Jackie Krafft Groupe de Recherche en Economie, Droit Economique et Gestion GREDEG, UMR n°7321

1. 2013 Summer School« Knowledge dynamics, industry evolution, economic development »Corporate Governance and Performance: International comparisons and the issue of innovation Jackie Krafft Groupe de Recherche en Economie, Droit Economique et Gestion GREDEG, UMR n°7321 Université de Nice – Sophia Antipolis et CNRS

2. Background • Since the 1980s, the literature on corporate governance has developped in two directions: - the promotion at a theoretical level of a model of corporate governance, essentially agency-based - the elaboration of metrics and scores of good governance • These directions are closely related: From the 1980s till today, agency-based models have served as the key reference to the elaboration of metrics

3. Dominant theory today • At a theoreticallevel, ‘good governance’ increasesfirm value and performance as itinvolves : • better monitoring, greatertransparency and public disclosurebetween the principal (the investor) and the agent (the manager) • increase in investor trust and, conversely, decrease in manager discretion and rent expropriation • Lessrisk, more efficient operations, reduced audit and monitoring costs for well-governedfirms => Theseelements tend to alleviate the cost of capital and generatehigherexpected cash flow stream, which in turncreatehigherfirmvaluation and higher performances

4. Dominant practice today • At a practical level, international investors now generally regard corporate governance as an important criterion when making investment decisions • According to Mc Kinsey (2002), 15% of institutional investors consider corporate governance to be more important than firms’ financial issues, such as profit performance or growth potential • More and more countries started to tighten up rules and regulations in the governance field by adopting new standards largely inspired by US codes of best practice to establish guidelines for publicly listed companies in an attempt to improve the overall governance of firms • OECD acknowledges that an effective corporate governance system will lower the cost of capital and encourage firms to use resources more efficiently, thereby, underpinning growth

5. Questions • All this implicitely and explicitely support the following belief: « better governance will result in higher firm value and more profitable firm performances » => true there, true everywhere => true for any kind of investments, including innovative ones • But, do we really have robust evidence on that? • And what if considering innovation performances of firms, and not only financial performances ? • What are the challenges ahead?

6. Outline • Resultsso far • Data and empiricalstrategy 2.1. International comparisons 2.2. Innovation 3. Where do we go?

7. 1. Results so far

8. True everywhere? • The issue of international comparisons! • US corporate governance as a best practice and its diffusion worldwide • Some commentators persistently advocate the importance of the institutional context in which the governance system operates, and tend to support the idea that there is a lack of convergence towards the US model, and even a reluctance to adopt it, leading to a co-existence of distinct national models of corporate governance

9. True everywhere? • Until the mid 1990s, most of the work on corporate governance has been in the context of US firms • Over the last decade, international comparisons started to develop, stimulated by the work of La Porta, Lopez de Silvanes, Shleifer and Vishny (1997, 1998, 2000a, 2000b, 2002) • Much of this work has focused on differences between countries’ legal systems, and has studied how such differences relate to differences in how economies and capital markets perform • A substantial body of research about US firms showed that cross firm differences in governance have substantial effect on firm value and performance (Gompers et al., 2003; Bebchuk et al., 2008; Core et al., 2006) • However, much less documented is how non US firms are performing when they adopt the US best practice

10. Inputs from theory • Agency theory, transaction costs economics, new property rights theory are based on different assumptions • However, they converge to say that good governance is needed to i) realign the incentives of the manager in the interests of the shareholder, ii) guarantee high cash flow and low cost of capital, iii) use resources more efficiently and stimulate growth • They also converge on key attributes of good governance: board of directors, proxy fights, hostile takeovers, corporate financial structure • As the US model of corporate governance was elaborated to come up with these issues then, from these theories, it should spread over the world both in US and non US firms • Issue of convergence of corporate systems and regulations: convergence here being understood as the domination of a system of corporate governance identified as ‘superior’ … and not as a gradual interpenetration of rules and practices leading to a mix of different co-existing systems

