The Market Reaction to Corporate Governance Regulation

The following post comes to us from David Larcker, Professor of Accounting at Stanford University; Gaizka Ormazabal of the Accounting Department at Stanford University; and Daniel Taylor, Assistant Professor at the University of Pennsylvania.

In the paper, The Market Reaction to Corporate Governance Regulation, which was recently made publicly available on SSRN, we investigate the market reaction to recent legislative and regulatory actions pertaining to corporate governance. The managerial power view of governance suggests that executive pay, the existing process of proxy access, and various governance provisions (e.g., staggered boards and CEO-chairman duality) are associated with managerial rent extraction. This perspective predicts that broad government actions that reduce executive pay, increase proxy access, and ban such governance provisions are value enhancing. In contrast, another view of governance suggests that observed governance choices are the result of value-maximizing contracts between shareholders and management. This perspective predicts that broad government actions that regulate such governance choices are value destroying.

With regard to executive pay regulation, the evidence suggests that shareholders react increasingly negative for firms with highly paid CEOs. One possible explanation for this result is that the market perceives that the regulation of executive compensation will ultimately result in less desirable contracts and potentially decreases the supply of high-quality executives to public firms.

Regarding proxy access regulation, the evidence suggests the market reaction is decreasing in the number of large blockholders and decreasing in the number of coalitions small institutional investors can form in order to control a combined 1% of shares outstanding. This is consistent with critics’ claims that shareholders (and shareholder coalitions) who hold 1% or more will use the privileges afforded them by proxy access regulation to manipulate the governance process to make themselves better off at the expense of other shareholders. Because the costs and benefits of proxy access vary significantly across firms, our results suggests that shareholders may best be served by voluntary proxy access in which shareholders themselves (rather than the government) to determine the rules that govern proxy access on a company-by-company basis (e.g., Grundfest, 2009).

With regard to regulations that ban specific governance practices, the evidence suggests the market reaction is increasingly negative for firms with staggered boards. This is consistent with the notion that the presence of a staggered board is a value-maximizing governance choice, such that banning staggered boards decreases shareholder value.

Across all tests, we find robust evidence of negative stock price reactions for firms whose governance practices would be affected by the proposed regulations. The results support the notion that the proposed governance regulations harm shareholders of affected firms. However, an important caveat is that the results do not rule out the possibility that there exists some form of governance regulation that is wealth increasing for shareholders.

The full paper is available for download here.

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  1. Andrew Clearfield
    Posted Monday, September 20, 2010 at 10:52 am | Permalink

    Corporate governance is risk factor, not a growth factor. Absent a specific situation, such as ongoing bid speculation, there is little reason to suppose that changes in a company’s governance regime will have an immediate effect upon the share price. Any study that considers a change in a firm’s governance as an ‘event,’ and looks at short-term price responses, is inherently biased against governance, whether the authors realize this or not.

  2. Michael Spalding
    Posted Tuesday, September 21, 2010 at 1:49 pm | Permalink


    Can you point me an article or paper that more fully discusses the distinction between risk factor and growth factor?