THE LINK BETWEEN CORPORATE GOVERNANCE AND CORPORATE PERFORMANCE
One can conceive of linkages between corporate governance and corporate performance that might affect a wide range of social, political and economic issues. From a broad perspective corporate performance might be about more than enhancing shareholder wealth. For example, it could be evaluated for its impact on the cost of funds (efficiency in the financial markets), the role of labor in management (up to and including labor-owned firms), the role of corporations in education and training (efficiency in the labor market), and the contribution of corporations to research and development (efficiency in the knowledge market). Corporate performance could also be judged by its contribution to a country's ability to compete successfully in international markets. Some commentators have even put forward a broad agenda for corporations and their institutional owners.
For example, Robert Monks and Nell Minow write that because the holdings of pension plans are so diversified, "This endows them with a breadth of concern that naturally aligns with the public interest. For example, pension funds can be concerned with vocational education, pollution, and retraining, whereas an owner with a perspective limited to a particular company or industry would consider these to be unacceptable expenses because of competitiveness problems." Likewise, Olena Berg, Assistant Secretary of Labor for Pension and Welfare Benefits, said in an address to the AFL-CIO Asset Managers Conference on September 2, 1993: "These two objectives, of maximizing pension fund performance and investing pension fund assets in a manner which strengthens the American economy, need not be, and indeed, are not inconsistent."
These comments, however, have largely been made by observers -- not participants. When institutional owners in the United States come to justify their concern with corporate governance most adopt the narrow view and echo former CalPERS' CEO Dale Hanson when he says an institutional investor has only "one overriding objective: the maximization of long-term investment returns." By rejecting concerns other than profit maximization, Hanson's statement recalls Milton Friedman's famous remark that "Few trends could so thoroughly undermine the foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible." This view is supported by a recent Conference Board survey which found concern with company performance ranked as the highest concern expressed by institutional investors in the thirteen countries surveyed.
While for much of this century there has been a tension between narrow and broad views of corporate performance, it is clear that those who bear the fiduciary duty see enhancing shareholder wealth as the primary, if not the only, goal for the corporation. Consequently, the literature investigating the link between governance and performance is heavily weighted toward the wealth enhancing effects of various measures.
When institutional activists apply the pursuit of 'long-term investment returns' to issues of corporate governance, they are implicitly accepting the following model: management actions matter to performance; corporate governance sets the framework in which management acts; 'good' corporate governance aligns management actions with owners' desires; and, since owners desire the 'maximization of long-term investment returns,' the end result is improved economic performance. Without 'good' corporate governance, the principal-agent problem embedded in this logic implies management will pursue its own goals (power and prestige enhancing acquisitions, large salaries, perquisites such as company jets, etc.) to the detriment of the owners' interests in wealth maximization. The consequence, of course, is poor economic performance and lower long-term investment returns.
The proposition that governance matters -- and that governance was in need of improvement -- was strongly reinforced by the takeover boom of the 1980s. Since, acquirers often willingly paid a premium in order to gain control of a company (that is, for the privilege of exercising the rights of ownership), they must have believed managerial changes could be made to justify the premium paid -- and more. From this observation it is a short step to the conclusion that current management must have been failing to realize the 'full' value of the company and that an improvement in corporate governance was in order. The logic of this argument was particularly compelling when the acquirers were the current management -- the group best placed to know the many ways in which current management was failing to maximize long-run returns to shareholders. This, of course, is a cornerstone of the finance theory of government discussed in Part II.
As compelling as the argument is for a strong, direct connection between corporate governance and corporate performance, there is a counter view. For example, Roe notes that:
...corporate governance--even if we knew how to achieve the perfect system--is not the key to economic performance and competitiveness. While extremely pathological governance...will disable firms, within the [normal] range...macroeconomic policies, competition, industry structure, and the education and motivation of managers and employees affect competitiveness and productivity more than governance alone.
Corporate governance should matter least in highly competitive markets...managers who seriously err will be out of business....it does matter when the other means of accountability are weak [as in oligopolistic markets]...managers who err there will not face the consequences of error immediately....governance [in these circumstances], although secondary, is rarely irrelevant.
In the light of this and other criticism, Gilson is correct when he points out that, "the existence of an important link between corporate governance and corporate performance is not self-evident; it is a hypothesis, not revealed truth." What follows is a brief, not exhaustive overview of the literature that attempts to establish the hypothesis that corporate governance matters to corporate performance.
