Originally published in the Harvard Law School Forum on Corporate Governance and Financial Regulation - https://corpgov.law.harvard.edu/2017/04/10/voluntary-corporate-governance-proportionate-regulation-and-small-firms-evidence-from-venture-issuers/
Following the implementation of the Sarbanes-Oxley Act, many scholars and business leaders argued that one-size-fits-all corporate governance imposed disproportionately high compliance costs on small businesses, weakening their competitiveness vis-à-vis larger firms.  As an alternative, these critics contended that “proportionate regulation,” in the form of regulatory exemptions for small firms, is an appropriate means of minimizing disclosure obligations. While at first glance it may seem that small firms would seek to comply with less costly governance standards, is it possible that they would nonetheless voluntarily adhere to stricter standards?
The notion that proportionate regulation can provide investor protection while nonetheless minimizing the regulatory burden for small firms has been debated in both the United States and Canada. In 2011, President Obama called for a review of existing regulation to reduce “the burden regulations may place on small business.”  Subsequently, the Jumpstart Our Business Startups (JOBS) Act was signed into law on the basis of the belief that “cost-effective access to capital for companies of all sizes plays a critical role in our national economy.”  Similarly, in 2015 the head of the Canadian Securities Administrators (CSA) suggested that their proposed changes would “alleviate the disclosure burden imposed on venture issuers without compromising investor protection.”  Despite the regulatory attention given to proportionate regulation, there is little empirical evidence to either support or dismiss it. This article aids in closing this gap by delving deeply into a specific instance of proportionate regulation to shed light on venture issuers’ governance preferences and voluntary behaviour.
Our contribution to the literature is twofold. First, we provide specific insights on the perceived benefits for investors and firms of a particular regulatory exemption for venture issuers. Second, our empirical findings suggest that many of the arguments in support of implementing proportionate regulation were not relevant given voluntary adoption among small firms. These findings lead us to stress the importance of empirical legal scholarship in this area of securities regulation. We call for more empirical work on the costs and benefits of regulatory exemptions for small firms prior to further exemptions being granted for these firms.
Our particular setting involves Canadian venture issuers trading on the TSX Venture Exchange. We employ an event study to examine the stock price response of these firms to announcements related to regulatory requirements pertaining to audit committee composition and subsequent exemptions from these requirements. These announcements provide a natural experiment on the response of investors to proportionate regulation. In addition, we examine the actions of the firms themselves to infer firm perspectives on the proposed audit committee requirements and the exemptions. Exemptions for small firms effectively change mandatory legal requirements applicable to all public companies into voluntary ones for the select few. In the particular example that we analyze, venture firms are free to adopt any audit committee composition they choose, as long as they adequately disclose member characteristics.
But if venture issuers perceive there to be value in the mandatory legal requirements, either for improving the quality of governance or implementing practices consistent with larger peers, they may choose to comply with the recommended audit committee guidelines, irrespective of any formal requirement to do so.  Using hand-collected data regarding the characteristics of venture issuer boards, we examine whether these firms chose to comply with the requirements. In so doing, we can infer that a subset of these firms perceive there to be advantages in complying with stricter board committee standards. By contrast, if venture issuers chose not to adjust their audit committee composition, their inaction may support the use of proportionate regulation in this setting.
Examining the reaction of venture issuer stocks to regulatory announcements involves several challenges. First, the stocks of these firms are thinly traded so that observed closing prices are based on very little turnover. Second, the ownership of these firms is quite concentrated as insiders, founders, or specialized investment funds hold large blocks of shares for relatively long time periods. This further exacerbates low liquidity levels.  Finally, the prices of many of these shares are extremely low and thus movements of a few cents, say from $0.10 to $0.12, may result in extremely high percentage returns, thereby skewing the overall return distribution.
Despite these challenges, we conduct an event study around two announcement dates related to audit committee requirements for all firms and the subsequent venture issuer exemption. We experiment with several formats for our tests and use a variety of event windows to compensate for thin trading in these stocks. Our findings suggest limited statistically or economically significant stock price reactions to the proposed audit committee changes, leading us to further probe the governance mechanisms employed by these firms.
Using data from the System for Electronic Document Analysis and Retrieval (SEDAR), we find that a large proportion of venture firm audit committees already complied with the proposed standards. This finding undermines arguments that the requirements were particularly onerous for these firms since, when left to their own devices, many voluntarily chose to comply. As a result, the announcement was viewed by investors as a non-event. This finding is consistent with previous research on voluntary compliance, demonstrating that firms will often adopt governance recommendations in the absence of any legal requirement to do so. 
