1. Corporate Governance Indices and Construct Validity
Bernard Black
Northwestern, Pritzker Law School and Kellogg School of Management
(coauthors: Antonio Gledson de Carvalho; Vikramaditya Khanna; Woochan Kim; Burcin Yurtoglu)
(GCGC Conference, June 2016]

2. Construct Validity Very much an exploratory project
Term borrowed from education, psychology
Research questions:
What is “good” Corporate Governance?
What goes into a “good” corporate governance index
How does it vary across countries?
Different local rules, institutions
Construct validity questions:
How good are our proxies?
How can we tell?
Very much an exploratory project

3. Prior research: Black et al. (J Econometrics 2014)
Study Brazil, Russia, India, Korea, Turkey: “BRIKT”
Related governance indices in each country
Built from governance “aspects”, proxied by “subindices”
Board structure
Disclosure
Board procedure
(Minority) Shareholder rights
Ownership structure
Control of RPTs
Different subindex “elements” across countries

4. Very different elements
Governance elements must be:
Measurable
Meaningful (in judgment of local coauthors)
attend to local rules, institutions
We think they might reflect “good” governance
Lots of judgment here!
Significant variation across firms
Not useful if required by law; nearly universal; or rare
Not too similar to another element
similar across countries to extent feasible (often not)
Turns out: elements are very different

5. Brazil Corp Gov Index (BCGI)
Use Brazil to illustrate approach and complexities
Subindices (each 0 ~ 100) for:
Board Structure (7 elements)
Ownership Structure (5 elements)
Board Procedure (6 elements)
Disclosure (11 elements)
Related Party Transactions (5 elements)
Minority Shareholder Rights (7 elements)
BCGI = [∑(subindices)/6]
Range: [19, 92]
BCGInorm = normalized [∑(normalized subindices)]

6. Importance of local institutions
Brazilian institution: fiscal board
Can be permanent (in charter) or near-permanent (demanded every year or most years by minority shareholders)
We use (4 years out of 5) as out measure of “near-permanent”
Function similar to audit committee
often a substitute
Audit committees rare (mean = 0.14)
Fiscal board common (mean = 0.68)

7. Compare Brazil to Korea for Board Structure
Brazil Element (NP = not public)
Korea Element
Board includes ≥ 1 indep directors (NP)
Required
≥ 30% independent directors (NP)
Requires 25% independent directors
≥ 50% indep directors (NP; mean = 0.20)
in KCGI
Strict majority of indep. directors
CEO is NOT board chairman
Not available
Audit committee exists (rare; mean = 0.14)
Near-permanent fiscal board exists
Not meaningful
Audit committee or permanent fiscal board includes minority shareholder representative
Not available; rare
Rare (NP)
Compensation committee exists
Outside director nom. committee
Only common elements are:
50% outside directors (uncommon in Brazil) (NP)
audit committee (rare in Brazil; misleading alone)
Only public common element: audit committee
Rare in Brazil, misleading alone

8. Example 2: Board procedure subindex Start with Brazil & India: see if avail in Korea, Turkey
Overall Procedure subindex
Brazil
India
Korea
Turkey
≥ 4 regular board meetings per year NP X
available
Average board meeting attendance rate ≥ 80%
Outside directors attend minimum % of meetings
Firm has system to evaluate CEO
Firm has system to evaluate other executives
Firm evaluates nonexecutive directors
Firm has succession plan for CEO
Firm has nonexecutive director retirement age
Directors receive regular board training
Outside directors only annual board meeting
NP, rare
Board receives materials in advance
Nonexecutives can hire own counsel & advisors
Directors’ positions recorded in board minutes
Firm has code of ethics
Specific bylaw/policy to govern board
Firm has ≥ 1 foreign outside directors
Shareholders approve outside directors’ aggregate pay
NP = not public (use surveys). With public data, can’t build Brazil subindex at all
Even with surveys, can’t build consistent subindex across countries

9. Lesson: CG index must be country-specific
If require same elements in each country:
Can measure little
What we measure may not be very relevant
Problem gets worse if add more countries

