What Matters in Corporate Governance? by SSRN
Harvard Law School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR) and European Corporate Governance Institute (ECGI)
Tel Aviv University – Eitan Berglas School of Economics; Harvard Law School; National Bureau of Economic Research (NBER)
Harvard Law School; European Corporate Governance Institute (ECGI)
September 1, 2004
Review of Financial Studies, Vol. 22, No. 2, pp. 783-827, February 2009
Harvard Law School John M. Olin Center Discussion Paper No. 491 (2004)
Abstract:
We investigate which provisions, among a set of twenty-four governance provisions followed by the Investor Responsibility Research Center (IRRC), are correlated with firm value and stockholder returns. Based on this analysis, we put forward an entrenchment index based on six provisions – four constitutional provisions that prevent a majority of shareholders from having their way (staggered boards, limits to shareholder bylaw amendments, supermajority requirements for mergers, and supermajority requirements for charter amendments), and two takeover readiness provisions that boards put in place to be ready for a hostile takeover (poison pills and golden parachutes). We find that increases in the level of this index are monotonically associated with economically significant reductions in firm valuation, as measured by Tobin’s Q. We present suggestive evidence that the entrenching provisions cause lower firm valuation. We also find that firms with higher levels of the entrenchment index were associated with large negative abnormal returns during the 1990-2003 period. Moreover, examining all sub-periods of two or more years within this period, we find that a strategy of buying low entrenchment firms and selling short high entrenchment firms out-performs the market in most such periods and does not under-perform the market even in a single sub-period. Finally, we find that the provisions in our entrenchment index fully drive the correlation, identified by prior work, that the IRRC provisions in the aggregate have with reduced firm value and lower stock returns during the 1990s; we do not find any evidence that the other eighteen IRRC provisions are negatively correlated with either firm value or stock returns during the 1990-2003 period.
Data on the entrenchment index for the period 1990-2007, and a list of over seventy-five studies using our entrenchment index, is available for downloading at Lucian Bebchuk’s home page.
What Matters In Corporate Governance? – Introduction
There is now widespread recognition, as well as growing empirical evidence, that corporate governance arrangements can substantially affect shareholders. But which provisions, among the many provisions firms have and outside observers follow, are the ones that play a key role in the link between corporate governance and firm value? This is the question we investigate in this paper.
An analysis that seeks to identify which provisions matter should not look at provisions in isolation without controlling for other corporate governance provisions that might also influence firm value. Thus, it is desirable to look at a universe of provisions together. We focus in this paper on the universe of provisions that the Investor Responsibility Research Center (IRRC) monitors for institutional investors and researchers interested in corporate governance. The IRRC follows 24 governance provisions (the IRRC provisions) that appear beneficial to management, and which may or may not be harmful to shareholders. Prior research has identified a relationship between the IRRC provisions in the aggregate and firm value. In an influential article, Gompers, Ishii, and Metrick (2003) found that a broad index based on these 24 provisions, giving each IRRC provision equal weight, was negatively correlated with firm value, as measured by Tobin’s Q, as well as stockholder returns during the decade of the 1990s. Not surprisingly, a substantial amount of subsequent research has utilized this index (the “GIM index”) as a measure of the quality of firms’ governance provisions.
There is no a priori reason, of course, to expect that all the 24 IRRC provisions contribute to the documented correlation between the IRRC provisions in the aggregate and Tobin’s Q, as well as stock returns in the 1990s.2 Some provisions might have little relevance, and some provisions might even be positively correlated with firm value. Among those provisions that are negatively correlated with firm value or stock returns, some might be more so than others. Furthermore, some provisions might be at least partly the endogenous product of the allocation of power between shareholders and managers set by other provisions. In this paper, we look inside the box of the IRRC provisions to identify which of them are responsible for the correlation between these provisions in the aggregate and firm value.
We begin our investigation by identifying a hypothesis for testing. In particular, we hypothesize that six provisions among the 24 provisions tracked by IRRC play a significant role in driving the documented correlation between IRRC provisions and firm valuation. We include in this list of six provisions all the provisions among the IRRC provisions that have systematically drawn substantial opposition from institutional investors voting on precatory resolutions. To confirm that focusing on these provisions is plausible, we also performed our own analysis of their consequences, as well conducted interviews with six leading M&A practitioners.
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