Corporate governance and firm performance

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Abstract

How is corporate governance measured? What is the relationship between corporate governance and performance? This paper sheds light on these questions while taking into account the endogeneity of the relationships among corporate governance, corporate performance, corporate capital structure, and corporate ownership structure. We make three additional contributions to the literature:

First, we find that better governance as measured by the Gompers, Ishii, and Metrick [Gompers, P.A., Ishii, J.L., and Metrick, A., 2003, Corporate governance and equity prices, Quarterly Journal of Economics 118(1), 107–155.] and Bebchuk, Cohen and Ferrell [Bebchuk, L., Cohen, A., and Ferrell, A., 2004, What matters in corporate governance?, Working paper, Harvard Law School] indices, stock ownership of board members, and CEO-Chair separation is significantly positively correlated with better contemporaneous and subsequent operating performance.

Second, contrary to claims in GIM and BCF, none of the governance measures are correlated with future stock market performance. In several instances inferences regarding the (stock market) performance and governance relationship do depend on whether or not one takes into account the endogenous nature of the relationship between governance and (stock market) performance.

Third, given poor firm performance, the probability of disciplinary management turnover is positively correlated with stock ownership of board members, and board independence. However, better governed firms as measured by the GIM and BCF indices are less likely to experience disciplinary management turnover in spite of their poor performance.

Introduction

In an important and oft-cited paper, Gompers, Ishii, and Metrick (GIM, 2003) study the impact of corporate governance on firm performance during the 1990s. They find that stock returns of firms with strong shareholder rights outperform, on a risk-adjusted basis, returns of firms with weak shareholder rights by 8.5%/year during this decade. Given this result, serious concerns can be raised about the efficient market hypothesis, since these portfolios could be constructed with publicly available data. On the policy domain, corporate governance proponents have prominently cited this result as evidence that good governance (as measured by GIM) has a positive impact on corporate performance.

There are three alternative ways of interpreting the superior return performance of companies with strong shareholder rights. First, these results could be sample-period specific; hence companies with strong shareholder rights during the current decade of 2000s may not have exhibited superior return performance. In fact, in a very recent paper, Core, Guay and Rusticus (2005) carefully document that in the current decade share returns of companies with strong shareholder rights do not outperform those with weak shareholder rights. Second, the risk-adjustment might not have been done properly; in other words, the governance factor might be correlated with some unobservable risk factor(s). Third, the relation between corporate governance and performance might be endogenous raising doubts about the causality explanation. There is a significant body of theoretical and empirical literature in accounting and finance that considers the relations among corporate governance, management turnover, corporate performance, corporate capital structure, and corporate ownership structure. Hence, from an econometric viewpoint, to study the relationship between any two of these variables one would need to formulate a system of simultaneous equations that specifies the relationships among these variables.

What if after accounting for sample period specificity, risk-adjustment, and endogeneity, the data indicates that share returns of companies with strong shareholder rights are similar to those with weak shareholder rights? What might we infer about the impact of corporate governance on performance from this result? It is still possible that governance might have a positive impact on performance, but that good governance, as measured by GIM, might not be the appropriate corporate governance metric.

An impressive set of recent papers has considered alternative measures of corporate governance, and studied the impact of these governance measures on firm performance. GIM's governance measure is an equally-weighted index of 24 corporate governance provisions compiled by the Investor Responsibility Research Center (IRRC), such as, poison pills, golden parachutes, classified boards, cumulative voting, and supermajority rules to approve mergers. Bebchuk, Cohen and Ferrell (BCF, 2004) recognize that some of these 24 provisions might matter more than others and that some of these provisions may be correlated. Accordingly, they create an “entrenchment index” comprising of six provisions — four provisions that limit shareholder rights and two that make potential hostile takeovers more difficult. While the above noted studies use IRRC data, Brown and Caylor (2004) use Institutional Shareholder Services (ISS) data to create their governance index. This index considers 52 corporate governance features such as board structure and processes, corporate charter issues such as poison pills, management and director compensation and stock ownership.