Blair provides a comprehensive review of the empirical literature on the proposition that large, active investors can add value to a corporation "by using their voting power and other mechanisms of influence to prevent adoption of anti-takeover governance rules, or to get them reversed if they have already been adopted." In her review Blair identifies four types of evidence than might be brought to bear on this question: 1) descriptions by business historians of the role large investors have played at particular companies; 2) comparisons between the performance of companies operating in widely different corporate governance regimes (e.g. the US, Germany and Japan); 3) 'indirect' evidence that corporate governance rules and structures affect the value of firms, and 4) "direct quantitative evidence about the impact that large investors actually have on corporate behavior and performance." Even though the first two types of evidence -- biography and international comparisons -- heavily influence many observers, Blair dismisses them as 'anecdotal' and concentrates her analysis on studies of "the latter two types of evidence, since such systematic evidence forms a more reliable basis for policy."
The indirect evidence Blair cites focuses on 1980s research that showed "the shareholders of companies that were targets of takeovers, buyouts, or other control transactions received substantial premiums -- on the order of 30 to 40 percent on average to their shares". By implication any corporate governance feature that makes it harder to take over a company ought to reduce shareholder value and any change that makes it easier should be wealth enhancing.
Blair finds support in the literature for the proposition that only three types of corporate governance changes affect the value of the shares of the adopting company. Those changes are supermajority amendments, poison pills, and elimination of cumulative voting rights. All lower the value of the adopting company's shares. The effect ranges from a high of about 3 percent of value for supermajority amendments, to as little as .34 percent of value for poison pills in companies where there is no takeover speculation. Blair concludes, "Thus the value effects of these governance arrangements appear to be small, but they are statistically significant."
Blair also reviews the literature on the relationship between large minority block shareholders, especially institutional investors, and the adoption or removal of antitakeover corporate governance arrangements. The proposition is that large shareholders would be more effective in this area than small dispersed shareholders. Blair concludes:
In sum, there is evidence that large, minority block shareholders, especially outside shareholders, resist some antitakeover amendments, and that shareholders in general bid down the shares of companies that adopt them. But there is little or no evidence that antitakeover amendments, even those that result in stock price declines, actually cause any decline in the underlying performance of the companies that adopt them, and there is little or no evidence that actions by large investors to change certain antitakeover corporate governance policies can increase stock prices in the long run.
The other area which Blair surveys concerns the direct impact of large-block shareholders on corporate performance. These investors may be institutional investors such as CalPERS or individuals such as Warren Buffett. What they have in common is that they are long term holders and may posses the detailed knowledge of the firm and its markets necessary to add value as a monitor.
Among the sixteen studies Blair reviews three standout. Jones, Lehn and Mulherin find that companies with large proportion of their stock held by institutional investors experienced greater increases in liquidity (and, therefore, presumablly a lower cost of capital) in the 1980s compared to companies with a low proportion of their stock held by institutional investors. They also found these firms had higher levels of spending on R&D and capital investments. In the second study, McConnell and Servaes find that institutional ownership correlates with Tobin's q and with accounting measures of profitability. Finally Nesbitt finds that as a group the 24 firms CalPERS targeted as 'underperformers' in 1990 - 1992 underperformed the market by an average of 86% over the five years leading up to CalPERS' involvement and in the two years after they out performed the market by 28%. As noted, these firms were primarily chosen because of their poor stock market performance, and not because of particularly poor corporate governance features.
After her review Blair reaches two "modest" conclusions. The first is that large-block shareholders don't seem to be able to add 'lasting value' simply by pressing for shareholder-friendly governance rules. The second conclusion is more positive. Blair concludes that there is "quite a bit of evidence that large block investments either by insiders (management) or by outsiders can help to increase the value of a company." It appears ownership matters, but the mechanism doesn't appear to be through formal corporate governance.
While Blair surveys the field, the following study tries to address the nexus between corporate governance and corporate performance directly.
In an attempt to answer the question, 'Does governance matter?', Gordon and Pound use a sample of about 1,100 large US corporations to directly investigate the impact of a set of ten antitakeover governance measures (supermajority amendments, poison pills, etc.) on six measures of corporate performance. They divided their sample into firms with restrictive governance structures (along several different definitions of restrictive such as number of features, presence of poison pill, etc.). The 1,100 firms were grouped by Standard Industrial Classification (SIC) codes into thirteen industries in order to control for inter-industry differences in performance. Finally, the authors performed "chi-square tests of the null hypothesis that the incidence of 'great,' 'medium,' or 'poor' performance is the same for samples of firms with more or less restrictive governance features."
