The Impact and Effectiveness of Corporate Governance Reforms
[Sponsored Article]
FAUVER, Larry | HUNG, Mingyi | LI, Xi | TABOADA, Alvaro G.
Journal of Financial Economics 125, 120–142
The past 20 years has seen a marked global increase in the amount of corporate board reforms aimed at increasing firm value. It is believed that with greater outside representation on the board, insiders – such as top executives and shareholders – will be discouraged from reaping private rewards, and instead will encourage investment in projects that benefit everyone. In addition, it will also hopefully improve financial reporting transparency. This should then reduce the cost of capital by increasing outside financing, and thus increase firm value.
Reforms may be necessary if firms are prevented by corporate insiders from investing in good practices. Indeed, government enacted reforms can help immensely, as they require firms to improve board practices – regardless of controlling shareholders’ views – and encourage conventions that would not otherwise be adopted. Alternatively, critics of board reforms point out that existing practices reflect the optimal route once all factors have been considered. Any change to this balance is therefore unnecessary and may be harmful. As such, board reforms have been the subject of much research. However, it has so far always focused on single countries and has yielded mixed results. In response, a recent study by Fauver, Hung, Li, and Taboada has investigated the impact of corporate board reforms on firm value on a worldwide scale.
Using a difference-in-differences design, they first gathered stock price data from DataStream and financial data from WorldScope. Then, using reports from the World Bank, the European Corporate Governance Institute, local stock exchange regulators, as well as earlier studies, information on major corporate governance reforms in 41 countries between 1990 and 2012 was obtained. This represented almost 95 percent of the total market capitalisation worldwide. In doing so, the study examined the major components of the reforms and their approaches, the role of country-level legal conditions, and evaluated the changes in board structure as a result of the reforms.
Finding that board reforms do increase firm value, the research showed that an increase occurred on or after the reforms came into effect, with no suggestion of changes taking place beforehand. Importantly, the results showed that reforms involving board independence, but not those involving separation of chairman and CEO positions, drive the valuation increases.
Surprisingly, though the effects of reforms were found to be similar across Civil-law and Common-law countries, the effectiveness of reform approaches varied. A ‘comply-or-explain’ approach – where firms can choose to explain their non-compliance, and which generally occurs in countries where reform is more necessary – showed a greater increase in firm value; as opposed to a rule-based approach, where compliance is mandatory. Both, however, have their downsides, as the former is ultimately just a suggestion, and the latter runs the risk of overregulation. The authors conclude that “the subsequent change in board independence plays a vital role in explaining the effectiveness of the reforms”.
While the study successfully answers important questions that existing literature is unable to address, it also uniquely documents the effect of worldwide board reforms on firm value and identifies the underlying factors responsible for the impact on firm value.
