A Lawyer’s Guide to Empirical Corporate Governance

Debates about corporate governance ultimately rest on empirical studies that evaluate whether a particular type of governance enhances shareholder value. In recent years, lawyers have increasingly engaged with these studies, by either criticizing or praising them, and given them greater publicity. Likewise, judges in cases involving corporate governance matters such as anti-takeover devices and fiduciary duties have cited those studies when assessing the consequences of different governance mechanisms for firm value. The challenges for lawyers are that, first, many of them are not trained in statistical methods and econometrics and, second, many empirical studies reach conflicting results. Accordingly, it is difficult for lawyers to give their clients clear advice regarding which governance provisions to adopt.

In a recent article, I provide a guide to empirical corporate law that can inform lawyers’ understanding of such studies and their results. The key to evaluating empirical studies is to understand the strategies that underlie them. There are essentially three basic strategies. The first is to compare the value of firms with and without a specific governance provision: Are firms with the relevant provision more valuable than firms without it? The second is to evaluate what happens to firms’ values after they adopt or remove a governance provision. That is, we compare what happens to a firm that changes its governance with what happens to a firm that does not. The third is to evaluate the impact of a legal change, such as legislation or a judicial decision that requires firms to adopt a governance provision or to remove it. Thus, the question is what happens to firms after the law requires them to change their governance as compared with other firms unaffected by the law.

Each of these strategies may provide valuable evidence about the impact of different governance regimes. However, they all suffer from various weaknesses. Firms with a specific governance provision (e.g., dual-class structure) may be less valuable than firms without the provision simply because they are inherently less valuable, not because the governance provision made them so. The value of firms that adopt a governance provision (e.g., poison pill) may be affected by other confounding events (e.g., a transaction, such as a merger), rather than the provision. When examining the effect of a legal change, it is necessary to consider whether the relevant change actually made an impact on firm governance. For example, even if a law mandates a particular provision (e.g., staggered boards), it will only affect those firms that had not previously adopted it. But the affected firms may be of higher quality (perhaps because better managed firms avoid staggered boards) than firms that chose not to adopt the governance provision prior to the law. Thus, their value may have increased simply because these firms were better managed to begin with.

The guide explains how the different methodologies for evaluating the relationship between governance mechanisms and shareholder value work. The three main methods are (a) regressions that examine the association between Tobin’s Q, which is a popular (yet highly criticized) measure of firm value, (b) event studies that estimate the abnormal returns associated with governance changes, and (c) long-term portfolio analysis that assesses the returns on a portfolio of firms that adopted a specific governance mechanisms. These methodologies may be used in connection with each of the three strategies discussed above. For example, we can evaluate what happens to firms’ Tobin’s Q after they adopted a governance provision, or alternatively, how the stock market reacted to the adoption, or how a portfolio of firms that adopted the governance provision perform in the long run.

The assessment of empirical studies ultimately depends on common sense, practical experience, and a thorough study of the institutional setup. Lawyers, including law students, are well-positioned to form their opinions as to whether the imperfections of different strategies are particularly concerning or trivial in a given context. The plausibility of different empirical strategies may be subject to different interpretations, and in most cases, there is legitimate scope for policy debate even when results seem to point to specific outcomes. Thus, lawyers may still take views that appear to be inconsistent with the findings of a specific study based on their personal experience and subjective perspectives. However, in doing so, they should be able identify the weaknesses of that study, and ideally propose alternative tests that might yield different conclusions.

I also offer some thoughts on how lawyers can use their experience and insights to contribute to debates on corporate governance. Despite the staggering number of governance studies, there is a great deal that we do not yet know. We know relatively little about why various firms adopt different governance mechanisms. Some believe these provisions are adopted for substantive reasons, such as enabling managers to focus on long-term projects, others believe that they are adopted by insiders who seek to entrench themselves, and still others believe that governance is mostly determined in a crude process based on boilerplate lawyers’ advice or the recommendations of proxy advisers. Lawyers can shed light on the negotiation process in which governance is determined and the influence that different actors have on this process. Likewise, the way in which different governance provisions interact with each other is still relatively underexplored and poorly understood. For example, to the best of my knowledge, there are few studies that examine how antitakeover devices interact with exemption from the duty of loyalty, which effectively gives managers more latitude in takeovers, or perhaps more importantly with executive compensation that arguably gives managers incentives to focus on short-term shareholder profit-maximization.

Making advancements in empirical corporate governance studies requires not only empirical skills, but also nuanced institutional analysis, and a good dose of intuition about how managers and shareholders interact with one another. Lawyers’ expertise, insights and experience are thus critical for developing the theory and framework for such studies. Lawyers sometimes get frustrated that empirical studies do not yield conclusive results or are clouded by technical jargon. But lawyers have a stake in these studies because their clients seek their advice on related issues, and because these studies affect broader legal policies and corporate practice. Moreover, as data analysis becomes more sophisticated, lawyers’ input in study design will become increasingly important. This guide is an attempt to help lawyers understand the basic intuition underlying these studies and put them in a position to evaluate their significance for policy and practice.

This post comes to us from Ofer Eldar, a professor of law, economics, and finance at Duke University School of Law and the Fuqua School of Business. It is based on his recent article, “A Lawyer’s Guide To Empirical Corporate Governance,” available here.