The Core Corporate Governance Puzzle: Contextualizing the Link to Performance

By Fox, Merritt B.; Gilson, Ronald J. et al. | Boston University Law Review, October 2019 | Go to article overview

The Core Corporate Governance Puzzle: Contextualizing the Link to Performance


Fox, Merritt B., Gilson, Ronald J., Palia, Darius, Boston University Law Review


Introduction

There is a critical puzzle at the core of corporate governance theory: Is corporate performance really linked to a firm's governance structure? Promoting "good" corporate governance has become a global industry. Large international organizations, such as the Organisation for Economic Co-operation and Development ("OECD"), have adopted corporate governance codes of best practice,1 and major institutional investors have adopted guidelines setting out how they will vote the shares in their portfolios on governance issues.2 As well, corporate governance concerns were at the center of the conditions that the International Monetary Fund ("IMF") imposed on financial assistance to countries after the East Asian financial crisis.3 In the United States, both the Sarbanes-Oxley legislation following the Millennial accounting scandals and the Dodd-Frank legislation following the "Great Recession" sought, among other things, to improve the corporate governance practices of the companies the statutes cover.4 In turn, Delaware courts over the last twenty-five years have devoted a great deal of attention to reshaping and highlighting the governance content of Delaware corporate law.5

This emphasis on governance is built on the premise that "better" corporate governance structures lead to greater firm value. Here, though, is where the core puzzle comes into play. A nagging concern persists as to whether this foundational premise is accurate.6 This concern suggests three central questions: Is there in fact a relationship between the firm's governance structure and its capacity to create value, and if so, when and why?

A large academic literature in law and finance has arisen seeking to test empirically the link between certain corporate governance attributes and firm value.7 One genre in particular-the index study-suggests a positive relationship between a firm's performance and the quality of its corporate governance. The index lists a set of what the author believes to be favorable governance attributes and assesses the quality of a firm's governance by counting how many of these attributes a firm displays.8 These studies show a statistically and economically significant positive relationship between firms with governance structures that receive favorable index ratings and their Tobin's Qs, a widely used measure of firm value creation.9

Other scholars, though, have challenged these index studies, arguing that there is no sensible story to explain how many of the governance attributes that determine a company's index rating could in fact affect firm value.10 For example, not currently having a poison pill takeover defense in place is scored in the index studies as a positive attribute. However, a firm's board, without shareholder approval, can quickly adopt a pill if its management feels the need in the face of an actual immediate takeover threat. Hence, the critics argue, the absence of a pill prior to such an immediate threat should have no consequence for firm value.11 In effect, any company not having a pill already in place has a "shadow" pill that can be activated at any moment and achieve exactly the same effects.12

But these criticisms raise their own problem: they advance a theory as to why the index studies should not yield empirical results but no theory as to why they nevertheless appear to do so. Given the absence of careful theory on either side, we come face to face with the core corporate governance puzzle: What is the link between governance and performance?13

Our central thesis is that corporate governance is more complicated, and its effects more contingent, than the governance theories used to construct the indices on which the governance index studies are based. This point is largely missed by the debate to date.14 The existing index studies, for example, only measure the average impact of a set of attributes on firm value across a large number of corporations over a considerable period of time. …

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