Evidence on the Market Response to Corporate Governance Deficiencies
Carol Ann Frost*
Joshua Racca**
Mary Stanford***
*University of North Texas
**University of Alabama, Birmingham
*** Texas Christian University
April 2013
Abstract
We provideevidence that equity market participants value Nasdaq’s enforcement of corporate governance listing rules. We document a significantly negative market response to news that a firm has receiveda Nasdaq corporate governance deficiency notice. More specifically, we show that market participants react negatively to disclosure of noncompliance with audit committee independence requirements and that the most negative shareholder reaction is observed for firms failing to review and certify financial statements in conformance withSOX. This evidence indicates that market participants learn about these corporate governance failures throughthe Nasdaq enforcement process, supporting the current self-regulatory model.
Key Words: Corporate Governance, Listing rule deficiencies, stock exchange regulation
Acknowledgements: We are gratefulhelpful comments and suggestions from workshop participants at Rice University, and formany useful discussions with Nasdaq Stock Market, Inc. staff.Financial support from Texas Christian University,the University of Alabama-Birmingham, and the University of North Texas is gratefully acknowledged.
1
Evidence on the Market Response to Corporate Governance Deficiencies
- Introduction
The effect of corporate governance on firms’ financial and market performance and accounting irregularities has received much attention in the past decade.[1] However, few studies assess how market participants respond tochanges in corporate governance effectiveness.One exception is Defond, Hann and Hu (2005), which examines the market reaction to an increase in corporate governance effectiveness: the appointment of an accounting financial expert to the audit committee. However, Defond et al., find somewhat mixed results; appointment of a financial expert to the audit committee leads to a positive market response only for firms with strong governance, suggesting a complementary relation.
In this study, we document an adverse market response to news of firms’ noncompliance with Nasdaq’s corporate governancerequirements.Our study is motivated by the generally mixed evidence on the association between corporate governance quality and firm financial and market performance.Gompers et al. (2003) provide evidence that firms with stronger shareholder rights exhibit higher firm value, higher profits, and higher sales growth, using a sample of 1,500 firms during the 1990’s. However, many later studies using the Gompers Index and other proxies for corporate governance find contrasting evidence. One concern with this line of research is that the weak evidence on the effects of corporate governance may simply reflect researchers’ inability to identify the most important corporate governance matters.
We use governance standards established by the Nasdaq Stock Market as proxies for market participants’ minimum expectations.We test the joint hypothesis that (1) Nasdaq’s corporate governance requirementsreflect shareholder expectations about corporate governance effectiveness, and that (2) news of a company’s inability to remain above at least one regulatory minimum is associated with a decrease in firm value. We document a significantly negative market response to news that a firm has receiveda Nasdaq corporate governance deficiency notice indicating non-compliance with listing rules.This decline in share priceis consistent with the view that Nasdaq enforcement of its corporate governance requirements provides new and significant information to the market that leads to revised expectations about the integrity of a firm’s financial statements and about that firm’s future profitability or risk.
Our study isalsomotivated bythe limited evidence available on how exchanges perform the important investor protection role of stock exchange self-regulation, which includes developing and enforcing their own listing requirements. In 2004 the SEC announced a major reassessment of the self-regulatory system in light of changes in the ownership structure of stock exchanges and increased competition (SEC 2004a, Cox 2006). Consistent with this,Sirri (2006) notes that increasing competition for market share by exchanges has increased concerns about inherent conflicts of interest in the self-regulatory system. Although several studies provideevidence on certain aspects of regulatory delisting, delisting, the most severe outcome,isonly one part of the enforcement process.[2],[3]We find that almost all companies receivinggovernance deficiency notices from Nasdaq regain compliance and continue to trade on Nasdaq.Thus, the self-regulatory process appears to identify, enforce, and promote the correction of corporate governance problems, at least at the Nasdaq market.[4] Further, our stock return evidence indicates that equity market participantsuse the information in deficiency notices to revise their expectations about firm value, suggesting thatstock exchange enforcement of corporate governance requirements isvalued.
