The Impact of Regulatory Governance Mandates on Poorly Governed Firms

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday May 28, 2012 at 8:51 am
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Editor’s Note: The following post comes to us from Reena Aggarwal, Robert E. McDonough Professor of Business Administration at Georgetown University; Jason Schloetzer of the Department of Accounting at Georgetown University; and Rohan Williamson, Professor of Finance and Stallkamp Research Fellow at Georgetown University.

In our paper, The Impact of Regulatory Governance Mandates on Poorly Governed Firms, which was recently made publicly available on SSRN, we investigate the relation between regulatory governance mandates and firm value by assessing the impact of recent governance mandates on the firms that were most affected by changes in governance regulation. We exploit the cross-sectional variation in compliance with governance mandates in the pre-regulatory period to identify firms that were most affected by the governance mandates promulgated by congressional action and the associated changes to NYSE and Nasdaq listing requirements (“affected firms”) and firms that were less affected by such mandates (“control firms”). We use propensity score trimming (Crump et al. 2009; Imbens and Wooldridge 2009) to form a sample of affected and control firms that display covariate balance, facilitating comparisons across the pre- (1996 through 2004) and post-regulatory (2005 through 2009) periods. An important objective of recent governance mandates was to improve board monitoring. Hence, we identify affected and control firms using the governance mandates most closely related to board monitoring (please see our paper for more details). Our research design helps to mitigate endogeneity concerns by combining a quasi-natural experiment with the identification of firms differentially affected by the regulatory governance mandates.

Our empirical analysis proceeds in two steps. First, we assess the difference in firm value of affected firms in the pre- and post-regulatory period relative to firms that were less affected by the governance mandates. We obtain governance data from Institutional Shareholder Services for firms in the Russell 3000 to construct our sample. We begin by providing evidence on the impact of governance mandates on firm value for those firms most affected by the regulations relative to firms that were less affected. We then investigate differences between affected and control firms along three measures of board oversight―executive pay-performance sensitivity, CEO turnover, and earnings quality―to assess the potential channels through which firm value was impacted.

We establish that the value of affected firms, measured using Tobin’s q, was significantly lower relative to control firms in the pre-regulatory period. However, after affected firms were required to adopt governance mandates in the post-regulatory period, the value of affected firms increased relative to control firms. We find that the relative increase in firm value for affected firms in the post-regulatory period eliminated the value difference between affected and control firms after controlling for other firm characteristics. Further, we show that the relative increase in firm value for affected firms was concentrated between 2004 and 2007, the period immediately after the implementation of regulatory mandates. Our evidence also indicates that firm value for all firms, both affected and unaffected, is lower in the post-regulatory period relative to the pre-regulatory period which is consistent with prior studies. The results are robust to a variety of model specifications, alternative methods of identifying affected firms, and the addition of corporate governance mandates beyond those specifically related to board monitoring.

Next, we present evidence that the relative increase in firm value of affected versus control firms appears to be due to heightened board monitoring in affected firms. Our results indicate that the boards of affected firms modified the sensitivity of CEO pay-to-accounting and pay-to-stock return performance. In particular, we document that the sensitivity of CEO pay-to-accounting performance after the adoption of governance mandates is negative, indicating that the relative use of accounting-based pay-for-performance sensitivity (PPS) decreased in the post-regulatory period compared with control firms. In addition, the sensitivity of CEO pay-to-stock returns performance after the adoption of governance mandates is positive, indicating that the relative use of stock returns-based PPS increased in the post-regulatory period compared with control firms. Hence, by placing increased emphasis on stock returns-based performance, the boards of affected firms appear to have modified the alignment of CEO incentives relatively more toward those of shareholders.

We extend our analysis to examine whether boards engaged in more extensive monitoring of top management in the post-regulatory period. We find that affected firms had a significantly lower likelihood of CEO turnover in the pre-regulatory period compared with control firms, consistent with boards of affected firms playing a relatively less active monitoring role during the pre-regulatory period. However, in the post-regulatory period, the likelihood of CEO turnover increased for affected firms relative to control firms, suggesting that boards adopted a more active monitoring role in the post-regulatory period. We also find improvements in earnings quality as measured by lower absolute levels of discretionary accruals in the post-regulatory period relative to control firms, implying that the boards of affected firms engage in more extensive monitoring of financial reporting quality after the adoption of regulatory mandates. Overall, our results are consistent with regulatory mandated governance improving board monitoring in those firms most affected by the regulations, which, in turn, is associated with higher firm value.

The full paper is available for download here.

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