A Dissertation
by
THEODORE CLARK MOORMAN
Submitted to the Office of Graduate Studies of
Texas A&M University
in partial fulfillment of the requirements for the degree of
DOCTOR OF PHILOSOPHY
May 2005
ABSTRACT
Extant literature finds that long-term abnormal stock returns are generated by a strategy based on corporate governance index values (Gompers, Ishii, and Metrick 2003). The result is inconsistent with efficient markets and suggests that information about governance is not accurately reflected in market data. Control firm portfolios are used to mitigate model misspecification in measuring long-term abnormal returns. Using a number of different matching criteria and governance indices, no long-term abnormal returns are found to trading strategies based on corporate governance. The effect of a change in governance on firm value is mixed, but some support is found for poor governance destroying firm value. These results have a number of implications for practitioners, researchers, and policy makers.
Introduction
Corporate governance has been a recent source of interest to investors, policy makers, and corporations. In the wake of recent corporate scandals, investors have asked what must be done to get corporations to maximize shareholder weatlh. Policy makers have responded by passing legislation requiring corporate governance standards. Corporations have been working, not always without complaint, to meet the demands of the new laws.
In Jensen and Meckling’s (1976) framework, the best interest of the agent- manager is not always aligned with the principal-owner. The structure of monitoring devices to align the interests of principals and agents describes a firm’s corporate governance characteristics (Farinha 2003). Researchers, corporate managers, and shareholders are interested in the relationship between corporate governance and firm value. A manager with partial ownership does not bear the full consequences of her actions and has incentives to deviate from maximizing shareholder wealth.
Consequently, the value of the firm will be less than it would be if the manager had full ownership. However, separating ownership and control has a purpose. Managerial skill and wealth endowment are often mutually exclusive. Additionally, diffuse ownership allows the bearing of risk to be shared (Fama and Jensen 1983). Researching the effect of corporate governance on firm value attempts to address whether sufficient monitoring mechanisms exist. Can a manager with partial ownership act more like a manager with full ownership who is also willing to bear a large degree of risk?
1.1.2 Views of Governance and Firm Value
Researchers hold a number of views about the effect of corporate governance on firm value. The clearest dichotomy in the views is that either corporate governance affects firm value or it does not. The nuances of each view have received the majority of the attention in the literature.
The view that governance affects firm value considers the costs of agency to besignificant. Governance mechanisms should be effective in reducing agency costs. One nuance is that adding a particular governance mechanism improves firm value for all firms insofar as the mechanism can be added. This could be called the no costs nuance. An example is Agrawal and Chadha’s (2005) study of the effect of boards of directors arrangements on accounting earnings restatement announcements. Negative abnormal returns around earnings restatement announcement dates suggest that earnings restatements destroy firm value (Palmrose, Richardson, and Scholz 2004). Agrawal and Chadha (2005) study legislation from the Sarbanes-Oxley act. The act requires at least one financial expert on the auditing committee of the board of directors. Agrawal and Chadha (2005) find a lower likelihood of accounting earnings restatements for companies with a financial expert on the board of directors auditing committee. The simple addition of a single governance mechanism, a financial expert on the board of directors auditing committee, is found to improve firm value.
Another nuance consistent with governance affecting firm value is that governance mechanisms have costs and benefits. All corporations can trade off the costs and benefits of a governance mechanism to maximize firm value. The costs and benefits nuance is consistent with Stulz’s (1988) model of how the extent of managerial ownership affects takeover premiums and takeover likelihood. As an inside manager’s ownership share increases, an outside bidder must offer a higher premium to make a successful bid; however, the gain for a bidder from a takeover decreases with the bid price. If a takeover bid price is too high, no bid will take place. Managers will be entrenched and will have fewer reasons to maximize shareholder wealth. An optimal level of managerial ownership trades off the premium obtained from a higher bid and the value destruction from entrenched management in the case of low takeover probability. Morck, Shleifer, and Vishny (1988) test Stulz’s (1988) theory. Firm value, as approximated by Tobin’s Q, increases in board ownership of zero to five percent, decreases in board ownership of five to twenty five percent, and increases in board ownership above twenty five percent. Morck, Shleifer, and Vishny (1988) interpret the non-linear relationship between ownership and firm value as supporting Stulz’s (1988) theory of an optimal level of ownership over most of the ownership level range. The highest levels of ownership reflect close alignment of principal-agent interests because of less separation of ownership and control. For firms with relatively diffuse ownership, this evidence implies that the marginal benefits of increased incentive alignment must equal the marginal costs of increased entrenchment when determining the best ownership level for the firm.
