The belief that governance best practices lead to superior firm performance is widespread. But as academic research and this article demonstrate, most studies prove that there is no link between governance and performance. Nor is there proof that the highly desirable director independence has a positive impact on firm performance.
During the bull market of the 1990s, the American model of corporate governance was heralded as the most successful in the world at creating value. Indeed, corporate law scholars Henry Hansmann and Reiner Kraakman predicted, in a 2000 paper provocatively titled "The End of History for Corporate Law," that global corporate governance would converge around the U.S. shareholder-oriented model as a result of its exemplary record at creating value. (see www.ssrn.com; January, 2000).
The corporate scandals that began in October 2001 with the collapse of Enron and that continue to the present day have shaken investors' faith in the capital markets and the efficacy of existing corporate governance practices in promoting transparency and accountability. The Conference Board's Commission on Public Trust and Private Enterprise remarked in January 2003 that "[t]he events of the last year suggest that, in many instances, [the] compact among shareowners, boards, and management has been significantly weakened, diminishing the trust investors and the general public have in our system of corporate governance."
Congress and regulators responded to this crisis of confidence by imposing new corporate governance requirements on public companies. For their part, investors started to take corporate governance issues more seriously. Moody's Investor Services announced plans to incorporate governance assessments into credit ratings. To date, these and other measures have been premised on the assumption that corporate governance affects financial performance in some way. As an empirical matter, however, that proposition is far from settled. Indeed, researchers disagree on the existence and strength of the relationship between various corporate governance features and performance.
This article summarizes the results of studies that attempt to correlate corporate governance with firm performance. Because the literature is so vast, this article will address only governance issues relating to the board of directors and takeover defenses, which have received the bulk of the attention from researchers, and are considered particularly important by institutional investors.
The board of directors
A large proportion of the regulatory changes have focused on boards of directors. This is unsurprising, given the critical functions performed by the board and its key committees--audit, compensation and nominating/governance. Many prominent witnesses testified before Congress and the national stock exchanges that captive boards were a major contributing factor in the corporate scandals, and that reforms designed to increase the independence and competence of boards were crucial to restoring investor confidence. For example, former SEC chairman Arthur Levitt testified that "company boards often fail to confront management with tough questions"; he recommended toughened independence standards. The Sarbanes-Oxley legislation marked the first time federal legislation imposed an independence requirement on public company boards, requiring companies to have an audit committee composed exclusively of independent directors and defining independence more narrowly than previous regulatory provisions. Sarbanes-Oxley also prohibited new company loans to directors. Proposed changes to the listing standards of the New York Stock Exchange and Nasdaq would require a majority of directors on listed company boards to be independent, as well as all directors on key committees, and would strengthen the independence definition.
Some individual companies have taken additional steps to increase the independence of their boards. …