Our sample consists of 406 firms that received Nasdaqdeficiency noticesbetween January 1, 2004 and December 31, 2011 regarding a total of 472 corporate governance deficiencies.The deficiencies we examine are related to Nasdaq requirements for audit committees, board independence, shareholder approval, Sarbanes-Oxley Act-related reviews and certifications, and nomination and compensation committees. Our evidence shows that firms receiving deficiency notices are smaller, less profitable, more levered, and havelower return on assets and market to book ratios than their Nasdaq-listed industry counterparts that do not receive such notices.These findings are consistent with evidence from several studies showing a positive association between financial and market strength and the occurrence of accounting restatements and other irregularities, and internal control weaknesses.[5]
More importantly, we examine short-window cumulative abnormal returns (CARs) surrounding deficiency notice datesto assess the extent to which news of Nasdaq enforcement actions conveys information to the market.[6] We find a negative mean (median) three-day CAR of -1.28% (-1.20%),significant at the .001 (.01) level (two-sided tests usedin all analyses) on the days surrounding theearliest deficiency notices received by each firm. Results are similar when we use a five-day return window.
We also analyze each deficiency type subsample (audit committee, board independence, review and certification, shareholder approval, and nomination and compensation). For audit committee deficiencies, we document a significant negative response, the mean (median) three-day CARs is –1.79% (-1.42%)significant at the .001 level. This finding is consistent with investors’ awareness that audit committees’ play a central role in ensuring the integrity of financial statements. Among these firms, we identify three reason for a board members departure from audit committees, resignation, retirement, and death. The market response is significant forresignations and retirements but not for deaths. In addition, we also determine whether or not the departing board member is designated as the financial expert on the audit committee. The mean (median) market response to the departure of the financial expert is -2.29 (-1.70) with a t-statistic of -2.45 (-1.71) providing support for the requirement that audit committees have a financial expert.
The finding of an adverse market response to noncompliance with Nasdaq’s audit committee requirement is also consistent with Defond et al.’s (2005) evidence of a positive market reaction to an increase in the financial expertise of audit committee members, sincethe departure of an audit committee member is most common reason for audit committee noncompliance in our study. Our finding is also consistent with the Hoitash et al. (2009) result that audit committee characteristics are linked to internal control weaknesses under section 404 of Sarbanes-Oxley, which requires auditor certification, but not under section 302, which does not require auditor certification.
The strongest negative market reaction is for the 18firms that do not comply with the financial statement review and certification requirements mandated by SOX.These firms exhibit a mean (median) three-day CAR of -5.43% (-2.24%), significant at the .001 (.05) level. This finding is consistent with the view that the SOX certification process is a critical aspect of ensuring financial statement integrity, and that disclosure of Nasdaq deficiency notices is a primary means by which market participants learn of certification failures. However, closer examination of these 18 firms indicates several reasons for management’s decision to not certify the financial statements. Most of these deficiencies, 16 out of 18, occur in 2004 and 2005shortly after SOX was mandated. Not surprisingly, the most common reason for lack of certification is management’s failure to assess internal controls or problems identified with internal controls. Other reasons given for managements refusal to certify the financial statements include auditor resignations, audit delays and mergers resulting in no financial statements being issued.
Our review and certification results are in contrast to findings in Chang et al. (2006). Chang et al. (2006) reports no significant market response for the 12 firms that did not comply with the SEC’s certification order (but does document a positive market response to the SEC’s administrative order requiring top management of large firms to certify financial statements in 2002).[7]
We do not find a significantly negative market response to news of noncompliance with Nasdaq’s independent directors requirement. This result may suggest that market participants do not view board independence issues as significant as audit committee issues. That is, while board independence may be desirable, its absence does not directly impair the integrity of financial statements. However, we are currently reading the 8-Ks and press releases to determine the reasons for these departures from the board. Initial findings suggests that some reasons for departure may be positive, such as becoming CEO of the firm, while others are negative.
