Product-market competitiveness and investor reaction to corporate governance failures

•Product market competition is proposed as a substitute for quality of corporate governance•Revelation of self-serving behavior by managers in presumably well governed firms is a leads to investor surprise and negative stock price response•Option backdating announcements are an example of self-serving managerial behavior•Backdating firms in highly competitive industries experienced greater wealth loss as did firms with presumably higher quality of corporate governance•Product market competition is an implicit substitute for the performance discipline imposed by high quality of corporate governance

Is industry competition a substitute for the quality of corporate governance? If so, and if self-serving behavior by corporate executives at presumably well governed firms is a greater surprise to investors, then the price reaction to the news of governance failure should vary by the degree of competition prevailing in the firm's industry. For a sample of firms that backdated employee stock options, we find that firms operating in more competitive industries experienced significantly larger wealth declines upon revelation of the news of governance failure (backdating of stock option grants). We interpret our findings to suggest that the quality of corporate governance is less critical for firms operating in more competitive product markets since product market competition acts as an implicit substitute for the performance discipline imposed by high quality of corporate governance.