1. 1 Corporate Governance & Firm Performance Sanjai Bhagat and Brian Bolton sanjai.bhagat@colorado.edu

2. 2 How is good corporate governance measured? Recent NYSE and NASDAQ corporate governance listing requirements: Board independence. See SEC ruling “NASD and NYSE Rulemaking Relating to Corporate Governance,” in http://www.sec.gov/rules/sro/34-48745.htm, and http://www.sec.gov/rules/sro/nyse/34-50625.pdf.

3. 3 How is good corporate governance measured? Gompers Ishii, Metrick (2003): The G-Index is constructed from data compiled by the Investor Responsibility Research Center ("IRRC"). A firm's score is based on the number of shareholder rights-decreasing provisions a firm has, such as Poison pills. Golden parachutes. Supermajority rules to approve mergers. Staggered boards. Limitations of shareholders’ ability to call special meeting. The index ranges from a feasible low of 0 to a high of 24. A high G-Score is associated with weak shareholder rights, that is, poor corporate governance.

4. 4 How is good corporate governance measured? Bebchuk, Cohen, Ferrell (2004): The E-Index is constructed from IRRC data. It uses a 6-provision subset of the G-Index. The index ranges from a feasible low of 0 to a high of 6. A high E-Score is associated with weak shareholder rights, that is, poor corporate governance.

5. 5 How is good corporate governance measured? Brown and Caylor (2004) governance score is constructed from data compiled by Institutional Shareholder Services ("ISS"). Fifty-two firm characteristics and provisions are used to assign a score to each firm. Bylaws (poison pills, supermajority provisions, …). Board structure (independence, CEO/Chair duality, nominating committee, …). Audit committee (independence, auditor’s consulting fees, auditor rotation). Management and Director compensation (no interlocks in compensation committee, option repricing prohibited, directors receive fees in stock). Progressive practices (director term limits and mandatory retirement age). The feasible range of scores is from 0 to 52. A high governance score is associated with better corporate governance.

6. 6 How is good corporate governance measured? The Corporate Library is a commercial vendor of corporate governance data, analysis and risk assessment tools. The benchmark score is based on over a 100 criteria: Bylaws (poison pills, supermajority provisions, …). Board structure (independence, CEO/Chair duality, nominating committee, …). Audit committee (independence, auditor’s consulting fees, auditor rotation). Management and Director compensation. Progressive practices (director term limits and mandatory retirement age). The feasible range of scores is from 0 to 100. A high governance score is associated with better corporate governance.

7. 7 How is good corporate governance measured? Stock ownership of median board member: Can a single board characteristic be as effective a measure of corporate governance as indices that consider multiple measures of corporate charter provisions, management compensation structure, and board characteristics? Corporate boards have the power to make, or at least, ratify all important decisions including decisions about investment policy, management compensation policy, and board governance itself. It is plausible that board members with appropriate stock ownership will have the incentives to provide effective monitoring and oversight of important corporate decisions noted above; hence board ownership can be a good proxy for overall good governance.

8. 8 How is good corporate governance measured? Stock ownership of median board member: … Furthermore, the measurement error in measuring board ownership can be less than the total measurement error in measuring a multitude of board processes, compensation structure, and charter provisions.

9. 9 Gompers, Ishii and Metrick’s (2003) results: Stock returns of firms with strong shareholder rights outperform firms with weak shareholder rights by 8.4% per annum on a risk adjusted basis. Efficient Market implications?  Their G-Index is becoming the de facto measure of governance in most industry reports and academic research papers.

10. 10 GIM Abnormal Return Results GIM Original Results – 9/1990 to 12/1999 αRMRFSMBHMLMOM 0.71**-0.04-0.22*-0.55*-0.01 GIM Original Results – 9/1990 to 12/1999 Using Ken French’s Momentum Factor αRMRF SMB HMLUMD 0.48-0.02-0.21*-0.49**0.19* Out of Sample Results – 1/2000 to 1/2003 αRMRFSMB HMLMOM -0.260.12-0.02-0.56**0.09 All Available Years– 9/1990 to 12/2003 αRMRF SMB HMLMOM 0.380.02-0.12-0.61**0.07

11. 11 Model Specification: 4 Equations Performance = f 1 (Governance, Ownership, Capital Structure, Industry Performance, Size, RDA Expenses, Board Size, Volatility, Treasury Stock) Governance = f 2 (Performance, Ownership, Capital Structure, RDA Expenses, Board Size, Active CEOs, Board Ownership %, Volatility) CEO Ownership = f 3 (Performance, Governance, Size, Leverage, RDA Expenses, Board Size, Volatility, CEO Tenure / CEO Age) Capital Structure = f 4 (Performance, Governance, Ownership, Size, Industry Leverage, Market-to-Book, Board Size, Volatility, Z-score)

12. 12 Primary Variables Governance: GIM G-Index BCF E-Index The Corporate Library Benchmark Score BC GovScore Median Director Stock Ownership CEO-Chair Separation Board Independence Performance: Return on Assets (ROA) Stock Return Tobin’s Q Ownership: CEO Ownership

13. 13 Compare to GIM’s results ROA t+1 = f(GOV t, Z t, u t ) Coefficient on GOV shown; p-values in parentheses

14. 14 Summary of Results – Part 1 1.Better governance leads to better current and future operating performance: Gompers, Ishii, and Metrick G-Index. Bebchuk, Cohen and Ferrell E-Index. Stock ownership of board members. CEO-Chair separation. 2.Board independence is negatively related to operating performance. 3.No measure of governance is related to future Stock Returns or Tobin’s Q.  Contrary to GIM’s results. 4.Estimation method matters.  There is an endogenous relationship between Governance and Performance.

15. 15 Part 2: Governance & CEO Turnover CEO turnover should be more likely following bad performance. Identify 1,923 CEO changes from 1992-2003. Review the press release to classify the change as “Disciplinary” or “Non-Disciplinary.”

16. 16 Reasons for CEO Turnover

17. 17 Multinomial Logit - Disciplinary Turnover Results

18. 18 Multinomial Logit - Disciplinary Turnover Results with Industry Adjusted Returns

19. 19 Summary of Results – Part 2 Given poor firm performance, the probability of disciplinary management turnover is positively correlated with stock ownership of board members, and board independence. Given poor firm performance, better governed firms (as measured by GIM and BCF indices) are less likely to discipline their CEO.

20. 20 Policy Recommendations Efforts to improve corporate governance should focus on stock ownership of board members – since it is positively related to both future operating performance, and to the probability of disciplinary management turnover in poorly performing firms. Proponents of board independence should note with caution the negative relation between board independence and future operating performance. –If the purpose of board independence is to improve performance, then such efforts might be misguided. –If the purpose of board independence is to discipline management of poorly performing firms, then board independence has merit.

21. 21 Policy Recommendations Even though the GIM and BCF good governance indices are positively related to future performance, –policy makers and corporate boards should be cautious in their emphasis on the components of these indices since this might exacerbate the problem of entrenched management, –especially in those situations where management should be disciplined, that is, in poorly performing firms.