What Matters in Corporate Governance?

Editor’s Note: This post is by Lucian Bebchuk, Alma Cohen, and Allen Ferrell of Harvard Law School.

This month’s issue of The Review of Financial Studies features our article, “What Matters in Corporate Governance?.”

The article investigates the relative importance of the 24 provisions followed by the Investor Responsibility Research Center (IRRC) and puts forward an entrenchment index based on six provisions: staggered boards, limits to shareholder bylaw amendments, poison pills, golden parachutes, and supermajority requirements for mergers and charter amendments. The article shows that increases in the index level are monotonically associated with economically significant reductions in firm valuation as well as large negative abnormal returns during our period of examination. The other eighteen IRRC provisions not in our entrenchment index were uncorrelated with either reduced firm valuation or negative abnormal returns.

Since the initial version of our study was first circulated in the fall of 2004, many researchers have used the entrenchment index we put forward. A list of over 75 studies using the index is available here. For those who might wish to use the entrenchment in subsequent research, data on firms’ entrenchment index levels during the period 1990-2007 is available here.


Below we describe the article’s results and contributions: There is now widespread recognition, as well as growing empirical evidence, that corporate governance arrangements can substantially affect shareholders. But which provisions, among the many provisions firms have and outside observers follow, are the ones that play a key role in the link between corporate governance and firm value? This is the question on which our article focuses.

Our investigation focuses on the universe of provisions that the Investor Responsibility Research Center (IRRC) monitors for institutional investors and researchers interested in corporate governance. The IRRC follows 24 governance provisions (the IRRC provisions) that appear beneficial to management, and which may or may not be harmful to shareholders. Prior research has identified a relationship between the IRRC provisions in the aggregate and firm value. In an influential article, Gompers, Ishii, and Metrick (2003) found that a broad index based on these 24 provisions, giving each IRRC provision equal weight, was negatively correlated with firm value, as measured by Tobin’s Q, as well as stockholder returns during the decade of the 1990s. Not surprisingly, a substantial amount of subsequent research has utilized this index (the “GIM index”) as a measure of the quality of firms’ governance provisions.

There is no a priori reason, of course, to expect that all the 24 IRRC provisions contribute to the documented correlation between the IRRC provisions in the aggregate and Tobin’s Q, as well as stock returns in the 1990s. Some provisions might have little relevance, and some provisions might even be positively correlated with firm value. Among those provisions that are negatively correlated with firm value or stock returns, some might be more so than others. Furthermore, some provisions might be at least partly the endogenous product of the allocation of power between shareholders and managers set by other provisions. In our article, we look inside the box of the IRRC provisions to identify which of them are responsible for the correlation between these provisions in the aggregate and firm value.

To develop a hypothesis for testing, we examine which IRRC provisions have systematically drawn substantial opposition from institutional investors, as well as conduct interviews with leading M&A practitioners. Based on our analysis, we hypothesize that six provisions among the 24 provisions tracked by IRRC play a significant role in driving the documented correlation between IRRC provisions and firm valuation. Of the six provisions, four set constitutional limits on shareholder voting power, which is the primary power shareholders have. These four arrangements—staggered boards, limits to shareholder amendments of the bylaws, supermajority requirements for mergers, and supermajority requirements for charter amendments—limit the extent to which a majority of shareholders can impose their will on management. Two other provisions are the most well-known and salient measures taken in preparation for a hostile offer: poison pills and golden parachute arrangements.

We construct an index, which we label the entrenchment index (E index), based on these six provisions. Each company in our database is given a score, from zero to six, based on the number of these provisions that the company has in the given year or month.

We first explore whether these entrenching provisions are correlated with lower firm value as measured by Tobin’s Q. We find that, controlling for the rest of the IRRC provisions, the entrenching provisions—both individually and in the aggregate—are negatively correlated with Tobin’s Q. Increases in our E index are correlated, in a monotonic and economically significant way, with lower Tobin’s Q values. Moreover, the provisions in the E index appear to be largely driving the correlation that the IRRC provisions in the aggregate have with Tobin’s Q. We find no evidence that the eighteen provisions not in the E index are negatively correlated, either in the aggregate or individually, with Tobin’s Q.

