Restraining Overconfident CEOs Through Improved Governance

In our recent paper, Restraining overconfident CEOs through improved governance: Evidence from the Sarbanes-Oxley Act, forthcoming in the Review of Financial Studies, we use the joint passage of the Sarbanes-Oxley Act and changes to the NYSE/NASDAQ listing rules to analyze the impact of improved governance in moderating the behavior of overconfident CEOs. 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 rules 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 (see e.g., O’Connor, 2003). A permissive board that exhibited groupthink and inadequate oversight likely compounded these troubles. 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. We use both options-based and press-based measures of overconfidence. The premise behind the option-based measures is that a CEO’s human capital and personal wealth is tied to his/her company. Since CEOs are relatively undiversified, they should rationally exercise deep-in-the-money options and cash-out the shares as and when they vest. Hence, holding deep in-the-money vested options represents a degree of overconfidence. In robustness tests, we examine other measures of overconfidence, including press-based measures of overconfidence.

We have several important findings. We first examine the investment choices by overconfident CEOs. Our results indicate that, prior to SOX, overconfident CEOs invest more aggressively than their peers. However, after the passage of SOX, overconfident CEOs appear to moderate their capital expenditures, SG&A expenses, PP&E growth, and asset growth, bringing them more in line with the CEOs of otherwise comparable firms in their industries. SOX also affects the sensitivity of investment to cash flows of overconfident managers: post-SOX, overconfident CEOs’ investment-sensitivity-to-cash-flow decreases. In addition, post-SOX, firms with overconfident CEOs exhibit a significant drop in corporate risk. SOX is also associated in an increase in the market value, earnings, and takeover performance of overconfident CEOs’ firms.

We conduct a number of robustness tests to increase our confidence in the results and their interpretation. As noted above, we conduct falsification tests to show that, for the most part, these SOX-related changes are concentrated in the companies that were not previously compliant with SOX and the listing rule requirements (in relation to the need for an independent audit committee and a majority independent board). Specifically, by using both difference-in-difference type tests, and sub-sample tests, we find that the impact of SOX on overconfident CEOs concentrates in those firms that were previously non-compliant with SOX’s mandates. Also, the SOX-related effects observed for overconfident managers are not present for CEOs with confidence in the bottom quartile. Together, these falsification tests suggest that our results reflect the impact of SOX in moderating the implications of CEO overconfidence. We undertake other robustness tests to mitigate other econometric concerns.

Our results contribute to the literatures on managerial overconfidence and market regulation. We confirm that CEO overconfidence can lead to excessive risk-taking and expenditure. The results provide (some) support for exogenously mandated improvements in certain governance practices. While it might be more of an unintended consequence, SOX and the NYSE/NASDAQ rule changes appear to have been beneficial in terms of mitigating significant value-destruction and in capitalizing on the positive aspects of CEO overconfidence. Hence, the paper provides novel evidence on the benefits of SOX and the listing rule changes: these benefits go beyond limiting expropriation and perquisite consumption by powerful CEOs and are important in terms of moderating the excesses of highly overconfident CEOs.

The full paper is available for download here.