Restraining Overconfident CEOs Through Improved Governance: Evidence from the Sarbanes-Oxley Act

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Restraining Overconfident CEOs through Improved Governance: Evidence from the Sarbanes-Oxley Act by SSRN

Suman Banerjee

College of Business, University of Wyoming

Mark Humphery-Jenner

UNSW Business School; Financial Research Network (FIRN)

Vikram K. Nanda

Rutgers, The State University of New Jersey – Rutgers Business School at Newark & New Brunswick

October 20, 2014

Review of Financial Studies, Forthcoming

UNSW Australian School of Business Research Paper No. 2013 BFIN 05


The literature posits that some CEO overconfidence benefits shareholders, though high levels may not. We argue adequate controls and independent viewpoints provided by an independent board mitigates the costs of CEO overconfidence. We use the concurrent passage of the Sarbanes-Oxley Act and changes to the NYSE/NASDAQ listing rules (collectively, SOX) as natural experiments to examine whether board independence improves decision-making by overconfident-CEOs. The results are strongly supportive: Post-SOX, overconfident CEOs reduce investment and risk exposure, increase dividends, improve post-acquisition performance, and have better operating performance and market value. Importantly, these changes are absent for overconfident-CEO firms that were compliant prior to passage.

Restraining Overconfident CEOs Through Improved Governance: Evidence from the Sarbanes-Oxley Act – Introduction

Overconfidence can lead managers to overestimate returns and underestimate risk. The literature suggests that while some CEO overconfidence can benefit shareholders, a highly distorted view of risk-return profiles can destroy shareholder value. An intriguing question is whether there are ways to channel the drive and optimism of highly overconfident CEOs while curbing the extremes of risk-taking and over-investment associated with such overconfidence. We explore such a possibility in this paper. Specifically, we investigate whether appropriate restraints on CEO discretion and the introduction of diverse viewpoints on the board serve to moderate the actions of overconfident CEOs and, in the end, benefit shareholders.

While governance issues, such as board independence, have been viewed mainly through the lens of managerial agency, they have a bearing in the context of CEO overconfidence as well. For instance, while the scandals that precipitated Sarbanes-Oxley Act of 2002 (SOX) and the changes to NYSE/NASDAQ listing rules1 are usually attributed to poor governance and unethical behavior, they were likely exacerbated in many cases by managerial hubris. In the case of Enron, for instance, it is claimed that overconfidence may have rendered managers slow to recognize their mistakes and quick to engage in risky behavior in their attempt to cover up these mistakes (O’Connor, 2003). These troubles were likely compounded by a permissive board that exhibited group-think and inadequate oversight. SOX and the changes to the NYSE/NASDAQ listing rules were intended to mitigate such problems by, inter alia, increasing independent oversight in both the board and the audit committee. This package of reforms, combining increased board and audit-committee independence, represents a significant strengthening in oversight (Clark, 2005). The increased oversight, and the diverse set of view-points, promoted by an independent board, could help to attenuate the impact of managerial moral-hazard and biased beliefs.

While the consequences of SOX and the listing rules have been studied in the context of poorly governed firms, the question for us is whether the increased oversight and other governance changes also helped to reign-in the more harmful aspects of CEO overconfidence.

Evidence that SOX improved the decision-making of overconfident-CEOs would demonstrate that appropriate governance structures and advice can help to better channel the optimism of overconfident managers toward creating shareholder value.

The double-edged nature of confidence is evident from the literature. Confidence is essential for success in myriad domains, including business (Puri and Robinson, 2007). Not surprisingly, CEOs tend to be more optimistic, and less risk-averse, than the lay population (Graham et al., 2013). Overconfidence can be a desirable trait in managers when, for instance, there are valuable, but risky, investments to be made in developing new technologies or products (see e.g., Galasso and Simcoe, 2011; Hirshleifer et al., 2012; Simsek et al., 2010). The downside is that overconfidence can lead to faulty assessments of investment value and risk, resulting in suboptimal decision making.

We use the concurrent passage of the Sarbanes-Oxley (SOX) Act of 2002 and the changes to the NYSE/NASDAQ listing rules as a natural experiment to investigate whether governance changes can moderate the impact of CEO overconfidence. In some ways these changes provide an ideal setting for such a test: they were exogenous to the circumstances of specific firms, but were associated with improvements in governance, disclosure, and monitoring (see e.g., Coates, 2007), which we briefly discuss in Section 2. By requiring a fully independent audit committee and a majority of directors to be independent, SOX, coupled with the NYSE/NASDAQ rule changes (collectively, just `SOX’), is believed to have helped bring new perspectives and greater scrutiny into the board room. Consequently, we would expect SOX to mitigate the extent to which overconfident CEOs could hold sway over insider-dominated boards.

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