 0.875, this figure reflects a highly correlated relationship, implying that this kind of firm remove lots of CEOs following SOX because of higher level of corporate governance. Outside directors shows a positive and significant coefficient that equals 1.460, which means more outside directors will lead to more CEO turnovers. In a well-governed firm outside directors become less tolerant of undesirable firm performance, even a interim small decline in performance may stimulate CEO turnover, more outside directors seat on the board, more eyes on monitoring and the likelihood that unqualified CEOs would be replaced increase. The coefficient for ROA(-0.780) is negative and significant, Which indicates that higher ROA leads to less CEO turnovers. The reason is easy to understand, because increased monitoring lead to better performance of firms and higher ROA, which reflects that CEOs are hard working and capable, as a result, outside directors do not have to make judgment to decide whether a CEO should be replaced or not, as a result, less CEO is removed based on performance. Column 3 also shows a significant positive coefficient for audit committee. Audit committee and outside directors work together to help firms to avoid unpromising financial reports and financial fraud by removing unqualified CEOs.
Compared to firms who decrease monitoring, the absolute value for ROA is higher in firms who increase monitoring, indicating that outside directors play an important role in taking place bad-performance CEOs, and this supports my hypothesis 2 that that CEO turnover became significantly less sensitive to performance after the firms decreased their independence level. Also the coefficient for audit committee in column 3 is 0.511, higher than that of in the second column(0.134), because firms who increase outside directors are positively response to requirements of SOX, not only in the aspect of number of outside directors, but they also stress more on audit committee. Audit committee governs firms by reviewing reports of public registered firm, so audit committee is also a way of corporate governance, more audit committees result in more incumbent CEOs being
removed.
Generally speaking, the coefficients on the control variables have expected signs. The control variables that are consistently significant is audit committee. I have already explained the reason. And I observe the coefficient for board size is negative in first two columns and positive in the third column. Board size is composed of the total number of outside and inside directors. In firms who decrease or do not change outside directors, increase in board size means increase in inside directors, inside directors are less effective in removing incumbent CEOs, as a result, CEO turnover decrease. In firms who increase outside directors, increase in board size usually result in increase in outside directors, hence CEO turnover increase therewith.
In conclusion, Table 5 shows a greater CEO turnover performance sensitivity in firms who increase their outside directors, which supports my hypothesis 2 that CEOs are more likely to be replaced as a result of poor performance in firms who increase outside directors than firms who decease or remain independence after SOX.
Table 5. Logistic regression for turnover performance sensitivity after SOX
Decrease No change Increase
SOX 0.170 -0.194 0.875 0.041** 0.960 0.018** Outside Directors -0.17 -1.099 1.460 0.031** 0.601 0.026** Inside Directors -0.172 -0.105 -0.325 0.073* 0.699 0.507 EBIT -1.93 -0.105 -0.10 0.998 0.818 0.149 ROA -0.223 -0.336 -0.78 0.477 0.211 0.004*** Audit Committee -0.768 0.134 0.511 0.027** 0.079* 0.021** Board Size -0.223 -0.182 0.042
0.077* 0.697 0.892
Age -5.2 -4.541 -3.147
0.999 0.583 0.850
Notes: This table presents logistic regression analysis for turnover performance sensitivity after SOX. The first column provides information for firms who decrease outside directors after SOX, the second and the third column provides information for firms who make no change or increase outside directors. This table reveals what factors influence the possibilities of CEO turnover in three different categorizations of firms. Significant coefficients at the 1%, 5%, and 10% levels are noted by ⁎⁎⁎, ⁎⁎ and ⁎, respectively.
6. Conclusion
The Sarbanes-Oxley Act was adopted following a series of severe accounting and financial scandals to enhance the quality of corporate governance and to bring back trust and faith of investors. In my paper, I primarily investigate how SOX influence the relationship between CEO turnover and outside directors. I also investigate CEO turnover performance sensitivity in different types of firms to prove CEOs are removed based on poor performance. In this way, I assess how effective of SOX in improving monitoring of corporate governance. Firms who have more outside directors seat on their board are always better at removing incumbent CEOs. More specific, I study how SOX influences board compositions, CEO turnovers, CEO turnover performance sensitivity based on EBIT and ROA as well as the authority of audit committee.
I have three main findings. Firstly, my result is consistent with prior literature which concludes that increased independence on corporate governance leads to greater oversight and effectiveness in monitoring bad-performance CEOs. In fact I find that nearly 50% of firms choose to increase outside directors and there is toward SOX, they take actions to meet the requirements of SOX, in doing so, firms can not only avoid severe non-compliant punishment, increased board independence also helps to enhance the quality of financial reports and confidence of investors. Likewise
