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Rev Quant Finan Acc (2009) 32:129144 DOI 10.

1007/s11156-007-0082-3 ORIGINAL RESEARCH

Corporate governance and rm operating performance


Lawrence D. Brown Marcus L. Caylor

Published online: 8 January 2008 Springer Science+Business Media, LLC 2008

Abstract Using a unique dataset provided by Institutional Shareholder Services (ISS), we relate 51 governance provisions to rm operating performance as proxied by return on assets and return on equity. We identify six corporate governance provisions that are signicantly and positively linked to return on assets, return on equity or both using at least two of our six regressions. We examine nine governance provisions that have been recently mandated by the three major U.S. stock exchanges, and we nd none of them to be signicantly and positively related to rm operating performance. Our results reveal that the governance provisions recently mandated by the U.S. stock exchanges are less closely linked to rm operating performance than are those not so mandated. Keywords Corporate governance Firm operating performance U.S. stock exchanges

JEL Classications D21 G34 M41 M42

1 Introduction In response to many corporate scandals such as Enron, Worldcom and Adelphia, the SEC approved in late 2003 major governance reforms initiated by the three major U.S. stock exchanges (New York Stock Exchange, Nasdaq Stock Market, and American Stock Exchange). These reforms were initiated to restore investor condence in publicly traded
Data availability: The nancial statement data are available from Compustat. The corporate governance data are provided by Institutional Shareholder Services. L. D. Brown (&) J. Mack Robinson College of Business, Georgia State University, 35 Broad Street, Atlanta, GA 30302, USA e-mail: ldb@gsu.edu M. L. Caylor Moore School of Business, University of South Carolina, 1705 College Street, Columbia, SC 29208, USA e-mail: marcus.caylor@moore.sc.edu

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rms by creating a system of greater controls over managerial actions. According to the NYSE, the exchange provisions were mandated to further the ability of honest and wellintentioned directors, ofcers, and employees of listed issuers to perform their functions effectively and allow shareholders to more easily and efciently monitor the performance of companies and directors in order to reduce instances of lax and unethical behavior (see http://www.sec.gov/rules/sro/34-48745.htm). Ceteris paribus, greater controls over managerial actions should reduce principal-agency problems, enhancing rm performance. However, these reforms may have been initiated to inuence investor perceptions rather than to protect shareholder interests so they may not be linked to rm performance. Brown and Caylor (2006) provide evidence that only one exchange reform (board guidelines are in each proxy statement) is associated with a higher Tobins Q, a marketbased measure of rm value, suggesting that regulators did not act as if they enacted corporate-governance related exchange reforms to improve rm performance. In the spirit of studies examining corporate governance and rm performance (e.g., Bebchuk et al. 2005; Core et al. 2006; Gompers et al. 2003; Cremers and Nair 2005), we examine if any of the exchange reforms in our database is associated with higher operating performance, a measure of rm protability. Gompers et al. (2003) provide evidence that investors do not always understand implications of corporate governance for current rm valuation. More particularly, they show that investors would have reaped abnormal returns by buying (selling) rms that were (not) well governed, suggesting that rm corporate governance is related to future (not current) rm valuation. For this reason, Core et al. (2006) suggest that operating performance is a better measure for examining performance and corporate governance. By using Tobins Q to evaluate the efcacy of exchange reforms, Brown and Caylor (2006) may have stacked the deck in favor of nding no results if investors did not perceive these governance provisions to be value relevant when they were initiated. By linking exchange reforms to accounting-based measures, we provide evidence whether regulators acted as if they enacted corporate-governance related exchange reforms to improve rm performance. We examine which of 51 corporate governance provisions are signicantly and positively associated with contemporaneous rm operating performance, proxied by both return on assets and return on equity immediately before implementation of exchangebased reforms. We determine how many of the nine corporate governance provisions in the ISS database that were mandated by the three major U.S. stock exchanges are signicantly and positively related to operating performance. We identify six governance provisions that are signicantly and positively related either to return on assets or return on equity using at least two of our six regressions (two proxies for operating performance 9 three econometric approaches for each proxy). None of the six provisions are amongst the nine mandated by the three major U.S. stock exchanges. We make several contributions to the literature. First, we identify four governance provisions that are positively linked to the operating performance of U. S. rms that have not been identied before by the literature: (1) no former CEO serves on board; (2) nonemployees do not participate in company pension plans; (3) CEO serves on no more than two boards of other public companies; and (4) auditors were ratied at the most recent annual meeting. Second, we show that none of the nine governance provisions in the ISS database that were mandated by the three major U.S. stock exchanges are signicantly and positively linked to rm operating performance, whereas six of the 42 governance provisions not so mandated are signicantly and positively linked to rm operating

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performance. Thus, we nd that exchange-based governance provisions are less linked to rm operating performance than are non-exchange based governance provisions.1 Third, similar to other studies relating corporate governance provisions to other measures of rm performance (Bebchuk et al. 2005; Larcker et al. 2007), we show that most factors are not linked to rm operating performance, increasing the validity of both our study and these other studies. We proceed as follows. We review the literature and introduce our two research questions in Sect. 2. We discuss our data and methodology in Sect. 3. We provide our main results in Sect. 4, discuss policy implications in Sect. 5, and summarize our study in Sect. 6.

