The Elusive Quest For Global Governance Standards

The Harvard Law School Program on Corporate Governance recently issued The Elusive Quest for Global Governance Standards, a discussion paper I co-authored with Professor Assaf Hamdani. The paper is scheduled for publication in the University of Pennsylvania Law Review. Our slides from a recent presentation of the paper at the Sloan Foundation corporate governance research conference are available here.

We focus in our paper on the substantial efforts by researchers and shareholder advisers to develop metrics for assessing the governance of public companies around the world. These important and influential efforts, we argue, suffer from a basic shortcoming. The impact of many key governance arrangements depends considerably on companies’ ownership structure: measures that protect outside investors in a company without a controlling shareholder are often irrelevant or even harmful when it comes to investor protection in companies with a controlling shareholder, and vice versa. Consequently, governance metrics that purport to apply to companies regardless of ownership structure are bound to miss the mark with respect to one or both types of firms. In particular, we show that the influential metrics used extensively by scholars and shareholder advisers to assess governance arrangements around the world—the Corporate Governance Quotient (CGQ), the Anti-Director Rights Index, and the Anti-Self-Dealing Index—are inadequate for this purpose.

We argue that, going forward, the quest for global governance standards should be replaced by an effort to develop and implement separate methodologies for assessing governance in companies with and without a controlling shareholder. We also identify the key features that these separate methodologies should include, and discuss how to apply such methodologies in either country-level or firm-level comparisons. Our analysis has wide-ranging implications for corporate-governance research and practice.

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Here is a more detailed description of the paper: There is now widespread recognition that adequate investor protection can substantially affect not only the value of public firms and their performance but also the development of capital markets and the growth of the economy as a whole. This view has naturally led to heightened interest in identifying and bringing about corporate-governance improvements at both firm- and countrywide levels. These developments also have sparked substantial demand for reliable metrics for evaluating the quality of corporate governance in public firms. And both academic researchers and shareholder advisers have made considerable efforts to develop such metrics.

The notion of a single set of criteria to evaluate the governance of firms around the world is undoubtedly appealing. Both investors and public firms are, after all, operating in increasingly integrated global capital markets. Our paper argues, however, that the quest for a single, global governance metric is misguided.

The incidence of controlled and widely held firms varies considerably around the world. In the United States and the United Kingdom, most public companies do not have a controlling shareholder. In most other countries, companies with a controller dominate. The literature has recognized the fundamental differences both in the nature of the agency problems underlying controlled and widely held firms and in the means for addressing these problems. But the critical implications of these differences have not been adequately reflected in either the design or the use of governance metrics.

Because the fundamental governance problems of controlled and widely held firms differ significantly, the effect of many governance arrangements critically hinges on whether the company has a controlling shareholder. As a result, as we explain in our paper, governance-rating methodologies that use a single metric for assessing investor protection worldwide, at either the firm or the country level, are likely to produce an inaccurate or even distorted picture. Academics and practitioners, we argue, should abandon the effort to develop a single governance metric. Rather, they would do better to develop separate methodologies for assessing the governance of companies with and without a controlling shareholder.

We begin in Part I with an overview of the quest for global governance standards and the most influential global governance metrics. Among academics, the most influential effort has been made by a team of financial economists who put forward successively two indices for measuring countries’ level of investor protection, the Anti-Director Rights Index and the Anti-Self-Dealing Index.. These indices have been applied by more than one hundred academic studies and have had considerable influence on corporate-governance research. Among practitioners, the most influential effort to date has been RiskMetrics’s Corporate Governance Quotient (CGQ) system for rating firms’ corporate governance arrangements. The CGQ system has been widely used by investors and pubic firms, and its use among academics is growing.

In Part II, we discuss the relationship between firms’ ownership structures and the governance arrangements that would best protect their investors. We begin by describing the basic differences between controlled and widely held firms in terms of the governance problems that their outside investors face. We then analyze the implications that these differences have for key sets of governance arrangements: those regulating control contests, voting procedures, the allocation of power between directors and shareholders, the distribution of power among shareholders (i.e., the allocation of power between majority and minority shareholders), director independence, and corporate transactions that may divert value to insiders.

With respect to each of these important areas, we show that the impact of governance arrangements on outside investors depends significantly on whether the firm has a controlling shareholder. As a result, the failure of the Anti-Director Rights Index, the Anti-Self-Dealing Index, and the CGQ system to properly take into account the relationship between ownership structure and corporate governance substantially undermines the indices’ ability to serve as effective metrics for the governance quality of firms or countries worldwide.

Consider, for example, antitakeover defenses such as the poison pill. These arrangements determine the extent to which a widely held company is subject, for better or worse, to the discipline of the market for corporate control. In companies with a majority shareholder, however, a hostile takeover is not feasible even in the absence of antitakeover impediments. Thus, even though takeover defenses are consequential for outside investors in widely held firms, they are unimportant in controlled companies. Using a single metric for assessing both firms with and firms without a controller will therefore (1) overlook an important issue for widely held firms to the extent that the metric does not give sufficient weight to antitakeover considerations, (2) give weight to a largely irrelevant issue for controlled firms to the extent that the metric gives significant weight to antitakeover considerations, or (3) produce some combination of both outcomes. Likewise, using a single metric for comparing countries where concentrated ownership is prevalent to those where widely-held firms dominate, or more generally, countries that have a different mix of these two types of firms, is likely to produce results that would be inaccurate for many purposes.

Our analysis should be distinguished from another type of criticism that can be raised against existing governance metrics. Some writers question the value of any attempt to assess firms’ corporate governance based on objective, externally verifiable criteria. They argue that any useful governance evaluation must take into account a rich set of dimensions (such as the character of the individuals involved) that can only be assessed subjectively. In contrast, we do not question the feasibility of developing a methodology for large-scale governance assessments based on objective criteria. Rather, our critique is constructive: we seek to advance the project of developing governance metrics based on objective and generally applicable criteria, not to abandon it altogether.

We therefore discuss in Part III how the assessment of corporate-governance arrangements should proceed. We argue that academics and practitioners should seek to develop separate systems—one for controlled and another for widely held firms—with each based on a set of objective and externally verifiable dimensions. We contribute to this effort by identifying, for both controlled and widely held firms, which governance dimensions should occupy an important role and—no less important—which dimensions should not. When assessing an individual company, one should use the rating methodology that fits the company’s ownership structure. We also discuss how one should use these separate systems to assess investor protection at the country level. Specifically, we explain why keeping separate scores for how a country protects investors in companies with and without a controlling shareholder is valuable for researchers, policymakers, and investors.

The paper is available here.