A few differences can be seen immediately in the implications of the no costs and the costs and benefits nuances. The no costs nuance implies that if the addition of a certain governance mechanism increases firm value, firm value should be improving insofar as one can keep adding that governance mechanism. I will illustrate why the no costs nuance is extreme and suggest that most of the governance literature has not argued for the no costs nuance. Yermack (1996) in a study on board size finds that smaller boards are associated with greater firm value. Small boards improving firm value supports arguments made by Jensen (1993) that large boards are ineffective. To the extent that a smaller board size causes greater firm value, the no costs nuance implies that board members continually be taken away to increase firm value. The problem with following such advice is that only a board of made up of management or no board at all (a legal impossibility) would remain. Management would be unmonitored and unrestrained. From the outset, the governance literature has not taken the no costs view. Jensen and Meckling’s (1976) seminal work focuses on the costs of diffuse ownership. They also point out that diffuse ownership creates value since entrepreneur managers are often wealth constrained. The costs and benefits nuance is at least more realistic than the no costs nuance.
Governance may affect firm value significantly. However, most firms may have optimal governance structures. In this case, a relationship between any single governance mechanism and firm value cannot be detected by a researcher. This could be called the optimality nuance. Demsetz and Lehn (1985) provide some of the economic intuition behind the optimality nuance. In finding no relationship between ownership structure and firm performance they conclude that no relationship should be expected. When shareholders make conscious decisions about ownership structure, they understand the costs and benefits of a particular ownership structure on firm value. Controlling for the other determinants of firm value and accounting for the way ownership concentration varies with firm characteristics, no relationship between ownership concentration and firm value should be expected.
Governance may affect firm value significantly and no relationship can be observed empirically for a number of reasons. First, a number of governance mechanisms may be close substitutes or complements for each other. In this case, no single governance mechanism would be necessary to solve agency conflicts. Any optimal combination of governance mechanisms would be sufficient. After controlling for the interdependence among a number of governance mechanisms, Agrawal and Knoeber (1996) detect only a negative effect of board outsiders on firm performance.
Governance mechanisms included in the study are the use of debt, the market for managers, and the market for corporate control, inside shareholding, institutional shareholding, block shareholding, and board outsiders. A second reason for observing no empirical relationship between governance and firm value may be that amenity potential and severity of agency costs may vary from firm to firm and by industry. In this case, the unique situation that each firm faces plays an important role in choosing governance. There can be no single governance standard improving value for all firms. Kole and Lehn (1999) argue that firms change their governance structure in response to a change in the underlying firm environment. Deregulation in the airline industry appears to cause a change in a number of governance mechanisms. Finally, since all firms have incentives to choose the best form of governance no empirical relationship may be observed between firm value and governance. Shareholders desire the maximization of firm value. If inadequate governance is chosen and high agency costs are unrestrained, investors would move capital to better forms of governance. Firms with high agency costs and poor governance structures may have difficulty surviving competitive product markets with insufficient capital.
Differences and similarities between the costs and benefits nuance and the optimality nuance should be noted. The costs and benefits nuance implies that a relationship between governance and firm value can be observed empirically for all firms. If such a relationship is detected, many firms are not choosing governance optimally. Hermalin and Weisbach (2003) suggest that this is an out-of-equilibrium phenomenon that calls for a particular governance standard to be encouraged or mandated. In this instance, some firms are not choosing an optimal form of governance.