2 Literature review and research question development Most prior research examine a small subset of corporate governance provisions yielding results suggesting that some provisions are linked to rm operating performance while others are not. For instance, Fosberg (1989) nds no link between the proportion of outside directors and various rm performance measures (i.e., selling, general and administrative expenses; sales; number of employees; and return on equity). Bhagat and Black (2002) nd no relation between the proportion of outside directors and either return on assets or asset turnover. Klein (1998) does not show a relation between overall board independence and operating performance, but does between insider presence on certain (nance and investment) committees and operating performance. Yermack (1996) documents an inverse relation between board size and rm protability. Cheng et al. (2008) provide evidence that this relation is more pronounced in the presence of an active market for corporate control. More recently, studies have examined the impact of a summary measure of governance based on external governance provisions on rm operating performance (e.g., Core et al. 2006; Gompers et al. 2003). While these studies suggest that external governance provisions are related to operating performance, they provide little evidence regarding the importance of internal governance provisions. An exception is Cremers and Nair (2005) who show that shareholder activism, their proxy for internal governance, is important for rm operating performance. However, their results do not speak to which individual governance provisions are important for rm operating performance. We utilize a database that allows us to examine the link between rm operating performance and many more internal and external corporate governance provisions than have been employed previously by prior research. Consistent with the prior corporate governance literature (e.g., Gompers et al. 2003; Dey 2005; Larcker et al. 2007), we have no exante expectations as to which governance provisions are positively related to rm performance. Our rst research question is: RQ1: Which governance provisions are positively and signicantly related to rm operating performance?

Three other governance provisions in our sample were required by regulatory or quasi-regulatory bodies. The Sarbanes-Oxley Act of 2002 required auditors to provide (at most) limited non-audit services to clients and audit committees to be independent. The Financial Accounting Standards Board required companies to recognize stock option expense for scal years ending on or after June 15, 2005.

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Theoretically, governance provisions enacted by the U.S. stock exchanges should benet shareholders because U.S. stock exchanges have a duciary responsibility to act in their shareholders best interests. However, Romano (2005) cautions against policy-making that follows crises or scandals, arguing that low- or no-cost governance mandates are often inefcient ways to deal with macro-economic issues. The U.S. stock exchanges initiated reforms, similar to The Sarbanes-Oxley Act of 2002, shortly after the period of accounting scandals so these reforms may have been quick xes rather than attempts to benet shareholders. Moreover, all of the nine mandates in our sample have little or no cost for rms to implement so these provisions cannot provide a credible signal. There is no prior empirical evidence indicating whether or not the exchange-initiated reforms are linked to rm operating performance. Our second research question asks: RQ2: Were the corporate governance provisions required by the three U.S. stock exchanges more likely to be signicantly and positively linked to rm operating performance relative to non-mandated corporate governance provisions?

3 Data and methodology 3.1 Sample selection Using a database recently made available by Institutional Shareholder Services (ISS), we code each of 51 individual governance factors as either 1 or 0 depending on whether or not ISS considers the rms governance to be minimally acceptable.2,3 We conduct our analyses using February 1, 2003 governance data because it precedes the effective dates of the provisions enacted by the exchanges.4 We use two common proxies to measure operating performance: return on assets (ROA) and return on equity (ROE).5 To mitigate
2

ISS provides 61 individual measures and three combination measures. We omit the combination factors and we separate one provision into two (poison pill and blank check preferred stock). We omit ten of the 61 provisions that only apply to a subset of rms; four related to charter/bylaw measures (poison pill with TIDE provision, poison pill with sunset provision, poison pill with a qualied offer clause, and poison pill has trigger threshold), and six related to the state of incorporation (not incorporated in a state with a control share acquisition statute or company opted out, not incorporated in a state with a control share cash-out statute or company opted out, not incorporated in a state with a freeze-out provision or company has opted out, not incorporated in a state with a fair price provision or company has opted out, not incorporated in a state with state stakeholder laws or company opted out, and not incorporated in a state that endorses poison pills). Consistent with Gompers et al. (2003), we omit the ISS provision for dual class capital structure as well as rms that have dual class capital structures.

ISS does not code its data as representing minimally acceptable governance but ISS Corporate Governance: Best Practices User Guide and Glossary (2003) provides ample information for one to determine what ISS considers to be minimally acceptable governance. We code a rms governance as acceptable (coded 1) or unacceptable (coded 0). The exchange provisions were approved in late 2003, whereas our governance dataset is as of February 1, 2003, which largely reects data for the 2002 proxy season. Conducting an examination of a post-exchange listing requirement period would be problematic as there is little cross-sectional variation in mandated governance provisions.

