Working paper 05-03
May 2005
Risk Management and Corporate Governance:
The Importance of Independence and Financial Knowledge
for the Board and the Audit Committee
Georges Dionne∗ and Thouraya Triki∗
*Department of Finance and Canada Research Chair in Risk Management, HEC Montreal
First Draft (February, 2005), this draft (May 24th, 2005)
ABSTRACT
The new NYSE rules for corporate governance require the audit committee to discuss and review the firm’s risk assessment and hedging strategies. They also put additional requirements for the composition and the financial knowledge of the directors sitting on the board and on the audit committee. In this pape
r, we investigate whether these new rules as well as those set by the Sarbanes Oxley act lead to hedging decisions that are of more benefit to shareholders. We construct a novel hand collected dataset that allows us to explore multiple definitions for the financially knowledgeable term present in this new regulation.
We find that the requirements on the audit committee size and independence are beneficial to shareholders, although maintaining a majority of unrelated directors in the board and a director with an accounting background on the audit committee may not be necessary. Interestingly, financially educated directors seem to encourage corporate hedging while financially active directors and those with an accounting background play no active role in such policy. This evidence combined with the positive relation we report between hedging and the firm’s performance suggests that shareholders are better off with financially educated directors on their boards and audit committees. Our empirical findings also show that having directors with a university education on the board is an important determinant of the hedging level. Indeed, our measure of risk management is found to be an increasing function of the percentage of directors holding a diploma superior to a bachelor degree. This result is the first direct evidence concerning the importance of university education for the board of directors. Keywords: Corporate governance, risk management, corporate hedging, financial knowled
ge, board independence, audit committee independence, board of directors, university education, empirical test, unrelated directors, NYSE rules, Sarbanes Oxley act, audit committee size, financially educated directors, financially active directors, firm performance.
JEL classification: G 18, G 30.
We are very grateful to Narjess Boubakri, Bernard Fortin, William Greene and Lawrence Kryzanowski for their helpful comments and recommendations. Thouraya Triki acknowledges financial support from the Fonds Québécois de la Recherche sur la Société et la Culture (FQRSC) and IFM2.
∗ Please send all correspondence to:
HEC Montréal, Canada Research Chair in Risk Management, 3000, Chemin de la Côte-Sainte-Catherine, Montreal, Quebec, Canada,
H3T 2A7
(Phone): + 514 340 6596
(Fax): +514 340-5019
(E-Mail): iki@hec.ca
Introduction
The recent corporate scandals reported in the press have outraged the financial community and have clearly revealed serious flaws in the US corporate governance system. Of course, the board of directors, considered as an important part in a corporate governance system, took the largest part of the blame and directors were accused of failure in their watchdog role. For example in the Enron’s case, the Powers1 report concluded that Enron’s board “failed to monitor …to safeguard Enron’s shareholders”. These scandals have served as catalysts for legislative and regulatory changes. New rules were adopted in order to prevent the recurrence of disasters similar to the Enron or WorldCom’s cases. In this context, the Sarbanes-Oxley act (SOX hereafter) enacted in 2002 tried to restore credibility to the US corporate governance system by setting stricter rules on the functioning and the independence of the external auditor, enabling the board of directors to acquire higher levels of fiduciary and statutory responsibilities and also by proposing new rules aimed to enhance the quality of financial disclosures by firms. More recently, the NYSE adopted a new set of rules designed to complement the SOX requirements in the matter of corporate governance2.
Interestingly, the SOX does not set any particular requirements for the board as a whole entity, but does require that the audit committee should be entirely composed of independent directors and should count at least one financially knowledgeable member3. The new rules set by the NYSE define additional conditions concerning the independence of the board of directors and the composition of the audit, compensation and governance committees4 . Overall, this new regulation on corporate governance significantly focuses on the audit committee and the independence of the board of directors.
1 Report of investigation by the special investigation committee of the board of directors of Enron Corp, William C Powers Jr et al, 2002, at news.findlaw/wp/docs/enron/specinv020102rpt1.pdf
2We are aware that other US exchanges such as the AMEX amended rules to regulate corporate governance in their listed firms but we decided to limit our discussion to the regulation set by the NYSE because it is considered as the largest US Stock Exchange and consequently there is more money at stake motivating the analysis of its requirements. Indeed, according to the WFE official figures, as of December 31st, 2004, the NYSE market capitalization for domestic listed companies (excluding closed-end funds) is 12.7 trillions USD compared to 0.08 trillions USD for the AMEX and 3.7
trillions USD for the NASDAQ.