There is a related strand of the literature that considers corporate board characteristics as important determinants of corporate governance: board independence (see Hermalin and Weisbach, 1998, Hermalin and Weisbach, 2003, and Bhagat and Black (2002)), stock ownership of board members (see Bhagat, Carey, and Elson (1999)), and whether the Chairman and CEO positions are occupied by the same or two different individuals (see Brickley, Coles, and Jarrell (1997)). Can a single board characteristic be as effective a measure of corporate governance as indices that consider 52 (as in Brown and Caylor), 24 (as in GIM) or other multiple measures of corporate charter provisions, and board characteristics? While, ultimately, this is an empirical question, on both economic and econometric grounds it is possible for a single board characteristic to be as effective a measure of corporate governance. Corporate boards have the power to make, or at least ratify, all important decisions including decisions about investment policy, management compensation policy, and board governance itself. It is plausible that board members with appropriate stock ownership will have the incentive to provide effective monitoring and oversight of important corporate decisions noted above; hence board independence or ownership can be a good proxy for overall good governance. Furthermore, the measurement error in measuring board ownership can be less than the total measurement error in measuring a multitude of board processes, compensation structure, and charter provisions. Finally, while board characteristics, corporate charter provisions, and management compensation features do characterize a company's governance, construction of a governance index requires that the above variables be weighted. The weights a particular index assigns to individual board characteristics, charter provisions, etc. is important. If the weights are not consistent with the weights used by informed market participants in assessing the relation between governance and firm performance, then incorrect inferences would be made regarding the relation between governance and firm performance.

Our primary contribution to the literature is a comprehensive and econometrically defensible analysis of the relation between corporate governance and performance. We take into account the endogenous nature of the relation between governance and performance. Also, with the help of a simultaneous equations framework we take into account the relations among corporate governance, performance, capital structure, and ownership structure. We make four additional contributions to the literature:

First, instead of considering just a single measure of governance (as prior studies in the literature have done), we consider seven different governance measures. We find that better governance as measured by the GIM and BCF indices, stock ownership of board members, and CEO-Chair separation is significantly positively correlated with better contemporaneous and subsequent operating performance. Additionally, better governance as measured by Brown and Caylor, and The Corporate Library is not significantly correlated with better contemporaneous or subsequent operating performance.1 Also, interestingly, board independence is negatively correlated with contemporaneous and subsequent operating performance. This is especially relevant in light of the prominence that board independence has received in the recent NYSE and NASDAQ corporate governance listing requirements.2 We conduct a battery of robustness checks including (a) consideration of alternate instruments for estimating the system of equations, (b) consideration of diagnostic tests to ensure that our instruments are valid and our system of equations is well-identified, and (c) alternative estimates of the standard errors of our model's estimated coefficients. These robustness checks provide consistent results and increase our confidence in the performance-governance relation as noted above.

Second, contrary to claims in GIM and BCF, none of the governance measures are correlated with future stock market performance. In several instances inferences regarding the (stock market) performance and governance relationship do depend on whether or not one takes into account the endogenous nature of the relationship between governance and (stock market) performance.3 For example, the OLS estimate indicates a significantly negative relation between the GIM index and next year's Tobin's Q. However, after taking into account the endogenous nature of the relation between governance and performance, we find a positive but statistically insignificant relation between the GIM index and next year's Tobin's Q.

Third, given poor firm performance, the probability of disciplinary management turnover is positively correlated with stock ownership of board members, and with board independence. However, given poor firm performance, the probability of disciplinary management turnover is negatively correlated with better governance measures as proposed by GIM and BCF. In other words, so called “better governed firms” as measured by the GIM and BCF indices are less likely to experience disciplinary management turnover in spite of their poor performance.