While conceptually similar, one may argue that ROE is relatively better as it measures operating performance from shareholders point of view (i.e., interest expense is removed from earnings). Consistent with this view, Ohlson (1995) and Frankel and Lee (1998) use ROE in their theoretical and empirical valuation models, respectively.

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potential endogeneity problems, we follow Klein (1998) and include the lagged value of industry mean-adjusted operating performance in our regression models. We obtain Compustat data on rm-specic performance for the 2002 scal year end. We winsorize extreme (1st and 99th) percentiles of the protability measures and adjust them by their ISS industry means.6 To be included in our main analysis, a rm must have the following data as of February 1, 2003: all 51 governance provisions, operating performance measures, industry identication, and the three control variables, log of book-tomarket ratio (Gompers et al. 2003) log of market value of equity (Core et al. 2006), and lagged operating performance (Klein 1998). Table 1 shows the percent of our 2,363 sample rms in 2003 with minimally acceptable governance for the 51 corporate governance factors. We rst show the nine provisions mandated by the three major U.S. stock exchanges followed by the 42 other provisions. The governance provisions within the two groups are presented in increasing order of the percent of rms with minimally acceptable governance standards. We also show which of the eight ISS dimensions the governance factor belongs to. Nine governance provisions had over 90% of sample rms with minimally acceptable governance, including no interlocking directors on the compensation committee (98.41%), no option re-pricing in the past 3 years (95.19%), all directors with more than 1 year of service own stock (93.94%), and stock incentive plans were adopted with shareholder approval (92.26%). Twelve provisions had less than 5% of sample rms with minimally acceptable governance, including three exchange requirements: (1) outside directors meet without the CEO and disclose the number of times they met (1.16%); (2) board-approved CEO succession plan is in place (4.08%); and (3) board guidelines are in each proxy statement (4.98%).

3.2 Methodology To increase the internal validity of our study, we use three different econometric approaches to determine which governance provisions are signicantly and positively linked to operating performance. Our rst approach regresses industry mean-adjusted operating performance on all 51 individual provisions, and our controls: lagged operating performance, log of book-to-market ratio and log of the market value of equity. We estimate the following OLS regression: X Industry-adjusted ROA ROE a ci GovernanceProvisioni b1 LaggedROA LaggedROE b2 log B/M b3 log MVE e. 1 Return on assets is dened as income before extraordinary items (Compustat Annual Data Item 18) divided by total assets (Compustat Annual Data Item 6). Return on equity is dened as income before extraordinary items available for common equity (Compustat
6

ISS denes 23 unique industry groups based on 4-digit Global Industry Classication Standard (GICS) codes developed by Standard & Poors and Morgan Stanley Capital International. The 23 ISS industry groups are: Automobiles & Components, Banks, Capital Goods, Commercial Services & Supplies, Consumer Durables & Apparel, Diversied Financials, Energy, Food & Drug Retailing, Food Beverage & Tobacco, Health Care Equipment & Services, Hotels Restaurants & Leisure, Household & Personal Products, Insurance, Materials, Media, Pharmaceuticals & Biotechnology, Real Estate, Retailing, Software & Services, Technology Hardware & Equipment, Telecommunication Services, Transportation, and Utilities.

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Table 1 Descriptive statistics of 51 ISS corporate governance provisions (2,363 rms) Minimum governance standard ISS dimension Percent of rms with minimum governance standard

Nine Exchange Requirements Outside directors meet without the CEO and disclose the number of times they met A board-approved CEO succession plan is in place Board guidelines are in each proxy statement Performance of the board is reviewed regularly Option re-pricing is prohibited Qualitative Factors Qualitative Factors Board of Directors Qualitative Factors Executive and Director Compensation Board of Directors Board of Directors Board of Directors Executive and Director Compensation 1.16 4.08 4.98 6.15 20.37

Nominating committee is comprised solely of independent outside directors Compensation committee is comprised solely of independent outside directors Board controlled by over 50% independent outside directors Stock incentive plans were adopted with shareholder approval 42 Other Governance Provisions

26.77 66.18 73.87 92.26

Policy exists requiring outside directors to serve on no Board of Directors more than ve additional boards Director term limits exist Company has a formal policy on auditor rotation Company expenses stock options Qualitative Factors Audit Executive and Director Compensation Charter/Bylaws

0.39 0.77 0.90 1.76

Board cannot amend bylaws without shareholder approval or can only do so under limited circumstances

2.49

At least one member of the board has participated in an Director Education ISS-accredited director education program Incorporation in a state without any anti-takeover provisions State of Incorporation

2.75 3.39 3.61 4.13 5.67 6.70 7.56 9.15 9.93 17.53 25.78

Directors are required to submit their resignation upon a Qualitative Factors change in job status Board has outside advisors Directors are subject to stock ownership guidelines Shareholders have cumulative voting rights to elect directors Mandatory retirement age for directors exist Executives are subject to stock ownership guidelines Company is not authorized to issue blank check preferred stock Governance committee meets at least once during the year Shareholders may act by written consent and the consent is non-unanimous Qualitative Factors Ownership Board of Directors Qualitative Factors Ownership Charter/Bylaws Board of Directors Charter/Bylaws

