Corporate Governance Indices Roberta Romano Yale Law School, NBER and ECGI International Conference on Institutional Quality Madrid, Jan. 22, 2009.
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Corporate Governance Indices
Roberta RomanoYale Law School, NBER and ECGI
International Conference on Institutional Quality
Madrid, Jan. 22, 2009
Outline of Remarks
• Review evidence on the relation between key institutions of corporate governance and performance
• Review the prominent corporate governance indices and examine more closely whether there is a relation between governance indices and performance
• Consider policy implications of review’s bottom line (that there is no systematic relation between indices and performance)
Corporate Governance and Performance
• Research on governance mechanisms in U.S. has not systematically identified positive effects– Independent boards (no effect; may be negative)– Shareholder activism – proposals (no effect)– Shareholder activism - proxy fights (positive)– Inside ownership (nonlinear)– Outside blocks (evidence mixed)– Outside director ownership (no effect or positive,
depending on measure)– Executive compensation (evidence mixed)
• Concern: governance mechanisms are numerous and interaction effects probable
Corporate Governance Indices
• Index idea: because governance operates on many dimensions, desirable to combine elements into one number (index) to represent the quality of firms’ corporate governance
Academic Indices for U.S. Firms
• G-Index (Gompers, Ishii & Metrick 2003)– First and most prominent (2001 w.p.)– Equally weighted sum of 24 governance components
collected by IRRC (primarily takeover defenses)• E-Index (Bebchuk, Cohen & Ferrell 2005)
– Subset of 6 G-index components thought most effective at blocking hostile bids
• Gov-Score & Gov-7(Caylor & Brown 2006)– Eq. wt sum of 51 governance components collected
by ISS (board, compensation; few defenses)– Subset of 7 components (only 2 defenses); identified
empirically (correlated with performance)
Proprietary Governance Indices
• Vendors: RiskMetrics (ISS), Glass-Lewis, Egan-Jones, Governance Metrics Int’l, The Corporate Library
• Differences in construction from academic indices (marketing governance expertise):– Component weights vary– Takeover defenses deemphasized– Relative vs. absolute rankings
• Marketed to institutional investors for proxy voting and investment decisions
Governance Indices and Performance: Initial Research
• GIM: trading strategy of selling firms with worst governance and buying those with best produces abnormal returns (8.5% per year) in 1990s; good governance positively related to Tobin’s Q and stock returns
• BCF: E-index did as well as G-index; only components associated with performance are those in E-index
• Caylor & Brown: Relation between index and performance due mainly to compensation and board components, not defenses; Gov-7 does better than E-index in explaining performance
GIM’s Explanation
• Investor misperception of impact of governance on performance in 1990 (start of trading strategy period)
• Managers expect poor performance and adopt defenses
• Poor governance is correlated with something else that causes poor performance
Robustness of Findings
• Several studies find GIM results are not robust:– Example 1: Controlling for performance before
defenses adopted (1980s), relation in 1990s disappears (Lehn et al. 2006)
– Example 2: Analyst forecasts predict poor performance of poor governance firms; no difference in stock returns surrounding earnings announcements of poor and good governance firms; no trading gains in 2000s (Core et al. 2006)
– Example 3: Relation not independently significant but depends on interrelation of governance and block institutional ownership (high quality governance on both measures); those firms also appear to have greater risk (Cremers & Nair 2005)
Single Governance Mechanism vs. Governance Index
• Can a single mechanism ever be as effective a measure of quality as an index?– Theory: if board has right incentives it can provide
effective oversight, given pivotal position • Proxies: independence, outsider stock ownership
– Empirical: identification and measurement error should be lower with one variable, as governance institutions’ interactions are complex
• E.g., Gillan, et al. (2007): firms with more independent boards have more defenses (good governance components are substitutes not complements)
Note: few formal models of governance and no adequate theory of when or whether governance components are complements or substitutes)
Econometric Issues
• Governance quality and performance are not independent– Example: some governance features are
motivated by incentive-based models of managerial behavior, which also affect performance (e.g., ownership)
• Simultaneous equation estimation with instrumental variables a solution – But finding proper instruments is difficult
Comparing indices’ relative performance controlling for
endogeneity• Accounting performance (ROA)
– G and E indices significantly correlated; Gov-score, TCL unrelated
• Stock returns– No relation
• Disciplinary CEO turnover after poor performance – Better governed firms under G and E indices less likely to experience
such turnover after poor performance– Gov-Score, TCL unrelated
• Single governance measures do as well or better:– Outside directors’ median stock holdings positively related to ROA – Higher outside directors’ median stock holdings and higher % board
independent increase disciplinary turnover after poor performance
(Results from Bhagat & Bolton 2008)
Do Commercial Indices Do Better?
• Daines et al. (2008) find no systematic relation between leading commercial indices (ISS, TCL, GovernanceMetrics), and performance (ROA, excess stock returns, Tobin’s Q)– Note: does not employ simultaneous equation
methodology
• Bhagat & Bolton (2008) findings indicate more complex measures (e.g., Gov-Score), which are more like commercial indices, do not outperform simpler ones (e.g., G- index)
Policy Implications for Investors: Choice of an Index
• There is no one best governance index to identify a firm’s quality
• Appropriateness of index depends on use to be made (“best” is specific to context) – None useful if objective is to predict stock
performance – G or E index useful to predict accounting
performance
Policy Implications for Regulators: Choice of Regulatory Regime
• “One-size-fits-all” regulation should be rejected
• Preferred ordering of regulatory approach: (i) Disclosure (ii) Comply or Explain (iii) Mandates
– Best-practices equivalent to an equal-weighted index and therefore suffers from same problems: does not permit appropriate matching of governance to firms
– Burden on non-complier to explain inconsistent with implication that same governance system does not fit all firms or all contexts
– Disclosure – no such inconsistency (no benchmark), byproduct, some informational costs imposed
Speculation on Implication for Emerging Markets
• World Bank uses governance ratings• “Radical relativism” sensible for developed
markets may need adaptation– Background components of good governance
for legal/political system (e.g., “rule of law”, independent judiciary) may be more universal than firm’s corporate governance
– But local organization, culture differ across nations, which may affect relation between law and economic development
Conclusion
• There is no consistent relation between performance and governance indices, or individual governance devices
• There is, accordingly, no “best” measure of governance: it depends on context and firm circumstances
• Regulatory regime should therefore permit flexible variation in governance across firms
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