By Larry Fauver

The last two decades have witnessed an increase in corporate board reforms designed to create greater board independence, audit committee and auditor independence, and separation of the chairman and chief executive officer positions. Do these reforms affect firm value? Existing research on such reforms has typically focused on a single country and yielded mixed results. We examine the impact of corporate board reforms on firm value in 41 countries and find that such reforms do indeed increase firm value, with the effects determined by the type and nature of the reforms.

Our focus is on governance reforms related to board practices, given that boards are the fundamental governance mechanism of corporations and because board reforms are the major approach taken to address corporate governance issues. These issues began to come under the global spotlight following the issuance of the Cadbury Report in the UK in 1992, which underscored the importance of corporate governance. Since then, scores of countries have launched corporate board reforms across all major developed and emerging economies. However, several questions remain unanswered. How do the board reforms affect firm value? Does institutional quality affect the success of board reforms? Does the approach taken to adopt reforms matter? If so, how?

Supporters of board reforms argue that reforms should increase shareholder value because they encourage firms to adopt better governance practices. For example, having greater oversight by outside board members may discourage corporate insiders from extracting private benefits and encourage them to invest in projects that benefit all shareholders. In turn, outsiders’ willingness to finance the firm should increase, thereby reducing the cost of capital and enhancing firm value. Reforms may be necessary to overcome frictions that prevent firms from investing in good board practices because corporate insiders may not wish to lose their private benefits while gaining only part of the benefits from increased firm value.

However, critics of board reforms argue that existing board practices are the equilibrium outcome of a market solution and reflect the firm’s optimal choice. Thus, board reforms that push firms away from this arrangement could be unnecessary and potentially harmful. Some also contend that firms can appoint directors who appear to be independent but are, in fact, cronies of managers. Alternatively, having independent directors can be harmful because they can be overly conservative and constrain a firm’s growth given their lack of familiarity with company operations and the fact that their reputation and compensation are less dependent on earnings growth and profitability.

These issues all suggest that determining the average effects of board reforms on firm value is an empirical question, and this is the substance of our research. We use a set of major board reforms in 41 countries between 1990 and 2012 and employ a difference-in-differences (DID) design that includes firm and year fixed effects, and we control for concurrent non-board governance reforms. The findings reveal a positive effect of board reforms: on average, firm value increases following reforms and the effects are led by reforms that involve board and audit committee independence, but not the separation of chairman and CEO positions. Moreover, in an important additional test, we find that the greatest increases in value occur among firms that did not have majority board independence in the pre-reform period.

We also examine country-level legal origin and reform approaches, and assess whether they influence changes in firm value in the wake of reforms. The law and finance literature suggests that a country’s legal origin—whether it has adopted civil law or common law—is an important factor explaining its investor protection and capital market development. Somewhat surprisingly, we find that the effects of reforms are similar in civil law and common law countries. However, two approaches to reforms do result in different outcomes.

There are two main board reform approaches: comply-or-explain, in which firms can choose to explain why they do not comply, and rules-based which makes compliance mandatory. The UK Cadbury Report (formally, Financial Aspects of Corporate Governance) is an example of comply-or-explain, while the US Sarbanes-Oxley Act of 2002 is rule-based. Each approach has potential drawbacks—the rule-based reforms run the risk of encouraging overregulation, while comply-or-explain codes might not have enough teeth. However, our results indicate that comply-or-explain reforms are associated with a greater increase in firm value than rule-based reforms. This begs the question: why would the effect of reforms be similar across different legal origins but vary with reform approaches?

Legal origin does shed some light on that question. While the effects are similar across civil and common-law jurisdictions, there is a difference between the two in terms of majority board independence. Prior literature has found that firms in civil law countries have poor shareholder protection and corporate governance, and our findings show that civil law countries have a lower percentage of firms with majority board independence. Even though we find that both civil law and common law countries experience similar increases in this percentage following reforms, the differences between them persist. The likely reason may be because in civil law jurisdictions, the poor quality of investor protection prevents some firms (which should benefit more) from catching up and accruing the full benefits of the reforms.

Related to that, we also find a greater increase in majority board independence post-reforms in countries that use the comply-or-explain approach rather than the rule-based approach. The former group may have had greater deficits in board independence prior to the reforms, and it may be argued that they adopted a comply-or-explain approach as a political compromise, thus enabling the introduction of reforms where it is much needed. In addition, our investigation also identifies the importance of the speed of compliance in explaining the effectiveness of the reforms. This further confirms the importance of changes in board independence associated with reforms.

With increasing globalization, there is considerable interest in reforming corporate boards to improve investors’ confidence and to attract foreign investors. While such reforms can increase firm value, our findings show that it is important to tease out which reforms drive the effects. Reforms involving board and audit committee independence, rather than separation of chairman and CEO positions, are the more important drivers and this effect can be seen across different legal jurisdictions and approaches to reforms.


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