3 Section 301 of the Sarbanes-Oxley act requires that: “each member of the audit committee of the issuer shall be a member of the board of directors of the issuer, and shall otherwise be independent”. Section 407 requires that “the commission shall issue rules….to require each issuer, together with periodic reports… to disclose whether or not, and if not, the reasons therefore, the audit committee of that issuer is comprised of at least 1 member who is a financial expert”
4 Section 303A.01 of the NYSE’s listed company manual requires that “listed companies must have a majority of independent directors”.  Section 303A.04 requires that “listed companies must have a nominating/ corporate governance committee composed entirely of independent directors” while Section 303A.0
5 requires that “listed companies must have a compensation committee composed entirely of independent directors”. Finally, Section 303A.07 requires that “the audit committee must have a minimum of three members. Each member of the audit committee must be financially literate; as such qualification is interpreted by the company’s board in its business judgment, or must become financially literate within a reasonable period of time after his or her appointment to the audit committee. In addition, at least one member of the
We are aware that stricter rules for the audit committee and the independence of the board will help prevent financial scandals and ensure a better monitoring, but we are tempted to ask whether the independence of the board as a whole entity is sufficient to solve all the problems related to the US corporate governance system5. Obviously, no director of any board wants to find itself at the heart of a scandal. So, perhaps the scandals we observed recently are not caused by directors who lack the incentive to monitor properly the firm’s management (the independence argument) but simply by directors who are unable to do so. Indeed, when the directors sitting on the board are generalists (even if they are totally independent) and lack the technical financial knowledge needed to understand the complicated reports and operations presented to them, they could unconsciously vote for resolutions that do not necessarily increase shareholders’ wealth. In the Enron’s case, the Powers report concludes that Enron’s board “should be faulted… for failing to probe and understand the information that did come to it”6. The lack of financial expertise for the board members was recently confirmed by Buckley and Van Der Nat (2003) who reported disturbing levels of ignorance among independent directors in the matter of derivatives policy.
One might object that the lack of financial knowledge for directors is no longer a problem because the SOX and the new rules set by the NYSE do require the audit committee members to be financially kno
active下载wledgeable. This statement would not hold for two reasons. First, the financial knowledge requirement applies only to the audit committee members, which will certainly lead to improved monitoring of the firm’s accounting statements but not necessarily to a board that takes optimal decisions from a shareholder perspective. We think that financial knowledge should not be exclusive to the directors sitting on the audit committee.
Second, section 303A.07 of the NYSE’s listed company manual requires all members of the audit committee to be financially knowledgeable … or to become it in a reasonable period of time; and the definition of financially knowledgeable is left to the discretion of the board of directors. Even if a financially knowledgeable audit committee is sufficient to guarantee an effective monitoring from the board, this rule leaves too much room for interpretation. Section 303A.07 should provide a clearer
audit committee must have accounting or related financial management expertise, as the company’s board interprets such qualification in its business judgment”.  Unfortunately, the time consuming aspect of data collection oblige us to limit our discussion only to the requirements concerning the audit committee.
5 We are considering problems other than accounting scandals which are supposed to be prevented by the regulation on the audit committee.
6 Rosen (2003) reports comments made by professor William H Widden in which the latter states: “even though Enron was running a derivatives business, it seems that those on the finance committee and, more generally on the board, did not have
definition for the financially knowledgeable term. Likewise, the SOX definition of financial knowledge primarily focuses on whether the director has prior accounting related experience. Such definition is very restrictive and will limit the pool of qualified directors [Defond, Hann and Hu, 2004]. In this paper, we explore multiple definitions for a director who is financially knowledgeable: a director whose current or past activities/positions are related to finance (example: present or former CFO, an insurer; a financial analyst, a financial consultant, a banker, …etc), a director whose educational background includes financial literacy (MBA, BBA, B.Comm, ….) and finally a director with an accounting background (CA, CPA,…), in accordance with the SOX view.
The purpose of this paper is to verify the importance of the financial knowledge and independence arguments imposed by the new regulation. More precisely we have the intent to assess the effect, on the firm’s hedging policy, of two requirements set by the SOX (audit committee entirely composed of independent members and at least one member considered as financially knowledgeable) and four requirements set by the NYSE (majority of independent directors on the board, audit committee with a
minimum of three members, each member of the audit committee must be financially literate, and at least one member of the audit committee must have accounting knowledge). We decided to evaluate these rules by considering their possible impact on the risk management policy for three reasons.
First, section 303.07 (D) of the NYSE’s listed company manual requires the audit committee “to discuss policies with respect to risk assessment and risk management”. Consequently, there is a great chance that the rules concerning the board or at least those concerning the audit committee affect corporate hedging. Indeed, because these entities are henceforth legally responsible of the risk management policy, the changes in their composition or the background of their members is likely to affect their decisions in this matter.
