1 Endogeneity in Corporate Governance Studies Bhagat-Jefferis (2002) An econometric model for investigating, say, the impact of takeover defense on takeover activity has the following structure: Separation: f 1 (Governance, Ownership, Performance, Z 1,  1 ) Governance: f 2 (Ownership, Performance, Z 2,  2 ) Ownership:f 3 (Governance, Performance, Z 3,  3 ) Performance:f 4 (Governance, Ownership, Z 4,  4 ) Separation: takeover, management turnover Governance: takeover defense, corporate board structure, board and management compensation structures Ownership: equity ownership, capital structure

2 Endogeneity in Corporate Governance Studies Bhagat-Jefferis (2002) Identification requires some combination of exclusion restrictions, assumptions about the joint distribution of the error terms, and restrictions on the functional form of the f i. Maddala (1983) discusses restrictions that identify the model when the  i are normally distributed. Identification in single equation semiparametric index models, where the functional form of f 1 is unknown and the explanatory variables in that equation are continuous, known functions of a basic parameter vector is discussed by Ichimura and Lee (1991). Estimation of a system of the form (1)-(4) in the absence of strong restrictions on both the f i and the joint distribution of error terms is, to the best of our knowledge, an unsolved problem.

3 Endogeneity in Corporate Governance Studies Bhagat-Jefferis (2002) We are unaware of a model of takeover defense that implies specific functional forms for the f i. If these functions are linear, identification may be attained through either strong distributional assumptions or exclusion restrictions. Maddala (1983) and Amemiya (1985) discuss restrictions on the  i that identify the model in the absence of exclusion restrictions. But these restrictions are inconsistent with incentive-based explanations of takeover defense, since unobservable characteristics of managerial behavior or type will be reflected in all of the  i. Using panel data and firm-fixed effects it would be possible to control for unobservable characteristics of managerial behavior or type; however, a system such as in (1)-(4) would have to be specified and estimated. Aside from the non-trivial data collection effort required to estimate such a system, this system would not be identified when Z 2 = Z 3 = Z 4. Exclusion restrictions are therefore the most likely path to identification.

4 Endogeneity in Corporate Governance Studies Corporate Ownership and Performance  Diffused share ownership Costs: Manager-shareholder agency costs (separation of ownership and control) Benefits: Better risk-bearing  If the costs of diffused share ownership dominate: Greater management ownership should lead to better corporate performance.  However, corporate performance can also have an impact on management ownership! Why? Management compensation plans: Superior corporate performance leads to an increase in the value of stock options owned by management which, if exercised, would increase their share ownership. Insider information: If there are significant divergences between insider expectations and market expectations of future firm performance, then insiders have an incentive to adjust their ownership in relation to the expected future performance. Insider trading is legal subsequent to earnings/corporate announcements and with appropriate disclosure.

5 Endogeneity in Corporate Governance Studies Corporate Ownership and Performance  What determines the firm’s ownership structure? Ownership may be endogenously determined by the firm’s contracting/investment environment. If the scope for perquisite consumption is low in a firm, then a low level of management ownership may be the optimal incentive contract. For firms with significant growth opportunities, greater management ownership may be appropriate.  Ownership has an impact on corporate performance. Also, corporate performance has an impact on management ownership. Ownership:f 3 (Governance, Performance) Performance:f 4 (Governance, Ownership)

6 Endogeneity in Corporate Governance Studies Measurement of Corporate Performance  Market-based measures of performance. Industry- and size-adjusted stock returns. l Anticipation problem. Tobin’s Q (Current market value of the company/Replacement cost) l Denominator does not reflect cost of intangible assets. l Numerator includes value of market power.  Accounting-based measures of performance. Return on invested capital. Return on sales. l Avoids anticipation problem. l Avoids anticipation problem – no credit given for future sales/growth opportunities. l Some managerial discretion.