Corporate Ownership & Control / Volume 4, Issue 4, Summer 2007
IS THE TONE SET AT THE TOP? A REVIEW OF THE LITERATURE
RELATING CORPORATE BEHAVIOR TO CHARACTERISTICS OF THE
BOARD OF DIRECTORS
Wanda Causseaux*, Bruce Caster**
Abstract
The financial community has been stunned by the flood of reports of corporate accounting scandals.
Congress reacted swiftly with the Sarbanes-Oxley Act, and the Securities and Exchange Commission
(SEC) imposed sweeping changes for corporate boards of directors. One major objective of this
regulation was to improve corporate behavior by mandating changes in corporate governance
structures. But, do changes at the top actually permeate the corporation, or do such changes only
result in token attempts to comply with a list of rules, regulations and requirements? This literature
review covers: the relationship between board characteristics and high quality financial reporting;
the role of the board in corporate governance; and literature linking board characteristics with
corporate behavior.
Keywords: board of directors, corporate behavior, regulation, financial reporting
* Valdosta State University, Valdosta, GA USA 31698
** Corresponding Author: Valdosta State University, Valdosta, GA 31698 USA
Telephone: (229) 245-3809, Fax: (229) 249-2706, email: [email protected]
Introduction
The financial community in the U.S. has been
stunned by the flood of reports of corporate
accounting scandals. Over the past few years, Enron,
WorldCom, Aldephi, HealthSouth and others have
become both household names and also “code
words” for failures in corporate governance. More
recently, The Office of Federal Housing Enterprise
Oversight (OFHEO) launched an investigation into
accounting problems and failures of Fannie Mae’s
management and directors (Reuters’, 2006). On May
23, 2006, Fannie Mae agreed to pay a $400 million
fine as a result of the scandal. Certainly, the issue of
corporate governance has emerged from Wall Street
to Main Street (Fields, 2003).
In light of these scandals, the ability of the
investing public to trust the quality of the published
financial statements of U.S. corporations has become
a fundamental problem. The U.S. Congress reacted
swiftly to these scandals by passing the Public
Company Accounting Reform and Investor
Protection Act of 2002 (commonly referred to as the
Sarbanes-Oxley Act, or SOX), an amendment to the
Securities Act of 1934 (the 1934 Act). In addition,
two of the major U.S. stock exchanges, the New
York Stock Exchange and the NASDAQ, have
modified their listing requirements to place new
restrictions on listed firms. The impact of these
regulations is far-reaching, and many of them target
characteristics of corporate boards of directors. The
obvious assumption of these regulations is that
modifying the characteristics of the board of
directors will be an effective means of modifying the
behavior of corporations.
This review examines the empirical literature
that relates corporate behavior to characteristics of
the board of directors. The purpose of the review is
to determine whether the evidence supports this
regulatory strategy attempting to modify the
behavior of corporate management by regulating
certain characteristics of the board of directors.
Initially the the role of the board of directors in
corporate governance is reviewed. Thereafter, the
literature linking board characteristics with corporate
behavior is examined, and an attempt is made to
build a model of what an effective board looks like.
Next, a comparison is made between those
characteristics and the regulatory mandates, in order
to assess the likelihood that these new regulations
will be effective in fulfilling their purpose. The
concept of corporate culture is also introduced as a
counter-argument to the assumption that changes in
board characteristics will necessarily modify
corporate behavior. The review concludes with
suggestions for additional research that might link
changes in corporate governance to improved
financial reporting.
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Corporate Ownership & Control / Volume 4, Issue 4, Summer 2007
The Role of the Board of Directors in
Corporate Governance
The board of directors plays a crucial role in
corporate governance. The legal role of the board is
defined and regulated through state corporation laws,
SEC regulations, and SOX. The theoretical
framework for the board’s role in corporate
governance is provided by agency theory (Fama &
Jensen, 1983).
Agency theory examines the relationship
between an agent, one who acts on behalf of another,
and a principal, one on whose behalf an agent
operates. In the corporate setting, shareholders own
the corporation, but they typically employ nonowner managers to operate the corporation on their
behalf. This creates a principal-agent relationship,
with management acting as agents for the
shareholders.
