The Determinants of Corporate Governance and the Link between Corporate Governance and Performance: Evidence from the U.K. Using a Corporate Governance Scorecard Thesis Proposal by Luo Lei School of Business National University of Singapore 1. Introduction 1.1 Introduction Corporate governance practices in the U.K. have received increasing attention since the 1990s, with influential reports issued by the Cadbury Committee (1992), Greenbury Committee (1995), Hampel Committee (1998), and Turnbull Committee (2003) and Sir Derek Higgs (2003). These reports resulted in various corporate governance codes and recommendations, the most recent being the Combined Code on Corporate Governance, July 2003 (hereafter U.K. Code). In this study, we use a scorecard developed by Standard & Poor’s to assess the corporate governance of U.K. listed companies. It provides a comprehensive measure of the extent to which a company has adopted international best practices in corporate governance, as disclosed in their corporate governance disclosures. The evidence on whether there is a link between governance structure and performance remains weak. We argue that one possible reason could be due to the research methodology. Earlier research has examined subsets of governance mechanisms, usually one or two governance variables only. As the firms can choose and modify the structure of their governance system to suit their circumstances, we argue that we should examine a number of governance variables and over a longer time period. 1.2 Motivation of Study Some recent studies have used a broader measure of corporate governance through a composite corporate governance rating, including Gompers et al. (2003) for the U.S., Klapper and Love (2004) for fourteen emerging markets, Durnev and Kim (2002) for twenty seven countries, Bauer et al. (2003) for the EMU and the U.K These studies generally find a positive relationship between governance standards and firm value. Baure et al. (2003) and other studies are based on ratings of one or two years only, assuming that governance ratings should remain constant for a number of years. However our data shows otherwise — there is a significant upward trend for the corporate governance scores over the time. Without time series data, researchers cannot study how firms adjust their governance structure over time, or analyze the causality between 1 governance and firm performance found in Black et al. (2005). A recent study by Leora, Klapper and Love (2004) find that differences in firm-level contracting environment would affect a firm’s choice of governance mechanisms, in line with arguments put forth in Himmelberg et al. (1999). However because their governance data have no time variation, they are not able to control the fixed effects and to test the causality. Our study can make a potential contribution in this area by analyzing a number of corporate governance mechanisms based on time-varying firm-specific data. Using the methodology in Agrawal and Knoeber (1996), we examine the four mechanisms used in controlling agency problems — insider shareholdings, blockholdings, institutional shareholdings and leverage status of the firm. In addition, we also include a comprehensive measure of governance using a corporate governance scorecard and measuring governance over a longer time period. Our findings reveal an interesting relationship between governance and performance. It is the change of governance that determines performance rather than the governance level. We form an investment strategy that buys firms with greatest improvement in governance and sells firms with largest deterioration in governance. It yields 70.4 percent excess returns over the sample period. Contrary to the findings in Bauer et al. (2003), we find that investors will lose money if they buy firms ranking highest and sell firms ranking lowest. 1.3 Objective of Study This is an empirical study on whether better corporate governance leads to higher valuation through lower expected rate of return. We investigate the interdependence of various governance practices, the change of governance structure and the impact on the firm value. We look into the boxes of the aggregate governance index in order to find “key factors” associated with firm performance. We conduct a series of tests to differentiate the risk and mispricing explanations to excess returns resulting from governance improvement. 1.4 Potential Contributions of Study This study includes a more complete set of governance mechanisms including the 2 composite governance scorecard as well as ownership and firm leverage. We deal the unobserved firm heterogeneity with a fixed effects estimator and firm endogeneity with the simultaneous equation system. The margin effect of governance improvement is also a new finding in research on corporate governance. 1.5 Organization of Study The remainder of this study is organized as follows: Section 2 reviews the literature concerning to firm level corporate governance. Section 3 describes the sample and data. In Section 4 to 10, respectively, we present empirical evidence on the determinants of corporate governance, on the relationship between corporate governance and firm performance, its relationship with stock returns and distinguish between the risk and mispricing explanation of excess returns. Section 11 concludes. 2. Literature Review 2.1 The Interaction of Different Governance Mechanisms Corporate governance comprises many dimensions. Based on the U.K. Code, it can be divided broadly into the role of directors, directors’ remuneration, the role of shareholders, and accountability and audit. Some of the structures are complements while others are substitutes to certain extent. The previous research has found different governance patterns. For example, Peasnell et al. (2001) find evidence of a convex association between the proportion of outside board members and the level of insider ownership in the U.K. corporate control process. Shivdasani and Yermack (1999) observe, using U.S. data, that when the CEO serves on the nominating committee or no nominating committee exists, firms usually appoint fewer independent outside directors and more grey outsiders. Similarly, Vafeas (1999) discover that the likelihood of engaging a nominating committee is related to board characteristics such as inside ownership, number and quality of outsider directors for U.S. firms. Board structure is an important governance mechanism. Kenneth et al. (1995) note the substitution effects between outside directors, blockholders, and incentives to insiders 3 using eighty one U.S. bank-holding companies in his study. Both Dedman and Elisabeth (2002) and Young (2000) investigate the board structure determinants before and after Cadbury Report. They either find managerial entrenchment is reduced or non executive directors are increased following the imposition of new standards of “best practice” regarding board structure. 