The Sarbanes-Oxley Act was enacted on July 30, of 2002 as a collection of requirements to help overcome many of the inadequacies related to corporate governance and financial reporting that led to the corporate scandals of the 1990s. Sarbanes-Oxley required greater independence between the major parties involved with the firm such as management, the board of directors, and auditors, and greatly narrowed the definition of ‘independent’ to mean truly autonomous from the firm. Shortly thereafter (in August 2002) the New York Stock Exchange (NYSE) filed with the Securities Exchange Commission (SEC) proposed changes in its listing requirements. The changes, aimed at ensuring board independence and improving corporate governance practices of listed firms, require ‘the board of directors of each listed company to consist of a majority of independent directors’.1 Similar changes filed with the SEC by Nasdaq went into effect on November 4, 2003.
Institutional investors such as the California Public Employee's Retirement System (CalPERS) and their associations like the Council of Institutional Investors (CII) adopted similar guidelines regarding board independence five years before such requirements were adopted by the major stock exchanges. Outside the United States board independence as a means of improving corporate governance has been recommended for a decade or more. For example, in 1990 the government in the United Kingdom appointed the Cadbury Committee that issued The Code of Best Practice that included a recommendation for having at least 3 non-executive directors on the board. Similarly, the 1994 Dey report submitted to the Ontario Exchange Commission led to changes in governance-related disclosure requirements for firms listed on the Toronto Stock Exchange (TSE). Firms listed on the TSE are required to disclose the association of each board member with management and the firm, and whether or not a majority of their directors are independent. Clearly, large and influential entities such as the SEC view board independence as desirable and effective. Yet, there is no consensus in the financial economics literature to suggest that board independence is a necessary and/or sufficient condition for improving firm governance. Given the far-reaching consequences of requiring independent boards for so many firms in the economy, more and better evidence regarding the importance and effectiveness of board independence is needed.
The primary purpose of this study is to use director resignations to examine investors' perceptions of the importance of changes in board independence. A number of studies have examined whether firm value and performance are affected by board structure. The evidence is mixed and often contradictory. Baysinger and Butler (1985) and Hermalin and Weisbach (1991) find that board composition and firm performance are not closely related. In contrast, Rosenstein and Wyatt (1990) find a positive stock price reaction when a new outside director is announced implying that firm value is affected by a firm's proportion of outside directors. Byrd and Hickman (1992) find that when firms make tender offer bids, firms where outside directors hold at least half of the board seats experience a higher announcement return than other bidders. Yermack (1996) documents an inverse relation between board size and firm value and performance. Director resignations provide an abrupt and often unanticipated change in board structure that can be used to gauge the market's perception of the resulting changes in board independence. Although director appointments have been examined previously in the literature (Rosenstein and Wyatt, 1990 and 1997; and Shivdasani and Yermack, 1999), we have a priori reasons to believe that director resignations may be more meaningful to shareholders than are appointments. For example, there is a wealth of evidence in the auditing literature that auditor switches (when the firm chooses to change auditors) has little impact on shareholder wealth (e.g., Nichols and Smith, 1983; Johnson and Lys, 1990; and Klock, 1994). Alternatively, studies of auditor resignations, which typically occur for firms that are in poor financial health, show that resignations have a negative impact on stock prices (e.g., Beneish et al., 2001; Shu, 2000; DeFond et al., 1997; and Wells and Loudder, 1997).
We examine investors' reactions to director resignation announcements and classify the impact on board independence in two ways: First, we assume that the type of director resignation dictates the perceived change in board independence. That is, if an inside director resigns, board independence increases and so on. Second, we classify an increase, a decrease, and no change in the percentage of independent directors by the actual alterations to the board following the resignation announcement. Because the NYSE, CalPERS and others recognize that there are governance mechanisms (e.g., ownership structure) that can substitute for board structure we also examine the resignation announcements' impacts in the context of firms' existing governance structures.2
We find, using a sample of 744 director resignation announcements occurring from 1990 – 2003, that outside director resignations result in an average 1.22% loss (significant at the 1% level) in market value over a three-day period surrounding the announcement. The average abnormal return experienced when insiders or gray directors resign is not statistically significant. Additionally, when there is a net decrease in board independence within a year of the announcement of the director resignation, the average response at announcement is –1.17% (significant at the 5% level), and net increases and no changes to board independence result in negative, but statistically insignificant abnormal returns. The significant, negative stock price reaction to outside director departures can be an indication that investors view such resignations as signals regarding firm quality, and that they value the resulting alterations in board independence (that can result in lower firm quality due to less effective monitoring). Our findings are analogous to studies like Rosenstein and Wyatt (1990) and Rosenstein and Wyatt (1997) that examine investor responses to outsider and insider director appointments, respectively. While these studies (and our initial approach) appear to establish that director appointments (resignations) are deemed to be important events to investors, Rosenstein and Wyatt (1990) do not investigate the market reaction in the context of firms' other governance characteristics or seek to examine the importance of board independence in addition to signaling implications.3 Our multiple regression analysis in addition to our event analysis attempts to shed light on whether board independence is valued, and if so under what circumstances.
We find evidence that investors value board independence (beyond the event analysis) when outside directors resign. Specifically, after controlling for firm performance we find that investors react more negatively to outside director resignations and net decreases in board independence (than to insider or gray resignations and net increases or no changes in independence) when the degree of board independence prior to the resignation is low and institutional ownership is low. However, we find that the market reaction to a loss in board independence is more negative for firms with higher percentages of inside ownership and incentive compensation for their CEOs.