10. Severe construct validity questions
We’re not sure how to measure “governance”
Not sure what counts as “good” CG, for which firms, in which countries
We have. . .
Different overall indices in each country
Different subindices in each country
Very different subindex elements in each country
We hope:
CG indices & subindices proxy for similar concepts

11. Gov  Value: Neither Necessary nor Sufficient
One can ask (as all of this literature does):
Does gov predict firm value (proxied by Tobin’s q)
CGI as a whole, or particular subindices
Suppose not, why?
Maybe no effect of gov on value
Maybe bad construct
Suppose yes:
subindex predicts the outcome, but is poor construct; measures something else
Plus usual “endogeneity” concerns

12. Construct validity is a hard problem
Widely ignored
No easy solutions
We offer an exploratory study
We hope to make (some) progress . . .

13. If “valid construct”, what might we hope for
Build the elements and subindices first
“Design stage” (Rubin, 2008)
Cannot aim directly for construct validity
If you do, tests for validity are meaningless

14. Once subindices are built
Some correlation across subindices
Reasonable Cronbach α
Standard (but crude) measure of construct validity
But too high a score  not desirable
Reasonable inter-element correlation (within subindex)
But too high  bad element choice
Principal components are coherent
May onto subindices

15. Correlations Between Subindices
Brazil DS BS
OWN BP SR
RPT
Subindex complement
0.57
0.24
0.18
0.29
0.47
0.08
Disclosure Index (DS)
0.19
0.40
0.61
0.10
Board Structure Index (BS)
0.28
0.23
0.05
Ownership Structure Index (OWN)
0.04
Board Procedure Index (BP)
0.15
-0.01
Minority Shareholder Rights Index (SR)
0.07
India
0.17
0.09
0.13
0.14
-0.04
Korea
0.43
0.51
-0.09
0.44
0.46
0.42
-0.06
0.36
0.38
0.39
-0.12
Turkey
0.58
0.62
0.52
0.20
0.01
0.27

16. Correlations between Elements

17. Cronbach α
measure of correlation between elements of a multipart measure (0 ~ 1):
𝛼= 𝑛𝑟 1+ 𝑛−1 𝑟
n = number of governance elements
r = mean correlation among elements
High α  valid subindex?
We argue
Low r  worry sign
High r also a worry sign!

18. Cronbach α results Brazil India Korea Turkey All governance elements
Brazil
India
Korea
Turkey
All governance elements
Cronbach α
0.80
0.70
0.76
0.88
Mean r
0.09
0.05
0.10
0.14
All subindices
0.56
0.31
0.50
0.58
0.18
0.08
0.20
0.22
Board Structure Subindex
0.38
0.74
0.63
0.13
0.29
Board Procedure Subindex
0.49
0.61
0.19
0.07
0.24
Disclosure Subindex
0.84
0.69
0.43
0.86
0.32
0.15
0.21
Ownership Structure Subindex
0.64 ─
0.40
0.26
Shareholder Rights Subindex
0.68
0.11
0.33
0.42
0.23
0.03
RPTs Subindex
0.77
0.36

19. Why worry if high r?
Suggests elements are not measuring different things
Narrow subindex, many similar elements
vs. broader subindex, disparate elements
Lower α
But better capture of governance complexity

20. What counts as “high enough” α?
No theory
Some rules of thumb from psychology, education
But can increase α by having more elements
Higher n
Can lead to search for suspect elements
Or having more-similar elements
Higher r
But can be spurious guide to validity

21. Principal Component Analysis (PCA)
Principal Component Analysis (varimax rotation)
Example: Turkey
Element level: loadings > 0.4
Subindex Level
Element Level
Elements (mean loading)
Subindex
Factor1
Factor2
Factor 3
Board Structure
0.7039
5 (0.84)
Disclosure
0.8036
0.1283
7 (0.81)
4 (0.79)
Shareholder Rights
0.0964
0.8799
Ownership Structure
0.8908
Board Procedure
0.7803
0.0273