2.2 The Relationship between Governance Mechanism and Firm Performance Our study builds on Himmelberg et al. (1999) who use panel data to show that managerial ownership is explained by key variables in the contracting environment. A large fraction of the cross-sectional variation in managerial ownership is explained by unobserved firm heterogeneity. Moreover, after controlling for both observed firm characteristics and firm fixed effects, changes in managerial ownership do not affect firm performance statistically. Many other researchers have examined the relationship between variety of governance mechanisms and firm performance. However, the results are mixed. Some examine only the impact of one governance mechanism on performance as Himmelberg et al. did, while others investigate the influence of several mechanisms together on performance. None of them covers a complete set of governance mechanisms. Below, we will briefly review some of previous studies on the governance-performance relationship. (1) Board Composition It is suggested that higher proportion of non-executive directors in the board helps to reduce the agency cost. Kee et al. (2003) and Hutchinson and Gul (2003) support this view by showing that that higher levels of non-executive directors on the board weaken the negative relationship between the firm’s investment opportunities and firm’s performance. However, de Jong et al. (2002), Coles et al. (2001), and Weir et al. (2002) dispute it by stating that there is no significant relationship between non-executive directors’ representation and performance. In contrast, in the U.K., Weir and Laing (2000) find a negative relationship between non-executive director representation and performance. In addition, Yermack (1996) present that small board has a higher market valuation. Stronger support for the positive impact of non-executive directors comes from event 4 study analysis. The studies by Rosenstein and Wyatt (1990 and 1997) and Shivdasani and Yermack (1999) show that the appointment of non-executive directors increases company value. (2) Leadership Structure Although U.K. Code regards separation of the role of CEO and chairman as a sign of good governance, previous empirical analyses do not support it. For example, Coles et al. (2001), Weir et al. (2002), and Weir and Laing (2000) do not find any significant relationship between CEO duality and performance. Brickley et al. (1997) observe that costs of separation are larger than benefits for most large U.S. firms. (3) Board Ownership The findings of the primarily U.S. based literature suggest that management is aligned at low or possibly high levels of ownership but is entrenched at intermediate ownership levels (e.g., Morck et al., 1988; McConnell and Servaes, 1990). U.K. evidence confirms that U.K. management becomes entrenched at higher levels of ownership than their U.S. counterparts (e.g. Faccio et al., 1999; Short and Keasey, 1999). Hutchinson and Gul (2003) report that management share ownership and managers’ remuneration weaken the negative relationship between the firm’s investment opportunities and firm’s performance. In contrast, Coles et al. (2001) do not find any contribution to performance by managerial ownership. (4) Institutional Holdings As the U.K. Code encourages institutions to take an active role in governance, we may expect a positive relationship between institutional holdings and firm performance. Unfortunately, empirical evidence is not supportive of this recommendation. Both Faccio and Lasfer (1999, 2000) fail to find such a significant relationship for U.K. firms. Besides, de Jong et al. (2002) find that major outside and industrial shareholders negatively influence the firm value. (5) Committee Composition For U.K. companies, Conyon (1997) provides a thorough review of the workings of remuneration committees and shows that firms with remuneration committees pay directors less remuneration. Conyon & Mallin (1997) observe that U.K. firms have been slow in adopting nominating committees, a symptom of failure of the corporate 5 governance system. By contrast, audit committee use in the U.K. has been widespread (e.g. Conyon, 1994; Collier, 1993). The results in Forker’s (1992) study suggest that the quality of disclosure is only weakly related with audit committees and non-executive directors. (6) Managers’ Remuneration The empirical work shows that the role of managers’ remuneration in coordinating managers’ and investors’ interests is limited. Hutchinson and Gul (2003) find a positive role for managers’ remuneration, while Coles et al. (2001) do not. 2.3 Endogeneity of Corporate Governance Mechanisms in Firm Valuation Bhagat and Black (2002) find evidence that firms suffering from low profitability respond by increasing the independence of their board of directors, but no evidence that firms with more independent boards achieve improved profitability. Vafeas (1999) observes that the annual number of board meetings increases following share price declines. He further finds that operating performance improves following years of abnormal board activity. Some other studies are in the ownership area. None of them provides support to the governance-performance relationship. Oyvind and Bernt (2001) discover that qualitative conclusions are sensitive to choice of instruments. Demsetz and Villalonga (2001) fail to find significant relationship between ownership and performance. What is more, Cho (1998) concludes that investment affects corporate value and in turn