The Wealth Effect of NZX 2003 Compulsory Compliance: An Event Study

Abstract

In response to a global move towards more strictly regulated corporate governance, the NZX established the Code of Best Practice in 2003. In addition to several guidelines for good corporate governance, two compulsory compliance measures were imposed to enforce greater external monitoring: (1) firms must have a minimum number of independent directors and (2) firms must include an audit committee on their board. However, prior research suggests that boards are endogenously determined based on a firm’s individual characteristics; thus, the imposition of compulsory compliance may force some firms to move away from an optimal board structure.

Using event study methodology, with both long-horizon and short-horizon approaches, I examine the cross-sectional variation in stock market returns around the announcement and passage of the new regulations. I find that firms with high benefits of control and low monitoring costs have significantly higher stock market returns around the event than firms with opposing characteristics. Small, growth firms that are operating in uncertain environments have significantly higher costs of monitoring and lower benefits of control. The imposition of the compulsory compliance measures has a significantly negative wealth effect for these firms. Results are robust to the capital asset pricing model (CAPM) and Fama-French (1993) risk adjustments. Analysis of the reaction around individual events related to the NZX Code shows that the bulk of the expected wealth effect of the NZX Code on firms was priced into the market at the first announcement of the new proposed rules (on May 6th). Overall, the findings suggest that a blanket “one-size fits all” regulation pertaining to best board practice is not optimal for the New Zealand market.