Sarbanes-Oxley, Governance and Performance Sarbanes-Oxley, Governance and Performance Sanjai Bhagat University of Colorado, Boulder Brian Bolton University of New Hamps hire

Motivation What is the econometrically correct way to analyze the endogenous relation between corporate governance and firm performance? Can simple measures of corporate governance (such as board independence or director ownership) capture a firm’s corporate governance environment in the same way a complex index can? Has the relationship between corporate governance and performance changed since the Sarbanes-Oxley Act of 2002 ?

Contribution - 1 We introduce a consistent and unbiased estimation of the endogenous relationships among corporate governance, company performance, ownership structure, and capital structure. We study five different measures of corporate governance. Most extant studies focus on one measure. We show that none of the governance measures are correlated with future stock market performance (either Return or Tobin’s Q).

Contribution - 2 Given poor performance, the probability of the CEO’s disciplinary turnover is positively correlated with director ownership and board independence… But, is negatively related to “better” governance as measured by GIM G- Index and BCF E-Index. Negative relation between operating performance and board independence prior to 2002, ► but a positive relation between operating performance and board independence after Future corporate governance researchers should consider the dollar value of the stock owned by directors as a governance measure.

The Problem Performance, governance, ownership and capital structure are interrelated. A firm’s corporate governance measure might be affected by the same unobservable features of managerial behavior or ability that are linked to ownership and performance. If these variables are endogenously determined, standard estimation techniques (OLS) yield biased and inconsistent results.

The Solution Specify a system of 4 simultaneous equations allowing for performance, governance, ownership and capital structure to be endogenous. Estimate system using OLS, 2SLS and 3SLS. Stock & Yogo (2004), and Hahn & Hausman (2002) tests for weak instruments. Cragg-Donald (1993) test for underidentification. Hansen-Sargan test for overidentifying restrictions. Hausman (1978) specification test to determine the appropriate method of estimation.

System of 4 Equations (1a)Performance i,t =Governance i,t + Ownership i,t + Leverage i,t + IndustryPerformance i,t + FirmSize i,t +R&DAdvExp i,t + BoardSize i,t + Risk i,t + TreasStock i,t + εa i,t (1b)Governance i,t =Performance i,t + Ownership i,t + Leverage i,t + FirmSize i,t +R&DAdvExp i,t + BoardSize i,t + Risk i,t + Dir%Own i,t + Dir%CEOs i,t + εb i,t (1c)Ownership i,t =Performance i,t + Governance i,t + Leverage i,t + FirmSize i,t + R&DAdvExp i,t + BoardSize i,t + Risk i,t + CEOTenAge i,t + εc ai,t (1d)Leverage i,t =Performance i,t + Governance i,t + Ownership i,t + IndustryLeverage i,t + FirmSize i,t +R&DAdvExp i,t + MktBook i,t + BoardSize i,t + Risk i,t + ZScore i,t + εd i,t

8 How is good corporate governance measured? NYSE, NASDAQ, European exchanges’ corporate governance listing requirements: Board independence.

9 How is good corporate governance measured? Gompers Ishii, Metrick (2003): The G-Index is constructed from data compiled by the Investor Responsibility Research Center ("IRRC"). Poison pills. Golden parachutes. Supermajority rules to approve mergers. Staggered boards. Limitations of shareholders’ ability to call special meeting.

10 How is good corporate governance measured? Bebchuk, Cohen, Ferrell (2004): The E-Index is constructed from IRRC data. It uses a 6-provision subset of the G-Index.

11 How is good corporate governance measured? Glass Lewis Index uses a 5-provision subset of the E-Index.

12 How is good corporate governance measured? Brown and Caylor (2004) governance score is constructed from data compiled by Institutional Shareholder Services ("ISS"). Bylaws (poison pills, supermajority provisions, …). Board structure (independence, CEO/Chair duality, nominating committee, …). Audit committee (independence, auditor’s consulting fees, auditor rotation). Management and Director compensation (no interlocks in compensation committee, option repricing prohibited, directors receive fees in stock). Progressive practices (director term limits and mandatory retirement age).

