Governance Quality in a “Comply or Explain” Governance Disclosure Regime

• Author: Yan Luo,Steven E. Salterio
• DOI: http://doi.org/10.1111/corg.12072
• Date: 01 November 2014
• Published date: 01 November 2014

Governance Quality in a “Comply or Explain”

Governance Disclosure Regime

Yan Luo and Steven E. Salterio*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Do f‌irms take advantage of the f‌lexibility of the “comply or explain” corporate governance

disclosure regime to adopt governance practicesthat are best suited to their needs and value-added to the f‌irms as predicted

by economic theories of the f‌irm? Using the Canadian “comply or explain” corporate governance disclosure regime, we

construct a board score measure based on the Canadian code’s 47 “best practices.” We employ a unique approach by

positing that the “explain” disclosures indicate higher agency costs of best practice adoption or indicate the ability of the

f‌irm to improve its governance practices relative to “best practices” in light of f‌irm specif‌ic circumstances.

Research Findings/Insights: We f‌ind that our measure is strongly and positively associated with higher f‌irm value and

weakly and positively associated with better operational performance. Further, our measure is more strongly associated

with both than best practice adoption measures.

Theoretical/Academic Implications: Our unique measure of governance quality reveals differences in governance eff‌i-

ciency and effectiveness that are consistent with the theorized advantages of “comply or explain” governance disclosure

regimes. Further, our results suggest that f‌irms in a “comply or explain” regime are not employing, on average, the

discretion permitted by such a regime to avoid improvements to their corporate governance practices.

Practitioner/Policy Implications: Our results support the proposition that the f‌lexibility of a “comply or explain” gover-

nance regime provides tangible f‌inancial benef‌its to shareholders in terms of higher f‌irm value and returns on shareholders’

equity investment.

Keywords: Corporate Governance, Agency Costs, Comply or Explain, Firm Performance, Firm Value

INTRODUCTION

Nearly all countries that have addressed the regulation

of corporate governance practices for public com-

panies have adopted what has become known as the

“comply or explain” governance regime (e.g., Aguilera &

Cuervo-Cazurra, 2004, 2009; Haxhi & vanEes, 2010; Renders

& Gaeremynck, 2012). Such regimes feature a regulator-

endorsed code of best governance practices and require

f‌irms to either “comply” with those practices by adopting

them or “explain” how they will achieve the underlying

governance principle behind each practice that is not

adopted. The disciplining power of this regime is the

required public disclosure of governance practices that

allows market participants to evaluate the effectiveness of

the f‌irm’s governance system and to make informed assess-

ments of whether noncompliance is justif‌ied in particular

circumstances. Theadvantage of this governanceapproach is

that f‌irms can tailor their governance practices to meet their

underlying needs based on the trade-off between costs and

benef‌its resulting from additional monitoring, instead of

incurring compliance costs for mandated practices that do

not add value and/or create additional net costs for f‌irms

(Adams, Hermalin, & Weisbach, 2010).

As the ultimate goal of good governance is to maximize

shareholder value, in this study we focus on the effect of a

tailored governance system on f‌irm value and return on

shareholders’ investment. Specif‌ically, our study asks

whether the f‌lexibility to adopt alternative governance prac-

tices in a “comply or explain” regime results in more effec-

tive board monitoring that leads to better f‌irm performance

and higher f‌irm value. Answering this question provides

insights into whether the advantages of the “comply or

explain” approach to governance are, on average, real, or

whether this governance regime affords f‌irms a means to

avoid engaging in serious attempts to improve governance

(Zadkovich, 2007). The latter contention underlies the more

*Address for correspondence: Steven E. Salterio, Queen’s Centre for Governance,

Queen’s School of Business, Kingston ON, Canada K7L3N6. Tel:613-533-6926; E-mail:

ssalterio@business.queensu.ca

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Corporate Governance: An International Review, 2014, 22(6): 460–481

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12072

prescriptive approach to corporate governance that is fol-

lowed in the US (e.g., Dodd-Frank, 2010; Sarbanes-Oxley Act

of 2002 or SOX) and is based on the premise that alternative

voluntary approaches have failed (atleast in the US context).

The limited existing studies of “comply or explain” gov-

ernance disclosure regimes focus on whether f‌irms adopt

the codif‌ied best governance practices (e.g., MacNeil & Li,

2006); they do not consider how the tailoring allowed by

such regimes potentially allows f‌irms to createmore eff‌icient

and/or effective practices. In other words, most researchers

convert the “comply or explain” regime into a de facto man-

dated governance “best practice” adoption regime, by treat-

ing anything but the adoption of best practice norms as

“non-compliant.”

Unlike the previous research, this study does not start

from the assumption that the goal of “comply or explain”

regimes is to encourage the adoption of a code of “best

practices” (e.g., Hooghiemstra, 2012; MacNeil & Li, 2006).

