Sarbanes Oxley and Hidden Board Independence: Is a Gray Director the Smoking Gun?

Abstract

The Sarbanes-Oxley (SOX) Act requires all boards be majority-independent. But, an independent director (ID) can still have ties with the CEO that are either undisclosed (i.e., gray director (GD)) or invisible to outside investors (i.e., invisibly gray director (IGD)). This paper examines a post-SOX mechanism to infer invisibly gray boards. Knowing investors prefer an independent board, the CEO adds a GD to a non-gray board only when (s)he expects larger private benefits than a valuation loss and is short of IGDs. Investors then learn from the decision that existing IDs are likely IGDs and the board is invisibly gray. I argue the decision to turn a board gray is a signal only after the SOX. It made a GD well defined, setting criteria for director independence, and detected, mandating disclosure of relevant information. I show investors find an ID less valuable at a gray board when (s)he suddenly passes away; firm value drops substantially when a board turns gray but varies little when it turns grayer, less gray, and non-gray; and following an adverse shock on the CEO's pool of IGDs, gray boards are more likely, and firms suffer value loss.

Keywords: board independence, board composition, gray director, corporate governance

JEL Classification: G34, G38, K22