The board of directors also acts as an agent for
the shareholders. The board is elected by the
shareholders and normally oversees decision making
of the corporation. The board assists management in
formulating strategic business plans and policy
objectives, it functions to assure effective planning
and allocation of resources, and it oversees the
corporation’s
compliance
with
regulatory
imperatives and monitors financial performance
(Arfken, 2004). As the highest level in the corporate
governance structure, the board functions as the first
example of the ethical environment under which the
corporation will operate (Schwartz, Dunfee, & Kline,
2005).
As an extension of their role as agents for the
shareholders, the board of directors fills two
additional roles in corporate governance. The first is
a monitoring role. Agency theory proposes that every
principal-agent
relationship
must
include
mechanisms by which the principal can monitor the
behavior of the agent because the agent is constantly
tempted to perform actions that are based in the
agent’s own self-interest rather than the best interests
of the principal. In its monitoring role, the board is
involved in decision processes such as hiring or
terminating
top
management,
supporting
management decisions, setting compensation for top
management
positions,
and
delegating
to
management operating authority. The board ratifies
management decisions and monitors corporate
performance, and it keeps those functions separate
from the management functions of initiation and
implementation. The board thereby establishes the
separation of ownership and control: This separation
is intended to limit the ability of management to
confiscate the value that should accrue to the
shareholders.
The final role of the board of directors regards
fiduciary responsibility. The legal tradition of the
United States defines the board of directors as having
the duties of care and loyalty with respect to
managing the assets of the shareholders (Aguilera,
152
2005). This role may coincide with the board’s role
in guiding and assisting management in overseeing
management
decision-making
and
guiding
management in effective planning and allocation of
resources because the board’s responsibility is to
ensure that the assets entrusted to the corporation by
the shareholders are used effectively and efficiently.
The board is also required by its fiduciary
responsibility to contain the excess power that top
management sometimes exerts, which in some cases
has led to corporate scandals (Aguilera, 2005). One
way that the board exercises its fiduciary
responsibility is through the audit committee, which
oversees management’s financial reporting activities.
One concern of the audit committee is to ensure that
management does not expropriate wealth from
shareholders by misstating the corporation’s
financial results in order to increase the value of
management’s stock options or other bonuses while
misleading shareholders regarding the actual
performance of the corporation.
Since 1940 the SEC has required the boards of
directors of publicly-traded companies to have audit
committees comprised of non-officer board
members. Since that time, the SEC has issued
numerous additional rules, regulations and
requirements, many of which focus on the board of
directors and the committees of the board. Recently,
regulators have imposed significant mandates
regarding characteristics of the board of directors
and specifically the audit committee. Starting in
early 2004, SOX requires companies to have at least
one member of their audit committee with financial
acumen or expertise and to disclose the name of that
individual. Companies that do not have a financial
expert member must disclose why they do not have a
financial expert on the audit committee (SarbanesOxley, 2002). SOX defines a financial expert as a
person who has,
“…through education and experience as
a public accountant or auditor or a principal
financial officer, comptroller, or principal
accounting officer of an issuer, or from a
position involving the performance of
similar functions—1) an understanding of
generally accepted accounting principles and
financial statements, 2) experience in the
preparation or auditing of financial
statements…,3) experience with internal
controls; and 4) an understanding of audit
committee functions,” (Sarbanes Oxley,
2002, Sec. 407).
In addition, revised listing requirements of the
New York Stock Exchange and the NASDAQ that
became effective in 2003 require that a majority of
the members of the board be independent. An
independent director is defined as one who has not
been an employee of the company during the past
five years (three years for NASDAQ), is not a family
member of an executive of the company, has not had
a compensation committee interlock with any inside
Corporate Ownership & Control / Volume 4, Issue 4, Summer 2007
director for the past five years (three years for
NASDAQ), has not been an employee of the firm’s
auditor during the past five years (three years for
NASDAQ), and does not have a business
relationship with the firm that the board decides may
interfere with the director’s independent judgment
(Klein, 2003). Additionally, the audit committee
must have at least three members, all of whom are
independent, all of whom are financially literate, and
at least one of whom must be financially
sophisticated (a standard of expertise that is
somewhat lower than SOX’ definition of a financial
expert).
