Several major corporate scandals in the United States during the early 2000s brought attention to corporate governance of large U.S. companies. As a result, Congress passed the Sarbanes-Oxley Act (SOX), and the Securities and Exchange Commission (SEC) announced several regulations aimed at restoring public confidence in the governance of public corporations. While significant research has been conducted on the relation between corporate governance and firm performance, there is no agreement yet on whether changes in governance structure are beneficial for companies and improve firm performance, especially when the changes are dictated by regulation.
The main question is whether mandatory rather than voluntary changes in corporate governance rules on board independence have a positive impact on firm performance. Adjustments in board structure might be necessary in order to monitor firms’ management, which would then increase firm value and protect shareholders’ interests. However, one size might not fit all: Firms with different characteristics, internal dynamics, and needs might require different board structures. Some changes could increase firm performance for some firms but not others.
Boards typically become more independent and objective as the ratio of external to internal directors increases. More independent boards reduce agency costs through effective monitoring, because independent directors are strongly motivated to protect their reputational capital and are independent of internal incentives and company politics. Nevertheless, the degree of optimal board independence may differ across firms. Hence, a “one size fits all” style of regulation may not be optimal. Friendlier and less independent boards may work better for firms that need advice rather than more monitoring by the board. Also, mandatory governance changes that disregard firm-specific dynamics can hardly improve performance, and, therefore, such regulations should be optional for companies.
SOX instituted new requirements for public company boards, and, in 2003, the SEC approved and adopted governance-related reforms suggested by the three major U.S. stock exchanges: NYSE, NASDAQ, and AMEX. The most prominent requirement is that “… A majority of the board of directors must be comprised of Independent Directors ….” Before the regulatory changes, companies applied necessary board structure adjustments organically, in line with their needs to improve efficiency and performance. Starting in 2003, however, all U.S.-listed firms had to have a majority of independent directors.
Regulations which force firms from their preferred board structure presume that the prevailing board structures are not optimal. If, however, organically determined governance structures are indeed best for some firms, then these dictated changes make those companies worse off. Furthermore, imposing new board structures may cause internal firm conflicts that can destroy harmony in the organization and damage efficient systems within firms. Moreover, new independent directors hired just to comply with the rule may not be a good fit and may lower advisory functions of the board. Loss of those functions, additional costs, and potential internal conflicts due to mandatory governance adjustments may lead to poor management decisions and a decrease in firm performance.
In fact, further analyses show that return on assets and sales growth decrease for firms that must increase board independence through mandatory rules after 2003. The negative impact on firm performance is greater when those rules force firms to deviate further from their optimal governance structure. The negative effects are also greater for single-segment and smaller firms, which must bear higher costs relative to their size when they have to adjust their board structure in accordance with SEC rules.
Companies in high-tech, wholesale, retail, and other concentrated industries dominated by one or two big players are severely affected by mandatory changes in board structure. There may be no external control mechanisms in those industries due to a lack of competition, so those firms may have developed internal controls for good governance regarding firm-specific needs. If an external rule like SOX is imposed, the firms could deviate substantially from their optimal form of governance.
Furthermore, the performance of firms in financial distress and with high leverage, high stock-return volatility, low cash holdings, high growth, and high research and development (R&D) expenses can suffer from the mandatory rule of increased board independence. Interestingly, rules requiring the full independence of compensation and nominating committees also have a negative impact on sales growth and return on assets.
Although mandatory rules might help some firms, particularly those that strayed from an optimal governance structure, there is evidence that imposing changes in board structure uniformly across firms is not suitable for the majority of companies and destroys firm performance, on average.
It would be in the firms’ best interest to seek guidance on their management and governance decisions and take into account studies on regulatory changes. Moreover, policymakers should not propose a uniform rule but consider firm-specific dynamics while formulating legislation to improve companies’ performance.
This post comes to us from Professor Onur K. Tosun at the Warwick Business School of the University of Warwick. It is based on his recent article, “Changes in Corporate Governance: Externally Dictated vs Organically Determined,” available here.