11. Inputs from theory • Alternative theories (stakeholder perspective, varieties of capitalism, economics of innovation) suggest that the adoption of the US model in firms is not leading to the best results, as country-level or firm-level differences are at work • At the theoretical level, the issue is still unsolved: - some critical debates on the emergence of a US best practice on which all the other systems (and firms composing these systems) should converge - there is no overall ‘best’ system

12. True for any kind of investments? • The issue of innovation! • Today, innovation is only considered in the impact that corporate governance may have on firms innovation performances (thus not only stock market, firm value, or operational performances) • Innovation performances of firms can be measured by input measures (R&D), or output measures (patent) • However, most of the studies focus only on the impact of corporate governance on R&D, leaving the link between corporate governance and patenting completely unexplored • The general conclusion is that there is no general conclusion: further investigations are needed to better understand innovation in the field of corporate governance

13. Inputs from theory • Debate: (1) Because good governanceinvolvesbetter monitoring, greatertransparency and public disclosure, increasein investortrust, decrease in manager discretion and rentexpropriation, lessrisk, more efficient operations, etc. • itshouldbebeneficial to all investments, especiallyinnovativeones (2) Because good governanceputs a large emphasis on the interests of the shareholders as a primary goal • itshouldequallybedetrimental to innovativeinvestments as • shareholders and investors are mostlyinterested by dividends and returns on investments, not about R&D strategy, • itintroduces a short-term perspective while innovation is long-term

14. 2. Data and empirical strategy

15. 2.1. International comparisons (firm-level)

16. IRRC data • The Investor Responsibility Research Center (IRRC) publishes detailed listings of corporate governance criteria for individual firms • Data are derived from a variety of public sources (corporate bylaws and charters, proxy statements, annual reports, 10K, and 10Q documents) • All sample firms are drawn from the Standard & Poor’s 500 and the annual lists of Fortune, Forbes, and Business Week • The reports cover about 1500 US firms, and are published in 1990, 1993, 1995, and 1998

17. IRRC data • Gompers, Ishii and Metrick (2003, Quarterly Journal of Economics) construct a firm-level governance index (G-Index) based on the prevalence of 24 governance criteria • They add one point for every attribute that reduces shareholder rights • Firms with higher G-index values are reflecting less shareholder rights, e.g. poor governance • The authors test the impact of a change in G-index on firms stock market performance (stock price, dividend yield) and firms value (Tobin’s Q) • They find that firms with poor governance have significantly lower valuation than firms with lower index values • They find, however, that badly governed firms do not necessarily have lower operating performance (Net profit margin, Return on asset)

18. IRRC data • Bebchuk, Cohen and Ferell (2008, Review of Financial Studies) find similar results with a slightly different governance index (called the E-index for ‘entrenchment’ index), and consisting of a smaller set of provisions (6 criteria of governance) • Core, Guay and Rusticus (2006, The Journal of Finance) show that firms with weak shareholder rights exhibit systematically significant operating underperformance

19. Critics on IRRC data • IRRC data can only examine the effects of the external mechanisms of corporate governance, because the scores of corporate governance are indeed very close to a takeover defense index • IRRC data does not provide a measurement of overall corporate governance, especially of internal mechanisms at work • IRRC data is based on the largest US firms • The way in which corporate governance develops outside the US is not within the scope of IRRC data • IRRC data is not published each year • Important changes in governance occurring in the year where the report is not published may be ignored

20. CLSA data • Credit Lyonnais Securities Asia (CLSA) provides rankings in corporate governance, drawn from a questionnaire circulated among 495 companies • The sample is selected based on two criteria: firm size and investor interest • The CLSA corporate governance questionnaire covers 7 broad categories in 25 countries (US and non US) • The questionnaire is then completed by Credit Lyonnais analysts • The analysts add one point to each answer in favor of the best practice and then the percent of positive response to questions in each category is reported

