In 2002, Congress passed the Sarbanes-Oxley Act, which requires firms to assess internal controls and report internal control weaknesses. My study examines the causes and consequences of material weaknesses (MW) reported under Section 302 of SOX. First, I investigate whether firms that report MW are associated with less effective audit committees and boards of directors. Using 184 firms that reported MW and a matched-pair sample of control firms, I find that firms with lower audit committee financial expertise, smaller audit committees, and lower board independence are more likely to have MW. Second, I examine whether the managerial labor market imposes penalties on top management, audit committees, and boards of directors for internal control failures. I find that MW firms have significantly higher turnover of their audit committee members and outside directors than the control firms following the MW detection. Audit committee members and outside directors in the MW firms also lose more outside directorships than their counterparts in the control firms. Additional analyses show that the extent of reputational penalties increase with the severity of the MW detected. Third, I examine whether the MW firms improve their governance structures upon the MW detection. The results indicate that MW firms experience greater improvement in their governance structures than the control firms. By the second year following the MW detection, the MW and control firms no longer differ in terms of audit committee independence, audit committee financial expertise, audit committee size, and board independence. Last, I examine whether the market reacts positively to the improvement in governance structures. I find a positive relation between the two-year buy-and-hold abnormal returns and the MW firms improvement in audit committee size and board independence. This result is consistent with the improvement in governance structures restoring investor confidence in financial reporting.

Do firms face reputational penalties for committing environmental violations? This paper replicates the work of a previous empirical study to confirm the relationship between abnormal returns and legal penalties following the announcement of a violation. It then goes on to extend the study using more recent data to assess how reputational costs change over time. Across both sets of data, firms suffer abnormal stock price decreases following the announcement of an environmental crime. The size of prospective legal penalties is on average larger than the decrease in market value, indicating that investors base their reaction to violations off the present value of legal costs faced by the firm. Average abnormal returns decreased in size between the two studies, indicating that over time as investors started paying more attention to environmental responsibility, they became less surprised by new violations. The results of the studies taken together have public policy implications, indicating that at present investors face immediate penalties following a violation in the form of regulatory costs, but in the long term may also face reputational penalties due to increased investor attention to environmental performance.