Corporate Governance

1

• Corporate Governance Firm Performance
• Sanjai Bhagat and Brian Bolton
• sanjai.bhagat_at_colorado.edu

2
How is good corporate governance measured?

• Recent NYSE and NASDAQ corporate governance
  listing requirements
• Board independence.
• See SEC ruling NASD and NYSE Rulemaking Relating
  to Corporate Governance, in
• http//www.sec.gov/rules/sro/34-48745.htm, and
  http//www.sec.gov/rules/sro/nyse/34-50625.pdf.

3
How is good corporate governance measured?

• Gompers Ishii, Metrick (2003) The G-Index is
  constructed from data compiled by the Investor
  Responsibility Research Center ("IRRC").
• A firm's score is based on the number of
  shareholder rights-decreasing provisions a firm
  has, such as
• Poison pills.
• Golden parachutes.
• Supermajority rules to approve mergers.
• Staggered boards.
• Limitations of shareholders ability to call
  special meeting.
• The index ranges from a feasible low of 0 to a
  high of 24.
• A high G-Score is associated with weak
  shareholder rights, that is,
• poor corporate governance.

4
How is good corporate governance measured?

• Bebchuk, Cohen, Ferrell (2004) The E-Index is
  constructed from IRRC data. It uses a 6-provision
  subset of the G-Index.
• The index ranges from a feasible low of 0 to a
  high of 6.
• A high E-Score is associated with weak
  shareholder rights, that is,
• poor corporate governance.

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How is good corporate governance measured?

• Brown and Caylor (2004) governance score is
  constructed from data compiled by Institutional
  Shareholder Services ("ISS").
• Fifty-two firm characteristics and provisions are
  used to assign a score to each firm.
• Bylaws (poison pills, supermajority provisions,
  ).
• Board structure (independence, CEO/Chair duality,
  nominating committee, ).
• Audit committee (independence, auditors
  consulting fees, auditor rotation).
• Management and Director compensation (no
  interlocks in compensation committee, option
  repricing prohibited, directors receive fees in
  stock).
• Progressive practices (director term limits and
  mandatory retirement age).
• The feasible range of scores is from 0 to 52.
• A high governance score is associated with
• better corporate governance.

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How is good corporate governance measured?

• The Corporate Library is a commercial vendor of
  corporate governance data, analysis and risk
  assessment tools. The benchmark score is based
  on over a 100 criteria
• Bylaws (poison pills, supermajority provisions,
  ).
• Board structure (independence, CEO/Chair duality,
  nominating committee, ).
• Audit committee (independence, auditors
  consulting fees, auditor rotation).
• Management and Director compensation.
• Progressive practices (director term limits and
  mandatory retirement age).
• The feasible range of scores is from 0 to 100.
• A high governance score is associated with
• better corporate governance.

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How is good corporate governance measured?

• Stock ownership of median board member
• Can a single board characteristic be as effective
  a measure of corporate governance as indices that
  consider multiple measures of corporate charter
  provisions, management compensation structure,
  and board characteristics?
• 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
  incentives to provide effective monitoring and
  oversight of important corporate decisions noted
  above hence board ownership can be a good proxy
  for overall good governance.

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How is good corporate governance measured?

• Stock ownership of median board member
• 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.

9

• Gompers, Ishii and Metricks (2003) results
• Stock returns of firms with strong shareholder
  rights outperform firms with weak shareholder
  rights by 8.4 per annum on a risk adjusted
  basis. Efficient Market implications?
• Their G-Index is becoming the de facto measure of
  governance in most industry reports and academic
  research papers.

10
GIM Abnormal Return Results
GIM Original Results 9/1990 to 12/1999
a RMRF SMB HML MOM 0.71 -0.04 -0.22 -0.5
5 -0.01 GIM Original Results 9/1990 to
12/1999 Using Ken Frenchs Momentum Factor
a RMRF SMB HML UMD 0.48 -0.02 -0.21 -0.
49 0.19 Out of Sample Results 1/2000 to
1/2003 a RMRF SMB HML MOM -0.26 0.12 -
0.02 -0.56 0.09 All Available Years 9/1990
to 12/2003 a RMRF SMB
HML MOM 0.38 0.02 -0.12 -0.61 0.07
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Model Specification 4 Equations

• Performance f1 (Governance, Ownership, Capital
  Structure, Industry Performance, Size, RDA
  Expenses, Board Size, Volatility, Treasury
  Stock)
• Governance f2 (Performance, Ownership, Capital
  Structure, RDA Expenses, Board Size, Active CEOs,
  Board Ownership , Volatility)
• CEO Ownership f3 (Performance, Governance,
  Size, Leverage, RDA Expenses, Board Size,
  Volatility, CEO Tenure / CEO Age)
• Capital Structure f4 (Performance, Governance,
  Ownership, Size, Industry Leverage,
  Market-to-Book, Board Size, Volatility, Z-score)

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Primary Variables

• Governance
• GIM G-Index
• BCF E-Index
• The Corporate Library Benchmark Score
• BC GovScore
• Median Director Stock Ownership
• CEO-Chair Separation
• Board Independence

• Performance
• Return on Assets (ROA)
• Stock Return
• Tobins Q
• Ownership
• CEO Ownership

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ROAt1 f(GOVt, Zt, ut)Coefficient on GOV
shown p-values in parentheses
Compare to GIMs results
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Summary of Results Part 1

• Better governance leads to better current and
  future operating performance
• Gompers, Ishii, and Metrick G-Index. Bebchuk,
  Cohen and Ferrell E-Index. Stock ownership of
  board members.
• CEO-Chair separation.
• 2. Board independence is negatively related to
  operating performance.
• No measure of governance is related to future
  Stock Returns or Tobins Q.
• ? Contrary to GIMs results.
• 4. Estimation method matters.
• ? There is an endogenous relationship between
  Governance and Performance.

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Part 2 Governance CEO Turnover

• CEO turnover should be more likely following bad
  performance.
• Identify 1,923 CEO changes from 1992-2003.
• Review the press release to classify the change
  as Disciplinary or Non-Disciplinary.

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Reasons for CEO Turnover
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Multinomial Logit - Disciplinary Turnover Results
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Multinomial Logit - Disciplinary Turnover Results
with Industry Adjusted Returns
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Summary of Results Part 2

• Given poor firm performance, the probability of
  disciplinary management turnover is positively
  correlated with stock ownership of board members,
  and board independence.
• Given poor firm performance, better governed
  firms (as measured by GIM and BCF indices) are
  less likely to discipline their CEO.

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Policy Recommendations

• 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.
• Proponents of board independence should note with
  caution the negative relation between board
  independence and future operating performance.
• If the purpose of board independence is to
  improve performance, then such efforts might be
  misguided.
• If the purpose of board independence is to
  discipline management of poorly performing firms,
  then board independence has merit.

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Policy Recommendations

• Even though the GIM and BCF good governance
  indices are positively related to future
  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.