The new regulations of SOX and the SEC seek
to control or modify the behaviors of corporate
management by imposing mandates regarding the
characteristics of the board of directors (Securities
and Exchange Commission, 2003). That action
raises two obvious questions: First, what evidence is
there that the behavior of corporate management is
related to characteristics of the board of directors?
And, second, what evidence is there that changing
those characteristics will be effective in changing
management behavior? The next section of the
paper will examine the literature regarding the first
of those two questions. The second question will be
addressed later in the paper.
Review of the Literature Relating Board
Characteristics to Corporate Behavior
Table 1 presents a taxonomy of the research
literature reviewed in this paper, classified according
to the characteristic(s) that the researchers studied
and the behavioral outcome(s) that the researchers
examined in conjunction with those characteristics.
Many papers have examined relationships between
multiple board characteristics and multiple
behavioral outcomes. Accordingly, those papers
appear more than once in Table 1.
[Insert Table 1 about here]
Table 1 identifies four different groups of board
characteristics that have been studied. Three of those
groups (demographic characteristics, professional
characteristics, and relationship to the firm) relate to
the members of the board. The demographic
characteristics of board members that have been the
focus of empirical research have included gender and
ethnicity. The professional characteristics have
included degree of financial expertise, level and
length of experience, length of time on the board,
and total number of directorships held. Relationships
between directors and their firms have frequently
been divided as follows: Inside directors include
current or former employees, paid consultants, or
those with family ties to the company. Outside
directors are those with no financial or familial
relationship to the company. Outside directors are
frequently subdivided into grey directors, who would
otherwise be considered outside directors except that
they have affiliations with the company such as
being a supplier or vendor, and independent
directors, who are all other outside directors. The
fourth group of board characteristics relates to the
board itself, rather than the board members, and it
includes board size, frequency of board meetings,
and presence or absence of an audit committee.
Table 1 also divides the “outcomes” into major
categories. The first category, operational outcomes,
includes measures of firm value and firm
performance. It is sometimes difficult to decide
whether the dependent variable used in a particular
study indicates firm value or firm performance:
Abnormal stock returns are clearly a measure of
market value. Tobin’s Q is normally accepted as a
measure of performance. Return on equity (ROE)
and return on assets (ROA) are often described as
performance measures, but the authors of some of
these research studies have chosen to characterize
them as surrogates for firm value. In order to avoid
making arbitrary classification choices, Table 1
combines studies investigating firm value and studies
investigating firm performance into a single group.
The second major category in Table 1, financial
reporting outcomes, comprises a much wider variety
of dependent variables. These include restatements
of financial statements, SEC investigations, fraud or
misstatement, issues related to earnings quality,
earnings management or earnings manipulation, and
meritorious shareholder lawsuits.
Table 1 shows that these two major categories
provide a convenient method of dividing the papers
for purpose of analysis: Almost none of the studies
examine variables from both of the groups. The
following review will first focus on studies linking
board characteristics to operational outcomes, and
then it will consider research that links board
characteristics to financial reporting outcomes.
Relationships between Board
Characteristics and Operational
Outcomes
The literature relating board characteristics to firm
value or firm performance has primarily focused the
demographic characteristics of board members, often
characterized as “board diversity.” Much of that
literature is best characterized as advocacy literature,
which simply posits that boards should be diverse
and offers opinions as to the benefits that
corporations would obtain by embracing diversity,
without actually providing empirical results to
support those opinions. There has, however, been a
small amount of empirical research regarding the
relationship between board diversity and firm value.
Shrader, Blackburn, and Iles (1997) compared
the percentage of women on the board to two
measures of firm value, ROE and ROA. Their results
showed a negative relationship between the
percentage of women on the board and firm value in
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Corporate Ownership & Control / Volume 4, Issue 4, Summer 2007
some tests. By contrast, Daily and Dalton (2003)
reported positive stock returns for corporations that
have women on the board. Richard (2000) found no
support for his hypothesis that racial diversity is
positively associated with firm value. However,
when he extended his study to examine whether or
not the firm had a growth strategy, he found that
there was a positive association between racial
diversity on the board and firm value for companies
with a growth strategy.