Both nuances fall under the heading of governance affecting firm value. In the case of the optimality nuance, firms are on average choosing the optimal solution to agency problems. Governance is not ineffective. On the contrary, governance is effective – so effective that most firms have made sure their governance structures are optimal. In direct contrast to governance having an important and material effect on firm value is the view that governance has no effect on firm value. Two related nuances are worth mentioning. First, governance may have no effect on firm value because governance is powerless or ineffective in curbing agency costs. This could be called the ineffectiveness nuance. Jensen (1993) could come close to this view in citing the failure or shutdown of a number of governance mechanisms. Jensen’s suggestions for reforming governance mechanisms indicate that governance mechanisms could be effective but are not effective currently.
A second nuance to governance having no affect on firm value is that agency costs are minimal at best. This could be called the no agency costs nuance. Literature declaring that no agency costs exist is scant. With billions of dollars destroyed in the wake of the most recent corporate scandals, agency costs seem to be substantial. Perhaps voicing this view would suggest something counter to what seems obvious about human nature. When humans are given the opportunity to use corporate resources according to their own preferences and without bearing large costs of doing so, they will. Finally, a third view may bridge a gap between views arguing for the effectiveness or complete ineffectiveness of governance. This could be called the trivial effect view. Governance may affect firm value and agency costs may be real, but the impact of governance on firm value could be viewed as trivial in comparison with other economic factors. A recent paper questions the importance of corporate governance. Larcker, Richardson, and Tuna (2004) use principal components analysis to construct common governance factors. Governance explains only a small portion of the variation in a number of dependent variables related to firm value or firm performance. In addition, many of the governance variables often have unexpected signs. Larcker, Richardson, and Tuna interpret the relatively weak explanatory power of corporate governance as inconsistent with claims often made by academics and consultants regarding corporate governance.
1.1.3 Methodological Issues in Studying the Effect of Governance on Firm Value
The difficult task for a researcher involves distinguishing between the many different views of the effect of governance on firm value. The methodological hurdles are many. The most severe methodological hurdle may be the problem of endogeneity. Least squares estimation assumes independent variables are non-stochastic or are uncorrelated with regression error terms. Violations of this assumption result in biased coefficient estimates. Endogeneity is econometrically defined in this manner.
A primary manifestation of endogeneity in governance studies arises because explanatory governance variables are often determined simultaneously with dependent variables related to firm value. A third omitted variable might determine both governance and firm value (Hermalin and Weisbach 2003). As a result, researchers may detect a spurious correlation between governance and firm value. The simultaneous equations bias proves troubling in examining a cross section of firms because one is unable to see how adjustments are made to shocks in the system. Because variables of importance are determined simultaneously, the researcher faces the problem of determining the direction of causality. A related question in the governance literature has been whether board composition determines firm performance or firm performance determines board composition. A portion of the literature studying this question in a simultaneous equations framework has concluded that firm performance determines board composition (see Agrawal and Knoeber 1996 and Bhagat and Black 2002).
Among proposed solutions to the problem of endogeneity, two econometric methodologies have received attention in the literature. One solution has been to search for instrumental variables for the endogenous or predetermined variables of interest in a system of equations. Instrumental variables are to be an exogenous set of variables that come close to approximating the endogenous variables in the system of equations. The new approximated variable of interest should be exogenous and uncorrelated with the error term in a set of equations. Palia (2001) uses the instrumental variables approach to explore the relationship between firm value and managerial compensation. He finds an insignificant relationship between firm value and compensation. Palia interprets the insignificant relationship as an equilibrium condition in which firms choose the compensation mechanism of governance according to the contracting environment. A number of problems may arise in the instrumental variables approach. It may be difficult to determine which variables in a set of equations are exogenous. Instruments for the endogenous variables in a system may be difficult to find. Exogenous instruments may poorly approximate the endogenous variable of interest. If instrumental variables are too highly correlated with the endogenous variable they approximate they may also be correlated with the error term.
