Which Corporate Governance Factors Impact Shareholder Returns?

Posted on 15/11/2010


Lucian Bebchuk, Alma Cohen and Allen Ferrell of the John M. Olin Center for Law, Economics and Business at Harvard University published a study in 2004 entitled What Matters in Corporate Governance? They studied twenty-four different governance provisions and tested for correlations with firm value and stockholder returns.  They found that only six corporate governance factors are linked to firm value and equity returns.  Based on these factors, they put forward a management “entrenchment index”, higher levels of which are associated with  weaker returns.  They find that:

During the 1990-1999 period, buying an equally-weighted portfolio of firms with a 0 entrenchment index score and selling short an equally-weighted portfolio of firms with entrenchment index scores of 5 and 6 would have yielded an average annual abnormal return of approximately 7%.

These six key metrics are:

  • Staggered boards. Also known as a “classified” board , a “staggered” board refers to a situation in which only a proportion of directors on the board are up for election each year.  Such arrangements prevent shareholders throwing-out the whole-board in order to punish them for poor performance or alternatively to force-through changes that have the backing of a majority of shareholders but not from a majority of directors.  Clearly, such arrangements insulate directors from the need to be respond to the wishes of shareholders, exacerbating the principal-agent problem.  Ideally, the entire board of directors will be up for re-election each year.
  • Limits to shareholder by-law amendments. By preventing shareholders from proposing new bylaws that are voted-on at an AGM or EGM (and are binding upon the company), management can insulate themselves and the company from following a course of action that a majority of shareholders wishes the company to take.
  • Supermajority requirements for mergers and Supermajority requirements for charter amendments. By requiring supermajorities (often 75%) to approve a takeover or to make changes to the memorandum and articles, companies can prevent a majority of shareholders from exercising their wishes as to how the company should be run.  Clearly, where a 75% supermajority is required to make changes, managers can choose to ignore the wish of shareholders, knowing that the investors have little legal recourse.
  • Poison pills. The term poison pill refers to a legal device often described (by the companies that use them) by the euphenism “shareholder rights plan“.  Typically, such devices are triggered when the stake of any shareholder passes a certain threshold and invole the granting to all shareholders – except the shareholder who triggered the pill – of a large number of new shares.  Such schemes thereby dilute the holding of the potential acquiror and consequently limit the scope of: (a) shareholders to dispose of their stock to whom they wish; (b) activist investors to build positions in order to affect company strategy; and (c) potential acquirers to execute a takeover of the company without board approval.
  • Golden parachutes. These are clauses contained within the employment contracts of the executive management team and often grant rights entitling the directors to significant financial payments in the event that their employment contracts are terminated.  Such payments diminish the financial incentives of the management team as when they are in place the directors can receive bonuses for succeeding or their golden parachute for failing.  Consequently, golden parachutes create moral hazard for company directors.

In summary, when carrying-out investment research into potential investments, my analysis of a company’s corporate governance practices focuses upon the above points, which have been shown empirically to be the key factors that affect total shareholder return.