Carter, Simkins, and Simpson (2003) expanded
this line of research by the considering both board
diversity and also the presence of outside directors
on the board. They used Tobin’s Q as an indicator of
firm performance, and their results showed that the
presence of women, the presence of minorities, and
the presence of outside directors on the board were
each positively associated with firm performance. In
addition, they found that increased percentages of
women, ethnic minorities, and outsiders on the board
were each associated with improvements in firm
performance. Thus, both the fact that women,
minorities, and/or outsiders were on the board and
also proportions of any of these groups that were
present on the board were positively related to firm
performance.
Carter, Simkins, and Simpson (2003) also
reported that the presence of women on the board
and the presence of minority board members are
positively correlated to each other and to the
presence of outsiders on the board. Furthermore,
board diversity is also positively correlated with
larger board size and with larger firm size. These
findings point out a methodological problem that
affects most of the papers in this group. Carter et al
(2003) used a multivariate model that incorporated
gender, ethnicity, presence of outsiders, firm size,
and board size, and they were able to determine the
extent to which their results were related each of
those variables. The remaining papers in this group
did not consider these other variables in their
analyses. That omission confounds the analysis and
makes it impossible for them to conclude that their
results were truly attributable to board diversity.
Two studies examined the professional
characteristics of board members (e.g., financial
expertise or number of board affiliations) in relation
to firm performance and firm value. Defond, Hann,
and Hu (2005) asked whether or not the market
valued financial expertise on the audit committee.
Their results showed a positive market reaction to
the appointment of a director having accounting
expertise but no similar reaction to appointment of a
director with nonaccounting financial expertise. Fich
and Shivdasani (2006) looked at “busy directors”
(directors holding three or more directorships) and
found that boards with a majority of busy directors
are associated with lower market-to-book ratios and
weaker profitability. Furthermore, they found that
departures of busy directors from boards were
associated with positive abnormal stock returns.
154
Overall, the research literature examining the
relationships between board characteristics and firm
performance or firm value is not extensive, but it has
shown some positive relationships. Board diversity
has been shown to be positively related to firm value
(Carter, Simkins, & Simpson, 2003). However, other
diversity studies have shown contradictory results,
and methodological problems in most of those
studies call their results into question. Studies have
also shown that board members with accountingrelated financial expertise and board members who
are not overburdened with excessive numbers of
board affiliations are positively associated with firm
performance and firm value. (Defond, Hann, & Hu,
2005, Fich and Shivdasani, 2006).
Relationships between Board
Characteristics and Financial Reporting
Outcomes
The primary purpose of SOX, recent SEC
regulations, and recent changes in exchange listing
requirements is to improve the quality of financial
reporting. Since a primary target of many regulations
is the composition of the board and of the audit
committee, it is clear that regulators assume that the
composition of the board directly affects company’s
financial reporting practices. That proposition has
been the subject of numerous empirical studies. The
subjects of these studies have included the links
between
board
composition
and
fraud,
misstatements, restatements of published financial
statements, SEC investigations, earnings quality,
earnings management, earnings manipulation, and
meritorious shareholder lawsuits against the boards
of directors.
Fraud, misstatement, or restatement of financial
statements is an area that has received a lot of
research attention. Beasley (1996) pioneered this
research, using a matched-pair methodology to
compare the board characteristics of firms that had or
had not been accused of financial fraud. He found
that both the presence of outside directors and the
proportion of outside directors were negatively
associated with fraud, and it did not matter whether
the outside directors were independent or “grey.”
Furthermore, he found that the likelihood of fraud
increased as the size of the board increased and as
the number of board affiliations per board member
increased.
