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Shareholders may disapprove of firm’s audit committee, but staggered board elections stymie improvement: study

The staggered election of corporate directors, where, typically, one third are elected annually for three-year terms, has been under growing attack in recent years, as critics contend that a staggered (or classified) board structure fosters management entrenchment to the detriment of shareholders’ interests. As a result, the number of S&P-500 firms with staggered board structure (instead of one-year director terms) has fallen from 300 in 2000 to fewer than 50 today, even as debate about the issue continues.

Now, new research adds to the evidence against the practice: Staggered board structure, it suggests, interferes with shareholder influence on a key governance body – the board audit committee (AC) – and stymies improvements in its functioning.

In the words of the study in Auditing: A Journal of Practice & Theory, published by the American Accounting Association, "low shareholder approval rates in firms with non-staggered boards are associated with improvements in audit committee structure, activity, and financial reporting quality...[But] while non-staggered audit committees respond to low shareholder votes, staggered audit committees do not."

"Overall our results support the recent trend to de-stagger corporate boards," conclude the paper's authors, Ronen Gal-Or and Udi Hoitash of Northeastern University and Rani Hoitash of Bentley University. "Our results extend...evidence that staggered boards are less likely [than others] to react to low shareholder votes. This extension matters because the key difference between staggered and non-staggered boards is the ability of shareholders to promptly hold directors accountable through voting."

Audit committees (ACs), which typically have three or four members, have gained prominence in recent years in the wake of major corporate scandals at the turn of the century. In an attempt to restore public trust and to improve the quality of financial reporting, the Sarbanes-Oxley act of 2002 and other legislation increased the responsibilities of ACs, which serve as watchdogs for financial-reporting quality and audit processes. The new study probes how committees' ability to carry out these responsibilities is affected by a second major development of recent years, the increasing say that shareholders have come to exercise in the make-up and functioning of corporate boards.

The study asks four principal questions: 1) To what extent does shareholder voting (which is nonbinding) affect the composition of the AC – particularly committee members with expertise in finance and accounting?  2) How does it influence the frequency of committee meetings? 3) How does it influence the overall quality of company auditing and financial reporting? and 4) How are all these impacted by whether board membership is on a staggered or non-staggered basis?

To answer these questions the professors analyzed seven years' worth of shareholder election results along with information on director characteristics and committee memberships plus corporate auditing and financial data. In total, their analysis comprised 6.786 firm-years of data and 18,296 elections involving audit-committee members.

The researchers found that shareholder voting does significantly influence the composition of ACs in firms with non-staggered boards but not those with staggered boards. This was most striking in the case of accounting financial experts (AFEs), who are especially important to an AC’s functioning. Assessing shareholder approval by subtracting the average vote for the AC directors from the average for other directors, the professors found that almost half the departures from audit committees by AFEs occurred when the average shareholder vote for AC members fell well below that for other directors (specifically, in the bottom tenth of the range from highest positive to lowest negative). Low approval also significantly increased the likelihood that a departing expert would be replaced by another AFE, but it had no significant association with non-AFE departures.

What drives the changes in AC composition? "Because voting outcomes for each firm are reported in the same 8-K form," the professors write, "it is likely that AC members will observe and react to the votes of the AC relative to that of other, non-AC board members."

The professors also report that low voter approval of the AC is associated with increased frequency of committee meetings in the year following an election. Again, the effect is not seen in firms with staggered elections, but in the non-staggered group it was quite considerable. As the authors explain, "Low audit-committee support [that is, bottom tenth in approval] is associated with an increase of 44.4 percentage points in the number of audit-committee meetings. Since on average the AC meets 8.35 times, this translates to an increase in 3.7 meetings."

Why is this improvement not seen in staggered boards? "An increase to the number of AC meetings will require greater time from directors," professors write. "Since time is a scarce resource, an increase in this commitment is costly. Therefore, staggered directors that have lower incentive to appease shareholders will be less likely to increase meetings. Similarly, directors may be reluctant to change board composition, as they want to safeguard this lucrative position."

A low level of AC approval is associated with heightened committee diligence in another important respect: it leads to reduced reliance on external auditors for tax services. As the study explains, regulators and proxy-advisers tend to look askance at the provision of tax services by auditors, viewing it as a threat to their professional independence. Low shareholder approval was thus found to occasion a drop in the ratio of auditors' tax fees to auditors' total fees – but, again, the effect was not true for firms with classified board structure, only for those in the non-staggered category.

Finally, these improvements in diligence are reflected in enhanced quality of financial reporting, the study reveals. Low approval was found to lead in the two years post-election to a significant drop in discretionary accruals, non-cash accounting items that typically entail some element of guesswork and are often associated with earnings manipulation. Again the effect was seen only in firms with non-staggered boards, and suggests, in the words of the study, that in those firms "ACs respond to low votes by working with management to increase the accuracy of the financial reports."

In conclusion the authors see their findings as extending past research by showing that, "in addition to influencing the performance of corporate boards and the compensation committee, shareholders can also influence the performance of the audit committee and thus the quality of financial reporting. The differences in the efficacy of shareholder votes across staggered and non-staggered elections reveal that while non-staggered ACs respond to low shareholder votes, staggered ACs do not."