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E-MailSanjai Bhagat is Provost Professor of Finance at the University of Colorado Boulder Leeds School of Business and Brian J. Bolton is Associate Director at the Global Board Centre at IMD Business School. This post is based on their recent article, forthcoming in Journal of Corporate Finance. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance (discussed on the Forum here) and Executive Compensation as an Agency Problem, both by Lucian Bebchuk and Jesse Fried; Regulating Bankers’ Pay by Lucian Bebchuk and Holger Spamann (discussed on the Forum here); and The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008 by Lucian Bebchuk, Alma Cohen, and Holger Spamann (discussed on the Forum here).
Corporate governance continues to be a focus of not just the financial media but the popular media, as well. The scandals at Wells Fargo and Equifax are just the most recent in the long line of scandals involving large well-known public U.S. corporations. Going back in time—the financial crisis of 2008 was triggered by the implosion of the big banks. Further back in time, at the turn of the new millennium, the scandals in Enron, WorldCom, Tyco, and Qwest led to their demise.
After each set of these scandals, policymakers raised questions about the effectiveness of corporate governance mechanisms in these companies. This led to the inevitable call for more regulation and laws to constrain and regulate corporate behavior, to wit, the Sarbanes Oxley Act of 2002 and the Dodd-Frank Act of 2010. Have these two rather extensive set of laws addressed the governance concerns of corporate America? The recent Wells Fargo and Equifax episodes would suggest otherwise; these are particularly noteworthy because they are both in finance industries, which Dodd-Frank 2010 was explicitly designed to address. We think a more fruitful approach to addressing the corporate governance concerns is to focus on possible common themes underpinning the Enron, WorldCom, Tyco, Qwest, the big banks circa 2008, Wells Fargo, and Equifax scandals. We propose, on the basis of our more recent research, that misaligned CEO incentive compensation is a common theme underpinning the above corporate scandals.
In our 2008 paper, “Corporate governance and firm performance,” we focused on the question: How is corporate governance measured? We considered an extensive set of governance measures used in the finance, accounting, and law literature, as well as governance indices sold by commercial vendors. We found director stock ownership is most consistently and positively related to future corporate performance. Given that the essence of good governance is the set of processes that ensures outside investors a fair return on their investment, we suggested director stock ownership as a measure of corporate governance. Public policymakers and long-term investors should find this result especially relevant given their strong interest in long-term corporate performance. We consider the dollar value of stock ownership of the median director as the measure of good corporate governance. Our focus on the median director’s ownership, instead of the average ownership, is motivated by the political economy literature on the median voter. Also, directors, as economic agents, are more likely to focus on the impact on the dollar value of their holdings in the company rather than on the percentage ownership.
In our earlier paper we considered data through 2002. In this paper, we extend our sample period through 2016. These additional 14 years of data provide a powerful out-of-sample test of the specification and power of director stock ownership as a measure of corporate governance. We find director stock ownership most consistently and positively related to future corporate performance in several out-of-sample periods (2002-2006, 2007-2009, 2010-2016) across a battery of different specifications, estimation techniques, and for different sub-samples (S&P 500, S&P MidCap 400, S&P SmallCap 600). One particular sub-sample of considerable public interest is the 100 largest U.S. financial institutions during the financial crisis of 2008. Bank director stock ownership is positively related to future bank performance prior to and during the financial crisis, and bank director stock ownership is negatively related to future bank risk prior to and during the financial crisis; both above results should be of considerable interest to senior bank regulators.
Recently, there has been a growing trend among companies to implement CEO and director stock ownership guidelines. However, based on our 2014 paper, the amount of stock an insider sells (or acquires) may be as informative about future firm performance as the amount of stock he/she owns at any time. Therefore, in this paper we also propose an executive incentive compensation policy consistent with long-term firm performance. Specifically, we argue that better-aligned incentive compensation policies should be correlated with less (abnormal) selling by the CEO.
The complete paper is available for download here.