Abbott, Parker, and Peters (2004) found that
audit committee independence (proportion of
independent director members) and activity level
(meeting at least three times a year) were both
negatively associated with restatements, as was the
presence on the audit committee of a member with
financial expertise. Abbott, Parker, and Peters (2002)
also reported that audit committee independence and
activity level were negatively associated with fraud,
while the absence of financial expertise on the audit
committee was positively associated with fraud.
Corporate Ownership & Control / Volume 4, Issue 4, Summer 2007
Persons (2005) reported that an audit committee
comprised entirely of independent directors and audit
committee members with fewer board affiliations
were both negatively associated with fraud, as were
longer tenure by audit committee members and a
CEO who is not chairman of the board. Finally, once
these additional governance variables (CEO not
chairman, fewer board affiliations, and longer tenure
on the board) were added to the model, board
director independence and financial expertise on the
audit committee were no longer significantly related
to the likelihood of fraud.
Farber (2005) reported that fraud firms had
fewer outside directors, fewer audit committee
meetings, fewer financial experts on the audit
committee, and a higher percentage of CEOs who
were also chairmen of the board. Additionally, he
found that three years after fraud discovery, the firms
that made changes to correct their corporate
governance problems experienced superior stock
performance.
Geriesh (2003) took a much broader view of
fraudulent reporting and attempted to identify
aspects of the overall corporate culture that
predisposed a firm to fraud. One board-related
characteristic he identified was having the original
founder(s) still exerting major influence of the firm
by serving on the board of directors.
The remaining outcomes in this section, SEC
investigations, earnings quality, and shareholder
lawsuits, have received less attention. Deschow,
Sloan, and Sweeny (1996) studied SEC
investigations and found that firms that were targets
of SEC investigations had, on average, 53% insiders
on their boards, as compared to the control group
that had only 40% insiders. They also reported that
the presence on the board of the company’s founder,
who is also the CEO, was positively associated with
earnings manipulation.
Earnings manipulation, earnings management,
and earnings quality were also studied by Vafeas
(2005) and by Dhalival, Naiker, and Navissi (2006).
Vafeas (2005) used small earnings increases as a
proxy for poor earnings quality and found a positive
association between the number of affiliations of
audit committee members and the quality of
earnings. Dhalival, Naiker, and Navissi (2006)
investigated the links between financial and
managerial expertise on the audit committee and
discretionary accruals, a proxy for earnings
management. Their results showed a negative
association betwesn accounting-based financial
expertise and discretionary accruals, a positive
association between managerial expertise and
discretionary accruals, and no association between
nonaccounting financial expertise and discretionary
accruals.
Helland and Suykuta (2005) used shareholder
lawsuits as the indicator of poor corporate
governance and reported that boards with lower
levels of outsiders (50%) were more likely to be sued
by shareholders. Boards with higher levels of
outsiders (68%) were less likely to be sued. The
authors also note that the proportion of outside
directors in the group of firms more likely to be sued
is still high enough to meet the minimum level
required by current regulations.
Summary: Characteristics of an Effective
Board of Directors
Evidence confirms that there are direct links between
board characteristics and the board’s performance of
its roles as agent, monitor and fiduciary. For
example, an effective board is most likely to be
diverse and include outsiders; the old boy network,
the all-white, all-male gathering of corporate
insiders, is the antithesis of board effectiveness
(Bernardi, Bean & Weippert, 2003). There is
evidence of higher firm value and better firm
performance when the board includes women,
minorities, and outsiders (Carter, Simkins &
Simmons, 2003).
The presence of outsiders also matters. Agency
theory posits that board can only fulfill its
monitoring role if it is able to limit the power of
management. A number of circumstances might
interfere with a board’s ability to control
management. For example, if a board is primarily
composed of inside directors, or if a board controlled
by one dominating individual who may be the
founder and/or the CEO of the corporation, then the
separation of ownership of control required for
effective monitoring may be absent. In these
circumstances, one would predict that the board
would not be able to curb abusive behavior by
management (Fama & Jensen, 1983).