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Percent of rms with minimum governance standard 28.84 39.79 43.70 46.07 48.69 51.65 52.81

Shareholder approval is required to change board size Board members are elected annually Shareholders vote on directors selected to ll vacancies A majority vote is required to amend charter/ bylaws (not a supermajority) Shareholders are allowed to call special meetings

Board of Directors Board of Directors Board of Directors Charter/Bylaws Charter/Bylaws

The CEO and chairman duties are separated or Board of Directors a lead director is specied The average options granted in the past 3 years Executive and Director Compensation as a percentage of basic shares outstanding did not exceed 3% (option burn rate) Consulting fees paid to auditors are less than audit fees paid to auditors Audit

53.12 53.93 55.22 62.40 71.64 74.47 74.77

Auditors were ratied at the most recent annual Audit meeting Company either has no poison pill or a pill that Charter/Bylaws was shareholder approved The last time shareholders voted on a pay plan, Executive and Director ISS did not deem its cost to be excessive Compensation Audit committee consists solely of independent Audit outside directors A simple majority vote is required to approve a Charter/Bylaws merger (not a supermajority) Ofcers and directors stock ownership is at least 1% but not over 30% of total shares outstanding CEO is not listed as having a related party transaction in proxy statement No former CEO serves on board Ownership

Board of Directors Board of Directors

76.49 81.87 85.60 89.82 91.02 91.96

Size of board of directors is at least six but not Board of Directors more than 15 members Company does not provide any loans to executives for exercising options Executive and Director Compensation

Directors receive all or a portion of their fees in Executive and Director stock Compensation All directors attended at least 75% of board meetings or had a valid excuse for nonattendance Board of Directors

All directors with more than 1 year of service Ownership own stock Option re-pricing did not occur within last 3 years CEO serves on no more than two additional boards of other public companies Executive and Director Compensation Board of Directors

93.94 95.19 95.57

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Percent of rms with minimum governance standard 95.62

Non-employees do not participate in company pension plans No interlocks exist among directors on the compensation committee

Executive and Director Compensation Executive and Director Compensation

98.41

Managers respond to shareholder proposals within Board of Directors 12 months of shareholder meeting

99.44

Note: This table presents the percent of rms with minimally acceptable governance for 51 governance provisions for 2003 where minimally acceptable governance is based on what ISS considers as minimally acceptable governance. See the ISS Corporate Governance: Best Practices User Guide & Glossary (2003)

Annual Data Item 237) divided by the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74). The 51 governance provisions are shown in Table 1. We use the natural logarithm of the book-to-market ratio, the natural logarithm of the market value of equity, and the lagged value of the dependent variable as control variables. The natural logarithm of the book-to-market ratio is dened as the natural logarithm of the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74) divided by the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25). The natural logarithm of the market value of equity is dened as the natural logarithm of the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25). Our second approach involves a regression similar to that of Bebchuk et al. (2005). We regress industry mean-adjusted operating performance on each of the 51 provisions and the sum of the remaining 50 provisions [hereafter Rem50], lagged operating performance, log of the book-to-market ratio and log of the market value of equity.7 Our second approach estimates the following OLS regression: Industry-adjusted ROA ROE a c1 GovernanceProvisioni c2 Rem50 b1 LaggedROA LaggedROE b2 log B/M b3 log MVE e. 2 Our nal approach uses stepwise regression to identify which factors enter our model.8 We employ the White (1980) procedure to correct for heteroskedasticity when using the rst two methods. We run six regressions in all, i.e., we use three econometric approaches for each of our ROA and ROE regressions.

Bebchuk et al. (2005) run 24 regressions using IRRC data so their remaining summary measures sum up the other 23 factors. We run 51 regressions using ISS data so our remaining summary measures sum up the other 50 factors. We use the stepwise selection in SAS, which is a variant of the forward-selection technique, where variables already in the model do not necessarily stay there. In order to stay in the model, a coefcient must be signicant at the 10% two-tailed level.

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4 Main results 4.1 ROA Tables 24 provide results for return on assets (ROA) using the three econometric approaches discussed in Sect. 3.2. Table 2 provides results of regressions of ROA on all 51 governance provisions, lagged ROA, log of book-to-market ratio, and log of market value of equity. Five factors are signicantly and positively related to ROA: 1. 2. 3. 4. 5. No former CEO serves on board, Company is not authorized to issue blank check preferred stock, Non-employees do not participate in company pension plans, Director term limits exist, and Directors are required to submit their resignation upon a change in job status.

