Why Do Firms in Weak Institutional Environments Adopt Strong Corporate Governance? The Role of Government Regulation

Abstract

This study identifies one potential benefit of mandatory investor protection laws in weak investor protection countries neglected by the extant literature: laws help reduce firms’ bonding costs to strong corporate governance. We argue that corporate insiders (outside investors) have little incentive to voluntarily supply (demand) strong corporate governance in weak legal regimes because such voluntary bonding is not a credible commitment. However, once a corporate governance provision is mandated by law, it can serve as a more credible bonding mechanism at lower costs. Hence, firms that expect to benefit more from such bonding should be more likely to comply with the corporate governance provisions in the mandatory regime. Using two different and complementary corporate governance proxies, we find supporting evidence for our hypothesis. We also find that stock market investors react positively to firms’ adoption of such mandatory corporate governance provisions.