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RI Academic Digest, June 2011: Investor protections improve corporate governance and returns.

Review of Bebchuk, L. A. and Weisbach, M. S.. (2010) “The State of Corporate Governance Research.” The Review of Financial Studies, 23 (3): 939-961. RI’s regular digest of research published by the PRI Academic Network, June 2011.


Interest in corporate governance has grown in recent years due to such factors as the role of poor governance in the financial crisis and the increasing interest in corporate reporting on ESG issues. A recent issue of The Review of Financial Studies brings together seven recent studies on corporate governance, on subjects ranging from shareholder activities to board oversight and executive compensation. In general, the findings support the view of responsible investors that strong investor protections lead to improved corporate governance, which, in turn, can improve investment returns.

• Seven academic articles published in a 2010 issue of The Review of Financial Studies address the issue of corporate governance;
• The academic articles address shareholder activities, board independence, executive compensation, and politics; and
• In most cases, strong investor protections lead to improved corporate governance.h6. Main Review

Interest in corporate governance has grown in recent years, as authors Bebchuck and Weisbach point out in their overview of seven academic articles published in a 2010 issue of The Review of Financial Studies. The reasons for such increased interest are many; as the authors observe, the role of poor corporate governance in the financial crisis is one such reason. Another reason not overtly specified in the report is the growing insistence by responsible investors and others on reporting of environmental, social and governance (ESG) factors by companies. Not only is corporate governance one of the pillars of ESG; as Anthony Miller, the Economic Affairs Officer for the Investment and Enterprise Division of the United Nations Conference on Trade and Development (UNCTAD), recently stated, “Without good governance mechanisms, there is no responsible investment.” In their overview, the authors identify seven recent studies of corporate governance that represent “state of the art research”. The studies address a range of corporate governance issues, from shareholder activities to board oversight and executive compensation. A final study focuses on the role of politics in corporate governance.

As active owners in the corporations in which they invest, responsible investors engage with firms in order to pressure them into improving specific areas of corporate governance. The study by Becht et al. included in the issue sheds light on the engagement practices of Hermes, the UK-based responsible investment fund manager. A signatory to the Principles for Responsible Investment, Hermes often engages in “behind the scenes” activism as a means of monitoring corporate governance. According to the study, Hermes earned abnormal annual returns of 4.9% between 1998 and 2004; 90% of the abnormal returns, the authors found, can be attributed to the fund manager’s program of corporate engagement. In the US, the phenomenon of controlling minority shareholders—shareholders that own less than a majority of a company’s cash flow rights, but a majority of its voting rights—often occur through the use of dual-class shares. A 2009 article in the Economist ( observed that seven percent of IPOs in the preceding two years had dual class structures, and that high-profile firms such as Google and Facebook employ such a structure. The study by Gompers et al., according to Bebchuck and Weisbach, “makes a contribution to the accumulating empirical evidence that controlling minority shareholder structures are associated with increased agency costs and reduced firm value.” That is, a structure that serves to diminish the monitoring function of shareholders is likely to lead to reduced returns on investment. Two studies in the Review investigate the growing international scene for investing. One, authored by Aggarwal et al., uses data supplied by RiskMetrics (now part of MSCI) to compare firm-level corporate governance in the US and elsewhere. The author, not surprisingly, conclude that where country-level shareholder protections are lower than those found in the US, firms based in those countries invest less in corporate governance mechanisms. A study by Leuz et al. tests whether the percentage of foreign shareholders is higher in companies with superior level of disclosure,and concludes that poor corporate governance not only reduces foreign investment but impedes integration into the global economy as well. Two of the remaining studies in the Review address issues of ongoing concern to responsible shareholders. A study on board independence by Ravina and Sapienza found that the informational advantage enjoyed by independent directors is roughly equal to that of other officers. Bebchuck and Weisman differ with the study’s conclusion that such an advantage means that independent directors can do their jobs well. Instead, Bebchuck and Weisman suggest, shareholders should consider the possibility that independent directors, like other officers, are as likely to be driven by personal incentives as by shareholder value. In their study of executive compensation, Kaplan and Rauh come down on the side of an optimal contracting view, and defend against claims that compensation for top executives in financial industries has been excessive. However, noting the heightened interest in the issue since the financial crisis, Bebchuck and Weisman respond with “evidence that CEO pay is higher when outside directors serve on multiple boards, when the board has interlocking directors, when more of the outside directors have been appointed under this CEO, when there are no large outside blockholders, when a smaller percentage of shares is held by institutional investors, and when antitakeover protections are more significant”; in other words, when corporate governance is weaker. Another of the Principles calls on signatories to “support regulatory or policy developments that enable implementation”, and the final study included in the Review addresses politics. In that study, Bebchuk and Neeman evaluate how lobbying by three interest groups—corporate insiders, institutional investors, and entrepreneurs—affect investor protections. Of particular interest to responsible investors in the US, where debate over corporate political spending still rages, more than a year after the Supreme Court’s Citizens United decision, is their finding that investor protection is decreased by lobbying by corporate insiders.
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