Table 3 presents results of using the Bebchuk et al. (2005) approach with ROA. Four provisions are signicantly and positively associated with operating performance: 1. 2. 3. 4. CEO serves on no more than two additional boards of other public companies, A simple majority vote is required to approve a merger (not a supermajority), Company is not authorized to issue blank check preferred stock, and Non-employees do not participate in company pension plans.

Table 4 provides results of the stepwise regression approach to identifying which factors are positive and signicantly related to operating performance. Three provisions are signicantly and positively related to ROA:

Table 2 Regression of ROA on all 51 governance provisions and controls (1,714 Firms) Governance provision No former CEO serves on board Company is not authorized to issue blank check preferred stock Non-employees do not participate in company pension plans Director term limits exist Directors are required to submit their resignation upon a change in job status Adj. R2 Coefcient estimate 0.033955* (1.81) 0.06392*** (4.28) 0.056943*** (3.80) 0.065303* (1.94) 0.065339** (1.98) 0.1865

Note: ROA is regressed on all 51 individual governance provisions, log (B/M), log (MVE) and the lagged value of industry mean-adjusted return on assets. ROA is industry mean-adjusted using the 23 ISS dened industries after winsorizing the top and bottom 1% of its distribution. ROA is dened as income before extraordinary items (Compustat Annual Data Item 18) divided by total assets (Compustat Annual Data Item 6). The natural logarithm of the book-to-market ratio and the natural logarithm of the market value of equity are used as control variables and are dened as the natural logarithm of the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74) divided by the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), and the natural logarithm of the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), respectively. For ease of exposition, we exclude coefcient estimates for the intercept, log (B/M), log (MVE), the lagged value of ROA, and all governance variables that are not signicantly and positively associated with ROA. T-statistics, reported in parentheses, are based on White-adjusted standard errors ***,**,*Signicance at 1%, 5%, 10%, two-tailed level

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Table 3 Regressions of ROA on each individual provision and controls (1,714 rms) Governance provision Coefcient estimate Adj. R2

CEO serves on no more than two additional boards of other public companies 0.047263* (1.67) Company is not authorized to issue blank check preferred stock Non-employees do not participate in company pension plans 0.058701*** (4.09) 0.065495*** (5.10)

0.1871 0.1894 0.1877

A simple majority vote is required to approve a merger (not a supermajority) 0.027261** (2.24) 0.1874

Note: ROA is regressed on each of the 51 individual governance provisions, Rem50, log (B/M), log (MVE) and the lagged value of industry mean-adjusted return on assets. ROA is industry mean-adjusted using the 23 ISS dened industries after winsorizing the top and bottom 1% of its distribution. ROA is dened as income before extraordinary items (Compustat Annual Data Item 18) divided by total assets (Compustat Annual Data Item 6). REM50 is the sum of the remaining 50 governance provisions. The natural logarithm of the book-to-market ratio and the natural logarithm of the market value of equity are used as control variables and are dened as the natural logarithm of the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74) divided by the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), and the natural logarithm of the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), respectively. For ease of exposition, we exclude coefcient estimates for the intercept, log (B/M), log (MVE), the lagged value of ROA, and all governance variables that are not signicantly and positively associated with ROA. Tstatistics, reported in parentheses, are based on White-adjusted standard errors ***,**,*Signicance at 1%, 5%, 10%, two-tailed level

Table 4 Stepwise regression of ROA on all 51 governance provisions and controls (1,714 rms) Governance provision No former CEO serves on board Company is not authorized to issue blank check preferred stock Non-employees do not participate in company pension plans Adj. R2 Coefcient estimate 0.03108* (1.81) 0.06023*** (2.68) 0.06090* (1.73) 0.1966

Note: ROA is regressed on all 51 governance provisions, log (B/M), log (MVE) and the lagged value of industry mean-adjusted return on assets using a stepwise technique. We use the stepwise selection in SAS, which is a variation on the forward-selection technique, where variables already in the model do not necessarily stay there. In order to stay in the model, we require a coefcient to be signicant at the 10% twotailed level. ROA is industry mean-adjusted using the 23 ISS dened industries after winsorizing the top and bottom 1% of its distribution. ROA is dened as income before extraordinary items (Compustat Annual Data Item 18) divided by total assets (Compustat Annual Data Item 6). The natural logarithm of the book-tomarket ratio and the natural logarithm of the market value of equity are used as control variables and are dened as the natural logarithm of the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74) divided by the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), and the natural logarithm of the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), respectively. For ease of exposition, we exclude coefcient estimates for the intercept, log (B/M), log (MVE), the lagged value of ROA, and all governance variables that are not signicantly and positively associated with ROA. T-statistics are reported in parentheses ***,*Signicance at 1%, 10%, two-tailed level

1. No former CEO serves on the board, 2. Company is not authorized to issue blank check preferred stock, and 3. Non-employees do not participate in company pension plans.

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4.2 ROE Tables 57 provide results for ROE using the same three econometric approaches. Table 5 provides evidence for ROE when all 51 provisions are included in an OLS regression. Four provisions are signicantly and positively associated with ROE: 1. 2. 3. 4. CEO serves on no more than two additional boards of other public companies, Company is not authorized to issue blank check preferred stock, Non-employees do not participate in company pension plans, and Auditors were ratied at the most recent annual meeting.

