CFA Institute Journal Review June 2016 Volume 46 Issue 6
Restraining Overconfident CEOs through Improved Governance: Evidence from the Sarbanes-Oxley Act (Digest Summary)
Review of Financial Studies
Using the passage of the Sarbanes–Oxley Act of 2002 as their template, the authors examine how board controls and regulation affect the actions of normally confident and overly confident CEOs and the companies that they steward.
CEO confidence can benefit shareholders; excessive confidence can harm them. The authors demonstrate that the Sarbanes–Oxley Act of 2002 and changes to NYSE/NASDAQ listing rules (collectively referred to as SOX) moderate the impact of the overconfidence that some CEOs exhibit. In the wake of SOX, companies’ investment and risk exposure have decreased and operating and post-acquisition performance and market value have increased, along with dividends.
How Is This Research Useful to Practitioners?
Managerial confidence is a necessary leadership trait to achieve success in business and other endeavors. But there is well-documented evidence that overly confident CEOs can engage in reckless behavior that includes poorly conceived mergers and acquisitions as well as overinvestment in general. The passage of SOX created a unique opportunity to examine the degree to which the legislation moderated managerial excess and CEO overconfidence. An additional and important consideration is how this moderating influence affects shareholders.
The authors propose several hypotheses:
- SOX reduces the effect of CEO overconfidence on corporate investment.
- SOX mitigates the effect of CEO overconfidence on firm exposure to systematic and unsystematic risks.
- SOX causes firms to be less cash-flow sensitive by reducing CEO overconfidence.
- SOX retains and enhances the positive effects of CEO overconfidence on a firm’s value.
- SOX enhances CEO overconfidence to produce improved operating performance.
- SOX enhances the value of capital expenditures and R&D investment.
- SOX improves the effect of CEO overconfidence on producing value-enhancing mergers and acquisitions.
- SOX encourages the overconfident CEO to increase dividend payments.
Through rigorous evaluation and analysis of compensation data and measures of overconfidence during a 20-year period, the authors demonstrate the positive effects that improved scrutiny, governance, and disclosure following the passage of SOX have had on mitigating the actions of normally overly confident CEOs. The authors’ research makes a novel contribution to the literature on CEO overconfidence and the consequences of SOX. Although the legislation sought to reduce or eliminate corporate greed in the form of theft and excessive compensation, the findings, in part, reveal the benefits of SOX in the form of decreased excesses through the restraint of CEO overconfidence.
Students of regulation, as well as regulators themselves, will draw important lessons from how regulation can affect managerial conduct and shareholder value. Analysts and portfolio managers can use these insights to make more-informed decisions.
How Did the Authors Conduct This Research?
The authors review the relevant literature on the effects of CEO overconfidence as well as outline the salient issues in SOX to give context to their research. To investigate their hypotheses—that excessive CEO confidence is harmful to the well-being of the company and mitigating it could be beneficial—the analysis draws on CEO compensation observations from the ExecuComp database. The ExecuComp data are merged with the Compustat and CRSP databases to obtain firm-level variables as well as market returns. The Thomson Reuters Institutional Holdings (13-F) Database provides institutional ownership percentages, and their SDC Platinum database contains acquisition data.
These datasets form the basis for the construction of a “CEO confidence” metric based on a CEO’s retention of vested, in-the-money stock options. Holding such options when they are in the money rather than exercising them signifies some measure of overconfidence. Robustness tests confirm that the results hold up to numerous definitions of overconfidence. The authors also obtain variables of CEO tenure, age, and ownership percentage as well as the ratio of bonus to fixed salary because these variables could influence a company’s performance.
Using these data, the authors construct regression models that evaluate the extent to which the passage of SOX moderated CEOs’ overconfidence as expressed through their companies’ level of overinvestment; capital expenditures; R&D investment; asset growth; selling, general, and administrative expenses; investment sensitivity to cash flows; propensity to take risks; corporate performance (value creation); level of dividend payout; and post-acquisition performance.
The authors find that CEO overconfidence has declined in the wake of SOX. Excessive investment and outsize assumption of risk have also declined; operating performance and long-term value creation have improved as the value of capital expenditures and R&D investment has increased. CEOs in the post-SOX environment tend to make more prudent use of cash by increasing dividend payouts. Extensions and robustness tests are used to mitigate the potential for endogeneity or reverse causality in the results. These tests confirm the findings.
Both distant and recent history underscore the dangerous effects of managerial excess and unrestrained risk taking. Progress in finance can appear cyclical with opaque business practices and a shortage of governance, allowing CEO hubris and overconfidence to cloud business judgment and destroy shareholder value. As the authors demonstrate, regulation can exert positive effects. Using the passage and implementation of SOX, they show how control of CEOs’ excess confidence can lead to better-managed firms and more-satisfied shareholders. Additional research to reproduce the authors’ experiment studying non-US developed and developing economies with well-developed public markets could be a topic for further investigation.
About the Author(s)
Marc L. Ross, CFA, is a senior compliance consultant at John Hancock.