13 How is good corporate governance measured? The Corporate Library The TCL benchmark score is based on over a 100 criteria: Bylaws (poison pills, supermajority provisions, …). Board structure (independence, CEO/Chair duality, nominating committee, …). Audit committee (independence, auditor’s consulting fees, auditor rotation). Management and Director compensation. Progressive practices (director term limits and mandatory retirement age).

14 How is good corporate governance measured? Stock ownership of median board member: Can a single board characteristic be as effective a measure of corporate governance as indices that consider multiple measures of corporate charter provisions, management compensation structure, and board characteristics? Corporate boards have the power to make, or at least, ratify all important decisions including decisions about investment policy, management compensation policy, and board governance itself.

15 How is good corporate governance measured? Stock ownership of median board member: … It is plausible that board members with appropriate stock ownership will have the incentives to provide effective monitoring and oversight of important corporate decisions; hence board ownership can be a good proxy for overall good governance.

16 How is good corporate governance measured? Stock ownership of median board member: … Furthermore, the measurement error in measuring board ownership can be less than the total measurement error in measuring a multitude of board processes, compensation structure, and charter provisions.

Other Endogenous Variables Performance variables Return on Assets Stock Return Tobin’s Q All measured in three time periods relative to governance: Contemporaneous Next year Next two years Ownership variable Percent of stock owned by CEO Capital structure variable Long term debt / Assets

Instrumental Variables Performance: Treasury Stock / Assets Governance: % of directors who are CEOs CEO Ownership:CEO tenure / CEO age Capital Structure:Altman’s Z-score Graham (1996) marginal tax rates For robustness, we also use lagged values of the endogenous variables as instruments.

Governance & Performance 2SLS Estimate of the Governance-Performance Relation (p-value based on clustered standard errors in parentheses) Governance Measure Independence (0.00)(0.01) Director Ownership (0.02)(0.03) G-Index (0.00)(0.16) E-Index (0.00)(0.05)

Post SOX: Independence & Performance Positive relation between Board Independence and Operating Performance during : Significant only for firms that increased their number of independent directors during Insignificant for firms that did not increase their number of independent directors during

Post SOX: Independence & Performance (contd.) Positive relation between Board Independence and Operating Performance during Positive relation between Director Ownership and Operating Performance during Is Board Independence merely a proxy for Director Ownership? System of 5 equations. Both Board Independence and Director Ownership are significantly and positively related to performance.

SOX: Independence & Performance (contd.) Positive relation between Board Independence and Operating Performance during for all 5 size-quintiles.

SOX: Independence & Performance (contd.) Market Reaction to Compliance with SOX wrt Board Independence requirement Firms that became compliant and added independent directors to the audit committee. Not Compliant in year t-1 t-1 Compliant in year t Not Compliant in year t (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (1)- (6) Period CAR z- statistic Sample Size Postive: Negative Returns Non- parametric statistic CAR z- statistic Sample Size Postive: Negative Returns Non- parametric statistic Difference in means, p- value Post-SOX 0.41% : % : < % : % : < % : % : < % : % : % : % : < % : % : < % : % : <0.0001

Post SOX: Independence & Performance (contd.) Post SOX: Positive relation between board independence and operating performance. Positive market reaction to Compliance with SOX w.r.t. Board Independence requirement. Above findings are consistent with and supportive of the event-study results of Chhaochharia and Grinstein (2007) who find that firms that were less compliant with the rules imposed by SOX and the Exchanges earned more positive abnormal returns on the announcement of the rules.