Table 6 presents results using the Bebchuk et al. (2005) approach with ROE. Five provisions are positive and signicant: 1. 2. 3. 4. 5. Auditors were ratied at the most recent annual meeting, CEO serves on no more than two additional boards of other public companies, A simple majority vote is required to approve a merger (not a supermajority), Company is not authorized to issue blank check preferred stock, and Non-employees do not participate in company pension plans.

Table 7 provides results using the stepwise approach with ROE. Three provisions are signicantly and positively related to ROE: 1. Company is not authorized to issue blank check preferred stock, 2. Non-employees do not participate in company pension plans, and 3. Auditors were ratied at the most recent annual meeting.

Table 5 Regression of ROE on all 51 governance provisions and controls (1,714 rms) Governance provision CEO serves on no more than two additional boards of other public companies Company is not authorized to issue blank check preferred stock Non-employees do not participate in company pension plans Auditors were ratied at the most recent annual meeting Adj. R2 Coefcient estimate 0.167448** (2.43) 0.166283*** (3.34) 0.256969** (2.11) 0.086951** (2.00) 0.2634

Note: ROE is regressed on all 51 individual governance provisions, log (B/M), log (MVE) and the lagged value of industry mean-adjusted return on equity. ROE is industry mean-adjusted using the 23 ISS dened industries after winsorizing the top and bottom 1% of its distribution. ROE is dened as income before extraordinary items available for common equity (Compustat Annual Data Item 237) divided by the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74). The natural logarithm of the book-to-market ratio and the natural logarithm of the market value of equity are used as control variables and are dened as the natural logarithm of the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74) divided by the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), and the natural logarithm of the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), respectively. For ease of exposition, we exclude coefcient estimates for the intercept, log (B/M), log (MVE), the lagged value of ROE, and all governance variables that are not signicantly and positively associated with ROE. T-statistics, reported in parentheses, are based on White-adjusted standard errors ***,**Signicance at 1%, 5%, two-tailed level

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Table 6 Regressions of ROE on each individual provision and controls (1,714 rms) Governance provision Coefcient estimate Adj. R2

Auditors were ratied at the most recent annual meeting

0.091593** (2.11) 0.2652

CEO serves on no more than two additional boards of other public companies 0.166377** (2.47) 0.2641 A simple majority vote is required to approve a merger (not a supermajority) 0.073798** (2.12) 0.2638 Company is not authorized to issue blank check preferred stock Non-employees do not participate in company pension plans 0.150498*** (3.18) 0.326634*** (2.84) 0.2649 0.2666

Note: ROE is regressed on each of the 51 individual governance provisions, Rem50, log (B/M), log (MVE) and the lagged value of industry mean-adjusted return on equity. ROE is industry mean-adjusted using the 23 ISS dened industries after winsorizing the top and bottom 1% of its distribution. ROE is dened as income before extraordinary items available for common equity (Compustat Annual Data Item 237) divided by the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74). REM50 is the sum of the remaining 50 governance provisions. The natural logarithm of the book-to-market ratio and the natural logarithm of the market value of equity are used as control variables and are dened as the natural logarithm of the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74) divided by the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), and the natural logarithm of the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), respectively. For ease of exposition, we exclude coefcient estimates for the intercept, log (B/M), log (MVE), the lagged value of ROE, and all governance variables that are not signicantly and positively associated with ROE. Tstatistics, reported in parentheses, are based on White-adjusted standard errors ***,**Signicance at 1%, 5%, two-tailed level

Table 7 Stepwise regression of ROE on all 51 governance provisions and controls (1,714 rms) Governance provision Company is not authorized to issue blank check preferred stock Non-employees do not participate in company pension plans Auditors were ratied at the most recent annual meeting Adj. R2 Coefcient estimate 0.15806** (2.21) 0.31508*** (2.82) 0.09138** (2.18) 0.2737

Note: ROE is regressed on all 51 governance provisions, log (B/M), log (MVE) and the lagged value of industry mean-adjusted return on equity using a stepwise technique. We use the stepwise selection in SAS, which is a variation on the forward-selection technique, where variables already in the model do not necessarily stay there. In order to stay in the model, we require a coefcient to be signicant at the 10% twotailed level. ROE is industry mean-adjusted using the 23 ISS dened industries after winsorizing the top and bottom 1% of its distribution. ROE is dened as income before extraordinary items available for common equity (Compustat Annual Data Item 237) divided by the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74). The natural logarithm of the book-to-market ratio and the natural logarithm of the market value of equity are used as control variables and are dened as the natural logarithm of the sum of the book value of equity (Compustat Annual Data Item 60) and deferred taxes (Compustat Annual Data Item 74) divided by the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), and the natural logarithm of the market value of equity (Compustat Annual Data Item 199*Compustat Annual Data Item 25), respectively. For ease of exposition, we exclude coefcient estimates for the intercept, log (B/M), log (MVE), the lagged value of ROE, and all governance variables that are not signicantly and positively associated with ROE. T-statistics are reported in parentheses ***,**Signicance at 1%, 5%, two-tailed level