corporate value affects ownership but not vice versa. Agrawal and Knoeber (1996) examine the use of seven mechanisms to control agency problems between managers and shareholders. These mechanisms are: shareholdings of insiders, institutions, and large blockholders; use of outside directors; debt policy; the managerial labor market; and the market for corporate control. The findings are consistent with optimal use of each control mechanism except outside directors. Closely following their approach, we construct a simultaneous equation system to investigate the influence of corporate governance scorecard on firm performance. Barnhart and Rosenstein (1998) investigate the combined effect of ownership structure and board composition on corporate performance. The results indicate that managerial 6 ownership, board composition, and Tobin’s Q are jointly determined. Vafeas and Theodorou (1998) examine a broad group of board structure variables for U.K. firms. Contrary to expectations, the results reveal an insignificant relationship between board structure (percentage of non-executive directors, leadership structure, board ownership and committee composition) and firm performance. 2.4 Corporate Governance Scorecard in Examining Stock return, Firm value and Performance Other than focusing on one or two separate variables for corporate control, recently there have been an increasing number of studies that employ corporate governance scorecard as a comprehensive measure to examine the agency problem. It has the advantage to implicitly incorporate either the substitutive or complementary effect of variety of governance practices into one study. The empirical literature on the relationship between firm value and corporate governance scorecard usually analyzes either inter-country difference or inter-firm variation within a country. The most prominent example of studies on inter-country difference is LaPorta et al. (2002), who investigate differences in governance standards among twenty seven countries. Their evidence shows that firms incorporated in countries with better governance standards tend to have higher valuations. Examples of studies investigating inter-firm variation within one country are Drobetz et al. (2003) for Germany, Gompers et al. (2003) and Marry and Stangeland (2003) for the U.S., Klapper and Love (2004) for fourteen emerging markets, Durnev and Kim (2002) for twenty seven countries, Bauer et al. (2003) for the EMU and the U.K., Black et al. (2005) for Korea, Black (2001) for Russia, and Callahan et al. (2003) for Fortune 1000 firms. The results appear to confirm a positive relationship between governance standards and firm value. More importantly, the relationship seems to be stronger in countries with less developed standards. To the best of our knowledge, only Klapper and Love (2004), Durnev and Kim (2002) and Black et al. (2005) investigate the determinants of corporate governance scorecard. Overall Klapper and Love (2004) find that firm-level governance is correlated with firm size, sales growth and assets composition. Moreover, they report that good governance is positively correlated with market valuation and operating performance. Simliarly, Durnev 7 and Kim (2002) report higher disclosure level and in turn higher market valuation for firms with greater growth opportunities, greater needs for external financing, and more concentrated cash flow rights. Black et al. (2005) document size and firm risk as important factors affecting firms’ corporate governance practices. Our study differs from theirs in the following ways: Firstly, we use time-varying governance scorecard to control unobserved firm heterogeneity with fixed effects. Secondly, we broaden governance measurements with governance scorecard as well as shareholding variables. Finally, we explicitly put governance mechanisms into a simultaneous equation system to address the endogeneity problem. Among the inter-firm variation studies, Gompers et al. (2003), Marry and Stangeland (2003), Klapper and Love (2004), and Bauer et al. (2003) examine the impact of the governance standards on firm performance approximated by profitability ratios as well. All of them document a positive relationship between governance scorecard and performance except for Bauer et al. (2003) who surprisingly detect a significant negative relationship. When set up a zero investment portfolio, investors can earn abnormal returns by buying firms from higher level corporate governance group and short-selling those from lower level corporate governance group (Gompers et al., 2003; Drobetz et al., 2003; Bauer et al., 2003). Drobetz et al. (2003) and Chen et al. (2003) investigate the influence of governance scorecard on cost of equity capital for Germany and nine Asia markets respectively. Their findings show that good corporate governance helps to reduce such cost. Creamers et al. (2003) find that external and internal governance mechanisms are strong complements in association with long term abnormal returns and accounting measures of profitability. Besides, Q’s of firms with both high takeover vulnerability and high public pension fund ownership are high, but lower than the Q’s of firms where only one of the two governance mechanisms is high. 3. The Data The starting point of our sample is the set of firms listed in Index Constituent Rankings FTSE 100 and Index Constituent Rankings FTSE 250 from FTSE European 8 Monthly Review, January 2001 issue. It will be denoted FTSE 350 hereafter. We exclude financial firms as they have different financial reporting formats and many of the key variables needed in our study are not available in COMPUSTAT database. For each of the remaining industrial and commercial firms, with at least three years of annual reports containing the relevant corporate governance information over the time-period 1999 till 2003, we calculate its corporate governance score using the corporate governance disclosure scorecard provided by the S&P. In this study, scorecard will be used interchangeably with score, rating, ranking and/or index. S&P’s corporate governance disclosure scorecard is a methodology based on a synthesis of governance codes and guidelines of global best practices, as well as its own