Corporate Governance and Firm Value: The Impact of the 2002 Governance Rules

The 2001 to 2002 corporate scandals led to the Sarbanes–Oxley Act and to various amendments to the U.S. stock exchanges’ regulations. We find that the announcement of these rules has a significant effect on firm value. Firms that are less compliant with the provisions of the rules earn positive abnormal returns compared to firms that are more compliant. We also find variation in the response across firm size. Large firms that are less compliant earn positive abnormal returns but small firms that are less compliant earn negative abnormal returns, suggesting that some provisions are detrimental to small firms. THE HIGH-PROFILE CORPORATE FAILURES IN THE UNITED STATES over the 2001–2002 period have led to the Sarbanes–Oxley Act of 2002 (SOX) and to various amendments to the stock exchanges’ regulations. These rules include different provisions whose purpose is to ensure alignment of incentives of corporate insiders with those of investors, and to reduce the likelihood of corporate misconduct and fraud. For example, SOX imposes higher penalties on officers who are charged with forging documents and requires more timely disclosure of equity transactions by corporate insiders. It also requires independence of audit committees, certification of financial statements by the chief executive officer and the chief financial officer, procedures to evaluate the effectiveness of the firms’ internal controls and increased oversight over audit firms. The exchange regulations require a majority of independent directors on corporate boards and independence of the board committees that choose new directors and compensate managers. Proponents of the rules argue that such rules are necessary because the corporate scandals indicate that existing monitoring mechanisms in U.S. public corporations should be improved. Yet, it is not clear whether the provisions of the rules indeed lead to more effective monitoring and to higher corporate value. To the extent that these provisions are only cosmetic in nature, they might not have any material effect on firm value. But even if the provisions have an effect, it is not clear whether all firms should benefit from them. Optimal governance structure depends both on a firm’s monitoring needs and the costs and benefits of different monitoring mechanisms. To the extent that these costs and benefits vary across firms and ∗Vidhi Chhaochharia is from University of Miami and Yaniv Grinstein is from the Johnson School of Management, Cornell University.