In late December, the U.S. House of Representatives passed the Corporate Governance Reform and Transparency Act on a bipartisan basis. This bill is good news for investors in our capital markets, managers, employees, and other stakeholders of public corporations.
Corporate governance took on a new urgency in the aftermath of Enron’s collapse and a succession of accounting scandals. It became a topic of intense media and activist institutional investor interest, in the hope that closer scrutiny of corporate governance could prevent further Enrons. At the same time, corporations were being forced to reconsider their governance by federal legislation and stock exchange listing requirements that were enacted in reaction to the scandals and that emphasized corporate governance solutions.
{mosads}Moreover, mutual funds were pushed to become more involved in governance under regulation adopted by the U.S. Securities and Exchange Commission, which required funds to adopt written policies on proxy voting and to disclose their specific votes. In turn, the heightened attention accorded corporate governance increased the demand for third-party corporate governance-related services by institutional investors for research and advice on proxy voting and by corporations for advice on how to improve their governance ratings.
Two concerns have been raised about the companies that provide such corporate governance and proxy voting advice. First, do the recommendations of these corporate governance and proxy advisors enhance the shareholder value of the companies they are advising? We, and others, have published several papers in scholarly finance and law journals that focus on just this very question.
These papers consider the relation between corporate performance and governance attributes recommended by the governance and proxy advisors for thousands of U.S. companies over the past two decades. Remarkably, there is no consistent evidence of any positive correlation between corporate performance and governance attributes recommended by the governance and proxy advisors.
One of the products sold by governance and proxy advisors to institutional investors and corporations is governance rating. The idea underlying ratings construction is to benchmark a firm’s governance features against what the index constructor considers to be best practices. Accordingly, a firm’s score on the index or rating is intended to provide a readily comparable, summary measure of governance quality.
Governance ratings constructed and sold by two of the better known governance and proxy advisors, namely, Glass Lewis, and Institutional Shareholder Services, incorporate several dozen variables. These variables include antitakeover provisions including poison pills, golden parachutes, supermajority rules to approve mergers and staggered boards, board independence, board audit committee independence, board nominating committee independence, board compensation structure, auditor rotation, executive compensation structure, director term limits, and dozens of other governance-related company-specific attributes.
These governance and proxy advisors have compiled an impressive amount of governance-related characteristics for thousands of U.S. and foreign companies. However, as suggested earlier, several published papers in scholarly finance and law journals find no relation between governance ratings sold by governance and proxy advisors and company performance.
On the other hand, we propose a much simpler and more transparent governance measure, to wit, the median dollar stock ownership of the directors of the company. This simple director ownership variable is consistently and positively related to company performance for the largest 1,500 publicly-held companies over the previous two decades, and for several periods during these decades. If policymakers and institutional investors are concerned about corporate governance, they should focus on the skin in the game that directors have.
The second concern with the governance and proxy advisors is their conflict of interest with the very shareholders of companies they are advising. In marketing their products and services, governance and proxy advisors often emphasize the usefulness of their ratings in portfolio decisions, with voting decisions listed as an additional use or service. Because governance and proxy advisors also provide governance consulting services to companies, some have criticized its use of its own governance rating in its proxy voting advice as creating an inherent conflict of interest.
The Corporate Governance Reform and Transparency Act is squarely focused on addressing this conflict. The bill requires governance and proxy advisors to disclose to the U.S. Securities and Exchange Commission any conflict of interest they have when advising institutional investors on how to vote on various proxy items. It also provides for a standard process and timeframe for companies to review and provide feedback to the governance and proxy advisors on important company decisions including proxy items, before the advisors send their recommendations to investors.
I urge the U.S. Senate to take up this bill for consideration. Passage of this bill will enhance corporate governance practices in the United States to the benefit of investors, corporate employees and other stakeholders, and our capital markets.
Sanjai Bhagat is the provost professor of finance at the University of Colorado and the author of “Financial Crisis, Corporate Governance, and Bank Capital,” published by Cambridge University Press.