Fourth, we contribute to the growing literature on the relation between corporate governance, and accounting and finance variables. Ashbaugh-Skaife, Collins, and Lafond (2006) investigate the relation between corporate governance and credit ratings. They consider the GIM index and various board characteristics including board independence and compensation as separate governance measures. Cremers and Nair (2005) focus on the interaction between several governance measures and firm performance. They consider the GIM index as a measure of external governance and pension fund block ownership as a measure of inside governance; they also investigate other similar governance measures. Defond, Hann and Hu (2005) consider the cross-sectional relation between the market's response to the appointment of an accounting expert on the board and its corporate governance; they construct a governance index that gives equal weight to six variables including board independence, the GIM index, and audit committee structure. Bowen, Rajgopal, and Venkatachalam (2005) analyze the relation between corporate governance, accounting discretion and firm performance; they consider several board characteristics and the GIM index as separate measures of governance.4 Even this brief review of the literature on the relation between governance, and accounting and finance variables suggests lack of an agreed upon measure of governance. This study proposes a governance measure, namely, dollar ownership of the board members - this measure is simple, intuitive, less prone to measurement error, and not subject to the problem of weighting a multitude of governance provisions in constructing a governance index. Consideration of this governance measure by future researchers would enhance the comparability of research findings.

The above findings have important implications for researchers, senior policy makers, and corporate boards: Efforts to improve corporate governance should focus on stock ownership of board members — since it is positively related to both future operating performance, and to the probability of disciplinary management turnover in poorly performing firms. Second, proponents of board independence should note with caution the negative relation between board independence and future operating performance. Hence, if the purpose of board independence is to improve performance, then such efforts might be misguided. However, if the purpose of board independence is to discipline management of poorly performing firms, then board independence has merit. Third, even though the GIM and BCF good governance indices are positively related to future operating performance, policy makers and corporate boards should be cautious in their emphasis on the components of these indices since this might exacerbate the problem of entrenched management, especially in those situations where management should be disciplined, that is, in poorly performing firms.5 Finally, our recommendations on incentive effects of board stock ownership are consistent with the implications of Hermalin and Weisbach (2007) who analyze the role of disclosure on the contractual and monitoring relationship between the board and the CEO. Hermalin and Weisbach highlight the costs and benefits of greater disclosure. Greater stock ownership by the board would help internalize these costs and benefits-making (board) level.

The remainder of the paper is organized as follows. The next section briefly reviews the literature on the relationship among corporate ownership structure, governance, performance and capital structure. Section 3 notes the sample and data, and discusses the estimation procedure. Section 4 presents the results on the relation between governance and performance. Section 5 focuses on the impact of governance in disciplining management in poorly performing companies. The final section concludes with a summary.

Section snippets

Corporate ownership structure, corporate governance, firm performance, and capital structure

Some governance features may be motivated by incentive-based economic models of managerial behavior. Broadly speaking, these models fall into two categories. In agency models, a divergence in the interests of managers and shareholders causes managers to take actions that are costly to shareholders. Contracts cannot preclude this activity if shareholders are unable to observe managerial behavior directly, but ownership by the manager may be used to induce managers to act in a manner that is

Data

In this section we discuss the data sources for board variables, performance, leverage and instrumental variables. All variables including governance measures are described in Table 1.

Corporate governance and performance

Table 4 summarizes our main results of the relationship between governance and performance. While previous studies have used both stock market based and accounting measures of performance, we primarily rely on accounting performance measures. Stock market based performance measures are susceptible to investor anticipation. If investors anticipate the corporate governance effect on performance, long-term stock returns will not be significantly correlated with governance even if a significant

Corporate governance and management turnover

The preceding analysis focused on the relation between governance and performance generally. However, governance scholars and commentators suggest that governance is especially critical in imposing discipline and providing fresh leadership when the corporation is performing particularly poorly. It is possible that governance matters most in only certain firm events, such as the decision to change senior management. For this reason, we study the relationship between governance, performance, and

Summary and conclusions

Our primary contribution to the literature is the consistent estimation of the relationship between corporate governance and performance, by taking into account the inter-relationships among corporate governance, corporate performance, corporate capital structure, and corporate ownership structure. We make four additional contributions to the literature:

First, instead of considering just a single measure of governance (as prior studies in the literature have done), we consider seven different

Acknowledgments

We thank Lucian Bebchuk, Marc Goergen, Paul Gompers and seminar participants at Cornell University, Dartmouth College (Tuck), European Financial Management Symposium (Bocconi University), New York University, Northwestern University, Stanford University, UCLA, University of Chicago, University of Rochester, the University of Sheffield — ECGI Symposium on Contractual Corporate Governance, and Yale University for helpful comments on a previous draft of this paper.

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