SOX Section 404 Material Weaknesses and Shareholder Dissatisfaction with Directors

Given the board of directors’ oversight role with respect to internal control systems, we examine how disclosures of internal control material weaknesses under Sarbanes-Oxley Section 404 affect shareholders’ voting in director elections. We find that the presence of material weaknesses is associated with shareholder voting, but the effect varies with the type of director (overall board, managers, and audit committee members), the type of material weakness, and the company’s restatement status. In both the board and manager samples, shareholders react negatively to account balance-level material weaknesses when there is no restatement (directors are possibly sharing the blame for an adverse internal control opinion viewed as unduly harsh in the absence of a restatement) and react negatively to company-level material weaknesses where there is a restatement (this reaction is more negative than for account balance-level weaknesses; thus, directors are possibly sharing the blame for very serious accounting problems). By contrast, regardless of restatement status, audit committee directors are not penalized for material weaknesses, but these directors are penalized for certain restatements. We also find, across all three samples, that shareholders are more satisfied with directors when a Big 4 auditor is in place, but less satisfied when nonaudit fees are higher. Overall, the results provide new insights into the effects of internal control strength, restatements, and auditor quality on shareholder dissatisfaction with directors. We also discuss implications and avenues for future research