The Unintended Consequences of Regulatory Reform
Larcker D. F.; Ormazabal Sánchez, Gaizka; Taylor, D.J.
Original document: The Market Reaction to Corporate Governance Regulation
As the ongoing financial crisis continues to lay bare serious corporate governance failings, regulation has attracted increasing attention among policy makers and economists.
There is an ongoing debate in both the media and academia on whether existing governance practices are characterized by rent extraction or shareholder wealth maximization.
The managerial power view of governance suggests that executive pay, the existing process of proxy access (which limits shareholders' ability to designate board nominees) and various governance provisions (e.g., staggered boards and CEO/chair duality) are associated with managerial rent extraction.
In contrast, some economists hold that such governance practices are the result of value-maximizing contracts between shareholders and management.
If existing governance practices are defined by rent extraction, legal and regulatory reform should increase shareholder value. If defined by value, reform could decrease shareholder value.
To find out which is more likely, IESE's Gaizka Ormazabal, Stanford's David F. Larcker and Wharton's Daniel J. Taylor traced the reaction of stock prices to economy-wide corporate governance regulation from 2007 to 2009.
Their findings may have important implications for policy makers and regulators on both sides of the Atlantic.
Post-Crisis Regulatory Frenzy
In the aftermath of the 2007-08 financial crisis, a broad coalition in the United States that included the Securities and Exchange Commission (SEC), the state of Delaware, and various senators and congress people proposed substantial regulations to restore confidence in global markets.
The proposed reforms include provisions to limit executive pay, restrict the firm's control of the proxy process -- opening the way for greater shareholder participation in the board nomination process -- and ban certain corporate governance practices such as staggered boards (where only a fraction of board members are elected each time instead of en masse) and CEO/chair duality.
Given the ambitious nature of these proposed changes, it is perhaps unsurprising that they have been met with stiff resistance from business-friendly organizations such as the U.S. Chamber of Commerce and the Business Roundtable, while activist shareholder groups like CalPERS and CalSTRS have broadly welcomed them.
But what would their effect be on the shareholder value of the firms most affected by the reforms?
Impact on Firm Value
To measure the repercussions of the regulations, the authors took a broad sample of 18 events related to economy-wide corporate governance regulation from 2007 to 2009.
The authors divide the events into two categories. The first concerns executive pay events, relating to regulations that would limit executive pay or demand shareholder votes.
Such events began to appear in 2007, when the Shareholder Vote on Executive Compensation Act was introduced into the U.S. House of Representatives by Barney Frank.
The second concerns proxy access events, relating to regulations that give increased power to shareholders or shareholder coalitions with stakes greater than 1 percent. This category also included proposals to ban staggered boards and CEO/chair duality.
The authors found that the proposed regulations regarding CEO pay, proxy access and staggered boards tended to produce abnormal negative returns for company shareholders, lending credence to the notion that the proposed governance regulations adversely affect shareholders.
While the authors acknowledge other factors may have contributed to the stock-price movements, they feel that the evidence is sufficiently robust to draw into question the widely held belief that giving shareholders greater access to the board, capping executive pay and banning staggered boards can only be good for shareholder value. If anything, the results suggest the opposite.
The authors stress that their results do not mean there is no place for corporate reform, and that alternative means of regulation that increase shareholder value may exist.
But the results do highlight the dangers of jumping on reform bandwagons that take a one-size-fits-all approach to corporate governance.