Corporate Governance: A Review of Current Research Alexander Settles

Corporate Governance: A Review of Current Research

Alexander Settles

Sources of Research Agenda

• Finance– Agency theory – investigation of different

corporate governance practices and firm performance

• Law

• Management– Firm life cycle– Stakeholder analysis

Research

• Effectiveness may be based on a number of different dimensions of corporate governance, ranging from monitoring and control over managerial discretion to promoting corporate entrepreneurship and innovation.

• Regulating managerial power

Research

• Board characteristics and composition

• Resource dependency approach

• Transaction costs theory

• Role and effects of independence of non- executive directors

• Codes of best practice

• Internal and external control mechanisms

Research

• Board processes

• Effects of duality of CEO role

• Stewardship theory

• Executive compensation

• Managerial stock ownership and performance

Market Efficiency• Fama (1970) defines an efficient market as one

in which “security prices fully reflect all available information”. (CRSP)

• Important implications for accounting research– If markets are efficient, then gains from fundamental

analysis are severely limited. In other words, accounting doesn’t add value since it is not a timely source of information.

– Conversely, if security prices react to new accounting information, then accounting information is useful.

Market Efficiency (Continued)• Two types of tests: short- and long-horizon

event studies and cross-sectional tests of return predictabilities (anomalies research)– Event studies – examine the stock market reaction

around a specified event (or date in time)• Examples: Bernard and Thomas (1989, 1990), Ball and

Bartov (1996)– Cross-sectional tests of returns predictability –

examines whether the cross section of returns on portfolios formed periodically using a specific trading rule generates abnormal returns.• Examples: Sloan (1996), Collins and Hribar (2000)

Valuation Models• Firm-value is defined as the present value of

expected future net cash flows, discounted at the appropriate risk-adjusted rate of return.– Financial Accounting Standard Board’s (FASB)

conceptual framework states financial statements (F/S) should help investors and creditors in “assessing the amounts, timing, and uncertainty of future cash flows.” (FASB, 1978)• Relation between current performance and future cash

flows• Relation between current performance and security prices

(Easton 1985)

Information Content of Earnings, Cash Flows, and Accruals

• Conducted as event studies or association studies– Event study: Does an event (i.e., earnings

announcement) convey new information to market participants as reflected in changes in the level or variability of security prices or trading volume over a short period of time surrounding the event?

– Association study: Tests for positive correlation between an accounting performance measures (e.g., earnings or cash flows from operations) and stock returns, both measured over relatively long, contemporaneous time periods, e.g., one year

– Does not assume accounting reports are only source of information to market

– No causal connection is inferred

Information Content of Earnings, Cash Flows, and Accruals

• Evidence: Accounting matters– Earnings surprise correlated with stock returns (Ball and Brown

1968)– Return volatility and trading volume (evidence of information flow

to market) increase during earnings announcements (Beaver 1968)

– Accounting information is not timely (stock prices lead earnings) (Beaver et al. 1980)• Earnings are not informative about future stock prices (or maybe

markets are inefficient), but stock prices are informative about future earnings

– Market response to earnings news is asymmetric (good news gets incorporated into price faster than bad news) (Bernard and Thomas 1989, 1990)

– Earnings is more highly correlated with stock returns than is cash flows (Wilson 1986, 1987; Dechow 1994)

Earnings (Financial Statement) Management

• Schipper (1989) defines earnings management as “purposeful intervention in the external reporting process with the intent of obtaining some private gain to managers or shareholders.” (Smoothing)

• Can be income-increasing or decreasing (cookie jar reserves) (Healy 1985)

Managerial Ownership/Insider Trading

• Does managerial ownership affect the informativeness of accounting numbers because of the separation of corporate ownership and control?– Warfield, Wild and Wild (1995) show

managerial ownership is positively associated with earnings' explanatory power for returns and inversely related to the magnitude of accounting accrual adjustments.

Corporate Governance• Do differences in corporate governance

structures affect the degree of information asymmetry in capital markets and, in turn, influence the timing and strength of the relation between security returns and earnings information?

• Shareholder rights (Gompers et al 2003)

• Board characteristics (Klein 1998)

Operating Performance

• Fich, Eliezer M. and Anil Shivdasani, 2006. Are Busy Boards Effective Monitors?

• Primary findings– Firms with busy boards exhibit lower

operating performance– A significant relation between performance

and CEO turnover exists only when a majority of board members are not regarded as busy

Operating Performance (cont.)

• Dahya, Jay and John J. McConnell, 2007. Board Composition, Corporate Performance, and the Cadbury Committee Recommendation

• Primary findings– Compliance with the Cadbury Report results

in an increase in operating performance

Operating Performance (cont.)

• Core, John E., Wayne R. Guay, and Tjomme Rusticus, 2006. Does Weak Governance Cause Weak Stock Returns? An Examination of Firm Operating Performance and Investors’ Expectations

• Primary findings– Weak shareholder rights are associated with

poor operating performance

Stock Returns – Market Efficiency

• Core, John E., Wayne R. Guay, and Tjomme Rusticus, 2006.

• Primary findings – Weak shareholder rights are associated with

poor operating performance – However, analysts’ forecast errors and

earnings announcement returns show no evidence that this underperformance surprises the market

Managerial Ownership/Insider Trading

• Does managerial ownership affect the informativeness of accounting numbers because of the separation of corporate ownership and control?– Warfield, Wild and Wild (1995) show

managerial ownership is positively associated with earnings' explanatory power for returns and inversely related to the magnitude of accounting accrual adjustments.