Noncompliance with Nasdaq corporate governance requirements other than those related to board independence and audit committees isrelatively less common, resulting in relatively small sample sizes. Market reactions to news of deficiency notices related to nomination or compensation committees(11 firms)are negative (mean three-day CAR is -1.36%) but not statistically different from zero at conventional levels.Market reactions to deficiencies related tofailure to seek shareholder approval(41 firms)are also negative (mean three-day CAR is -1.55%) but not significantly different from zero at conventional levels. Finally, we show that equity market participantsidentify those firms for which the corporate governance failure is a symptom of deeper problems with the company’s viability. The subsample of 59 firms that are delisted within three years of the deficiency notice date have mean (median) negativethree-day CARsof -4.69% (-2.29%), significant at the .001(.05) level around the date of the deficiency notice.
We complement our event study analyses with cross sectional regression estimations to determine whether firm characteristics previously associated with internal control weaknesses help explain the magnitude of the market response to the issuance of staff deficiency notices. Our findings with respect to firm attributes previously linked to poor internal controls, firm complexity, growth opportunities, and bankruptcy risk, are insignificant. However, we find that the three-day CAR for an audit committee deficiency is more negative for firms that delist within three years but less negative for firms with a restructuring plan in place in the year of or year before the notice. This suggests that market participants assess the likelihood of delisting as an additional risk and react less negatively when they know management has implemented a restructuring plan.
Our study contributes to the broad literature on the role of corporate governance in requiring management to act in the shareholders’ best interest. Compared to prior cross-sectional studies, this study provides a more powerful test of how the market assesses changes in corporate governance. Because receipt of a corporate governance deficiency notice indicates that a company’s corporate governance effectiveness has fallen below a minimum allowable level, our evidence of a decline in share price indicates that the market views Nasdaq listing requirements as minimum corporate governance standards and that the deficiency notices provide new and valuable information. Further, thestrong negative reaction to declines in the audit committee’s independence complement and extend prior studies that document a relation between audit committee independence and future firm performance. Finally, we provide the first evidence of a negative reaction to departures of the financial expert from the audit committee, indicating that market participants are aware of and value financial expertise on the audit committee.
This study is also relevant to those considering the costs and benefits of U.S. stock exchange requirements and the self-regulation process. The evidence supports the following inferences. First, the Nasdaq enforcement process identifies manycompanies that fall out of compliance with corporate governance listing rules, mostof whom remedy their deficiencies. Second, Nasdaq enforcement actions convey new information to the market about corporate governanceproblems, particularly those related to audit committee independence and management’s review and certification of financial statements. Thus, equity market participants recognize and value stock exchangeself-enforcement of these corporate governance requirements.
The rest of this paper is organized as follows. Section 2 describes the self-regulatory nature of stock exchanges and then summarizes Nasdaq listing requirements and the enforcement process. Discussion of sample and data is in section 3. Empirical results are presented in section 4, and conclusions appear in section 5.
2. Nasdaq’s Incentives, Listing Requirements, and Enforcement Process
Nasdaq, a Self Regulatory Organization (SRO), was founded in 1971 as a wholly-owned subsidiary of the National Association of Securities Dealers (NASD). It became a for-profit company with private ownership on June 28, 2000, and a registered national securities exchange in August 2006.[8] As an SRO, Nasdaq establishes and enforces initial and continued listing requirements for its markets, subject to SEC approval.[9]
The Sarbanes-Oxley Act of 2002 (SOX) (U.S. Congress 2002) expandedthe enforcement responsibilitiesof U.S. stock exchanges. The Act required the SEC to draft a rule prohibitingstock exchangesfrom listing companies that do not comply with the audit committeerequirements in Title III, Sec. 301 of the Act. Nasdaq also enforces various review and certification requirements imposed by the Act, including requirements for officers’ certification of annual and quarterly reports (Sec. 302), and for the preparation of, and auditor reports on, internal control reports (Sec. 404).[10]
The 2010 Dodd-Frank financial reform law (U.S. Congress 2010) further expanded the corporate governance enforcement role of U.S. stock exchanges. Dodd-Frankrequires the SEC to issue rules directing the stock exchanges to prohibit the listing of issuers not in compliance with the Act’s compensation committee requirements. (The SEC issued its final rule in June, 2012 [U.S. SEC 2012].)
