Corporate Governance: A
Review of Current Research
Alexander Settles
Sources of Research Agenda
• Finance
– Agency theory – investigation of different
corporate governance practices and firm
performance
• Law
• Management
– Firm life cycle
– Stakeholder analysis
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
Research
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Board characteristics and composition
Resource dependency approach
Transaction costs theory
Role and effects of independence of nonexecutive directors
• Codes of best practice
• Internal and external control mechanisms
Research
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Board processes
Effects of duality of CEO role
Stewardship theory
Executive compensation
Managerial stock ownership and
performance
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.
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)
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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.
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Examples: Sloan (1996), Collins and Hribar (2000)
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)
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Relation between current performance and future cash
flows
Relation between current performance and security prices
(Easton 1985)
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
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Does not assume accounting reports are only source of
information to market
No causal connection is inferred
Information Content of Earnings,
Cash Flows, and Accruals
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Evidence: Accounting matters
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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)
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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)
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)
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.
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)
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
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
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
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
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.
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?
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?
La Porta et al. 1998
• Unit of analysis – country; generalized to
legal family
• Methods – statistical analysis of investor
protection; student t-test
La Porta et al. 1998
• Independent Variables
– Country
– Legal Family
• Dependent variables
– Shareholder rights
– Creditor rights
– Enforcement
– Ownership
Results
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
Shleifer and Vishny 1997
• Agency problem
– Contracts
– Managerial Discretion
– Incentive Contracts
– Evidence on agency problem – does it exist?
• How to solve?
Shleifer and Vishny 1997
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Finance without governance – reputation
Legal Enforcement of Rights
Large Investors
Takeovers
Large Creditors
Shleifer and Vishny 1997
• Debt versus equity choice
• LBO
• Cooperatives and State ownership
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.
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
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
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
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
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
Jensen 1993
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How to improve CG?
Board culture
Information problems
Legal liability
Oversized boards
No shareholder democracy – but more
activism
• Separate CEO and Chair
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)
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)
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)
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 a study 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.
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
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