When there is turmoil in financial markets, investors become concerned about the effectiveness of securities market regulation, and usually call for more and stricter regulation. A recent example is the Sarbanes-Oxley (SOX) Act, introduced in the US in 2002 in response to several serious corporate and accounting scandals including Enron, Tyco International and WorldCom, which caused billions of dollars in losses for investors.

Most would agree that the Securities Act of 1933, which was a response to the Wall Street Crash of 1929, and the subsequent creation of the Securities and Exchange Commission (SEC) to enforce it, is still the most significant change to US financial regulation in the past 100 years. The New York Stock Exchange (NYSE) had the most stringent listing standards at that time, and the SEC effectively took those NYSE listing standards, converted them into federal law, and applied them to all US firms on all regional stock exchanges. This created two groups of US listed companies – those affected by the regulation (the non-NYSE listed firms), and those unaffected (the NYSE listed firms). By comparing the difference in board governance and firm valuation between these two groups of companies, a new research study co-authored by CEIBS Zhongkun Group Chair Professor of Finance Henrik Cronqvist explores the effect of significant changes to corporate governance regulation.

Specifically, the researchers studied the effect of the SEC creation on a broad set of governance measures related to board independence, size and director location as well as firm valuations. How did the creation of the SEC affect the governance of firms listing in the US? Their results suggest that the regulation had a significant effect on listing firms’ board governance design. The researchers found that one of the most significant effects of the creation of the SEC was to cause the boards of affected firms to become less independent – their results show a 30 percent reduction in board independence. The researchers also found a trend towards larger boards and less local director monitoring. It is much less clear whether the regulation added any significant value for investors, as there appears to have been no significant effect on firm valuations.

Did the creation of the SEC accomplish anything that firms could not already have attained with respect to corporate governance?  In fact, the findings suggest that the creation of the SEC may have imposed “too much” governance on some firms, and many offset the governance pressure imposed on them. Before the SEC, an independent board was an important governance mechanism to reduce asymmetric information when selling new equity issues to investors, as independent directors may provide a more credible signal of the quality of the firm. After the SEC, this benefit was significantly smaller because of the disclosure rules of the 1933 Act, and the results suggest that firms changed their board governance designs in response to the new regulation.

One implication of the findings is that governance reforms are inherently difficult, or perhaps even impossible, as long as firms are allowed to freely change their governance designs. Imposing one set of federal securities rules on all firms, with the implicit assumption that “one size fits all”, but which may be neutralized by market-based governance design choices by firms, may not result in any substantial improvements in firm valuations.

The results of the study appear in the paper titled “Corporate Governance and the Creation of the SEC” which Prof. Cronqvist co-authored with Arevik Avedian of Harvard Law School and Marc Weidenmier of Claremont McKenna College, Robert Day School of Economics and Finance, and NBER. The paper received the Outstanding Paper Award in the "Applied Corporate Finance" category from the Midwest Finance Association.

View the paper here