The evidence shows a lower likelihood of fraud
or restatement of financial statements when the
board contains outsiders (Beasley, 1996, Farber,
2005) and when the audit committee contains
outsiders (Abbott, Parker & Peters, 2002, Persons,
2005). Having the CEO as chairman of the board is
positively related to fraud (Abbott, Parker & Peters,
2002, Persons, 2005, Farber, 2005), and the mere
presence of the CEO on the board is positively
associated with SEC investigations and earnings
manipulation (Deschow, Sloan, & Sweeny, 1996).
The presence of the company founder on the board,
whether or not as CEO, is also positively associated
with fraud (Geriesh, 2003).
An effective board meets frequently. Its
members are experienced, and they have sufficient
time to devote to their board responsibilities.
Frequent board meetings are negatively associated
with fraud (Abbott, Parker & Peters, 2002), as are
frequent meetings of the audit committee (Farber,
2005). More experience – longer tenure on the audit
committee – is negatively associated with fraud
(Farber, 2005). Board members typically hold
multiple board affiliations (Catalyst, 2005) and these
multiple affiliations have been associated with the
155
Corporate Ownership & Control / Volume 4, Issue 4, Summer 2007
perception that board members are more experienced
(Fich & Shivdasani, 2006). Having board members
with larger number of board affiliations is associated
with higher quality earnings (Vafeas, 2005).
However, the presence of “busy” directors, directors
with three or more board affiliations, is associated
with reduced profitability (Fich & Shivdasani, 2006).
The evidence is divided regarding the
importance of financial expertise on the board.
Financial expertise on the audit committee may be
negatively related to fraud (Abbott, Parker, & Peters,
2004, Farber, 2005). However, after other corporate
governance factors (e.g., CEO as chairman, fewer
board member affiliations, and longer tenure on the
board) are taken into consideration, financial
expertise on the audit committee may not be
associated with reductions in fraud (Persons, 2005).
The type of financial expertise does seem to matter,
however. Accounting-related financial expertise on
the audit committee is associated with positive
changes in stock price (Defond, Hann, & Hu, 2005)
and a lower incidence of earnings management
(Dhalival, Naiker & Navissi, 2006). Both of these
studies found no similar effects for nonaccountingrelated financial expertise.
Finally, board size matters, but it matters in
contradictory ways. Larger boards are associated
with increased incidence of financial fraud (Beasley,
1996). On the other hand, boards that contain
women, minorities, and outside members tend to be
more effective (Beasley, 1996, Deschow, Sloan, &
Sweeny, 1996, Carter, Simkins & Simpson, 2003,
Farber, 2005, Persons, 2005), and they also tend to
be larger (Carter, Simkins & Simpson, 2003). Thus,
board size seems to have both positive and negative
dimensions, and it is difficult to reach a conclusion
regarding the relationship of size to board
effectiveness.
Likely Effectiveness of Recent
Regulations
The previous review of the literature has identified
many characteristics of an effective board. Many of
those characteristics are being regulated by SOX,
recent SEC mandates, and the new exchange listing
requirements. Those new regulations move in
directions that are supported by the empirical
findings: more independent directors, more financial
expertise on the audit committee, etc. Some of them
do not seem to go far enough. For example, the
firms in the Helland and Suykuta (2005) study that
had a higher probability of fraud and lower
proportions of outside directors on the board actually
had as many outsiders as the new regulatory
requirements mandate. Nonetheless, these new
regulations seem to be moving in directions that
suggest that they might be effective.
However, there is a powerful counter-argument
against the effectiveness of these regulations:
Corporate culture. In 1940, Edwin Sutherland argued
156
in an article in the American Sociological Review
that corporate culture contributes to white-collar
crime (Geriesh, 2003). Much more recently Geriesh
(2003) identified specific characteristics of corporate
culture that predispose firms to committing
fraudulent acts: Fraud firms are more likely to
engage in related party transactions, to have the
founders still exerting major influence over the firm,
to have fewer professional accountants, and to have
prior history of illegal violations. If fraud,
misstatements, earnings management, etc., are all
outgrowths of an internal culture, then reducing
those outcomes requires modifying that culture. And
the anecdotal evidence on the efficacy of changing
corporate culture by external mandate is not
encouraging.
