What Matters in Governance?

In the past 20 years, many corporate law scholars have come to the view that governance arrangements protecting incumbents from removal are what really matter for firm value, arguing that such arrangements help entrench managers and harm shareholders. A major factor supporting this view has been the rise of empirical studies using corporate governance indices to measure a firm’s governance quality. Providing seemingly objective evidence that protecting incumbents from removal reduces firm value, these studies have encouraged the idea that good corporate governance is equivalent to stronger shareholder rights.

In our recent article, we challenge this idea, presenting new empirical evidence that calls into question prior studies that rely on corporate governance indices and developing a novel theoretical account of what really matters in corporate governance.

In revisiting the results of these studies, we focus on the entrenchment index or E-Index, introduced in 2009 by Lucian Bebchuk, Alma Cohen, and Allen Ferrell (BCF). The E-Index provides evidence that six entrenchment provisions matter the most for firm value: staggered boards, poison pills, golden parachutes, supermajority requirements for charter amendments, supermajority requirements for bylaw amendments, and supermajority requirements for mergers. As of March 2017, over 300 empirical studies have used the E-Index as a measure of governance quality, suggesting that this index has become a standard reference to define entrenchment and, hence, “bad” governance. Yet, in estimating the association between the E-Index (and each of its six constituent components) and firm value, BCF only relied on a 12-year period (from 1990 to 2002). We rely on a much more comprehensive dataset over a much longer period (from 1978 to 2008), allowing for a more robust statistical analysis of the association between corporate governance and firm value.

Our empirical findings call into question the kitchen sink approach to incumbent protection from removal adopted by the E-index. In contrast to that approach’s assumption that any form of incumbent protection harms shareholders, we show that only protective arrangements that can be unilaterally adopted by directors—poison pills, golden parachutes, and supermajority requirements to amend the bylaws—are associated with decreased firm value and hence fit the entrenchment theory of incumbent protection. Conversely, protective arrangements that require shareholder approval—staggered boards, supermajority requirements to amend the charter and supermajority requirements to approve mergers—are associated with increased firm value. This finding suggests that these bilateral arrangements serve a constructive, rather than detrimental, governance function.

We suggest that the constructive governance function of these bilateral arrangements is as devices that commit shareholders to preserve a board’s ability to pursue long-term strategies that maximize firm value. Absent such devices, shareholders have no basis on which to decide not to challenge the board or seek board removal, or dump their shares after a disappointing short-term outcome. This is because shareholders are unable to tell whether such an outcome is due to mismanagement or to the pursuit of a project whose value will not be realized until later, which leads to what we refer to as the shareholders’ “limited commitment problem.”  In response to this problem, directors and managers may rationally favor short-term stock price gains over long-term cash flows. Similarly, shareholders’ inability to commit to the long term absent some ex-ante commitment devices may distort the incentives of other firm stakeholders, including employees, customers, suppliers, and creditors. Indeed, these stakeholders may be induced to make sub-optimal investments in a firm if the specificity of their investments make them vulnerable to short-term changes in investment policy. In either case, the result is reduced firm value in the long run.

Consistent with this theoretical approach, and the results two of us have described in a forthcoming article in the Journal of Financial Economics regarding staggered boards (see Cremers, Litov, and Sepe, 2017), we document that the use of bilateral protection arrangements is more valuable to firms where the limited commitment problem of shareholders appears to be more severe—such as firms with more long-term innovation, and firms for which firm-specific investments by non-financial stakeholders (such as employees and customers) are likely to be more important.

Overall, our theoretical and empirical results suggest that committing firm and shareholders to the long-term matters as much as—and potentially more than—reducing entrenchment in corporate governance. Therefore, stronger shareholder rights are not an all-purpose remedy in corporate governance. Rather, the traditional board-centric model of the corporation seems better positioned to respond to the market imperfections that make shareholders unable to commit to long-term value creation. It can do so by ensuring that directors and managers benefit from protection in the short-term, when they are more likely to have competitive information that the market lacks, without depriving shareholders of the ability to discipline firm insiders in the longer-term. After all, a staggered board does not permanently remove directors from the judgment of the market. On the contrary, it provides shareholders with more time and better information for evaluating directors. Similarly, supermajority requirements to amend the charter and to approve mergers do not reduce long-term accountability for directors but do strengthen board authority in the short-term.

Our analysis also has noteworthy policy implications. Proxy advisors have given tremendous credibility to the practice of using governance indices to support shareholder empowerment. Indeed, the governance indices used by such firms share not only the methodology of academic indices, but also the assumption that enhanced shareholder rights are unequivocally good. This creates a potential conflict of interest, because supporting stronger shareholder rights promotes increased shareholder activism, which, in turn, leads to more voting advisory activity and increased revenues for proxy advisors. In response, the Securities and Exchange Commission should, as a first step, require disclosure of the proprietary algorithms used in the construction of commercial indices to encourage more transparency and discussion about the governance recommendations provided by proxy advisors. Similarly, our evidence challenges the reforms that have increasingly sustained shareholder empowerment in the past two decades. Policymakers would do well to reconsider the case for limiting shareholder power in the short-term and the direction governance policies ought to take to support long-term value creation.

This post comes to us from Professor Martijn Cremers at the University of Notre Dame’s Mendoza College of Business, Visiting Professor Saura Masconale at the University of Notre Dame Law School (starting Fall 2017), and Professor Simone M. Sepe at the University of Arizona’s James E. Rogers College of Law. It is based on their recent article, “Commitment and Entrenchment in Corporate Governance,” available here.