21. CLSA data • Klapper and Love (2004, Journal of Corporate Finance) use CLSA firm-level data of 374 firms from 14 emerging countries • They report that better corporate governance is highly correlated with better operating performance and higher market valuation • This gives some support that non US firms increasingly adopt US firms’ practices in terms of corporate governance

22. Critics on CLSA data • However this index is highly based on analysts’ subjective views • About 70% of the questions are based on objective facts and the remaining questions represent analysts’ opinion, which could be biased by knowledge of stock returns • Additionally, since CLSA has conducted only one study, the data generated from this study is quite static • Obvious limits in the generalization of results in terms of convergence in systems of corporate governance

23. Single-market data • Single-market survey-based governance index • These firm-specific corporate governance indexes are constructed by following broad surveys among listed companies in a single market • Black, Jang and Kim (2006, The Journal of Law, Economics and Organization) construct a Korean Corporate Governance Index (KCGI) for 515 Korean companies • The study is based on a survey of corporate governance practices by the Korea Stock Exchange in 2001, sent out to all listed firms on the Korea Stock Market • The authors extract 38 variables from the survey questions, which are classified into 4 sub-indices, and then they combine sub-indices into the overall index-KCGI • They report an increase in KCGI predicts a 0.47 increase in Tobin’s Q

24. Single-market data • Drobetz, Schillhofer and Zimmermann (2004, European Financial Management) document a positive relationship between governance practices and firm valuation for German public firms by constructing broad corporate governance rating related to the German Corporate Governance code • To construct their sample, they sent out questionnaires to 253 German firms in different market segments and received answers from about 36% of these firms • Data are limited to one observation, March 2002 • Results exhibit a positive, significant relation

25. Single-market data • Beiner, Drobetz, Schmid, Zimmermann (2006, European Financial Management) sent out a questionnaire based on the suggestions and recommendations of the Swiss Code of Best Practice to all Swiss firms quoted at the Swiss Stock Exchange in 2003 • The index consists of 38 governance attributes divided into 5 categories • They report that an increase in the corporate governance index by one point causes an increase of the market capitalization by roughly 8.52%

26. Critics on single market data • These contributions are all in line with an increasing convergence in systems of corporate governance • However there are several limitations with these studies • most of the studies are based on one single year, or work under the assumption of constant historical ratings • and a longer period of study should be required to draw general results • a country case study raises the question of generalization to other countries • empirical studies should be based on data that explicitly considers several countries • More systematic results should be expected on the following dimensions • From academic to investors data…

27. Investors data: TCL • The Corporate Library was founded in 1999 with the goal to provide to its clients corporate governance, executive and director compensation information and analysis • In 2003, it launched its Board Effectiveness Ratings, now known as The Corporate Library (TCL) Ratings • These ratings cover four key components: board structure (50%), CEO compensation (30%), takeover defenses (10%), and accounting (i.e., screens for earnings management 10%). • They cover five categories (higher to lower): A, B, C, D, and F • TCL also provides the following eight sub-ratings: Board Composition, Shareholder Responsiveness, Litigation and Regulatory Problems, Strategic Decision-making, CEO Compensation, Takeover Defenses, Accounting, and Analyst Adjustment • These sub-ratings also range from A to F

28. Investors data: GMI • Governance Metrics International (GMI) was founded in 2000 to provide tools to its clients to monitor firms’ corporate governance • GMI considers various aspects of governance such as, board accountability, financial disclosure and internal controls, shareholder rights, executive compensation, market for control and ownership base, and corporate behavior • Companies are scored on a scale of 1.0 (lowest) to 10.0 (highest). • GMI global ratings measure the strength of corporate governance relative to all other companies in the GMI universe

