Corporate Governance and Financial Peer Effects

• DOI: http://doi.org/10.1111/fima.12240
• Author: Douglas (DJ) Fairhurst,Yoonsoo Nam
• Published date: 01 March 2020
• Date: 01 March 2020

Corporate Governance and Financial

Peer Effects

Douglas (DJ) Fairhurst and Yoonsoo Nam∗

Growing evidencesuggests that managers select financial policies partially by mimicking policies

of peer firms. Wefind that these peer effects in capital structure choice areunique to f irms operating

under weak external corporate governance.Cross-sectional tests suggest that this finding is best

explained by a quiet life hypothesis in which managersmay be able to avoid the effort required to

optimize financial policies and the scrutiny of market participants. Leverage ratios of mimicking

firms display less sensitivity to a profitability shock. Finally, mimicking correlates to higher

financing costs and lower future profitability,especially if it results in high leverage.

I. Introduction

The financial policies of peer f irms play a significant role in the selection of a fir m’s own

financial policies. For instance, peer firms impact capital structure choice (Lear y and Roberts,

2014), dividend payment decisions (Grennan, 2018), and the choice a firm faces whether to split

its stock (Kaustia and Rantala, 2015). However, it is unclear whether peer firm influence on

financial policy choice is optimal from the perspective of shareholders. Firms may learn optimal

financial policies by observing the policies of more successful peer fir ms. However,f irms that are

unable to determine their own optimal financial policy may also lack the ability to infer optimal

policies by observing peers. In this case, mimicking peers may result in suboptimal financial

policies.

Yet, it is empirically challenging to determine the optimality of basing financial policies on peer

firms. In this study, we consider the impact of firms’ external corporate governance environments

on the propensity to mimic peer firms. Managers of f irms with strong corporate governance are

more likely to make decisions, including financial policy decisions, which are optimal from the

perspective of shareholders. If the use of peer firms’ financial policies in the selection of a f irm’s

own policies is value-increasing, weexpect the presence of these peer effects to be most apparent

in firms with strong corporate governance.

Alternatively, managers in poorly governed firms may make financial policy choices that are

detrimental to shareholders. For example, poorlygoverned f irms tend to havelower cash holdings

as managers spend the cash on self-serving projects (Harford, Mansi, and Maxwell, 2012).

Managers of firms operating under weak corporate governance may simply pursue “the quiet life”

(Bertrand and Mullainathan, 2003) in regard to setting financial policies. Specif ically, managers

may maximize their own utility by minimizing the cost or effort required to select financial

We thank Daniel Greene, Rajkamal Iyer (Editor), George Jiang, Jonathan Lee, Tanakorn Makaew, Matthew Serfling,

James Weston,David Whidbee, and an anonymous referee, as well as participants at the 2017 Financial Management

Association Annual Meeting for helpful comments. We are grateful to Robert Bird and John Knopf for sharing with us

their state-level data on the strength of the enforceabilityof non-competition agreements.

∗Douglas (DJ) Fairhurstis an Assistant Professor in the Department of Finance and Management Science at Washington

State University in Pullman, WA.Yoonsoo Nam is a Ph.D.student in the Department of Finance and Management Science

at WashingtonState University in Pullman, WA.

Financial Management •Spring 2020 •pages 235 – 263

236 Financial Management rSpring 2020

policies. However, shirking the responsibility to optimize financial policies raises scrutiny from

market participants. Scharfstein and Stein (1990) imply that it is potentially costly to financial

managers’ reputations to deviate from “the herd.” As such, peer mimicking may avoid both

the costs of optimizing policies and outside scrutiny. In this case, peer effects would be more

pronounced for firms operating under weak governance.

Weuse the empirical models of Leary and Roberts (2014) documenting peer influence in capital

structure choice to test these competing hypotheses. These models indicate that leverage changes

in peer firms resulting from the peers’ idiosyncratic stock returns impact f irms’ capital structure.

The use of idiosyncratic returns of peer firms ensures that the effect is driven by firm-specif ic

variations in the peers’ capital structure and not by omitted characteristics that impact industry-

level changes in capital structure. These models also provide a setting where the financial policy

decision (i.e., leverage) is faced by a broad cross-section of firms. As such, this approach allows

for tests of a large, pooled sample of firm years.

Using a broad sample of US firms from Compustat from 1965 to 2014, we find peer effects

similar to Leary and Roberts (2014).1We then split the sample of firms into those with a

weak/strong corporate governance environment to determine whether the use of peer effects

to determine capital structure policy varies based on the quality of corporate governance. We

first test this prediction using institutional ownership concentration as a proxy for corporate

governance. Institutional owners with high ownership concentrations have greater incentives to

monitor the firm (Hartzell and Starks, 2003). We find evidence of peer effects in capital structure

choice only for those firms with a low concentration of institutional ownership or, in other words,

weak corporate governance.

One potential concern with this finding is that institutional ownership concentration is an

endogenous measure of governance. To address this concern, we use the takeoverindex developed

in Cain, McKeon, and Solomon (2017) that measures the strength of the external takeover market

as a measure of governance. This measure has severaladvantages. The use of the external takeover

market as an important part of the corporate governance environment is consistent with numerous

other studies (Bertrand and Mullainathan, 1999, 2003; Gompers, Ishii, and Metrick, 2003). Also,

the takeover index allows for the inclusion of a long sample period and broad cross-section

of firms that ensures the results are not driven by unique macroeconomic environments or a

misrepresentative subsample of firms. Finally, and most importantly, the index is based on the

legal environment surrounding the firm, macroeconomic conditions, and an exogenous firm-

level characteristic. As such, this measure likely captures an exogenous dimension of corporate

governance.

Using this takeover index, we continue to find that peer effects are only evident in firms with

weak corporate governance. In addition to being robust to two separate measures of governance,

the finding that peer effects are driven by weakly governed firms holds regardless as to the

estimation procedure [ordinary least squares (OLS) or two-stage least squares (2SLS)]. In other

words, firms with poor corporate governance are more likely to follow idiosyncratic changes to

their peers’ capital structure when setting their own level of leverage.This evidence is consistent

with managers in weaklygoverned fir ms enjoyingthe quiet life by mimicking their peers’ f inancial

policies and implies that mimicking peers is not optimal from the perspective of shareholders.

We next look at a variety of cross-sectional tests to support the argument that this finding

is driven by managers seeking the quiet life in selecting financial policies when corporate

governance is weak. We first consider the variation in incentives for managers to maximize the

1Utility firms (standard industrial classification (SIC) codes 4900-4999), f inancial firms (SIC codes 6000-6999), and

quasi-public firms (SIC codes greater than or equal to 9000) are excluded.