Their results "suggest systematic and sizable differences in performance distributions as a function of governance structure." For three measures of corporate performance -- return on assets, operating margin, and cash-flow-to-price multiples -- companies with less restrictive governance structures are 30% to 50% more likely to have 'great' performance.
Three of the performance variables -- earnings to price ratios, one-year stock returns, and five-year stock returns -- did not display systematic performance difference as a function of governance structure. The authors state one shouldn't expect different governance structures to be related to these three stock-market measures of corporate performance because any effect of the enactment of restrictive governance provisions should show up in market value at the time of adoption, but "during the measurement period ... each firm should [like comparable firms with good governance structures] earn its required equilibrium rate of return."
Gordon and Pound conclude their results "support the theory that restrictions making outside shareholder initiatives more difficult are associated with a reduction in performance over the long run." So, for Gordon and Pound, governance matters. Pound individually draws similar conclusions on the basis of an examination of various studies of proxy initiatives (mostly event studies), and of changes in corporate policy after various forms of formal and informal political pressure from shareholders. He also points out that event studies probably underestimate the positive effect of all forms of what he terms pressures on management brought about through a 'political process'.
The following study presents contrasting results from a review of the literature on the relationship between board independence and corporate performance.
One of the dangers highlighted by the principal-agent framework is that boards of directors may be captured by management. This is most likely to occur when the board is not independent of management as when the CEO and the chairman of the board are the same person or when a substantial number of board members are not truly independent outsiders. The implication is that less independent boards will prevent shareholder interests from being realized -- and that governance reforms that promote independence will help solve the principal-agent problem inherent in the divorce of ownership from control.
To a large degree and in response to pressure for governance reforms the current trend in board makeup is toward smaller boards with fewer inside directors. In a survey of boards of directors at 100 large corporations the executive search firm Spencer Stuart found "The bulk of this board downsizing is directly attributable to reductions in the number of inside directors." Still, Monks and Minow report, "In 76 percent of the largest US companies, the chief executive officer is also the chairman of the board."
In order to assess the importance of independence to performance, Donaldson and Davis survey the literature in this area. After considering studies that relate board independence to economic performance, the degree of diversification, R&D spending, and acts of corporate illegality, the authors conclude "Overall, the agency theory that non-executive boards produce more positive outcomes is not supported. These studies yield at least as much support for the contrary proposition that mainly executive boards are beneficial to the corporation and its shareholders." With respect to the issue of economic performance they conclude, "The empirical research studies have failed to find any consistent support for the proposition that independent boards lead to better outcomes such as greater profit or shareholder wealth." If fact, the authors go so far as to assert that "Moves to impose non-executive boards on companies in the belief that this would thereby raise their performance are to be viewed as courting danger."
The most direct way in which shareholders can influence the corporate governance policies of companies in which they invest is to sponsor a proxy proposal on a particular governance issue. We now turn to a study of corporate governance proxy proposals.
Karpoff, Malatesta and Walkling
In a study of a sample of 866 shareholder initiated proxy proposals on governance issues at 317 publicly traded companies during the period March 1986 to October 1990, Karpoff, et al. use the event study methodology to answer two questions: What types of companies attract these proposals? and How do the proposals affect firm values?
In answer to the first question the authors find "Shareholder-initiated corporate governance resolutions tend to target poorly performing firms, as measured by market-to-book ratio, operating returns, and recent sales growth." In answer to the second question, they "find little evidence .... of wealth gains that might arise from such improvements. The average wealth effect associated with shareholder-initiated corporate governance proposals was close to, and not significantly different from, zero." The authors also "find little evidence that shareholder proposals facilitate significant policy changes" such as CEO turnover. In conclusion, "Even the most successful proposals do not significantly alter their target firms' policies or stock values."
The following two studies evaluate the 'targeting' programs at two associations, United Shareholders Association (USA), and the Council of Institutional Investors (CII). While these studies don't systematically evaluate the effect of specific corporate governance features, they do investigate the broader issue of what is called 'relationship investing' -- owners acting as owners. These two studies complement the findings of Nesbitt reported under Blair, above. Recall, the Nesbitt study found strong evidence of substantial excess returns to the group of 24 underperforming firms targeted by CalPERS in 1990 - 1992. The targeting programs by USA and CII are similar to the targeting program undertaken by CalPERS during this period.