29. Investors data: ISS/Risk Metrics • Founded in 1985, Institutional Shareholder Services (ISS) provides research and proxy advisory services to institutional investors • In 2002, ISS introduced its Corporate Governance Quotient which aims to ‘measure the strengths, deficiencies and overall quality of a company's corporate governance practices and board of directors’ • ISS considers the following factors: Board of directors, audit committees, their independence and the presence of a financial expert, charter and bylaw provisions, anti-takeover provisions, executive and director compensation, qualitative factors such as board performance reviews, meetings of outside directors, CEO succession plan, director and executive ownership, and director education. • CGQs range from 0 to 100 and measure the quality of governance relative to other firms in the company’s primary stock market index. • To date this is the most exhaustive data, covering about 8000 firms in 25 countries and 25 sectors

30. Data available

31. Reliability of data? • There are increasing (academic) criticisms against investors data: • metrics is not based on the most recent analytical developments and, consequently provide partial and even wrong evaluation leading to over or under estimations of what firms really do in terms of corporate governance • difficulty to synthetise the complex reality of corporate governance into one score • objectivity of the measure and of the evaluators • companies with good/bad scores are not systematically the ones that perform the best/worst (exemple: Enron/Google) • Indicators are often short term oriented, and depreciate some sectors over others • no account of the variation of scores due to country and or industry effects

32. Review: empirics (firm level) • US data: - Gompers et al. (2003), Bebchuk et al. (2008), Core et al. (2006): firms with better governance (higher shareholder rights) have higher performance in the US • International comparisons: - Klapper and Love (2004): better governance is highly correlated with better operating performance and higher market valuation (14 emerging countries, 1 year study) - Black et al. (2006): better governance involves an increase in Tobin’s Q (1 country, Korea) - Drobetz et al. (2004): positive relationship between governance practices and firm valuation (1 country, Germany) => Convergence operates: non US firms increasingly adopt US firms’ best practice in terms of corporate governance

33. Krafft, Qu, Quatraro, Ravix (2013)Industrial and Corporate Change • At the theoretical level, the issue of convergence has to take country level and firm level differences on board if some progresses are to be made • Maybe one way to overcome this theoretical dead-end is to develop some further empirical results • But empirical studies should be based on data that explicitly considers: - non US firms in several countries - a long period of study • We aim at providing an empirical contribution on the adoption of the US best practice by non US firms (24 countries, more than 2500 firms), over the period 2003-2008

34. Hypotheses • H1: Better governed firms should have higher stock market performances, measured on the basis of Stock Return or Dividend Yield • H2: Better governed firms should have higher value, measured by the Tobin’s Q • H3: Better governed firms should have higher operating performance, measured by Return on Assets or Net Profit Margin

35. Data and variable • Data: - ISS Risk Metrics, largest corporate governance data provider • Variables: - Corporate Governance variable: CGQ, as score metrics developped by the data provider, based on 55 governance factors which span over 8 attributes of corporate governance - Performance variables: Stock return, Dividend yield, Tobin’s Q, ROA, NPM - Control variables: Size, R&D/sales, Sales growth, Market capitalisation, Market to book value

36. Methodology • Governance and stock market performance: • Impact of CGQ on Stock return and Dividend yield • Endogeneity: CGQ is exogenous for Dividend yield, CGQ is endogenous for Stock return • Stock return and CGQ is estimated by using the instrumental variables technique • Governance and firm value: • Impact of CGQ on Tobin’s Q • Endogeneity: CGQ is exogenous for Tobin’s Q • Governance and operating performances: => Impact of CGQ on Return on asset and Net profit margin • Endogeneity: CGQ is exogenous for NPM, CGQ is endogenous for ROA • ROA and CGQ is estimated by using the instrumental variables technique

37. Results • Governance and stock market performance: • Positive relationship between CGQ and Stock Return, significant at 1% (2SLS) • Positive relationship between CGQ and Dividend Yield, significant at 1% (OLS) • Governance and firm value: • Positive relationship between CGQ and Tobin’s Q, significant at 1% (OLS), significant at 5% (FE) • Governance and operating performance: • Positive relationship between CGQ and ROA, significant at 1% (2SLS) • Positive relationship between CGQ and NPM, significant at 10% (OLS), significant at 5% (FE)

