Corporate Governance and the Creation of the SEC

The following post comes to us from Arevik Avedian of Harvard Law School; Henrik Cronqvist, Professor of Finance from China Europe International Business School (CEIBS); and Marc Weidenmier, Professor of Economics at Claremont Colleges.

Severe turmoil in financial markets—whether the Panic of 1826, the Wall Street Crash of 1929, or the Global Financial Crisis of 2008—often raises significant concerns about the effectiveness of pre-existing securities market regulation. In turn, such concerns tend to result in calls for more and stricter government regulation of corporations and financial markets. It is widely considered that the most significant change to U.S. financial regulation in the past 100 years was the Securities Act of 1933 and the subsequent creation of the Securities and Exchange Commission (SEC) to enforce it. Before the SEC creation, federal securities market regulation was essentially absent in the U.S. In our paper, Corporate Governance and the Creation of the SEC, which was recently made publicly available on SSRN, we examine how companies listing in the U.S. responded to this significant increase in the provision of government-sponsored corporate governance. Specifically, did this landmark legislation have any significant effects on board governance (e.g., the independence of boards) and firm valuations?

Before the creation of the SEC, corporate governance among U.S. publicly listed companies was largely deferred to private markets. For example, the emergence of board governance predates much regulation, as pointed out by, e.g., Adams, Hermalin, and Weisbach (2010). Monitoring by the board, in particular by independent directors and chairmen, may be expected to reduce asymmetric information related to the sale of new securities. Other noticeable sources of market-based governance that existed already in the early 20th century include stock exchange regulation (i.e., “listing standards”), which had been strengthened significantly, particularly on the New York Stock Exchange (NYSE), during the 1920s (e.g., Berle and Means (1932) and Simon (1989)). Industry self-regulation had also been enhanced leading up to the SEC creation, in particular with the creation of the Investment Bankers’ Association of America (IBAA) in 1912 (e.g., Carosso et al. (1970)), one of the predecessors of some of today’s self-regulatory institutions.

Corporate governance may also come in the form of government-sponsored governance. For example, the State of New York passed general incorporation laws as early as in the 19th century. State-level securities regulation was first adopted by the State of Kansas in 1911, and by 1931 all U.S. states except one had implemented so-called “blue sky laws” (e.g., Agrawal (2013)). As for federal securities market regulation, it was limited to the Clayton Antitrust Act of 1914 which contained provisions that were designed to force investment bankers sitting on railroad company boards to resign or stop providing services to these companies (e.g., Frydman and Hilt (2013)).

The general observation that securities markets in the U.S. were subject to many potentially important sources of corporate governance already before the SEC creation results in two hypotheses, which we examine in this paper. One view is that there was insufficient provision of market-based governance in U.S. securities markets before the creation of the SEC. Under this hypothesis, the creation of the SEC was an exogenous increase in the supply of government-sponsored governance that may resolve a market failure and improve the governance and valuation of publicly listing companies in the U.S. An alternative hypothesis is that there was already sufficient provision of corporate governance mechanisms. If there are costs of both too little, but also too much, governance (e.g., Hermalin and Weisbach (2012)), substitutions of governance mechanisms may be expected around regulation changes that affect the provision of governance, as long as firms are able and allowed to freely choose their corporate governance designs. For example, an increase in government-sponsored (SEC) governance may significantly reduce the need for market-based (board) governance.

Our empirical identification approach makes use of an important feature of the regulatory change: The SEC effectively took the NYSE listing standards at the time, converted them into federal law, and applied them to all U.S. firms on all regional stock exchanges (i.e., both NYSE and non-NYSE firms were governed by the same regulation post-SEC). This prompted Simon (1989) to conclude that: “It is difficult to identify information required by the 1933 Act that had not been previously required by the NYSE.” This approach to the regulation change resulted in a quasi-natural experiment, which we exploit in this study. Specifically, non-NYSE listing firms are in the treatment group because they were affected by the regulation and NYSE listing firms are in the control group because they were not affected as they had to comply with the listing standards of the NYSE even during the pre-SEC period. As a result, we may compare the difference in board governance and firm valuations for affected (non-NYSE) firms and non-affected (NYSE) firms before and after the SEC. The difference of those differences is our empirical estimate of the regulation’s effect on the studied governance and valuation measures.

We find that the creation of the SEC resulted in a large and statistically significant reduction in board and chairman independence among affected non-NYSE listing firms. Our estimates reveal that there was a 30 percent reduction in board independence, i.e., one of the most significant effects of the creation of the SEC was to cause the boards of affected firms to become less independent. That is, an independent board and an independent chairman appear to have been more valuable in the pre-SEC era compared to in the post-SEC period. There is also some evidence that board governance was affected more broadly. For example, the creation of the SEC resulted in larger boards and less local director monitoring, but these results are weaker than the board independence results. These results are robust to using a variety of model specifications and robustness checks and controlling for the 1929 Wall Street Crash and the ensuing Great Depression.

The evidence reported in this paper is consistent with a “substitution of governance mechanisms” hypothesis where firms endogenously trade off market-based and government-sponsored governance. These results are broadly supportive of the endogenous nature of corporate governance, as previously argued by, e.g., Demsetz and Lehn (1985) and Hermalin and Weisbach (1998, 2012). The evidence of a substitution effect suggests that it is not clear that firm valuations should be significantly affected by the creation of the SEC. Indeed, in our search for valuation effects of the SEC creation, we find no significant effects on firm valuations. The lack of a significant valuation effect for non-NYSE firms also suggests that the regulatory change did not create a sample selection problem in our empirical analysis by increasing the average quality of firms that listed on the regional stock exchanges.

The full paper is available for download here.

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