Corporate Governance

1. Corporate Governance Handout 7

2. Corporate governance index and firm performance In the previous handout, we have discussed the effects of various corporate governance practices on firm performance. Most of the discussions are about Japanese corporate governance practices. In this handout, we will see evidence of the effects of corporate governance in the US.

3. Discussion is based on Gompers et al. (2003). Gompers et al. (2003) view a corporation as a republic. The ultimate authority rests with voters (shareholders). These voters elect representatives (directors) who delegate most decisions to bureaucrats (managers).

4. As in any republic, the actual power sharing relations depend upon the specific rules of governance. A republic with significant voter rights may be called ‘Democratic’ whereas a republic with significant restrictions to voter rights may be called ‘Dictatorial’. The question the authors ask is ‘Does a democratic corporate governance system enhance firm performance?’

5. First, by examining many dimensions of corporate governance, the authors constructed a ‘corporate governance index’. In the following, I briefly explain how the authors constructed the index. The authors identified 5 groups of practices that restrict shareholders’ rights. Each group contains a number of practices. Since the list of practices is extensive, I present only a part of them.

6. The restriction to shareholders’ rights Group 1 (Delay): Restrictive governance provisions that are intended to slow down hostile bidder. (1) Blank check (2) Classified board (Board of directors with staggered terms) (3) Limitation to special meetings (4) Requirement of written consent to establish majority threshold

7. The restriction to shareholders’ rights (Contd) 2. Group 2 (Protection): Practices that insure officers and directors against job-related liabilities. (1) Compensation plans allowing accelerated schedule to cash out options, or bonuses. (2) Contract that specifies to insure the managers against certain legal expenses resulting from lawsuit. (3) Golden Parachutes: Provides severance pay upon termination of contract and which is contingent on the change of control (4) Indemnification: use of bylaws or charters to insure officers and directors against certain legal expenses resulting form lawsuit pertaining their contract

8. The authors presented three other governance practices that restrict shareholders rights (see p112 of the article). For each type of restriction, the author created a dummy variable. If the value of the dummy variable is 1, the firm has a ‘bad’ governance practice. Their data are from the Investor Responsibility Research Center. Next Slide shows the summary statistics of the dummy variables.

10. The governance index The authors constructed the Corporate Governance Index, G, by summing all the dummy variables in the table in the previous slide. G= Sum of all the dummy variable Greater G means greater restrictions to the shareholder rights. Thus, G is the index to show the degree of ‘bad’ corporate governance. Smaller G means that the corporation has a good corporate governance system. Next slide shows basic statistics of this corporate governance index.

12. Which corporations have good corporate governance and which corporations do not.

13. Does a good corporate governance system enhance firm performance? In order to answer this question, the authors separated the data according to the governance index, then estimated the following. Rt=a+ß(RMRF)t+ß’(Other factors)t + errorst Where Rt is the monthly excess return (R-RF), and (RMRF) is the risk premium (RM-RF). The estimated can be interpreted as the abnormal return, or the excess return over the expected return as defined by CAPM. Note: On the interpretation of a, consider the simple case. Rt = a+ß(RMRF)t. Notice that a=Rt- ß(RMRF)t=(R-RF)- ß(RM-RF)=R-[RF+ß(RM-RF)]. Since RF+ß(RM-RF) is the CAPM definition of expected return, it turns out that a=R-Expected return. Thus a is interpreted as abnormal return.

14. Estimated a (abnormal return) by corporate governance index

15. Estimated a (abnormal return) by corporate governance index

16. Estimated a (abnormal return) by corporate governance index

17. Corporate governance and Tobin’s q. Another index often used to show firm performance is the Tobin’s q. The authors also estimated the following (Tobin’s q)=a+ß(G)+?(other variables)

18. The effect of governance index on Tobin’s q

19. Conclusion Good corporate governance (democratic governance) is strongly associated with better return. Firms with the most democratic governance is estimated to earn 3.8 abnormal return per year while dictatorial companies earn negative abnormal return (-5%). Democratic governance is also associated with greater Tobin’s q. Thus, a good corporate governance system can enhance firm performance considerably.

20. References Gompers, Ishi, and Metrick (2003). ‘Corporate Governance and Equity Prices’. The Quarterly Journal of Economics, Feb 2003 pp.107-55.