Center For The Study of Financial Regulation

Winter 2011 - Issue NO.4


by Daniel Taylor, an Assistant Professor of Accounting at the Wharton School of the University of Pennsylvania.

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Historically, debates on corporate governance have been among legal scholars. Early debates focused on arguments about the legal aspects of governance, fiduciary duty, and philosophical arguments as to whether certain governance practices would benefit or harm shareholders. As the economics discipline matured, it was only natural that economists began to formally analyze the arguments made in legal circles about the merits of various governance practices. Today, some of the most insightful arguments about corporate governance and its effect on shareholders come from formal economic analyses that appear frequently in leading academic journals dedicated to economics, finance, and accounting. This shift has fundamentally transformed the debate about corporate governance, from one that relies on skilled rhetoric and jurisprudence, to one that relies on analyzing the correlation between corporate governance and shareholder value.

However, this approach is not without drawbacks. Corporate governance practices are a choice, the outcome of decision-making among shareholders and managers. As such, the governance practices that maximize shareholder value at one firm may be very different from the governance practices that maximize shareholder value at another firm. In other words, there is not a one-size-fits-all approach to governance. The fact that certain governance practices increase shareholder value at some firms does not imply that those practices increase value at every firm. Thus, it is difficult to draw inferences about the overall desirability of governance practices by correlating a firm's governance practices with shareholder value.

An alternative approach taken by several recent studies is to examine the effect of changes in governance on shareholder value, when such changes are forced on the firm. Recently proposed corporate governance regulations mandate that all firms adopt specific governance practices. In this regard, the market's reaction to these regulations can provide insight on whether such practices increase shareholder value. If existing governance practices maximize shareholder value, and such practices vary by firm, then regulations that take a one-size-fits-all approach and mandate all firms adopt the same governance practice will decrease shareholder value. Of course, if existing governance practices are not value maximizing, then there is the possibility that mandating all firms adopt the same governance practice will increase shareholder value.

The last few years are ripe with examples of corporate governance regulation. Beginning in early 2007, a variety of legislative bills concerning executive compensation began to appear (e.g., the Shareholder Vote on Executive Compensation Act of 2007 the Corporate Executive Compensation Accountability and Transparency Act of 2008, the Excessive Pay Capped Deduction Act of 2009, the Excessive Pay Shareholder Approval Act of 2009, the Shareholder Bill of Rights Act of 2009, and the Shareholder Empowerment Act of 2009). These bills attempted to limit executive pay either by requiring non-binding shareholder votes, restricting tax deductions on pay, and/or placing outright caps on the maximum amount CEOs could earn. In addition to regulating pay, some of these bills would also (i) provide shareholders holding 1 percent or more the ability to nominate directors for inclusion in the proxy, (ii) require separation of the chairman and CEO positions, and (iii) require annual votes on all directors (i.e., ban staggered boards).

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In addition to these legislative initiatives, there have been significant recent developments at the SEC on proxy access regulation. The term "proxy access" (popularly labeled as "shareholder democracy") is related to the idea that certain shareholders or shareholder groups may require the corporation to include in the proxy statement a director (or slate of directors) nominated by shareholders to run against incumbent board members. The Dodd-Frank Act, passed in July 2010, gave the SEC explicit authority to adopt proxy access rules. Shortly thereafter, the SEC adopted rules giving shareholders holding 3 percent or more for three years the right to nominate candidates for up to 25 percent of board seats.

Regardless of the philosophical arguments for or against the regulation of corporate governance, whether regulation increases or decreases shareholder value is ultimately an empirical question. In recent research, Akyol et al. (2009, ALV) examine the market reaction to several events related to proxy access regulation. ALV find pronounced decreases (increases) in shareholder value across the entire U.S. economy when the probability of proxy access regulation increases (decreases). In addition to examining the market's reaction to proxy access regulation, Larcker et al. (2010, LOT) also examine the market reaction to regulations that would limit executive pay and ban specific governance practices (e.g., staggered boards). On average, LOT find a negative relation between the market's reaction to regulation and CEO compensation; the greater the pay, the more negative the reaction. This suggests that in many firms, existing pay practices maximize shareholder value, such that artificially capping or limiting pay would decrease shareholder value. Regarding specific governance practices, LOT find a negative relation between the market's reaction to regulation and the presence of a staggered board. This suggests that firms with staggered boards have them for good reason (perhaps as takeover defenses), such that banning staggered boards would decrease shareholder value. Regarding proxy access, LOT find a negative relation between the market's reaction and institutional ownership. The greater the likelihood that large shareholders would be able to nominate their own set of directors, the more negative the market's reaction. This is consistent with critics' claims that large shareholders will use the privileges afforded them by proxy access to manipulate the governance process to make themselves better off at the expense of other shareholders.

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Of course, analyzing the market's reaction to regulatory events is not without limitations. Other events related to macro-economic news may be occurring simultaneously with the regulatory events. Thus, on any given date, macroeconomic or firm-specific news might confound inferences. This is particularly a concern in studies focusing on the market reaction to a single regulatory event. However, both ALV and LOT find consistent results across multiple regulatory events, suggesting their results are not unique to any one regulatory event or attributable to confounding events.

Collectively, AKY and LOT find robust evidence of negative market 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. This is consistent with existing governance choices maximizing shareholder value. This does not mean that every firm's governance and compensation practices maximize value, but that on average such practices appear to be in the best interests of shareholders.


1. See Akyol et al. (2010), Cai and Walking (2010), and Larcker et al. (2010).

Cai, J., Walkling, R.A., 2010. Shareholders' say on pay: does it create value? Journal of Financial and Quantitative Analysis, forthcoming.

Akyol, A., Lim, W., Verwijmeren, P., 2010. Shareholders in the Boardroom: Wealth Effects of the SEC's Proposal to Facilitate Director's Nominations. working paper.

Larcker, D., Ormazabal, G., Taylor, D., 2010. The Market Reaction to Corporate Governance Regulation. Journal of Financial Economics, forthcoming.

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