During its seven years of operation, 1986 - 1993, USA provided a "conduit through which small shareholders could combine resources to monitor management." Part of USA's program was to develop a Target 50 list of firms characterized by "poor financial performance, top executive compensation plans that were not sensitive to firm performance, and policies that limited shareholder input on governance issues."
Strickland et al. examine the types of firms targeted, the success of proposals, how actions affected firm value, and whether USA was successful at improving the governance structure of targeted firms. In particular, they focused on the proxy proposals USA promoted. Over its life, USA submitted 216 proposals, 53 were negotiated and 163 were submitted to a shareholder vote. In a negotiated agreement the company agrees to some or all of the proposals in the proxy and the shareholder agrees to withdraw the proxy. A negotiated agreement is a clear-cut instance of investors affecting the corporate governance structure of a company. The proposals most frequently dealt with poison pills, golden parachutes, confidential voting and the adoption of an independent board of directors with outside directors on the nominating and compensation committees.
In assessing the impact of USA on shareholder value, the authors focused on the 53 proposals at 34 firms at which 'negotiated agreements' were reached. They applied the event-study methodology to these events and found that "over the two-day event window [the day before through the day of the USA announcement that it had negotiated an agreement with a firm to alter its corporate governance structure] ... the average USA-sponsored agreement resulted in an abnormal stock price reaction of approximately 0.9%. This abnormal return represents a gain to shareholder wealth of approximately $39 million per firm or approximately $1.3 billion in total." Since the authors estimate an upper bound on the cost of the program at $22.75 million, the cost-benefit-ratio is highly favorable. Strickland et al. also tested for abnormal returns around adoption dates of poison pills and golden parachutes, proxy mailing dates, and the day of the annual shareholder meeting. Abnormal returns around these event-dates do not differ from zero.
In addition to the wealth gain due to negotiated agreements, the authors state, "Potential benefits from USA-sponsored activism are: (i) competitive pressures on other firms in the target firm industry, (ii) SEC regulation of executive compensation disclosure, (iii) increased activism by public pension funds, and (iv) more outspoken monitoring by some outside directors."
Like the previous authors, Opler and Sokobin focus on a group of underperforming firms. In this case, the 97 firms that appeared on the Council of Institutional Investors' (CII) focus lists in 1991, 1992, and 1993. The methodology used by the authors is to calculate mean and median one year holding period returns for the stocks on the CII focus list and then compare these returns to the returns for a number of benchmarks. One benchmark was the S&P 500. Other benchmark portfolios were created along the following dimensions: size, market risk, short-run performance, long-run performance, book-to-market ratio and industry performance.
As a result of their analysis, the author's conclude, "Council listed firms significantly outperform all benchmark portfolios." For example, when the CII firms are compared to the S&P 500, the CII firms generated returns that were at least ten percentage points higher in each sample year. "Over the full sample, the CII portfolio exhibits a mean return of 22.99% in the year after listing (median 19.4%) compared to the market return of 14.01% (median 10.46%). The results hold up as well when compared to the other benchmark portfolios.
The authors attribute this success to "coordinated monitoring and 'quiet' governance activism by institutional investors." They feel this approach is more successful than programs such as USA's for two reasons. First, the firms on the CII focus list were subject to "coordinated activism rather than individual campaigns run by a single pension fund," and, second, firms are looked at relative to when they first appeared on the focus list. The authors felt this was important because firms subject to public governance events such as proxy proposals are more likely to be the most recalcitrant and least likely to improve firms. The value of CII's list is that it creates an opportunity for coordinated, quite governance activism. Poor performing firms have both the incentive to improve and the non-adversarial support to do it.
While the previous two papers looked at the effects of specific targeting programs, Wahal performs a pooled analysis of all firms targeted by nine major institutional investors from 1987 to 1993. Over this seven year period he identified 356 independent targetings of 146 firms. Wahal then uses the event study methodology to test for the presence of abnormal returns around important dates in the targeting process: letter date (when the firm was informed it was a target), proxy mailing date, press announcement date, and earliest information date. He also tested for long term effects on stock price and on accounting measures of performance.
Wahal's results broadly confirm the previous event studies. First, institutions are relatively successful at actually getting corporations to accept their proposals about confidential voting, changing the structure of corporate boards, and redeeming poison pills. Second, despite this success, for the sample as a whole there is on average, a zero average abnormal return for shareholder proposals. However, Wahal does detect "a positive abnormal return for attempts to influence target firms that did not employ shareholder proposals (i.e. non-proxy targeting)." Finally, on long-term measures of performance -- long-term stock price, operating income, and net income -- the author finds no significant improvement in targeted firm's performance relative to a variety of benchmarks.
