The Impact of a Principles-Based Approach to Director Gender Diversity Policy

A corporate governance issue that has drawn broad attention is the under­representation of females on corporate boards. Many attempts to address this issue follow a rules-based approach, in which mandated quotas for female representation in boards are imposed. An alternative to a prescriptive regulatory approach is a principles-based one, under which firms publicly disclose their compliance with suggested “best practice” guidelines, and, if their practices depart from the guidelines, firms must explain the reasons for their non-compliance. In the U.S., the SEC has recently approved a Nasdaq principles-based proposal aimed at improving board diversity, in which firms are required to have at least one director who self-identifies as female and another who self-identifies as an underrepresented minority or LGBTQ+. To avoid forced delisting, a firm must “diversify or explain”: either have the required number of diverse directors or explain why it does not. Fried (2021) argues that Nasdaq’s proposal will generate substantial risks for investors, as existing research has shown that increasing board diversity can lead to lower share prices. Fried notes that there has been no research on a “diversify or explain” regulation such as that proposed by Nasdaq.

We seek to fill this gap by studying the effects of a “diversify or explain” legislation that has been in place in Canada since 2014. The Ontario Securities Commission (OSC) introduced female representation policy disclosure requirements, which came into effect in December 2014. The amendment requires listed firms to disclose policies regarding the representation of females on the board and in the executive suite, or to provide an explanation for their absence.

First, we determine the market’s response to the regulation by conducting an event study around the OSC’s announcement. Notably, in contrast to the existing evidence on mandatory diversity regulation, we find that firms most likely to be affected by the amendment – those without a disclosed voluntary female representation policy and those with all-male boards – exhibit positive and statistically significant cumulative abnormal returns around the announcement. These results are in stark contrast to the negative abnormal announcement returns observed for California’s SB 826 law mandating gender diversity for firms headquartered there (Hwang, Shivdasani, and Simintzi (2020) and Greene, Intintoli and Kahle (2020)). For the mandatory regulation in California, announcement returns were more negative for firms for which the quotas are more binding (e.g., those with no female directors) − precisely the firms for which we observe significantly positive returns.

Second, we examine the impact of the OSC regulation on board composition. We find that the OSC’s principles-based diversity regulation has had a meaningful impact on board composition. The fraction of firms adding a female director to their board has doubled, and estimates from difference-in-differences regressions imply that, relative to a matched sample of U.S. firms, the amendment is associated with an increase in female director representation of 30 to 37%.

Finally, we examine the extent of compliance with OSC’s policy. Firms are increasingly more likely to consider gender diversity in director nominations and to employ target female board quotas over time. Moreover, we examine cross-sectional differences in gender diversity policies following the OSC’s amendment and find evidence consistent with firms optimally choosing to comply or explain based on the presence of economic frictions. First, firms headquartered in provinces with a higher fraction of female directors are more likely to consider gender diversity when nominating directors. Second, when studying determinants of target female director quotas, the number of connections with female directors in other firms and with firms that include target female director quotas is positively associated with the inclusion of a quota. Third, among firms that choose not to implement female director target quotas, we find that firms whose directors have fewer connections with female directors and those located in provinces with a lower fraction of female directors are more likely to indicate that they nominate directors based solely on skills, experience and/or merit, rather than using gender as a factor in the nomination decision.

Interestingly, supply frictions are also associated with the use of friendlier gender diversity language. Using statements related to board gender diversity in the proxy statement, we construct an index that measures firm sentiment towards gender diversity. Analysis using this index indicates that firms in provinces with a high female director ratio and with more connections with other firms with a targeted number of female directors employ friendlier language towards gender diversity in their proxy statements.

We find evidence suggesting firms that are less susceptible to pressure from outside investors (controlled corporations with dual class voting shares and/or that are closely held) are less likely to indicate they employ a target quota for female directors and use less welcoming language regarding board diversity (e.g., are more likely to indicate that quotas are unnecessary or that they appoint directors based solely on merit). Although we find some evidence consistent with worse governed firms opportunistically avoiding compliance, the main determinant of compliance seems to be economic frictions related to the supply of qualified female directors. That is, firms seem to explain their lack of compliance when they face higher costs to enhancing female representation in their boardroom, such as a limited supply of qualified female directors.

Overall, our results suggest that a principles-based approach potentially mitigates some of the costs of complying with rules-based approaches, while still achieving the same broad objective—in this case, increased female representation in boards. A major critique sometimes made against principles based regulation is that the flexibility afforded to firms regarding gender diversity on their boards means that not all firms will choose to comply—which may result in a level of compliance that is socially suboptimal. Nonetheless, we find that 94% of firms in our sample had female directors on their boards in 2018, compared with only 56% before the OSC announcement. Moreover, when we compare our sample firms with matched U.S. firms, we find that the ratio of female directors in Canada increased significantly more than for similar U.S. firms during the same period.

In contrast to the negative market reaction observed for approaches mandating board diversity, such as in Norway and California, we find that, for firms most affected by the ruling, market returns were significantly positive upon the announcement of the principles-based OSC regulation in Canada. Combined with the evidence suggesting that Canadian firms significantly increased board diversity following the ruling suggests that the comply or explain provision has had an impact in encouraging board diversity in Canada.

Our results provide policy implications for regulators. Whether a rules-based approach, such as that implemented in 2020 for California, or a principles-based approach, such as the OSC’s amendment we study or Nasdaq’s proposal, is best depends on the regulator’s objective. If the objective is to increase board diversity at any cost, certainly a mandate will achieve the objective. However, prescriptive mandates may not be appropriate for all firms. For some, the costs of compliance may be prohibitively high. Our results demonstrate that a principles-based, “comply or explain”, regulation such as that put forward in 2014 by the OSC can have the desired effect of increasing board diversity, while giving firms the opportunity to choose the optimal outcome for them, particularly when the cost of compliance is high.

The complete paper is available for download here.