Of course, the identified correlation between entrenching provisions and lower firm valuation does not necessarily indicate that entrenching provisions produce lower firm valuation; the correlation could be at least partly the product of the tendency of managers of low value firms to adopt entrenching provisions. It is worth noting that even if the identified correlation between low Tobin’s Q and high entrenchment were traceable to the tendency of low-Q firms to adopt high entrenchment levels (for some firms this occurred in the mid-1980s), it would have still been possible for entrenchment to play a key role in enabling the low-Q firms to retain their low-Q status. A high entrenchment level might protect low-Q firms from being taken over or forced to make changes that would raise their Tobin’s Q. Indeed, such an effect is presumably why low-Q firms might wish to adopt and retain a high level of entrenchment.

In any event, to explore this issue, we examine how firm valuation during the last five years of our sample period is correlated with firms’ entrenchment scores as of 1990. We find that, even after controlling for firm valuation in 1990, high entrenchment scores in 1990 are negatively correlated with firm valuation at the end of our sample period. In addition, in firm fixed effects regressions controlling for the unobserved time-invariant characteristics of firms, we find that increases in the E index during our sample period are associated with decreases in Tobin’s Q. Both of these results suggest that the identified correlation between entrenchment and low Q is not fully the product of the low Q that firms adopting high entrenchment levels had in the first place.

We also study the extent to which the six provisions in the index are responsible for the documented correlation between the IRRC provisions and reduced stockholder returns during the 1990s. We find that the entrenching provisions were correlated with a reduction in firms’ stock returns both during the 1990–2003 period we examine. A strategy of buying firms with low E index scores and, simultaneously, selling short firms with high E index scores would have yielded substantial abnormal returns. To illustrate, during the 1990-2003 period, buying an equally-weighted portfolio of firms with a zero E index score and selling short an equally-weighted portfolio of firms with E index scores of five and six would have yielded an average annual abnormal return of approximately 7%. In contrast, we do not find evidence that the eighteen IRRC provisions not in our E index are correlated with reduced stock returns during the time period we study. Our return results reinforce the significance that the E index provisions have among the larger universe of IRRC provisions.

Our identification of the provisions that matter within the universe of IRRC provisions contributes to work in corporate governance in several ways. First, our index can be used, and has already been extensively used, by work seeking to examine the association between shareholder rights and various corporate decisions and outcomes. To the extent that the eighteen provisions in the GIM index that are not in the E index represent “noise,” the E index can be useful by providing a measure of corporate governance quality that is not affected by the “noise” created by the inclusion of these provisions.

In addition, our work contributes by identifying a small set of provisions on which future research work, as well as private and public decision-makers, may want to focus. Knowing which provisions are responsible for the identified negative correlation between the IRRC provisions and firm performance can be useful for investigating the extent to which governance provisions affect (rather than reflect) value. In addition, to the extent that the identified correlation between the provisions in our E index and firm value at least partly reflects a causal relation going from entrenchment to firm value, these provisions are ones that deserve the attention of private and public decision-makers seeking to improve corporate governance. Indeed, even if the correlation was fully driven by the desire of firm insiders at low-valued firms to protect themselves, it would be beneficial for researchers and decision-makers to know the provisions on which such protection efforts are concentrated.

Finally, although our investigation is limited to the universe of IRRC provisions, our findings have significant implications for those investigating other sets of governance provisions. In particular, our findings cast some doubt on the wisdom of an approach recently followed by shareholder advisory firms. Responding to the demand for measures of the quality of corporate governance, some shareholder advisory firms have developed and marketed indexes based on a massive number of governance attributes. The influential shareholder advisory firm Institutional Shareholder Services (ISS, now operating under the RiskMetrics name), has developed a governance metric based on 61 elements. Governance Metric International has been even more ambitious, including more than 600 provisions in its index. The development and use of these indexes has put pressure on firms to change their governance arrangements in ways that will improve their rankings.

