Toward the end of last year, the markets were all aflutter with the news of initial public offerings and other capital-raising activity moving to European and Asian exchanges. The conventional wisdom: The companies were fleeing the excesses of Sarbanes-Oxley and good governance campaigns in the U.S.
But two new academic studies may give pause to those packing their bags and those who would invest in them. The reports by academics at Georgetown University, Cornell University and the World Bank conclude two things: Not only do U.S. companies have significantly better governance than their non-U.S. counterparts, but that better governance is being translated into overall better performance in equity markets.
In a paper entitled, "Do U.S. Firms Have the Best Corporate Governance?" Georgetown University professors Reena Aggarwal and Rohan Williamson and co-authors Isil Erel and Rene Stulz of Ohio State University examine the relationship between corporate governance and shareholder wealth in 23 developed nations. Working with the Global Governance Index–an index created by the academics consisting of 44 governance attributes–the researchers investigate how a foreign company's governance practices compare with an equivalent U.S. company and whether shareholders suffer or benefit when governance diverges from the U.S. governance practices. Aggarwal and company find that most non-U.S. companies had worse governance practices than their U.S. counterparts: only 8% out of 2,235 foreign companies outscore their U.S. counterparts.
The real news is that the market rewards those companies whose governance exceeds those of comparable U.S. companies. "Better governance is reflected in higher valuations," says Aggarwal. Topping the list of those attributes the market values most? Board and audit committee independence. At the bottom? Separation of board chairmanship and CEO functions. But it's not enough to simply mimic the U.S. governance standards: While the market does penalize those companies who have what the authors call a "negative governance gap," it really rewards those with a positive gap. "It's not asymmetrical: the positive gap is rewarded more than the drop that you have because of a negative gap," says Aggarwal. "If you're doing a lot better than the U.S. [in terms of governance], then the market really likes that."
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Of course, any study of governance always raises the issue of causation–what came first, the chicken or the egg? "Where a lot of governance studies founder is that there's an endogenous nature to governance," says Beth Young, a senior research associate at The Corporate Library, a corporate governance watchdog. "Which is [to say] that companies that are performing better may choose to have better corporate governance as opposed to better corporate governance makes them perform better."
That particular issue is sidestepped by economists Vidhi Chhaochhaaria of the World Bank and Yaniv Grinstein of Cornell University in their study, "Corporate Governance and Firm Value: The Impact of the 2002 Governance Rules." The researchers consider the effects of the new governance rules, starting from their announcements, on valuations. They find Sarb-Ox has a significant effect on company value, but paradoxically it is the companies that need to make more changes to their governance structure and insiders' behavior to comply with the new rules that outperform companies that need to make fewer changes. "We are looking at [the impact of Sarb-Ox] as an event. And in that event," says Chhaochhaaria, "these are the firms that are going to be most affected, [whereas] for the firms that already have good governance practices, we should see no returns [since] the markets are efficient [and good governance has been factored into the stock price]." To what extent does the market reward these corporate prodigal sons? The ballpark figure is 5% to 15%, say Chhaochhaaria and Grinstein. The positive effect is limited to big companies: small companies that need to make more changes underperform those that have to make fewer changes, lending support to small companies' assertion that Sarb-Ox penalizes them.
The next step is to go deeper into the governance business model. Chhaochhaaria and Grinstein will look at whether the outsize market gains persist for those with best governance practices, while Aggarwal plans to explore which attributes drive the results. Says Aggarwal: "Now we want to get more specific and say: [Given their laws and institutions], what's most important for Japan? What's most important for Germany?"
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