38. Summary

39. 2.2. Innovation

40. Driver and Guedes (2012)Research Policy • Agency theory: Good governance increases R&D because investors are assured that managers are not shirking => H1: Greater levels of governance induce more R&D spending • Innovation theory: There is a possibility of perverse effect of “good governance” on uncertain, long term investments => H2: Greater levels of governance induce less R&D spending

41. Data: • Investor base, single market (UK): Manifest global proxy governance and voting service database • 91 UK manufacturing and service (excluding financial) firms, with the highest averaged R&D expenditure in the period 2000–2005 • Results: • The governance variable in levels is significantly negative in all specifications (FE and GMM) • This suggests that there is a long-run negative effect of governance on R&D • This is consistent with the views of the minority of those who have argued that the adoption of the best practice can have contradictory or perverse effects, when innovation is taken into account

42. Lhuillery (2011)Industrial and Corporate Change • Data: • Investor base, single market (F): Vigéo • 5528 firms belonging to 110 large French listed business groups • Results (FE and GMM): • Support of agency theory set of hypotheses, i.e. adoption of the best practice increases firms’ performances • Support of the ‘additivity’ hypothesis, i.e. any additional provision further amplifies firms’ performances • However: • In France, no significant influence of good governance on R&D decisions • Possible doubts regarding the “Anglo-Americanization” of (some) Europeanfirms

43. Becker-Blease (2011) J. of Corporate Finance • Data: • IRRC, Financial accounting standards, NBER patent database,1984-1997, 600 US firms • Focus on antitakeover provisions on firm innovation

44. H1: Managerial myopia (Stein, 1988): threat of hostile acquisition can lead managers to avoid undertaking long term, risky investments because such projects can lead to a wide divergence between market and intrinsic values. Takeover provisions may shield managers from concerns related to short term performance and permit more long term, value-maximizing investment strategy that encourages greater innovation • H2: Quiet life (Bertrand and Mullainathan, 2003): if the presence of takeover protection reduces the effectiveness of the external disciplinary market, then the manager may exploit the opportunity to avoind difficult and risky investments, especially if these could reveal managers to be lower quality

45. Results: • Higherlevels of 23 takeover provisions are associatedwith innovation efforts (R&D expenditures, awarded patents, quality of patents, number of patents awarded per $ of R&D) => Innovation ispositivelycorrelatedwithantitakeover provisions • Some provisions are more important thanothers in this positive correlation (power hypothesis) • Firm-level provisions are significant in this positive correlation, while state-level provisions are not significant(visibilityhypothesis)

46. O’Connor and Rafferty (2012), J. of Financial and Quantitative Analysis • Data: • IRRC and Compustat, 1719 firms (1990-2005) • Effect of antitakeover provisions on long term investments • Hypotheses: • H1: Managerial myopia (Stein, 1988): positive relation • H2: Quiet life (Bertrand and Mullainathan, 2003): negative relation • Models: • Static models (OLS): negative relationship between corporate governance index and R&D activity, but not robust • Dynamic models (GMM): no relation, or only slightly positive

47. Krafft and Ravix (2008)Louvain Economic Review • Data: • RiskMetrics / International Shareholder Services • 2500 firmsfrom 25 Industries, 24 Countries (non US) • Oct 2003 to Dec. 2008

48. FE model • LnSPi,t = α + β1 LnCGQi,t + β2LnMVi,t + β3LnDYi,t + υi,t • Positive and significant relationship in Agro-Food and ICT • The impact of a variation in CGQ on performance is much more important in ICT compared to Agro-food

49. … and the CGQ itself is more instable in ICT industries than in Agro-Food

50. Innovative versus non-innovative sectors have an impact - Good governance principles have a stronger impact on stock market performance in innovative industries compared to more traditional ones - Increasing volatility may be the outcome, especially in a context where variations of CGQ are much more important in innovative industries than in more traditional ones • Suggests that the adoption of the best practice is amplifying the ups and downs of industrial development, especially of innovative industries