The Impact of a Change in Corporate Governance Regulations on Firms in Canada

Introduction Since the market crash of 2001-2002, regulators around the world are paying increased attention to the corporate governance of companies. The approaches adopted by regulators vary. One approach is a rules-based (1) approach that is best exemplified by the Sarbanes-Oxley Act of 2002 in the United States. The alternative is a comply-or-explain approach taken by countries such as the United Kingdom and Canada. Studies on comply-or-explain based approaches are limited (Anand et al., 2006). This study investigates the effect of the recent introduction of new governance rules (i.e., new Canadian governance rules in 2005) in a comply-or-explain regime. In Canada, the reform of corporate governance began with the 1994 Dey Report and the resulting Toronto Stock Exchange (TSX) comply-or-explain requirements in 1995. Studies of the effectiveness of these corporate governance rules are mixed. While the promulgation of these requirements resulted in a general improvement in corporate governance practices, there are areas where practices declined or were deficient. (See Swain et al., 2002 for a detailed summary.) As a result, securities regulators continued to focus on improving corporate governance practices. The outcome was the issuance of new corporate governance guidelines (National Policy 58-201 [Corporate Governance Guidelines] and National Instrument 58-101 [Disclosure of Corporate Governance Practices]) by the Canadian Securities Administrators (CSA) in 2005. Subsequently, the TSX also replaced its corporate governance requirements with the new guidelines. Given the considerable time and effort expended by the CSA to improve corporate governance guidelines, it is important that the impact of these efforts on company behavior be assessed. Drawing on this primary thrust, motivations for this study are threefold. First, given that compliance is voluntary for the comply-or-explain regime, it is relevant to examine the pertinent question--do the corporate governance practices of Canadian firms improve following the introduction of the new governance rules in 2005? To the extent that Canada's comply-or-explain system is representative of many other countries' corporate governance systems, answering the question of how publicly traded firms respond to new governance requirements will be of interest to international market regulators and investors. This question is especially relevant in Canada given the recent CSA proposal to move to a more principles-based approach. (2) Second, according to conventional wisdom, improved corporate governance practices are likely to affect a firm's performance positively. In reality, however, does the adoption of better corporate governance practices by firms translate into improved performance? A number of studies examine the relationship between firms' governance practices and performance and the results are mixed (e.g. Gompers et al., 2003; Klein et al., 2005; Core et al., 2006; Daines et al., 2008). This relationship needs to be re-examined with more recent data. Regulators, investors, and other market participants are now paying more attention to firms' corporate governance practices. As a result, the publicly traded firms feel pressure to comply with most of the governance guidelines. (3) Such compliance might be superficial and may not reflect true changes in corporate governance practices. Under this circumstance, the relationship between corporate governance practices and firm performance is likely to lose significance. Third, the current corporate governance literature reports a number of governance indices reflecting the strengths and weaknesses of firms' governance practices (for example, G-Index for USA; Globe and Mail Index for Canada). These indices, however, generally focus on certain governance practices (for example, G-index focuses on anti-takeover measures) or only larger firms (for example, the Globe and Mail Index for Canadian firms includes primarily TSX index firms). …

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