Does Corporate Governance Matter More for Firms with High Financial Slack?

We examine whether and how the effect of corporate governance depends on a firm’s financial slack, financial resources not committed to any specific use. On one hand, financial slack may be spent by self-interested managers for their private benefits, so its level is positively associated with the degree of agency conflicts. This implies that corporate governance matters more for high financial slack firms (wasteful spending hypothesis). On the other hand, financial slack provides insurance against future uncertainties; a low level of financial slack may signal that managers are imprudent and engage in excess risk taking. Then corporate governance is more effective for low financial slack firms (precautionary needs hypothesis). We differentiate the two hypotheses using the passage of anti-takeover laws to identify exogenous variation in governance. Consistent with the wasteful spending hypothesis, we find that the laws’ passage has a larger negative impact on the operating and stock market performance of high financial slack firms. Further analysis of the source of wasteful spending shows that these firms do not invest more but are less efficient at cost management than low financial slack firms after the passage of BC laws. Our findings suggest that shareholder activism and government regulations aiming to improve corporate governance can be more efficient by focusing on firms with high financial slack.