Following the 1986 launch disaster of the
Challenger space shuttle, NASA was subjected to
new rules and regulations, changes in top personnel,
and much internal re-examination. The purpose of
these changes was to prevent such an event from
occurring again. Following the 2003 accident with
the Columbia spacecraft, NASA convened an
accident investigation board to determine what went
wrong. Among other things, that accident report
examined NASA’s organizational culture and its
effects on both the Challenger shuttle accident and
the Columbia shuttle accident:
“Organizational culture refers to the
basic values, norms, beliefs, and practices
that characterize the functions of a particular
institution. At the most basic level,
organizational
culture
defines
the
assumptions that employees make as they
carry out their work, it defines ‘the way we
do things here’ An organization’s culture is
a powerful force that persists through
reorganizations and the departure of key
personnel.” (NASA, 2003, p. 101).
The report goes on to point out that, in spite of
new rules regulating the agency, no change in the
culture took place, and many of the behaviors in
existence at the time of the Challenger disaster were
still practiced at the time of the Columbia crash
(NASA, 2003). Furthermore, the report specifically
identified resistance to change in corporate culture as
a contributing factor to the shuttle Columbia crash.
The literature on corporate culture and change
repeatedly focuses on the absolute necessity of
commitment to change from the top levels of the
organization (Pfeffer, 2005, Barros & Cooperrider,
2000, Amabile, 1998, Ng, 2004, Perel, 2002). These
same studies also point out how persons may be
resistant to change, especially at the top of an
organization. Why would top managers and directors
of a corporation be resistant to change? The answer
is simply, the bottom line (Verschoor, 2005). Studies
are now emerging that provide support to the notion
that changes in corporate governance that are
implemented through a change in the corporate
culture do positively affect the bottom line. A Booze
Corporate Ownership & Control / Volume 4, Issue 4, Summer 2007
Allen report showed that 98% of companies that
were financial leaders (defined as outperforming
industry averages) include ethical and behavioral
issues in their value statements. In contrast, only
88% of companies that did not outperform their
industry averages included ethical and behavioral
issues in their value statements. The high performing
companies also included in their corporate values a
commitment to employees, to honesty and to
openness as core company values (Verschoor, 2005).
A comparison study of two Japanese firms,
Toyota and Cannon, and two U.S. firms, General
Motors and Xerox, questioned the necessity to resort
to the rule-burdened U.S. system of corporate
governance to achieve higher performance
(Yoshimori, 2005). The writer proposes that
corporate culture, corporate values and strategy are
important components of success. Royal Dutch Shell
and other long-lived companies view themselves as
“communities with a characteristic culture or
ideology” (Geus, 2002, p. 228). These companies
view corporate culture as a conscious part of a
company’s strategy.
In an environment of increased regulation
regarding corporate governance, one wonders
whether the additional regulations will actually
change corporate behavior or whether they will just
produce box-checkers to satisfy regulatory
requirements (Klein, 2003). An analysis of the
composition of the board of directors of Enron
revealed that the board met the then-current
regulatory requirements (Ramirez, 2003). Carter,
Simkins and Simpson, (2003) expressed concern that
the response to these new regulations may only be
tokenism, unless it can be demonstrated that there is
a real business purpose for the changes.
The research evidence reviewed in this paper
only examines relationships between characteristics
of corporate boards at a point in time and the
concurrent behaviors of the corporation. That body
of knowledge is really insufficient to use as a basis
for predicting the effects of change. To begin with,
predicting the results of change will require a
significant, and unwarranted, leap from association
to causation. To say that certain board characteristics
are associated with certain behavioral outcomes is
not equivalent to saying that the board characteristics
caused the outcomes. However, unless one has
evidence that one caused the other, one has no basis
for predicting that a change in one will change the
other.
Finally, there also seems to be strong evidence
suggesting that corporate culture is involved in firm
behavior. The literature on corporate culture suggests
that culture is not likely to change simply as the
result of external mandates. Instead, the internal
leadership has to accept, advocate, and lead the
change process. There is little reason to believe that
simply changing the number of outside board
members or tightening the definition of financial
expert will bring about such a process. Thus, it does
not seem that the research reviewed here provides
much support for the conclusion that these new
regulations will be effective in changing corporate
behavior.