A central regulatory issue concerns inherent conflicts of interest between stock exchanges and their listed companies. As self-regulatory organizations (SROs), stock exchanges monitor issuers and delist those that fail to meet minimum requirements. At the same time, exchanges face increasing pressure to attract and retain listings due to growing competition among themselves and with alternatives to stock exchanges.[11] A stock exchange that chooses to be a stringentregulator mayobtain a competitive advantage by increasing its credibility and reputation, and by avoiding SECdisciplinary actions. On the other hand, stringent enforcement may reduce the exchange’s listing revenues if it leads to numerousregulatory delistings and/ordeters companies from seeking to list on the exchange.
2.1 NASDAQ LISTING REQUIREMENTS
Nasdaq’s listing requirements are designed to promote investor protection and market quality.[12] Investor protection includes (1) providing investors material information, (2) monitoring and enforcing market rules, (3) preventing fraud in the public offering, trading, voting and tendering of securities, and (4) promoting comparability of information. Market quality refers to the market characteristics of fairness, orderliness, efficiency, and freedom from abuse and misconduct.
Nasdaq’s Marketplace Rules (2005) include initial and continued listing requirements for Nasdaq’s National Market (NM) and SmallCap (SC) Market.[13] The three types ofrequirement for continued listing are: (1) quantitative; (2) qualitative (corporate governance); and (3) timely filing/procedural. This study focuses exclusively on qualitative (corporate governance) deficiencies.
Qualitative (Corporate Governance) Requirements
Marketplace Rules§4350, summarized in Exhibit 1, presents the qualitative listing requirements for Nasdaq issuers.[14]These rules are the same for all issuers on Nasdaq exchanges, and are categorized as follows: (1) distribution of annual and interim reports; (2) board requirements (related to audit committees, independent directors, and compensation and nominating committees); (3) shareholder meetings; (4) conflicts of interest (in connection with related party transactions); (5) shareholder approval; (6) code of conduct; and (7) voting rights. Nasdaq also requires issuers to comply with the review and certification requirements contained in §§ 302, 404, and 906 of the Sarbanes-Oxley Act of 2002.[15]
Nasdaq includes deficiencies related to public interest concerns in the qualitative category. Specifically, Marketplace Rules §4330(a) states that “Nasdaq may … deny inclusion or apply additional or more stringent criteria if … Nasdaq deems it necessary to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, or to protect investors and the public interest.” We focus on corporate governance deficiencies and hence, do not include public interest-related deficiencies in our analysis.
2.2 THE NASDAQ ENFORCEMENT PROCESS
Nasdaq’s Marketplace Rules [2006, §4800] describe Nasdaq’s listed company enforcement process. When Listing Department staff determines that a company does not comply with at least one listing standard and the applicable grace period has expired, the staff immediately informs the company through a written Staff Deficiency Notice that limits or prohibits the continued listing of an issuer’s securities on Nasdaq.[16]
Information about companies’ noncompliance with Nasdaq listing requirements is promptly made public. Each trading day, Nasdaq publishes a list of companies that are not in compliancewithits continued listing requirements. Further, Nasdaqrequires issuers to publicly announce the receipt of deficiency notices within four business days of the notice. The SEC requires that a Form 8-K be filed disclosing receipt of the notice (SEC 2004b).