Second, it is well documented in the literature that risk management is beneficial to the firm because it reduces its tax payments [Smith and Stulz, 1985], its financial distress costs [Stulz, 1984], its information asymmetry costs [Stulz, 1990; DeMarzo and Duffie, 1991; Breeden and Viswanathan, 1998] and its financing costs [Froot, Scharfstein and Stein, 1993; Morellec and Smith, 2002]. Accordingly, corporate hedging should improve the firm’s performance. Our empirical evidence confirms this hypothesis. Indeed, we find that more corporate hedging leads to an increase in the firm’s owners’ rate of return, as measured by the return on equity. This finding holds even when we use an
a sufficient derivatives background to understand and evaluate what they were being told in the presentation. If they had this background, the identified risk mitigants would not have been accepted”.
instrumental variable approach to control for the endogenous aspect of the hedging activity. Consequently, we can assert that every characteristic of the board (audit committee) that encourages the firm to increase its hedging ratio is beneficial to shareholders.
Third, risk management implies dealing with derivatives and other financially sophisticated tools. Thus, considering the risk management decision makes it possible to test whether an independent board/audit committee is capable of taking complicated mandatory decisions that benefit shareholders, or whether we need to impose financial knowledge on the directors to achieve this goal.
We contribute to the risk management literature by proposing a new set of explanatory variables that have never been explored before. To the best of our knowledge, we are the first to establish a relationship between corporate hedging and the background and education of the board and the audit committee members. We also add to the literature on corporate governance by considering a broader definition for financial knowledge. Previous papers limit their analysis to directors engaged in financial activities and more precisely to those with a banking/insurance experience. We are the first to consider
that directors could have a financial background thanks to their education. Our empirical evidence shows the importance of education for directors and suggests that only financially educated members of the board and audit committee affect corporate hedging.
Our tests will shed light on the effectiveness of the new US corporate governance regulation but will also provide some references to make new recommendations and mainly to evaluate other corporate governance systems. This last point is very important in the present context because, as stated in Buckley and Van Der Nat (2003), the governance problem is not limited to a few rotten eggs in America.
Our empirical findings suggest that the new rules on the audit committee size and independence incite firms to seek more hedging while the requirement of a majority of unrelated directors on the board has no effect on the risk management level. Likewise, directors engaged in financial activities and those with an accounting background play no active role in the hedging policy. Only the directors’ financial education affects such activity. Overall, our empirical findings show the importance of education, in general, and of financial education in particular, for directors sitting on the board and on the audit committee.
The remainder of the paper is organized as follow. Section I reviews the literature on the board and audit committee independence and financial knowledge. Section II contains our research design where
we describe our sample and variables. Section III and IV correspond respectively to the univariate and multivariate analysis. In section V we investigate the importance of university education for the directors sitting on the board and on the audit committee. Section VI reports the results of our investigation when the board and the audit committee characteristics are considered jointly. In section VII we test the effect of corporate hedging on the firm’s performance. Section VIII concludes the paper.
I. Literature review
A. The board of directors as a corporate governance mechanism
A.1.The independence argument
The board of directors plays a central role in any corporate governance system and is viewed as a primary means for shareholders to exercise control over top management [Kose and Senbet, 1998]. The standard approach in empirical finance and in modern corporate America is to view the board’s independence as closely related to its efficiency. Following the same reasoning, section 303A.01 of the
NYSE’s listed companies manual requires a majority of independent directors on the board. Indeed, outside directors are viewed as superior monitors because their careers are not tied to the firm’s CEO and consequently they are free to take decisions that go against him without being afraid for their positions and future compensation. This view is often referred to as the monitoring effect theory. Also, outside directors have incentives to build reputations as expert monitors in order to obtain additional director appointments. Consequently, they are more likely to maintain proper control over the firm’s top management [Fama, 1980; Fama and Jensen, 1983].
Several papers have reported evidence supporting the monitoring effect theory. Rosenstein and Wyatt (1990) show that the market has a significant positive reaction following the announcement of outsider board appointments in the Wall Street Journal while Weisbach’s evidence (1988) suggests that CEO turnover is more sensitive to performance in firms with outsider dominated boards than it is in firms whose boards are dominated by insider directors. Likewise, MacAvoy and Millstein (1999) find that board independence is positively correlated with accounting-based measures of firm performance while Cotter et al. (1997) show that targets whose boards contain a majority of outside directors receive higher returns than similar firms without such majority. Other papers that reported evidence supporting

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