SOX: Governance and Acquisitions Table 10: Logit model estimating the probability of a firm making an acquisition relative to not making an acquisition Baseline Independen ceDirectorOwnCEO-DualityGIM G-IndexBCF E-Index Past 2 years return 0.469***0.471***0.396***0.467***0.490***0.483*** (0.00) Past 2 years industry return 0.469***0.470***0.471***0.472***0.463**0.454** (0.01) Governance *-0.084***-0.057**-0.008*-0.016* -(0.06)(0.00)(0.05)(0.06) CEO Ownership *-0.011* (0.11)(0.14)(0.06)(0.09)(0.34)(0.28) Size (Assets) 0.292***0.290***0.283***0.289***0.300***0.301*** (0.00) Leverage (0.70)(0.69)(0.39)(0.71)(0.29)(0.27) Market-to-Book (0.11) (0.21)(0.11)(0.12) CEO Age ** **-0.014**-0.015***-0.015** (0.01) (0.04)(0.01) CEO Tenure (0.99)(0.95)(0.72)(0.97)(0.83)(0.89) Observations 4,510 4,278 Panel A: Pre-SOX,

SOX: Governance and Acquisitions Table 10: Logit model estimating the probability of a firm making an acquisition relative to not making an acquisition Baseline Independen ceDirectorOwnCEO-DualityGIM G-IndexBCF E-Index Past 2 years return 0.343**0.340**0.261*0.339**0.347**0.345** (0.03) (0.10)(0.04)(0.03) Past 2 years industry return (0.22)(0.20)(0.23)(0.20) Governance *-0.138***-0.206***-0.002* (0.08)(0.00)(0.01)(0.09)(0.19) CEO Ownership *-0.019*-0.018* (0.09)(0.07)(0.10) (0.13)(0.14) Size (Assets) 0.204***0.209***0.190***0.211***0.200*** (0.00) Leverage (0.62)(0.61)(0.25)(0.56)(0.69)(0.70) Market-to-Book (0.30)(0.31)(0.19)(0.35)(0.31) CEO Age ***-0.023***-0.021*** *** (0.00) CEO Tenure 0.010* **0.008 (0.06)(0.12)(0.28)(0.04)(0.14) Observations 5,059 4,923 Panel B: Post-SOX,

SOX: Governance and Acquisitions Table 10: Logit model estimating the probability of a firm making an acquisition relative to not making an acquisition Panel C: Implied Probability of Acquisitions Governance Variable Baseline PerformanceIndependence t DirectorOwn t CEO-Duality t G-Index t E-Index t Implied Probability Acquisition- Pre-SOX31.5%31.3%31.4%31.6%31.8% Acquisition- Post-SOX30.0%27.5%29.0%31.7%32.0%31.9% Difference in Probabilities:1.5%3.8%2.4%-0.1%-0.2%-0.1% Pre-SOX - Post-SOX(0.02) **(0.00) *** (0.14)(0.19)(0.12)

SOX: Governance and Acquisitions Table 10: Logit model estimating the probability of a firm making an acquisition relative to not making an acquisition Market Adjusted Returns Equally Weighted Index (1)(2)(3)(4)(5)(6)(7) WindowSample Size Positive: Negative ReturnsCARz-statisticp-value Non-parametric statisticp-value (-1, +1) 4,8152,399:2, % <.0001 (-3, +3) 4,8152,360:2, % <.0001 (-3, +10) 4,8152,309:2, % <.0001 (-5, +5) 4,8152,346:2, % <.0001 (-10, +10) 4,8152,252:2, % Panel D: Acquisition announcement abnormal returns (CAR) for sample firms during

CEO Turnover: Disciplinary Turnover,

CEO Turnover: Disciplinary Turnover,

Conclusion After controlling for endogeneity Better operating performance is positively associated with better governance as measured by GIM G-Index, BCF E-Index, and stock ownership of board members - during Better operating performance is positively associated with better governance as measured by stock ownership of board members, and board independence - during None of the measures of governance are associated with better stock market performance in any period. Given poor performance, only stock ownership of board members and board independence are positively correlated with a higher probability of disciplinary managerial turnover.

Conclusion Post SOX: Positive relation between board independence and operating performance. Positive market reaction to compliance with SOX w.r.t. Board Independence requirement. Post SOX: Companies that had more independent directors, and more director stock ownership, were less likely to engage in acquisitions.

Conclusion Corporate governance environment has changed since 2002, but dollar value of the stock owned by directors is still an important and reliable measure of corporate governance. Future corporate governance researchers should consider the dollar value of the stock owned by directors as a governance measure.