Shareholder Voting in Director Elections and Initial SOX Section 404 Reports

Abstract

A primary channel for shareholders to express their dissatisfaction with the board is by withholding their votes in director elections. This study examines the relation between shareholders’ voting in director elections and initial Sarbanes-Oxley (SOX) Section 404 reports on internal control. We find that the presence of material weaknesses is associated with shareholder voting, but the effect varies between manager directors and audit committee directors. In the manager sample, shareholders react negatively to the existence of material weaknesses by withholding votes. Additional analysis of companies with material weaknesses reveals greater shareholder dissatisfaction when the number of material weaknesses is higher but less dissatisfaction when the company provided early warning disclosure of internal control problems during the fiscal year. By contrast, audit committee directors are not penalized for material weaknesses, but instead these directors are penalized for accounting restatements. Overall, the results provide new insights into the effects of internal control strength and restatements on shareholder voting for directors, and can potentially motivate directors to be more proactive in ensuring the quality of internal controls and the reliability of financial reporting.

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