DO FIRMS SEEK A TARGET BOARD STRUCTURE? EVIDENCE FROM THE POST‐SOX PERIOD

• Date: 01 July 2019
• Author: Donna L. Paul,Chune Young Chung,Chang Liu
• Published date: 01 July 2019
• DOI: http://doi.org/10.1111/jfir.12173

The Journal of Financial Research Vol. XLII, No. 2 Pages 361–381 Summer 2019

DOI: 10.1111/jfir.12173

DO FIRMS SEEK A TARGET BOARD STRUCTURE? EVIDENCE FROM THE

POST‐SOX PERIOD

Chune Young Chung

Chung‐Ang University

Chang Liu

Hawaii Pacific University

Donna L. Paul

Washington State University

Abstract

We investigate whether firms restructure board composition to align with changes in

their contracting environment. Board size and independence increase with firm

complexity, consistent with theoretical predictions. However, the hypothesized

negative relation between board independence and information costs is evident only

for firms completing acquisitions. Furthermore, board independence increases to

offset increases in CEO power in a sample of firms making acquisitions, but

decreases when CEO power increases in a large cross‐section of firms. We conclude

that after the Sarbanes–Oxley Act of 2002, firms face constraints adjusting to target

board structure, but these constraints can be mitigated by a shock to the contracting

environment via acquisition.

JEL Classification: G30, G34

I. Introduction

A large body of literature examines the characteristics of corporate boards that best

serve shareholder interests. The prevailing theoretical view is that a firm’s board

structure is determined endogenously by its contracting environment, and thus, there is

no unique board structure that suits all firms (Raheja 2005; Adams and Ferreira 2007;

Harris and Raviv 2006). Empirical evidence provided by Linck, Netter, and Yang

(2008), Coles, Daniel, and Naveen (2008), and Duchin, Matsusaka, and Ozbas (2010),

among others, supports this view that board structure varies with firm characteristics in

the cross‐section. However, there is considerably less evidence on how corporate

boards evolve over time as the contracting environment changes. Denis and Sarin

(1999) examine changes in board composition for 1983–1992, finding they are weakly

related to changes in firm‐specific determinants of board structure. Answering a similar

question for a later period (1991–2003), Cicero, Wintoki, and Yang (2013) find that

firms pursue economically meaningful adjustments to their board structure following

changes in their underlying characteristics. However, they also provide preliminary

evidence that firms adjusted their board structures less frequently during 2004–2009.

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© 2019 The Southern Finance Association and the Southwestern Finance Association

This suggests that the advent of the Sarbanes–Oxley Act (SOX) may have mitigated

adjustments toward desired target structures.

We pick up this important lead and examine how board structures adjusted to

changes in underlying firm fundamentals since SOX was enacted on July 30, 2002. The

intention of SOX was to enforce stricter governance standards following the outbreak

of corporate scandals involving firms such as Enron and WorldCom in the early 2000s.

Stock exchanges have since strengthened their listing requirements by pressing for

boards comprising a majority of independent outsiders and for strictly independent

audit and compensation committees.

1

In this environment, firms wishing to add

nonindependent directors to the board (or to decrease the number of independent

directors), as dictated by their contracting environment, face new constraints. These

well‐intended laws and regulations likely encourage asymmetric board changes,

particularly with respect to board independence, impeding some firms’ability to adjust

their board structure to desired targets. We investigate this potential dilemma of the

stickiness of board structures post‐SOX and whether it is surmounted following a

shock to the contracting environment resulting from a major investment via an

acquisition.

Linck, Netter, and Yang (2009) document increases in board size and

independence after the passage of SOX and suggest that some of these changes resulted

in outcomes that may not have been optimal for all firms. We argue that in this post‐

SOX setting, firms face implicit pressure against adjusting their board independence

downward, even when changes in the contracting environment dictate such an

adjustment. Thus, board structures post‐SOX may deviate more from firms’targets

than they did pre‐SOX. We examine whether a significant corporate event, such as a

merger, can ease this pressure and facilitate an adjustment toward targets that are

suitable for the new contracting environment.

We conduct our analysis from 2003 through 2014 using two samples of U.S.

firms. The first is a large sample of approximately 7,100 firm‐years (large sample), and

the second is a sample of approximately 1,900 acquisitions (merger and acquisition

[M&A] sample). The M&A sample provides an event setting that is especially

conducive to our investigation of whether firms seek a target board structure.

Acquisitions are important strategic moves by firms that we argue can shock the

contracting environment, for the following reasons. First, an acquisition typically

results in a major shift in the asset mix of the bidder merger after the target assets are

combined. Second, it is possible for a merger to shift the power balance between the

chief executive officer (CEO) and the board as select target board members and senior

management are assimilated into the merged firm. Finally, a merger can alter implicit

external monitoring to the extent that it changes the firm’s mix of investors, customers,

and/or suppliers. In this context, we argue that a merger provides an ideal setting in

which to observe whether boards are restructured toward a desired target. Any

significant change in firm fundamentals should motivate an adjustment of board

1

See, for example, NASDAQ Listing Rules 5605(b)(1), 5605(c)(2), and 5605(d)(2).

362 The Journal of Financial Research