Volunteering for Good Governance

When the U.S. Sarbanes-Oxley Act (SOX) came into force in 2002, bringing with it sweeping changes to corporate governance, its tremors were felt north of the border. Needing to maintain compatibility and competitiveness with the U.S., Canadian regulators adopted similar largely voluntary provisions. In 2003, Ontario passed what came to be known as the Canadian Sarbanes-Oxley or C-SOX, followed soon after by new regulations from the Canadian Securities Administrators (CSA) concerning disclosure controls and the financial literacy and independence of audit committees.

Executives from smaller public firms in both the U.S. and Canada were not impressed. They grumbled that the SOX and CSA guidelines would impose high compliance costs and reduce their ability to compete with larger players. They called for proportionate regulation — essentially, regulatory exemptions that would level the playing field.

To some extent, these allowances have been made. In the U.S., for example, the JOBS Act (Jumpstart our Business Startups) lowers regulatory requirements for smaller public firms looking to raise capital. It tacitly acknowledges that regulation affects large and small firms differently.

Still, complaints from smaller public firms persist. So Lynnette Purda of Smith School of Business and colleagues Anita Anand (University of Toronto) and Wayne Charles (Smith School of Business) decided to see if the CSA’s guidelines had been voluntarily adopted by smaller Canadian firms — and if proportionate regulation was even necessary. Their research, to be published in the Canadian Business Law Journal, appears to debunk the regulatory burden argument.

Investor Reaction

Purda and her colleagues used a natural experiment and data analysis to determine the impact of the regulatory guidelines. They focused on a set of Canadian firms known as venture issuers. These reporting issuers trade on the TSX Venture Exchange — they do not have their securities listed or quoted on the Toronto Stock Exchange, a U.S. marketplace, or a marketplace outside of Canada or the U.S. According to Canadian regulations, they are exempt from mandatory guidelines related to audit committees. They can adopt any audit committee composition they choose, even the mandatory approach if they thought doing so would improve the quality of governance. All they must ensure is that the membership of their audit committees is disclosed.

In the natural experiment, the researchers studied how investors in these firms’ stocks responded to two announcements from the CSA relating to regulatory requirements for audit committees. The first announcement, in 2002, concerned the requirement that all firms have financially literate audit committees. The second, issued the following year, exempted venture issuers from this requirement. The researchers expected the stock prices in their targeted firms to fall when the first announcement was made and to surge at the time of the second announcement if regulatory burden for compliance was high.

"The surprise for us was that despite the objections to the regulations, most small firms opted to adopt them voluntarily"

Instead, the researchers found the investors were largely indifferent to the news: there were “limited statistically or economically significant stock price reactions” to the proposed audit committee changes.

The researchers then turned their attention to the actions of the firms themselves to infer their views on the composition of audit committees. The researchers figured that if venture issuers chose to take advantage of their exemption and not adjust their audit committee composition to the mandatory model, this could help make the case for proportionate regulation.

Using hand-collected data, the researchers found that Canadian venture issuers largely complied with the stricter standards. About 88 percent of the firms studied had at least a majority of independent directors on their audit committee. The average audit committee size was approximately three members and, in most cases, at least two were independent. About 85 percent of the audit committees also had a majority of financial literate members.

Value of Good Governance

Purda says the findings were unexpected. “The surprise for us was that despite the objections to the regulations, most small firms opted to adopt them voluntarily,” she says. “These actions seem inconsistent with small firms’ frequent complaints of regulatory burden.”

So for all the supposed opposition of smaller firms, many chose an audit committee structure very similar to what was proposed under SOX. The question is, why? Purda says firms are placing a greater emphasis on good governance practices, something the tougher guidelines encourage.

“We suspect that it’s driven by the desire to certify their quality to outside investors,” she says. “Adopting these terms is a way for firms to signal that they care about good governance and are willing to adopt strong governance practices in the absence of any requirement to do so. It sends a good message to potential investors.”

Purda says that if the firms grow to a size where they need to raise capital in other ways, they may find that the regulations they were previously exempt from now apply. As a result, some may adopt the practices early in anticipation of an eventual requirement to do so.

While the researchers believe more research is needed, they say their findings suggest that many of the arguments in favour of proportionate regulation are not relevant. Small firms may still be vocal about the Sarbanes-Oxley bogey man, but following the more robust governance guidelines means good business.

— Anna Sharratt