1. Corporate Governance: A Review of Current Research
Alexander Settles

2. Sources of Research Agenda
Finance
Agency theory – investigation of different corporate governance practices and firm performance
Law
Management
Firm life cycle
Stakeholder analysis

3. 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

4. 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

5. Research Board processes Effects of duality of CEO role
Stewardship theory
Executive compensation
Managerial stock ownership and performance

6. 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.

7. 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)

8. 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)

9. 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

10. 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)

11. 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)

12. 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.

13. 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)

14. Operating Performance
Fich, Eliezer M. and Anil Shivdasani, 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

15. Operating Performance (cont.)
Dahya, Jay and John J. McConnell, Board Composition, Corporate Performance, and the Cadbury Committee Recommendation
Primary findings
Compliance with the Cadbury Report results in an increase in operating performance

16. Operating Performance (cont.)
Core, John E., Wayne R. Guay, and Tjomme Rusticus, 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

17. 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

18. 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.

19. 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?

20. 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?

21. La Porta et al. 1998
Unit of analysis – country; generalized to legal family
Methods – statistical analysis of investor protection; student t-test

22. La Porta et al. 1998 Independent Variables Dependent variables Country
Legal Family
Dependent variables
Shareholder rights
Creditor rights
Enforcement
Ownership

23. Results

24. La Porta et al. 1998
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

25. Shleifer and Vishny 1997 Agency problem How to solve? Contracts
Managerial Discretion
Incentive Contracts
Evidence on agency problem – does it exist?
How to solve?

26. Shleifer and Vishny 1997 Finance without governance – reputation
Legal Enforcement of Rights
Large Investors
Takeovers
Large Creditors

27. Shleifer and Vishny 1997 Debt versus equity choice LBO
Cooperatives and State ownership

28. La Porta et al. 1999
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.

29. 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

30. Responses to Bad Acquisition Bids
Paul, Donna L., 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

31. CEO Turnover
Lehn, Kenneth M. and Mengxin Zhao, 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

32. 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

33. 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

34. Jensen 1993 How to improve CG? Board culture Information problems
Legal liability
Oversized boards
No shareholder democracy – but more activism
Separate CEO and Chair

35. Survey of Dividend Theories
Free Cash Flow Theory
Dividends 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)

36. Survey of Dividend Theories
Signaling Theory
Lintner (1956) partial adjustment process towards a target payout ratio and communicate the level and growth of earnings or future prospects of the company to investors
Bhattacharya (1979); Miller and Rock (1985); Bernheim and Wantz (1995); Amihud and Murgia (1997)

37. Survey of Dividend Theories
Ownership Theory
Dividend may signal conflicts between large controlling shareholder and minority shareholders
Shleifer and Vishny (1997); Gugler (2003); Gugler and Yurtoglu (2003)

38. 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.

39. SEC and DOJ Enforcement Actions
Karpoff, Jonathan M., D. Scott Lee and Gerald S. Martin, 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

40. Derivative Lawsuits
Ferris, Stephen P., Tomas Jandik, Robert M. Lawless and Anil Makhija, 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