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4.3 Summary of results Three provisions are signicantly and positively linked to ROA using at least two of three econometric approaches: (1) no former CEO serves on board; (2) company is not authorized to issue blank check preferred stock; and (3) non-employees do not participate in company pension plans. Four provisions are signicantly and positively linked to ROE using at least two econometric approaches: (1) CEO serves on no more than two additional boards of other public companies; (2) company is not authorized to issue blank check preferred stock; (3) non-employees do not participate in company pension plans; and (4) auditors were ratied at the most recent annual meeting. Two provisions are found to be signicant and positively related to both ROA and ROE using at least two econometric approaches: (1) company is not authorized to issue blank check preferred stock; and (2) non-employees do not participate in company pension plans. One provision is found to be signicant and positively related to ROA using at least two approaches but is unrelated to ROE: no former CEO serves on the board. One provision is found to be signicant and positively related to ROE using at least two econometric approaches but it is unrelated to ROA: auditors were ratied at the most recent annual meeting. One provision is signicant and positively related to ROE in at least two of three econometric approaches, but it is signicant and positively related to ROA only once: CEO serves on no more than two additional boards of other public companies. One provision appears once for ROA and once for ROE: a simple majority vote is required to approve a merger (not a supermajority). We consider all six of these governance provisions to be signicantly and positively related to rm performance. Two governance provisions appear only once for ROA and zero times for ROE: (1) director term limits exist; and (2) directors are required to submit their resignation upon a change in job status. We do not consider these provisions as being signicantly and positively related to rm performance because, unlike the aforementioned six, which are positive and signicant in at least two regressions, these provisions are positive and signicant in only one regression.

5 Policy implications In late 2003, the SEC approved several governance reforms proposed by the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the Nasdaq Stock Market (NASDAQ).9 We now discuss in more detail the nine reforms included in the 51 ISS provisions we examined. All three stock exchanges require boards to have a majority of outside independent directors and rms to have independent processes for nominating directors. NYSE requires rms to have completely independent nominating committees; NASDAQ and AMEX require nominations to be made by at least a majority of independent board directors. NYSE requires rms to have compensation committees comprised solely of independent directors; NASDAQ and AMEX require compensation to be set by at least a majority of independent board directors.
9

The reforms proposed by NYSE and NASDAQ were approved by the SEC on November 4, 2003 (see http://www.sec.gov/rules/sro/34-48745.htm), while the reforms proposed by AMEX were approved by the SEC on December 1, 2003 (http://www.amex.com/atamex/news/34-48863_Approval_Order_on_Amex2003-65.pdf).

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NYSE requires all companies to disclose corporate governance guidelines similar to the provision that rms disclose board guidelines in its proxy statement, and it requires rms to state in their proxy statements or 10-K lings that the guidelines are available on the rms website or in print. NYSE requires board performance to be reviewed regularly and a board-approved CEO succession plan to be in place. NYSE and NASDAQ require outside directors to meet without the CEO and to disclose the number of times they meet. The three major U.S. stock exchanges require shareholder approval of newly created or signicant revisions to equity-based plans and shareholder approval of option re-pricing (similar to the ISS provision that option re-pricing is prohibited).10 We identify six governance provisions appearing at least twice in Tables 27. None of them are amongst the nine ISS provisions that were mandated by the three major U.S. stock exchanges. The rst non-mandated provision is no former CEO serves on the board. A potential problem with allowing former CEOs to serve on the board is that they may not be independent of the current CEO. The second provision is company is not authorized to issue blank check preferred stock. Cremers and Nair (2005) used this provision as one of their three entrenchment-related measures to construct their anti-takeover protection index. It provides rms with the opportunity to adopt poison pill-type mechanisms at any time, giving boards the power to issue preferred stock at its discretion with all the specics of the preferred stock issue determined by the board at the time of issuance. The third provision is non-employees do not participate in rm pension plans. Nonemployee directors who do not participate in pension plans are less likely to be subject to conicts of interest such as whether to over-fund pension plans. The fourth provision is CEO serves on no more than two additional boards of other public companies. CEOs who serve on too many boards may have their attention taken away from the daily running of the company. The fth provision is auditors were ratied at the most recent annual meeting. This is important because it reduces the opportunity for managers to select auditors whose independence may be compromised. Aggarwal et al. (2007) showed that non-U.S. rms without this provision are less valuable than U.S. rms with this provision. The sixth provision is a simple majority (not a supermajority) vote is required to approve a merger. This is one of the six provisions Bebchuk et al. (2005) used to construct their entrenchment index. In sum, none of the nine governance provisions in our sample that were mandated by the three major U.S. stock exchanges is related to rm operating performance. In contrast, six of the 42 governance provisions in our sample that were not mandated by these exchanges (14%) are signicantly and positively related to operating performance. Our results suggest that the governing boards of the stock exchanges did not act as if they selected provisions to benet shareholders.

