Corporate Governance: A Review of Current Research

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, 2006. 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, 2007. 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, 2006. 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 • 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 • 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., 2007. 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, 2006. 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 astudy 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, 2007. 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, 2007. 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