experience in reviewing individual companies. With the information extracted from company annual report, we answered 119 questions on governance practices for each company each year. It enabled us to construct a time-varying corporate governance scorecard for our study. Ninety three of the questions are binary questions and one point is given for each best practice complied with and zero otherwise or if the company did not disclose whether it had or not complied with such best practice. The remaining questions were answered with specific integers such as “number of members in the remuneration committee”. Since for a few questions, the answer corresponded to more than one score item, there are altogether 136 best practice items for the scorecard. Four out of the 136 items can score up to a maximum two points instead of one. Therefore, the maximum possible score for one company with the 136 score items is 140. After filling in the answers to these 119 questions, the formula automatically computes the total score for the company of interests. Generally such measure assigns an equal weightage to each disclosed item with the exception of the four items which can attain a maximum score of two. These four items carry slightly higher weightage. Scores on the 119 questions are grouped into five categories of corporate governance: Board Matters, Nomination Matters, Remuneration Matters, Audit Matters and Communication. We compute the composite governance scorecard by summing up the scores for each group. The financial data employed in our analysis are obtained from COMPUTSTAT 9 [...]... correlations among the variables employed in our study The variable definitions are in Appendix All variables are measured over the sample period from 1999 to 2003 The second and third columns of the table show the correlations between each of these variables with our absolute governance scorecard and change of the scorecard respectively The scorecard is negatively correlated with both Tobin’s Q and. .. elements); and Communication (5 elements) Table 5 lists each governance element, and percentage of firm meeting the governance criteria for our 136 corporate governance elements over time Table 5: Incidence of individual elements of corporate governance 1999 A1 A2 A3 A4 A5 A6 A7 A8 A9 A1 0 A1 1 A1 2 A1 3 Board Matters Is the frequency of board meetings disclosed? Did the board meet more than 4 times in the year?... on the variation in average corporate governance scorecard and performance levels across firms and will not utilize the variation over time in these variables for individual firm It is achieved by pooling all data and implicitly forcing equal intercepts In contrast, estimates from panel with firm fixed effects will depend only on the variation over time in corporate governance scorecard and performance. .. sales Y/S: operating income/sales RDUM: a dummy variable equal to unity if R&D data are available, and zero otherwise R&D/K: R&D expenditure to Property, Plant and Equipment I/K: capital expenditure/Property, Plant and Equipment The empirical analysis of determinants of corporate governance is summarized in Table 10 We begin our exploration of corporate governance determinants with ownership variables... analysis On the one hand, since fixed effects and instrument variables are alternative approaches to address the endogeneity, using them together further mitigates the endogenous problem On the other hand, as argued previously, we believe that the changes of governance have more impact on performance than the level of governance itself Third, since use of outsiders in the board has already been captured... seems that those firms already obtained the highest ranking in corporate governance disclosure usually do not further increase their governance next year Governance- improving firms may be ranked as the best-governed firms in the same 25 year Current year’s governance improvement leads to the highest ranking of governance level in current year rather than the other way round Table 9 shows the Pearson... better, changes in governance are of more importance than level of governance in determining market valuation This conclusion is useful to investors because they may find that information obtained from longitude corporate governance disclosure in annual report matters more than information gained from cross-sectional absolute governance ranking in performance evaluation The reason that higher absolute governance. .. some evidence of a mild sticky of firms over corporate governance measure About half of the best-governed firms are also lies among the best-governed firms in the previous year Although firms improve or deteriorate their governance practices autonomously, their relative ranking on the governance disclosure does not change quickly This may result from the relatively small magnitude of the changes The. .. capture the interdependence among various governance mechanisms as well as their impact on performance This study proceeds in two parts The first part deals with determinants of corporate governance In the second part, we explore the determinants of firm value In the first part, we regress SCORE on a vector of x variables with and without ownership variables In the second part, we test for a correlation... sum a firm’s score on the elements of a subindex, divide by the number of elements, and multiply this ratio by 20 Thus, each subindex has a value between 0 and 20 We define the overall standardized score as the sum of all the five subindices As the correlation between SCORE and standardized SCORE is 0.963 and significant at 0.01, we employ only SCORE for all of our investigations Table 3: Summary statistics . The Determinants of Corporate Governance and the Link between Corporate Governance and Performance: Evidence from the U.K. Using a Corporate Governance Scorecard Thesis. al. (2003), Marry and Stangeland (2003), Klapper and Love (2004), and Bauer et al. (2003) examine the impact of the governance standards on firm performance approximated by profitability ratios. financial reporting formats and many of the key variables needed in our study are not available in COMPUSTAT database. For each of the remaining industrial and commercial firms, with at least