6 Summary We relate corporate governance to operating performance based on 51 corporate governance provisions provided by Institutional Investor Services (ISS) as of February 1, 2003. We show how often our sample rms meet each of the 51 minimum governance
10 The equity based reforms proposed by NYSE and NASDAQ were approved by the SEC on June 30, 2003 (see http://www.sec.gov/rules/sro/34-48108.htm), while the equity based reforms proposed by AMEX were approved by the SEC on October 9, 2003 (see http://www.sec.gov/rules/sro/34-48610.htm).

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standards.11 We nd three (four) governance provisions to be signicantly and positively related to return on assets (equity) using at least two of our three econometric approaches. Six of 51 governance provisions appear at least twice in our six regressions (Tables 27). None of these six were amongst the nine ISS provisions that were mandated by the three major U.S. stock exchanges. Our results support the arguments by Romano (2005) that reforms enacted immediately following scandals or crises are likely to be ineffective solutions to complex problems. We close with some caveats. First, we do not provide a theoretical framework for why certain corporate governance factors but not others are signicantly and positively related to rm operating performance. While our approach is common in the literature (Gompers et al. 2003; Dey 2005; Larcker et al. 2007), future research should develop theoretical constructs for the links. Second, corporate governance is advocated for reasons aside from operating performance, and we do not examine corporate governance in other contexts. It is likely that corporate governance drivers of rm operating performance differ from those of other rm-specic contexts (Brown and Caylor 2006; Larcker et al. 2007). Third, we show a link between corporate governance and rm operating performance, but our results cannot be interpreted as denitively showing causality. We address endogeneity issues using a standard procedure in the literature, but these problems are pervasive in the governance literature and cannot be resolved (Larcker and Rusticus 2005). Nonetheless, our studys limitations are unlikely to have led to our primary result that non-mandated provisions are more closely linked to rm operating performance than mandated ones. Finally, it is conceivable that the three major U.S. exchanges did not intend to mandate governance provisions which are linked to rm operating performance. Even if this is so, the importance of operating performance as an input for rm value (Ohlson 1995; Frankel and Lee 1998) makes a better understanding of the link between mandated governance provisions and operating performance important to regulators, investors and academics. References
Aggarwal R, Erel I, Williamson R, Stulz R (2007) Differences in governance practices between U.S. and foreign rms: measurement, causes, and consequences. Working Paper, Ohio State University Bebchuk L, Cohen A, Ferrell A (2005) What matters in corporate governance? Working Paper, Harvard Law School Bhagat S, Black B (2002) The non-correlation between board independence and long-term rm performance. J Corp Law 27:231274 Brown L, Caylor M (2006) Corporate governance and rm valuation. J Acc Public Policy 25:409434 Cheng S, Evans J, Nagarajan N (2008) Board size and rm performance: the moderating effects of the market for corporate control. Rev Quant Finance Acc, Forthcoming Core J, Guay W, Rusticus T (2006) Does weak governance cause weak stock returns? An examination of rm operating performance and investors expectations. J Finance 61:655687 Cremers KJM, Nair VB (2005) Governance mechanisms and equity prices. J Finance 60:28592894 Dey A (2005) Corporate governance and nancial reporting credibility. Working Paper, University of Chicago Fosberg R (1989) Outside directors and managerial monitoring. Akron Bus Econ Rev 20:2432 Frankel R, Lee C (1998) Accounting valuation, market expectation, and cross-sectional returns. J Acc Econ 25:283319

11 Given the small within-sample variability of occurrence of these measures, it is not surprising that we nd many factors to be unrelated to operating performance. However, not all factors adhered to by few rms are unimportant for facilitating operating performance. For example, we nd that company is not authorized to issue blank check preferred stock is associated with both return on assets and return on equity in spite of the fact that this factor occurs only 9.93% of the time in our sample (Table 1).

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Gompers P, Ishii J, Metrick A (2003) Corporate governance and equity prices. Quart J Econ 118:107155 ISS Corporate Governance: best practices user guide & glossary, Rockville, MD (2003) Klein A (1998) Firm performance and board committee structures. J Law Econ 41:275303 Larcker D, Richardson S, Tuna I (2007) Corporate governance, accounting outcomes, and organizational performance. Acc Rev 82:9631008 Larcker D, Rusticus T (2005) On the use of instrumental variables in accounting research. Working Paper Ohlson J (1995) Earnings, book values, and dividends in equity valuation. Contemp Acc Res 11:661687 Romano R (2005) Quack corporate governance. Regulation 28:3644 White H (1980) A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity. Econometrica 48:817838 Yermack D (1996) Higher market valuation for rms with a small board of directors. J Financial Econ 40:185211

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