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Corporate governance rules are designed to ensure that firms are well run – that management decisions do not unjustly deprive certain stakeholder groups of value, for example. A major challenge for policymakers, however, as regular reports of poorly run companies in the media show, is devising effective governance provisions. Now though, using a novel approach, academics Boris Nikolov, Erwan Morellec, and Norman Schürhoff have devised a framework which can be used to gauge the actual impact on a firm’s value of some common governance problems and the relative impact on different stakeholder groups.
5 min read
Whenever there is a large corporate failure or financial market crash, an Enron or a credit crunch, it is usually followed by widespread calls for more and better corporate governance. The idea being that more effectively regulated firms and markets will minimize corporate and market failure. However, as it is difficult to measure the impact of potentially problematic corporate behavior, it is difficult to determine the effectiveness of any particular governance provision.
This is the situation that academics Boris Nikolov (HEC Lausanne, UNIL), Erwan Morellec (EPFL), and Norman Schürhoff (HEC Lausanne, UNIL) set out to address. One common approach used to assess how problematic a particular behavior is, is to look at the number of governance provisions aimed at dealing with a particular issue. But this is far from ideal. As the authors point out, it is like investigating an illness by counting the amount of pills a patient is taking, rather than investigating the underlying disease itself.
The authors adopt a novel approach. They focus on a particular type of corporate governance issue particularly prevalent in many mainland European firms, involving the competing interests of stakeholders (known as agency conflicts in the research literature) in a firm. Problems between those competing interests can lead to loss of value, for the firm overall and for certain stakeholders.
The authors investigated two types of governance issue. One is where a controlling shareholder is able to influence the decision making of the firm at the expense of the minority shareholders – expropriating value from the minority shareholders. For example, controlling shareholders might issue more shares in the firm in a way that dilutes minority shareholdings, or buy a corporate jet, which minority shareholders are unable to use but effectively subsidize.
Another is where a controlling shareholder acts at the expense of a bondholder. The absolute priority rule determines the order of payments if a company cannot service its debts and has to default; creditors are paid first, shareholders divide what remains. If a firm has €80, but owes €100 to its creditors, the creditors get €80, the shareholders get nothing. However, a controlling shareholder may attempt to set aside the terms of the original contract and renegotiate the order of payments, paying creditors €70 and keeping €10 – depriving the bondholder of value.
Most countries use governance rules to protect the interests of the vulnerable parties – minority shareholders and bondholders – in such situations. But it is difficult to tell exactly how damaging these type of situations are or how to effectively regulate them.
You can’t find the impact of these agency conflict issues listed in the annual report, but the authors believed that their impact could be detected and measured by looking at the managerial decision making in the firm. In particular, decisions relating to financing the corporation and the leverage ratio in the capital structure. With optimal decision making that maximized value, a controlling shareholder would exhibit a certain type of behavior – tend to opt for greater leverage, change the level of leverage more frequently as economic conditions evolve, and, in the event of trouble, default later. Deviation from the optimal behavior signaled the presence of the agency conflict. The authors developed a model that allowed them to detect the presence and measure the extent of this deviation from the optimal, and express that as a corporate governance index score.
They then tested their framework, looking at the relevant financing related managerial decisions made in 12,652 firms from 14 OECD countries (counties that differed widely in in their legal traditions and enforcement environment).
The results clearly demonstrated that the two governance issues being investigated were highly significant. Overall, the impact of these two types of conflict led to a 5.3% loss in firm value (market capitalization plus debt). Existing governance provisions were not completely eliminating these types of governance problem in the firms studied. More effective regulation would add considerable value to firms and be beneficial to both minority shareholders and bondholders.
A second important finding was that the differences in effective governance were greatest within countries, rather than between countries. There are often anecdotal claims that the companies in one country – Germany is often cited as model of good corporate governance, for example – are better run than in another, but there was no support for this in the findings in respect to these two corporate governance issues.
Instead, the findings show that firm specific factors account for most of the differences. Firms with more cash, higher market-to-book ratio, and more intangible assets demonstrated the greatest cost impact from the conflict of interests.
The authors also looked at differences between civil law countries (such as France) and common law counties (such as the UK). It is often asserted that common law countries have stronger shareholder and bondholder protection regimes, as they have more rules protecting minority shareholders and bondholders. But how effective are these rules? The research findings suggest that although better corporate governance is observed in common law countries, they are only better at limiting the cases of extreme deviation from the optimal i.e. better at limiting the massive corporate governance failures.
In practical terms, the authors have devised and made available a new corporate governance index, which can be used to score firms on how responsibly they behave. While for policymakers the index can be used to gauge the efficacy of particular governance provisions. This is something the authors actually demonstrate by showing the before and after impact of measures designed to help minority shareholder voice their concerns better.
The framework also provides invaluable information for anyone else with a focus on responsible corporate behavior, analysts, pension funds, and other institutional investors, for example, as it provides a novel perspective and a deeper view on corporate behavior than existing corporate governance indexes.
Related research paper (contains the presentation of the framework): Morellec, E., Nikolov, B., and Schürhoff, N., 2018, Agency Conflicts around the World, The Review of Financial Studies 31(11), 4232–4287.