Disciplining entrenched managers through corporate governance reform: Implications for risk‐taking behavior

• Published date: 01 July 2021
• Author: Oksana Pryshchepa
• Date: 01 July 2021
• DOI: http://doi.org/10.1111/corg.12370

EDITOR'S PICK

Disciplining entrenched managers through corporate

governance reform: Implications for risk-taking behavior

Oksana Pryshchepa

Accounting and Finance Section, Cardiff University Business School, Cardiff, UK

Correspondence

Oksana Pryshchepa, Accounting and Finance

Section, Cardiff University Business School,

Cardiff CF10 3EU, UK.

Email: PryshchepaO@cardiff.ac.uk

Abstract

Research question/issue This paper examines how enhanced monitoring by corpo-

rate boards following the passage of the Sarbanes–Oxley Act of 2002 and concurrent

reforms to stock exchange rules (SOX) mitigated risk-related agency conflicts preva-

lent 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 previ-

ously noncompliant 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 under-

scores 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 policymakers 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 chief executive officer (CEO)'s risk aversion. It is a fully independent compen-

sation committee that is instrumental in incentivizing CEOs to pursue risky projects

that also add value. Firms and policymakers need to be aware that the effectiveness

Received: 14 May 2019 Revised: 23 February 2021 Accepted: 26 February 2021

DOI: 10.1111/corg.12370

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reprodu ction in any medium,

provided the original work is properly cited.

© 2021 The Author. Corporate Governance: An International Review published by John Wiley & Sons Ltd.

328 Corp Govern Int Rev. 2021;29:328–351.wileyonlinelibrary.com/journal/corg

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 environments.

KEYWORDS

Corporate governance, antitakeover provisions, managerial entrenchment, risk-taking,

Sarbanes–Oxley Act

“Taking less risk than is optimal is not safer;

it just locks in a worse outcome.”

(Brown, 2011, p. 35).

1|INTRODUCTION

Risk-taking is fundamental to producing economic growth and welfare

(e.g.,John et al., 2008). Yet, managerial riskaversion and career concerns

create incentives for managers to invest in projects with less risk and

possibly negative net present values (Amihud & Lev, 1981; Coles et al.,

2006). This risk-related agency conflict between managers and share-

holders becomes especially acute as shareholder governance weakens

and managerial ability to pursue self-interest (i.e., entrenchment)

increases(Gormley & Matsa, 2016).Whether corporate governance reg-

ulationsthat increase board independence andrealign managerial incen-

tives can beeffective in alleviatingthis conflict is thereforean important

and so far little explored question. Specifically, can regulatory-imposed

improvementsin board composition and practices discipline entrenched

managers by forcing them to refocus on riskier and more value-

enhancingprojects? This paper addresses this question.

According to the managerial entrenchment hypothesis, a higher

number of antitakeover provisions (ATPs) subject managers to less

monitoring and disciplinary power of the market for corporate control,

leading to managerial entrenchment (e.g., Sundaramurthy, 2000).

Because managers hold undiversified portfolios and hence are

exposed to significant human capital risk, they have a preference to

reduce it by engaging in projects with less risk than optimal from the

viewpoint of shareholder value maximization or even in projects that

lower shareholders' wealth while also reducing risk

(e.g., Holmström, 1999). Gormley and Matsa (2016) refer to this man-

agerial misbehavior as “playing it safe”and demonstrate that it indeed

manifests in firms with poor external shareholder governance as mea-

sured by the number of ATPs adopted by the firm.

1

One of the mechanisms to alleviate this risk-related conflict is by

empowering the board to establish appropriate incentives and to dis-

cipline management. While prior literature shows that boards are

instrumental in moderating managerial preference for private benefits

and avoiding costly effort (e.g., Scholten, 2005; Hazarika et al., 2012),

there is no evidence on the role of internal corporate governance in

incentivizing managers to increase investments in risky projects to the

benefit of shareholders. I present such evidence in this paper.

Using the passage of the Sarbanes–Oxley Act and concurrent

reforms to national stock exchange rules (hereinafter collectively

referred to as “SOX”)

2

as a positive shock to a firm's internal gover-

nance, I test the hypothesis that risk-taking and investment of highly

entrenched firms significantly increased, leading to enhancements in

firm value and operating performance. I focus on SOX as an exoge-

nous governance shock because it mandated more independent

boards and board committees and tightened regulatory requirements

on firm's disclosures and internal controls. Specifically, SOX wrote

into law the requirement of independence of the majority of board

directors and of all members of nominating, compensation, and audit

committees. This mandatory increase in board and committees' inde-

pendence significantly reduced managerial discretion and power over

previously insider-dominated boards (e.g., Linck et al., 2009). Hence,

SOX can be expected to moderate managerial preferences for risk

reduction and increase value-creating risk-taking and investment even

when external shareholder governance, proxied by ATPs,

remained weak.

To measure risk-taking, I construct a total risk proxy similar to

Armstrong and Vashishtha (2012) and Aretz et al. (2019) and decom-

pose it into systematic and idiosyncratic components. Since it is more

difficult for managers to diversify away or hedge firm-specific risk

(Brisley et al., 2021), I expect that SOX had a greater impact on the

idiosyncratic, rather than systematic, risk of firms with entrenched

managers, if the reform was truly effective in moderating the risk-

related agency conflict.

As the main entrenchment proxy, I use E-index by Bebchuk et al.

(2009) based on six ATPs written in firms' statutes and by-laws. Using

this proxy mitigates the concern that a firm's managerial entrench-

ment is endogenous. E-index is a sticky measure of entrenchment that

shows little within-firm variation over the sample period.

3

In firms

with higher values of E-index, managers are better insulated from

internal pressure by shareholders and external control market and

hence are in a better position to act upon their innate preference “to

play it safe.”Prior evidence supports this conjecture by documenting

lower risk-taking in firms with higher E-index (Gormley &

Matsa, 2016). In this paper, however, I hypothesize that this negative

impact of ATPs, that is of external governance arrangements, will

weaken or even disappear following the improvements in internal

governance due to SOX. Based on this hypothesis, I expect the inter-

action term between the entrenchment proxy and SOX dummy to be

significantly positive in risk-taking and investment regressions.

PRYSHCHEPA 329