Directions for Future Research
SOX was implemented in 2004 and the exchange
listing requirements were implemented in late 2003.
It takes time to generate sufficient data regarding
changes in the operational and financial reporting
outcomes in the post-SOX era to do serious research
on the actual effects of SOX and the new listing
requirements. A sufficient quantity of data will be
available in the next year or so, and that is one
obvious source of future research topics.
As noted above, the literature regarding
demographic characteristics of board members is
incomplete, and much of it is impaired by
methodological flaws. Thus, the value to the firm –
the business purpose – of board diversity is far from
being established. The new regulations from SOX,
the SEC, and the stock exchanges will require firms
to locate increasing numbers of outside directors.
And there is a significant pool of women and
minorities who are available to serve as members of
corporate boards (Catalyst, 2005), if boards are
willing to accept them as board members. However,
as Carter, Simkins and Simpson (2003) noted,
change will only occur if it can be demonstrated that
there is a real business purpose for the change. This
appears to be a fruitful and very important area for
future investigation as well.
Another important area for future investigation
involves the coordination between research
regarding financial reporting outcomes (e.g., fraud,
restatements, etc.) and corporate culture. For too
long, financial reporting outcomes have been cast as
“accounting” problems, while corporate culture and
organizational change have been characterized as
“management” issues. Geriesh (2005) has begun the
process of integrating these two streams of research.
Further studies of that sort could provide additional
insights that could be of great use for developing
strategies for minimizing corporate misbehavior in
the future.
There are still areas of SOX and the SEC
regulations that have not been tested. For example,
no research has yet examined the effect that an
independent compensation committee will have on
CEO pay and financial reporting quality.
Furthermore, there are even inconsistencies between
the SOX and the SEC regulations. The SEC
regulations are not as stringent as SOX, which could
lead to situations where a company is in violation of
the Securities and Exchange Act of 1934 while still
maintaining a good standing with the SEC (Klein,
2003). These are areas of potential research as well,
especially when those regulations relate to the
composition of the board of directors.
157
Corporate Ownership & Control / Volume 4, Issue 4, Summer 2007
Research on the effects that the changed
regulations and laws have on corporate behavior has
the potential to have an effect on public policy.
Research findings that lead to improved investor
confidence in financial reporting could certainly
have a positive effect on financial markets. But most
important, these regulatory changes and the
implications for how boards of directors function and
guide the corporations through the changes provide
fertile ground for research. As a result of all these
changes and study, it is hoped that the new ways
businesses operate will impact long-term results. The
future will be interesting to watch as it relates to
board composition issues and economic and
fraudulent activity.
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Appendices
Table 1. Taxonomy of Literature Relating Corporate Behavior to Characteristics of the Board of Directors
Operational
Outcomes
Board Member Characteristics
Firm value or firm
performance
Financial Reporting Outcomes
Fraud, misstatements,
or restatements
Demographic
Characteristics
Shrader,
Blackburn, and
Iles, 1997
Richard 2000
Carter, Simkins, &
Simpson, 2003
Daily & Dalton,
2003
Professional
Characteristics
Defond, Hann &
Hu, 2005
Fich & Shivdasani,
2006
Relationship to
Firm
Carter, Simkins, &
Simpson, 2003
Other Board
Characteristics
Beasley, 1996
Abbott, Parker, &
Peters, 2002
Abbott, Parker &
Peters, 2004
Person, 2005
Beasley, 1996
Abbott, Parker &
Peters, 2002
Abbott, Parker &
Peters, 2004
Person, 2005
Farber, 2005
Deschow, Sloan, &
Sweeny, 1996
Beasley, 1996
Abbott, Parker,
& Peters,
2002
Abbott, Parker
& Peters,
2004
Vafeas, 2005
Dhalival, Naiker,
& Navissi
(2006)
Deschow, Sloan, &
Sweeny, 1996
SEC investigation
Earnings quality,
management or
manipulation
Shareholder lawsuits
Helland & Sykuta,
2005
159