La Porta et al. 1998

• Manuscript Type: Empirical and Conceptual

• Research Question/Issue: Do differences in legal protections of investors explain why firms are financed and owned so differently in different countries? Does a country’s membership in one of the two principle legal families affect the corporate governance mechanisms?

La Porta et al. 1998• Why do Italian companies rarely go public?• Why does Germany have such a small stock market but

also maintain very large and powerful banks ? • Why is the voting premium small in Sweden and the United

States, and much larger in Italy and Israel • Why were Russian stocks nearly worthless immediately

after• privatization—by some estimates 100 times cheaper than

Western• stocks backed by comparable assets—and why did Russian

companies have virtually no access to external finance ? • Why is ownership of large American and British companies

so widely dispersed?


• Unit of analysis – country; generalized to legal family

• Methods – statistical analysis of investor protection; student t-test


• Independent Variables– Country– Legal Family

• Dependent variables– Shareholder rights– Creditor rights– Enforcement– Ownership

Results


• Research Findings/Results: The results show that common-law countries generally have the strongest, and French civil- law countries the weakest, legal protections of investors, with German- and Scandinavian-civil-law countries located in the middle. Also found that concentration of ownership of shares in the largest public companies is negatively related to investor protections, consistent with the hypothesis that small, diversified shareholders are unlikely to be important in countries that fail to protect their rights

Shleifer and Vishny 1997

• Agency problem– Contracts– Managerial Discretion– Incentive Contracts– Evidence on agency problem – does it exist?

• How to solve?


• Finance without governance – reputation

• Legal Enforcement of Rights

• Large Investors

• Takeovers

• Large Creditors


• Debt versus equity choice

• LBO

• Cooperatives and State ownership


• Studied ownership structures of large corporations in 27 wealthy economies to identify the ultimate controlling shareholders of these firms.

• Found that except in economies with very good shareholder protection, relatively few of these firms are widely held, in contrast to Berle and Means’s image of ownership of the modern corporation.

• Rather, these firms are typically controlled by families or the State.

• Equity control by financial institutions is far less common. • The controlling shareholders typically have power over

firms significantly in excess of their cash flow rights, primarily through the use of pyramids and participation in management.

Yermack 1996

• Smaller boards of directors are more efficient than larger boards

• Theory– Large boards have higher monitoring costs– Larger groups are less able to reach

agreement and thus take no tough decisions

• Model: Tobin’s Q will vary inversely with board size

Responses to Bad Acquisition Bids

• Paul, Donna L., 2007. Board Composition and Corrective Action: Evidence from Corporate Responses to Bad Acquisition Bids

• Primary findings– Firms with independent boards are less likely to

complete value-decreasing bids– Board independence is also associated with

unusually high frequencies of asset restructuring for bids that are completed

CEO Turnover

• Lehn, Kenneth M. and Mengxin Zhao, 2006. CEO Turnover after Acquisitions: Are Bad Bidders Fired?

• Primary findings– An inverse relation exists between bidder

returns and the likelihood of CEO turnover– However, this relation is not associated with

governance structure

Jensen 1993

• Claims that since 1973 technological, political, regulatory, and economic forces have been changing the worldwide economy in a fashion comparable to the changes experienced during the nineteenth century Industrial Revolution.

• During the 1970s and 1980s indicate corporate internal control systems have failed to deal effectively with these changes

Jensen 1993

• IC systems have failed to require managers to make decisions to properly manage the efficient and capacity of their companies

• Misspending in R&D as example

Jensen 1993

• How to improve CG?• Board culture• Information problems• Legal liability• Oversized boards• No shareholder democracy – but more

activism• Separate CEO and Chair

Survey of Dividend Theories

Free Cash Flow TheoryDividends may mitigate agency costs by

distributing free cash flows that otherwise would be spent on unprofitable projects by the management Easterbrook (1984); Jensen (1986); Zwiebel (1996); Laporta, Lopez-de-Silanes, Shleifer, and Vishny (2000); DeAngelo, DeAngelo, and Stulz (2004)


Signaling TheoryLintner (1956) partial adjustment process towards

a target payout ratio and communicate the level and growth of earnings or future prospects of the company to investorsBhattacharya (1979); Miller and Rock (1985); Bernheim

and Wantz (1995); Amihud and Murgia (1997)


Ownership TheoryDividend may signal conflicts between large

controlling shareholder and minority shareholdersShleifer and Vishny (1997); Gugler (2003); Gugler and

Yurtoglu (2003)

Country studies on corporate governance and performance

Gompers, Ishii, Metrick (2003) using 1500 US listed companies present that CG results in higher annual returns than in companies with weak corporate governance rights.

Black, Jang, Kim (2003) based on a study of 526 Korean firms present that higher corporate governance standards increase the value of the company. A best to worst governance improvement predicted a 44% increase in company valuation as measured by Tobin’s Q.

SEC and DOJ Enforcement Actions

• Karpoff, Jonathan M., D. Scott Lee and Gerald S. Martin, 2007. The Consequences to Managers for Financial Misrepresentation

• Primary findings– Most lose their jobs– Culpable managers bear substantial financial losses

through restrictions on their future employment and SEC fines

– A sizeable majority face criminal charges and penalties

Derivative Lawsuits

• Ferris, Stephen P., Tomas Jandik, Robert M. Lawless and Anil Makhija, 2007. Derivative Lawsuits as a Corporate Governance Mechanism: Empirical Evidence on Board Changes Surrounding Filings

• Primary findings– Proportion of outside representation on the board

increases after a derivative lawsuit– Outside representation increases by 6% for

successful and by 2% for unsuccessful suits

Documents

Corporate Governance: A Review of Current Research Alexander Settles