Rather, we take an innovative approach by positing that the

“or explain” option can potentially result in greater benef‌its

to the f‌irm as it allows it to tailor its governance practices

to its particular circumstances. We argue that while “on

average” regulators may have identif‌ied “best practices” in

their codes, this identif‌ication does not lead to an “on

average optimal” best practice being optimal for individual

f‌irms. Thus, we posit that a departure from a “best practice”

that includes an explanationof how the alternative approach

achieves the goal of the non-adopted “best practice” sug-

gests that there are signif‌icant benef‌its (or alternatively that

signif‌icant costs are avoided) associated with the tailoring

of this governance practice to f‌irm-specif‌ic circumstances.

Using the Canadian “comply or explain” corporate gover-

nance disclosure regime as our research setting, we con-

struct a comprehensive board score measure based on the 47

governance dimensions embedded in the best governance

practices codif‌ied and endorsed by the Canadian Secu-

rities Regulators (i.e., Canadian Securities Administrators

[CSA], 2004a, 2004b). We code each f‌irm’s response to

each of the 47 items using a simple three-point scale: “0”

for noncompliance/non-disclosure; “1” for compliance

with the guideline; and “2” for an explanation of an alterna-

tive governance practice that allows the f‌irm to achieve

the governance principle embedded in the best practice

without actually adopting it. Noncompliance (by either non-

disclosure or stated non-compliance with no explanation)

suggests that managers are attempting to take advantage of

information asymmetries with shareholders and to reduce

the level of monitoring of their actions. The adoption of a

“best practice” indicates that the costs of tailoring a f‌irm-

specif‌ic alternative to a recommended practice exceed the

costs associated with the adoption of even a non-optimal

“best practice.”

Preliminary screening of our data suggests that less than 7

percent of our sample f‌irms fully adopt all of the suggested

best practices, indicating that the majority of our sample

f‌irms take advantage of the latitude allowed in the “comply

or explain” regime to customize governance practiceto f‌irm-

specif‌ic needs or, alternatively,evidence that f‌irms are avoid-

ing serious attempts to reform governance.About 45 percent

of the f‌irms complied with 42–46 of the 47 items, lending

support to the argument that in a “comply or explain”

regime, compliance “by explanation” rather than “by adop-

tion” is applied to practices that have high costs for the

f‌irm. It is unlikely that so many f‌irms would fail to comply

with the remaining handful of practices unless the costs of

complying outweighed the potential negative publicity

associated with not having completely adopted regulator-

endorsed “best practices.” As is common with many

“comply or explain” jurisdictions, Canada features regular

media reporting on f‌irm’s adoption of governance best prac-

tices including rankings based on such adoptions (see, e.g.,

Globe & Mail, 2012).

Among the items that are frequently dropped by f‌irms

that are very close to full adoption are the guidelines related

to the independence of the board and its subcommittees,

for example, the independence of the board chairman,

in-camera meetings by independent directors, seeking

outside advisers, and the complete independence of com-

pensation and nomination committees. Among these three

items, the independence of board chairman is the least often

“adopted” but most frequently “explained” item among the

47 best-practice guideline items in the entire sample. All

these most frequently dropped items are related to the well-

known problem of a limited talent pool of professionals

qualif‌ied to sit on boardsin the Canadian market resulting in

f‌irms having to compete for the limited pool of available

directors or accept less qualif‌ied directors (e.g., McFarland,

2013). These examples of best practices that are not adopted

demonstrate the value of the f‌lexibility allowed in a “comply

or explain” regime for if unmodif‌ied, mandatoryregulations

that require such practices to be adopted (e.g., completely

independent composition of compensation and nomination

committees) would likely be more costly for Canadian f‌irms

to implement.

In this study, we test the associations between our gover-

nance measures and the tangible f‌inancial benef‌its to share-

holders: f‌irm value and operating performance. We f‌ind that

higher governance scores under our unique coding scheme

are strongly associated with higher f‌irm value, as measured

by Tobin’s Q, and weakly associated with better operational

performance, as measured by return on equity (ROE). Such

f‌indings are consistent with the results of both survey and

empirical studies indicating that investors are willing to

pay more for companies with good corporate governance

(Durnev & Kim, 2005; La Porta, Lopez-de-Silanes, Shleifer,

& Vishny, 2002; McKinsey,2002). Our results further support

the arguments and f‌indings from studies of the economic

determinants of board effectiveness that some f‌irms may be

better served by a board that is different than the one essen-

tially mandated by “one size f‌its all” regulations (Boone,

Field, Karpoff, & Raheja, 2007; Coles, Daniel, & Naveen,

2008; Linck, Netter, & Yang, 2008).

We conduct additional analyses based on alternative mea-

sures used in prior “comply or explain” studies that are

based on assumptions that “compliance by adoption” is

superior to “compliance by explanation” or suggest thatany

action but adoption of best practice is “noncompliance.” The

positive association between our governance quality proxy

and both f‌irm value and performance becomes weaker, or

even disappears, when employing these more conventional

approaches to measuring governance quality in the “comply

or explain” regime. The evidence supports our contention

GOVERNANCE QUALITY 461

Volume 22 Number 6 November 2014© 2014 John Wiley & Sons Ltd