Our results indicate that this “kitchen sink” approach of shareholder advisory firms might be misguided. Among a large set of governance provisions, the provisions of real significance are likely to constitute only a limited and possibly small subset. As a result, an index that gives weight to many provisions that do not matter, and as a result under-weighs the provisions that do matter, is likely to provide a less accurate measure of governance quality than an index that focuses only on the latter. Furthermore, when the governance indexes of shareholder advisory firms include many provisions, firms seeking to improve their index rankings might be induced to make irrelevant or even undesirable changes and might use their improved rankings to avoid making the few small changes that do matter. Our results suggest that it would be best for future practice to focus not on a large set of governance provisions but on the small number of key provisions that matter.

Our article is available here.

Both comments and trackbacks are currently closed.


  1. J. George Pikas
    Posted Thursday, February 26, 2009 at 2:44 pm | Permalink

    The 61 elements used by RiskMetrics is no more misguided than the narrower set used in the Entrenchment Index. Both miss the point and reflect how easily academics and well intended interest groups can have their attention diverted to arguing data points related to counting angels on the head of a pin. For years.

    The problem is that corporate governance has become corrupted by the Delaware courts and share owners have been reduced to distant speculators and part of the lumpy stew of various “stakeholders”.

    The better idea is to reset the governance framework rather than suffer through continual, ineffectual gnawing on the ankles of the vested interests. The answer is to federalize corporate governance laws and give governance primacy to share owners. Then, let everything re-sort and re-balance.

    Here’s a few thoughts that go with that.

    Delaware’s chancery court and supreme court are the arbiters of governance cases and have used the “business judgment” rule to defer to boards under the claim of not second guessing decisions that would be made by a ‘prudent business person’. Case law interpretations allow boards to make decisions to the detriment of share owners if there is an argument that a decision is in the best interest of the corporate entity. And, this is where the corruption takes hold. Because share owners are a broad, diversified, sometimes unruly, and often emotionally disconnected bunch, Delaware courts interpret a board’s ‘Duty of Care’ in favor of the corporate entity and have created a sweet spot for abuse by the hired corporate agents. The result is egregious executive salaries, high living and high risk taking by the leadership.

    Delaware courts have become the enabler for this abuse by gutting the Duty of Care. Boards merely have to show that they followed a process in their decision making that is somewhat defensible. Any ritualistic process seems to work for the courts as a defense regardless of the outcome or pain to the share owners.

    An equally significant problem is that share owners have been conditioned to be simply speculators in pieces of paper or they have entrusted intermediaries to make stock buy decisions with their money. This has degraded to the point that mutual funds and institutions represent 60%-70% of the share ownership. The individual interested share owner is a minority and vast numbers of people allow intermediaries to make the stock buy decision for them. They have no clue as to what stock they “own”. The intermediaries’ interest in corporate governance swings from none to somewhat. So, from the view at the bottom where the individual investor is, there are varying layers of representation and legality that effectively insulate boards from accountability. Boards do as they wish because they can.

    Federalization of corporate governance will eliminate state level confusion and end Delaware’s choke-hold on common sense. President Obama has just shown that it’s doable in the limited scope he chose in regard to TARP money and CEO compensation.

    Equally important, good thinking and new processes are needed to re-condition the baseline investor to either participate in governance or to knowingly abdicate his voting interest. I personally favor a future where all public company boards and executive leadership are in a steady state of being terminated with an Internet based “continuance vote” every 6 months or so by the share owners. The technology is there to do it. But, the vested interest have be overcome and the stock owners at the bottom of the pyramid have to be be enabled to do more than complain when various intermediaries loot their wealth. Imagine a future where a stock owner can exercise his ownership rights by directly voting on governance matters or even selling his voting rights to the highest bidder. That will reinvigorate capitalism in America. And, it will provide a wealth of new research opportunities for academics as well as billable hours for the lawyers.

    Thank you.

  2. Jerry
    Posted Monday, March 2, 2009 at 1:00 pm | Permalink

    Is this data valid for the current market given its volatility?