Internal Control Weakness and Corporate Divestitures

Abstract

This study examines the influence of firms’ internal control weakness (ICW) reported under the Sarbanes-Oxley Act (SOX) on their subsequent divestiture decisions and the performance of these decisions. We argue that following ICW disclosure, firms are inclined to pursue corporate divestitures because such divestitures can reduce organizational complexity and help remedy firms’ ICW. We also propose that the positive influence of ICW disclosure on divestitures is stronger when a firm has recently appointed a CEO but weaker when there is a higher prevalence of ICW within the industry. Furthermore, we investigate the dual performance implications of divestitures following ICW disclosure. Although these divestitures, compared to divestitures not following ICW disclosure, are associated with higher stock market performance, they are also associated with slower sales growth for firms’ core businesses. We present empirical evidence that supports our arguments using a sample of S&P 1500 firms from 2003 to 2020. This study advances corporate strategy research by highlighting the role of ICW in shaping corporate divestiture decisions and documenting the multifaceted performance implications of such divestitures.