Rewards for good behaviour: better corporate governance pays
Vidhi Chhaochharia, Luc Laeven, 6 June 2007
Since Enron, WorldCom, Parmalat and a series of lesser scandals from 2001 onwards exposed the vulnerability of investors and workers to corporate malfeasance, governments have stepped in to tighten legal constraints on corporate governance – and shareholders have become increasingly focused on influencing the way firms are run.
‘Compliance’ with these new pressures has become an increasingly onerous part of the day-to-day running of big businesses, and many companies complain about the costs of tightening up their procedures. Two new CEPR research papers provide evidence that it’s worth their while: better corporate governance means a higher stock market valuation - and healthier financial performance.
CEPR Research Affiliate Luc Laeven and his co-author Vidhi Chhaochharia examine the rewards that accrue to companies prepared to go further than the laws or common corporate practices of their home market require.
They construct a ‘governance index’, using data collected by investor group Institutional Shareholder Services. It includes eight criteria about a firm’s constitution, including whether it has an unfair dual-class ownership structure, with some shares carrying weaker voting rights; whether the board can use ‘poison pill’ arrangements to block a potential takeover; and whether shareholders have the power to demand special meetings.
Using data from 2,300 firms, across 23 countries, the authors calculate the average corporate governance standard for each country, and compare the market valuations of companies which fall above and below that hurdle.
There are wide variations across countries. Firms listed in Israel and Luxembourg had the highest average score on the governance index, at 7, while companies based in the Cayman Islands had the lowest, at 2. Only in the US and France do firms attain the top score, of 8 – although variation within those countries is wide.
Notwithstanding these differences, across the 23 countries as a whole, firms that show their commitment to corporate governance by adopting higher standards than the average within their home country tend to have higher stock market valuations than their below-average peers. The authors suggest these firms may get access to cheaper finance, by signalling their intent to be better than the rest of the pack; or their stricter constitutions may be a credible commitment device, showing investors the firm will force itself to stick to the rules.
Not only do firms with stricter-than-average by-laws tend to have higher market valuations; they also offer stronger performance. The ISS data covers three years, from 2003 to 2005, making it possible to trace the performance of companies over that period. Chhaochharia and Leaven find that buying a portfolio of firms with an above-average score on the governance index for their country in 2003 would have generated a 19% return over the following two years. A portfolio of firms with below-average scores would have returned just 13%.
Chhaochharia and Laeven believe their results suggest that the ‘invisible hand’ of the market has a role to play in encouraging better corporate governance standards, and punishing firms that refuse to bring their behaviour up to the standards of their peers.
Few governments are willing to leave corporate governance to the invisible hand alone, however, and CEPR Research Fellow Paola Sapienza and her co-authors Yael Hochberg and Annette Vissing-Jorgensen have studied the impact of a particular piece of US legislation, the hugely controversial Sarbanes-Oxley Act, which was aimed at improving transparency and ensuring that a firm’s board could be held responsible for any financial misreporting.
Sarbanes-Oxley was passed in July 2002, as a direct result of Enron, WorldCom and other high-profile scandals. After the Act was passed, the job of drafting and implementing it was handed to the market regulator, the Securities and Exchange Commission, which began a consultation process, to ask the opinion of investors and corporations.
By examining the hundreds of letters sent to the SEC during that process, supporting or condemning elements of the Act, the authors identify which firms lobbied against the strictest implementation of it – and therefore which were likely to be most affected by the change in the law.
These ‘anti-Sarbanes Oxley’ firms generated cumulative returns 10% higher than the rest of the market in the four and a half months running up to the legislation’s being passed. Hochberg et al say that’s because investors were able to tell which firms would be most affected, and bet on their performance improving once they were forced to comply.
After the legislation was implemented, there was no difference between the performance of lobbiers and non-lobbiers, suggesting that the costs of complying with the new law didn’t swamp its benefits.
For firms feeling the pinch of stricter corporate governance standards, the findings of both these papers offer some comfort. When new rules bite, investors expect there to be financial benefits, and favour the firms most affected; and for companies prepared to take the moral high ground and go further than the law demands, there are rewards in the form of higher valuations, and better performance.
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