In sum, Wahal says his "results cast doubt on the efficacy of pension fund activism in improving firm performance." He goes on to say, "This lack of effectiveness suggests that shareholder activism is a poor substitute for an active market for corporate control." Significantly however, his finding that a "subset of firms subject to non-proxy targeting experience[d] significantly positive abnormal returns". This result confirms Nesbitt's findings for CalPERS, an institution that moved away from targeting firms for purely governance reasons and to targeting firms for performance reasons -- though often using proxies or the threat of proxies on governance issues as part of their overall strategy.
While the CalPERS, USA, and CII programs are formal, on going programs designed to identify firms with particularly poor governance structures or particularly poor performance relative to similar firms, institutional investors also put pressure on boards in order to bring about a change in management. While this tactic was particularly pronounced during the period October 1992 to December 1993 when the CEO's of six major long-term underperforming corporations were forced to resign, it was also used at a number of companies in 1990 and 1991. The power to force changes in top management at poor performing companies is the ultimate tool owners have to align management's interests with their own.
To estimate the importance of CEO turnovers Grundfest uses a case-study methodology to analyzes CEO terminations at four companies: Goodyear Tire & Rubber, Allied-Signal, Tenneco, and General Motors. In addition to detailed descriptions of crucial events at these four companies, Grundfest uses the event analysis methodology to determine whether excessive stock price changes occur in the days immediately surrounding the event. He also presents performance data over the year following the event in order to estimate the long-term impact of CEO turnover on performance.
Aggregating the results of his analysis Grundfest finds the "immediate stock price effects associated with CEO replacements at Goodyear, Allied-Signal, and Tenneco totaled more than $1.3 billion ... adding the gains associated with the April coup at General Motors, but conservatively excluding the gains associated with the October GM termination, brings the aggregate shareholder wealth increase to more than $2.7 billion."
In the longer term analysis the results are mixed. Goodyear and Allied-Signal substantially out performed the S&P 500 in the year and a half after the event. At Tenneco stock performance was not significantly different from the performance of the S&P 500. GM's stock performed slightly worse than the S&P 500 in the months after the events. Grundfest attributes this performance to the revelation of continuing problems at both companies and to the fact that the new CEO at Tenneco was diagnosed with brain cancer. In addition, he points out that both companies significantly underperformed the market for a substantial period before the CEO terminations so that merely matching the S&P 500 was an improvement. Grundfest also notes that looking for long term effects of specific events is a difficult conceptual task because of the multitude of other events that may occur subsequent to the event and which can be expected to affect stock price.
The studies presented in this section well represent the empirical work that has investigated the linkage between corporate governance and corporate performance. Those studies such as Donaldson and Davis that focus on direct links between governance features and performance generally fail to find a statistically reliable connection. Karpoff, Malatesta and Walkling also fail to find evidence that specific proxy proposals on governance issues translate into significant wealth gains. However, both Gordon and Pound and Blair do find evidence that anti-takeover measures reduce shareholder wealth. Apparently, except for measures that inhibit control changes, much more is at stake than specific features of good corporate governance such as board independence.
On the other hand, there does appear to be some considerable support for the proposition that active investors or investor associations such as CII or USA can effectively choose target firms and that the act of targeting itself may enhance shareholder value. Blair (particularly the Nesbitt study she cites); Opler and Sokobin; Strickland, Wiles, and Zenner, and Grundfest all provide evidence that targeting or, in the case of Grundfest, direct action at firms that have been identified as underperformers, can generate significant improvements in shareholder wealth. The implication appears to be that ownership matters even if specific governance features don't. A related and important implication, but one that has not been tested, is that it may be possible to improve the performance of all firms by simply targeting a few firms. The idea here is that expressed by John Biggs, Chairman and CEO of TIAA-CREF: "The significance [of shareholder activism] is not the three or four laggards you catch -- it's that you get the herd to run. We need to scare all the animals."
This observation leads to the question of the evolving role of institutional owners, not as sponsors of specific proxy proposals to change specific items of corporate governance, but as exercisers of the broad powers they possess as owners. In the next section we turn our attention to the evolving relationship between institutional owners and the companies in their portfolios -- to what is called 'relationship investing' by some and monitoring by others. Central to monitoring and perhaps relationship investing are the techniques that institutions have recently developed to deal with underperforming companies. In particular, the monitoring methods they have evolved and the various things they can do when called upon to act.