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    Corporate Governance Reform and Executive Incentives:...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.10 CEO Compensation 
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    Title:
    Corporate Governance Reform and Executive Incentives: Implications for Investments and Risk Taking.
    Practical Implications:

    The evidence speaks to the debate on how corporate governance regulation interacts with firms' and managers' incentives, and ultimately affects corporate operating and investment strategies. The evidence contributes to the literature on the economic effects of the governance regulations in SOX on CEOs’ compensation contracts and corporate investment strategies. The evidence also contributes to this literature by documenting how the period after SOX is associated with changes in stock- and option-based compensation. The authors find evidence that the changes in investments are related to lower operating performances of firms, suggesting that these changes were costly to investors.

    Citation:

    Cohen, D. A., Dey, A., & Lys, T. Z. 2013. Corporate Governance Reform and Executive Incentives: Implications for Investments and Risk Taking. Contemporary Accounting Research 30 (4), 1296-1332.

    Keywords:
    corporate governance, executive compensation, investments, risk-taking, executives
    Purpose of the Study:

    In response to a series of corporate scandals beginning with Enron, the U.S. Congress enacted the Sarbanes-Oxley Act (SOX) in 2002 aimed at regulating the governance of firms. While this has resulted in a large and growing body of research, the overall consequences of regulating firms’ governance structures is not yet well understood. For instance, one of the questions still under assessment is to what extent corporate governance regulation interacts with firms’ and managers’ incentives and ultimately affects corporate operating and investment strategies. The authors objective is to investigate how governance regulations in SOX and the exchanges are associated with chief executive officers’ (CEOs) incentives and risk-taking behavior. While there are no direct mandates in SOX regarding executive compensation, two provisions in SOX motivate the analyses. First, SOX requires that a majority of board members of all publicly traded companies be independent, thus increasing the role of independent directors. Second, SOX increases the liability of corporate officers and directors, including expanding the scope of their legal obligations by requiring CEOs and CFOs to certify financial statement information and increasing the penalties associated with violations of securities acts. The authors discuss how these requirements are likely to affect incentive compensation and risk-taking behaviors of executives.

    Design/Method/ Approach:

    The sample consists of industrial companies from the COMPUSTAT annual industrial and research files and ExecuComp and covers the period 19922006. For the analyses with board independence, the authors merge the above sample with RiskMetrics. This results in a sample of 1,158 firms and 12,486 firm-year observations. The final sample represents only firm-year observations where data for all variables included in the analysis are available.

    Findings:
    • The authors find that there were significant shifts in executive compensation to packages that have less incentive-based compensation.
    • The sample firms significantly reduced investments in risky projects in the period following SOX.
    • While the authors find a decline in incentive-based compensation, they also find that CEOs’ responses to risk-inducing incentives declined significantly in the post-SOX period. Therefore, the reductions in investments are not only the consequence of changes in incentive contracts but also the consequence of increased personal costs perceived by CEOs in the period after SOX.
    • Furthermore, the authors find evidence indicating that these changes in investments were, indeed, associated with reduced operating performance of the sample firms and that these changes are correlated with firm-specific stock price changes at the SOX events.
    • The authors find evidence that the changes in investments are related to lower operating performances of firms, suggesting that these changes were costly to investors.
    • The changes in investments were in part due to changes in executive compensation contracts and in part related to increased executives' personal costs of engaging in risky activities.
    Category:
    Corporate Matters
    Sub-category:
    CEO Compensation, Earnings Targets & Management Behavior