After closely examining the board and audit committee composition of our sample firms, it is clear that most boards exhibit a high level of audit committee independence and financial literacy. This suggests that venture issuers voluntarily chose to comply with the proposed guidelines either in anticipation of the guidelines’ impending enactment, or because they viewed adoption and compliance as truly beneficial. These actions seem inconsistent with small firms’ frequent complaints of regulatory burden. While the controversy and discussion surrounding the rules occurred during the time at which the Sarbanes-Oxley Act was adopted, the discussion remains relevant.
Our article provides an overview of the various legal approaches used to oversee firms’ corporate governance practices. The focus has been on increasing the use of proportionate regulation as a means for finding middle ground between the dual objectives of investor protection and calibrated regulatory oversight of small firms. Despite the ongoing debate about the merits of proportionate regulation, little empirical analysis has been done to help inform the debate. We point to this gap in the literature and, using an example of proportionate regulation from Canada, illustrate how the debate may be misguided.
Our findings lead us to call for additional empirical work that examines legal approaches to governance oversight, and the implications of these approaches for large and small firms. We suggest that policy makers may be ill-informed with respect to the potential benefits of these approaches due to the lack of empirical evidence.  While data collection and analysis of this information are difficult, especially with respect to small firms, our study illustrates that basic data collection and summary statistics can provide regulators and policymakers with additional (and necessary) insights to reduce unproductive.
The complete article is available for download here.
 Janis Sarra, Modernizing Disclosure in Canadian Securities Law: An Assessment of Recent Developments in Canada and Selected Jurisdictions (Toronto; Task Force to Modernize Securities Legislation in Canada, 2006); Stephen P. Sibold, “Assessing Canada’s Regulatory Response to the Sarbanes-Oxley Act of 2002: Lessons for Canadian Policy-Makers” (2009) 46 Alberta L.R. 769; Christopher C. Nicholls, The Characteristics of Canada’s Capital Markets and the Illustrative Case of Canada’s Legislative Regulatory Response to Sarbanes-Oxley, (Toronto: Task Force to Modernize Securities Legislation in Canada, 2006); Cristie Ford, Expert Panel on Securities Regulation: Principles-Based Securities Regulation, (Ottawa: 2009); Joseph A. Castelluccio, “Sarbanes-Oxley and Small Business: Section 404 and the Case for a Small Business Exemption” (2005) 71 Brook L. Rev. 429 (2005). See also F.H. Buckley, “Small Issuers under the Ontario Securities Act, 1978: A Plea for Exemptions” (1979) 29 U. Toronto L.J. 309.
 Carl Bialik, “Small Business Regulatory ‘Burden’ is Tough to Quantify,” Wall Street Journal, Jan. 29, 2011, online: http://www.wsj.com/articles/SB10001424052748703956604576110083387842092.
 Securities and Exchange Commission, SEC Spotlight: Jumpstart Our Business Startups (JOBS) Act, online: https://www.sec.gov/spotlight/jobs-act.shtml.
 Canadian Securities Administrators, Canadian Securities Regulators Finalize Rule Amendments to Reduce Regulatory Burden on Venture Issuers, online: https://www.securities-administrators.ca/aboutcsa.aspx?id=1345.
 For an analysis of the effect of venture capital firm backing on corporate governance mechanisms, see Douglas Cumming, Lars Helge Hass, Linda Myers & Monika Tarsalewska, Venture Capital and the Disclosure of Material Weaknesses in Internal Control¸ (2015), online: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2640873. Venture capital and private equity contracting is discussed in more detail in Douglas Cumming & Sofia Johan, Venture Capital and Private Equity Financing: An International Perspective, 2d ed. (Amsterdam: Elsevier, 2013).
 For commentary on the conditions for venture capital exits in Canada and the United States, see Douglas J. Cumming & Jeffrey G. MacIntosh, “Venture Capital Exits in Canada and the United States” (2003) 53 U. Toronto L.J. 101 and D. Gordon Smith, “The Exit Structure of Venture Capital” (2005) 53 UCLA L. Rev. 315.
 Anita Anand, Frank Milne & Lynnette D. Purda, “Domestic and International Influences on Firm-Level Governance: Evidence from Canada” (2012) 14 Am. L. & Econ. Rev. 68.
 A Wall Street Journal article “Regulatory ‘Burden’ Tough to Quantify” criticizes the lack of information in this realm and echoes these sentiments. See Bialik, supra note 2.