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25 janvier, 2008 16:51

David A. Katz and Laura A. McIntosh

New York Law Journal

January 25, 2008

As a new year begins and the 2008 proxy season approaches, it is an appropriate time to take a fresh look at corporate governance, particularly its relationship, if any, to corporate performance. For more than two decades, corporate governance advocates have championed corporate governance best practices as a path for improving corporate performance. In fact, widely cited corporate governance ratings are predicated on the assumption that good corporate governance will lead to good corporate performance. These ratings then are used by corporate governance advocates and shareholder advisory services, such as Institutional Shareholder Services (ISS), to target companies with "sub-par" governance structures on the basis that improving corporate governance will improve corporate performance. In light of a new academic study, however, casting votes on the basis of corporate governance scores appears to be a flawed strategy.

A working paper recently released by three law professors offers evidence that corporate governance indices do not consistently predict corporate performance by any measure. The paper, titled "The Promise and Peril of Corporate Governance Indices sounds a timely note of caution for both shareholders and regulators. In their paper, Professors Bhagat, Bolton and Romano draw several conclusions, which are in accord with our professional experiences:

First, "There is at present no best governance index with which to identify a firm's governance quality. The best measure of governance varies with the context for which it is to be used, as different measures of good governance are correlated with different performance measures

Second, "if future stock returns (the conventional performance measure of concern to investors) are the focus, then none of the academic indices, nor the related commercial ones, are helpful. In short, consumers of indices need to be aware of the indices' considerable limitations. ... The danger for investors, particularly the more poorly informed, is that indices can create the illusion of certainty regarding an assessment of firms' governance quality, when reality is, in fact, quite muddy."

Third, "[b]ecause there is no one best governance index ... shoe-horning firms into a uniform set of governance institutions would generate potentially serious costs for investors. More specifically, the data indicating that good governance measures are substitutes suggest that what is good governance for one firm need not be good governance for another. ... [I]t would not be desirable for all firms to fulfill all components in a good governance index, since for some firms the provisions will be working at cross purposes. Yet governance mandates [such as the independent director requirements of the Sarbanes-Oxley Act and the stock exchanges, as well as private-sector versions of mandates in the form of best practices lists] do precisely that."

Bhagat, Bolton and Romano persuasively argue that the corporate governance index -- which, as they correctly observe, is the dominant approach to governance compliance and assessment -- yields at best a simplistic evaluation of complex circumstances. One reason is that corporate governance indices tend simply to compile a number of features associated with "good governance" and then, using some system of weighting (which is problematic in itself), assign positive values to the features and produce a value or ranking. This methodology does not allow for the possibility that certain features of good governance may be substitutes for one another rather than complements to one another. Although they offer no theory for determining which aspects of corporate governance are substitutes for each another, Bhagat, Bolton and Romano refer to empirical research indicating that the possibility should be taken into account. For example, a 2000 study shows that a strong independent board is a substitute for, rather than a complement to, the market for corporate control. In other words, companies with strong independent boards adopt many takeover defenses. A large data set in the 2000 study bolsters the conclusion that independent boards (widely understood to be a "good" governance feature) are associated with potentially entrenched management based upon the adoption of takeover defenses (according to shareholder activists, a "bad" governance feature). Bhagat, Bolton and Romano conclude, based on the 2000 study and other data, that corporate governance indices likely yield results that are inaccurate or misleading because such results fail to take into account the interaction among governance features, as well as the individual context in which each company operates. As Bhagat, Bolton and Romano put it, "governance choices vary with specific characteristics of firms, and high quality governance on one dimension may offset a need for what are conventionally thought to be best practices on another governance dimension."

Due to the many developments in corporate governance since the 2000 study was undertaken, such as the Sarbanes-Oxley Act of 2002 and the independence requirements of the major stock exchanges, boards are more independent than ever and yet takeover defenses are declining steadily. In large part, this may be attributed to the increased influence of activist shareholders, the corresponding demonization of takeover defenses and the expanded use of corporate governance indices. For the past several years, activist shareholders have pressured public companies to eliminate their takeover defenses or subject them to shareholder approval. Generally, activist shareholders have been effective: the use of two of the most effective takeover defense mechanisms -- poison pills and classified (or staggered) boards -- has declined significantly over the last several years. In the S&P 500, for example, poison pills currently are in effect at only 29 percent of companies, as compared to 60 percent in 2002, while classified boards currently exist at only 36 percent of companies, as opposed to 61 percent in 2002. The 2000 study implies that, absent outside pressure, boards that are highly independent would not be eliminating takeover defenses, as many are doing every year, but implementing them. We continue to believe that takeover defenses are a crucial element of good governance, and we view the decline in defenses as a real cost imposed upon public companies and their shareholders by activist investors.

The debate over takeover defenses illustrates that the answer to the question of which practices are "best" can depend on the desired effect on the company. Independent boards support takeover defenses for the same reason activist hedge funds and institutional investors oppose them: because they help the board prioritize long-term value over short-term gain. In an era when the retail investor is declining in importance, corporate decisions risk being increasingly influenced by institutional investors, who typically favor short-term results to the detriment of long-term value.

Bhagat, Bolton and Romano also discuss so-called "comply or explain" regimes, popular in the United Kingdom and the European Union. Such regimes are, like governance indices, based upon a checklist approach to corporate governance: While companies are not required to fulfill all the stated governance requirements, to the extent that a particular requirement is absent, companies must explain why they do not meet the requirement, and the presumption is that a fully compliant company is better governed than one that has explaining to do. However, since no single governance index produces consistently better performance results, the requirement that noncompliers explain their deviance from checklists may be generating costs with no countervailing benefits. Interestingly, Bhagat, Bolton and Romano find that most empirical studies indicate that in such regimes, companies that are fully compliant with best practices do not outperform noncompliers.

Bhagat, Bolton and Romano conclude that best governance regulatory regime would be "disclosure without reference to a comparative benchmark." They concede that this would create a burden for investors who would have the responsibility of seeking the kind of information that is available in a comply-and-disclose regime, but it also would be less misleading because it would not establish a default governance portfolio that purports to be best practices for all companies. With respect to information that investors actually should consider in evaluating companies without indices, Bhagat, Bolton and Romano suggest that the best single measure of governance quality may be the stock ownership of directors. Among other advantages, this is information that is relatively easy to find and also can easily be compared among different companies.

Corporate governance is not a "one-size-fits-all" or "check-the-box" proposition. The "best" corporate governance strategies differ for each company, depending on its individual circumstances. When considering proxy votes this spring, shareholders should not make the mistake of thinking that a generalized rating system is an effective substitute for individualized consideration of a company's governance, potential performance or overall value. Moreover, shareholders should not press companies to eliminate takeover defenses simply to make the board and management more "accountable." Nor should directors acquiesce simply to score a few meaningless points on a corporate governance index. Directors need to consider carefully any decision that would result in weakening defenses and determine whether the benefits from such a decision actually outweigh the attendant risks. At any time, but particularly in a challenging economic environment, takeover defenses are among the most important tools that a company can use to protect and increase shareholder value. Shareholders should remember that their own interests may dictate a different definition of "good governance" than that of the activist investors and organizations who push governance hegemony in the service of increased influence, not improved corporate performance.

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