Another solution to the problem of endogeneity has been the use of panel data fixed effects. One source of endogeneity may be omitted variables related to firms, industries, or years. The effects of omitted variables are captured in the error term of a regression equation. If the error term is correlated with independent governance variables of interest, coefficient estimates on governance variables will be biased. To control for the effects of variables related to firms, industries, or years a fixed effects panel data model looks at the variation of governance variables of interest within firms, within industries, or within years. Himmelberg, Hubbard, and Palia (1999) use panel data fixed effects to control for differences in firm contracting environments possibly related to firm value. In doing so, they find no significant relationship between managerial ownership and firm performance. They interpret different levels of managerial ownership across firms as an “optimal incentive arrangement.” Like the instrumental variables approach, a panel data fixed effects model is limited in controlling for omitted variables. If the variable of interest in a regression equation is time invariant, as is often the case with governance studies, a fixed effects model will “wipe out” the variable and not allow for any interpretation. Zhou (2001) critiques the study by Himmelberg, Hubbard, and Palia (1999) on these grounds because managerial ownership is rather time invariant. Fixed effects can account for unobservable or omitted time invariant variables. If an omitted or unobservable variable changes over time, fixed effects cannot control for the influence of this variable on test results.
Another solution to the endogeneity problem is observing how an exogenous shock to one of the variables in a system of equations affects the other variables. Dahya and McConnell (2002) use a “natural experiment” to examine changes in corporate behavior. The U.K.’s Cadbury Report recommended at least three outsiders on a firm’s board of directors. This recommendation would later be mandated. Dahya and McConnell find an increase in the number of outside directors after the Cadbury Report is accompanied by an increase in the likelihood of an outside CEO appointment. Outside CEO appointment announcements are accompanied by positive abnormal stock returns. From this evidence, outside directors appear to make better decisions positively affecting firm value. A number of obstacles arise in conducting a natural experiment. The first may be in identifying the exact timing of the shock. Large macroeconomic events do not happen in isolation. A number of confounding events may also occur whose effects could be the economic catalyst for change in a given variable. Also debatable is whether a given event is truly a shock or a self-selected event. If firms respond immediately and optimally to a given shock, no relationship would be observed between governance and firm value even though the effects of governance structures on firm value could be substantial.
Another method attempting to bypass endogeneity issues in the study of how corporate governance affects firm value is the event study. Event studies examine the stock price reaction around the announcement date of a corporate event. (Long-run event studies look at stock price performance up to five years after an event date. Long- run event studies test the efficient markets hypothesis). Coates (2000) provides a survey of event studies on the adoption anti-takeover amendments. He points out that event studies assume stock prices are unbiased estimates of firm value. Even if stock prices are inaccurate, they are off by an amount close to zero on average in large samples. Coates concludes that the majority of the event study literature is inconclusive about the effect that anti-takeover amendment adoption has on firm value. He also provides a few problems encountered in interpreting event study evidence. Confounding announcements may have a material impact on event study outcomes. Since events are often self-selected, the stock price reaction to an event may be towards signaling information conveyed by an event rather than the event itself. For instance, Coates (2000) suggests a “shadow pill” is always present for firms. Since firms can easily adopt poison pills and similar anti-takeover amendments, actual adoption of a pill conveys nothing about the effect of a pill. Instead, pill adoption may convey that the manager of a firm has private information (about takeover prospects, etc.).
1.1.4 Conclusion
A number of views can be found in the literature discussing the effect of governance on firm value. Distinguishing between the many views of governance can be difficult. For instance, detecting no empirical relationship between governance and firm value may lead one to conclude that governance has no effect on firm value. Another may conclude that firms choose governance optimally and governance plays an important role in mitigating agency costs. In attempting to distinguish between views of governance, a researcher must overcome the problem of endogenously chosen governance structures. Most empirical technology is limited in producing inferences with clear indications of causality. On a brighter note, these are a few reasons why corporate governance has been and is likely remain an area for fruitful research.
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