Information Control, Career Concerns, and Corporate Governance

We examine corporate governance effectiveness when the CEO generates project ideas and the board of directors screens these ideas for approval. However, the precision of the board’s screening information is controlled by the CEO. Moreover, both the CEO and the board have career concerns that interact. The board’s career concerns cause it to distort its investment recommendation procyclically, whereas the CEO’s career concerns cause her to sometimes reduce the precision of the board’s information. More-over, the CEO sometimes prefers a less able board, and this happens only during eco-nomic upturns, suggesting that corporate governance will be weaker during economic upturns. Behind every great fortune is a crime. —Honore ́ de Balzac THE U.S. CORPORATE GOVERNANCE LANDSCAPE has been transformed in recent years by high-profile governance failures at Enron, WorldCom, Tyco, ImClone, Adelphia, Global Crossing, and others. In response, Congress passed the most important corporate governance legislation since the Securities Exchange Act of 1934: the Sarbanes-Oxley Act of 2002 (SOX hereafter).1 SOX has four key features. First, it requires accurate, extensive, and timely information disclo-sures, mandating public firms to establish and maintain “an adequate internal control structure and procedures for financial reporting ” with an annual assess-ment of the effectiveness of such internal controls that is attested to by external auditors. Second, SOX (along with the new listing standards of the New York Stock Exchange and the NASDAQ Stock Market) stipulates a measure of board independence, requiring that the board’s audit committee consist entirely of di-rectors that have no affiliation with the company (including its subsidiaries) and forbidding members of the committee from accepting “any consulting, ad-visory, or other compensatory fees ” from the company other than for his or her board’s service.2 Third, SOX sets more stringent standards for executiv