MFIN6210: Empirical Studies
in Finance
Governance, Managerial Entrenchment and Firm Value
Corporate Governance?
Refers to the internal mechanisms or structures a
firm has in place to ensure managers are more
accountable
This should be the “G” in ESG
What structures are we talking about?
2
Governance-
related
factors
Board of Directors
The board of directors
The Board
Shareholders
• Own the company (have
rights to cash flows and
votes)
Board
• Shareholders appoint to
manage the company on
their behalf
CEO/MD
• Directors appoint a
director to undertake day-
to-day management tasks
Board Structure
Board
Independent
Executive
Grey
Board
Audit
committee
Governance
committee
Nomination
committee
Remuneration
committee
etc
Board attributes
Independent board
• Any downsides of independent directors?
• Poor incentives
• Lack of knowledge
Higher quality directors
Independent audit committee
Independent nominating committee
Directors who are ‘experienced’ but are not too ‘busy’
Board Diversity
Push
• Push for “diversity” in some quarters
• Generally not evidence based
(https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3812642
)
• Conflicts with Fair Work Act Section 351
• Rejected by California Courts as violating equal opportunity
rights (https://www.reuters.com/legal/legalindustry/californias-
board-diversity-law-struck-down-what-now-2022-04-05/)
Directors’ duties
Board Independence in ASX
• ASX
• Corporate Governance codes:
https://www.asx.com.au/documents/asx-
compliance/cgc-principles-and-recommendations-
3rd-edn.pdf
• Some recommendations
• Majority independent nomination committee
(Recommendation 2.1)
• Disclose which directors are independent
(Recommendation 2.3)
• Majority independent board (Recommendation
2.4)
• Independent chair (Recommendation 2.5)
Board Independence
Benefits of Independent Directors Disadvantages of Independent
Directors
• Less incentive to monitor [i.e., lack
of incentive compensation; lack of
equity]
• Potential “board capture” (i.e., CEO
recommends appointment of
friendly directors)
• Potentially distracted by holding
multiple board positions
• Might not know much about the
firm (or industry) – they are
tautologically from outside the firm
so lack firm specific information
• Increased oversight
• Guo and Masulis (2015, RFS):
https://dx.doi.org/10.1093/rfs/hhv
038: Increased independence
increases turnover sensitivity to
poor performance
• Forces executives to consider
independent / outside perspectives
• Banerjee, Humphery-Jenner, Nanda
(2015, RFS):
https://dx.doi.org/10.1093/rfs/hhv
034: Increased independence
restrains overconfident CEOs
• Potentially brings additional
expertise to the board
Example:
Twitter’s
board (pre-
acquisition)
Disclosure
Requirements
Disclosure
obligations
• Australia:
• ASX Listing Rule 3.1
• Corporations Act
Section 674(2)
• Corporations Act
Section 1041E
• United States:
• SEC Rule 10b-5
https://www.asx.com.au/documents/about/abridged-continuous-disclosure-guide-clean-copy.pdf
Do the
disclosure
obligations
matter?
How
would you
test this?
Value-implications?
Impact on CEOs (are they punished)?
Impact on access to debt and debt
terms (lenders do not trust the
firm)?
Impact on customer and supplier
relationships?
Value-implications in specific
instances: Twitter
• Potential impact during the twitter merger
• Alleged false SEC filings could cause the takeover to fail because…
• Merger agreement specifically had a term in which Twitter stated
their SEC filings were correct (Section 4.6:
https://www.sec.gov/Archives/edgar/data/1418091/0001193125221
20474/d310843ddefa14a.htm )
• Merger contract could be ‘void ab initio’ if Elon Musk can establish
that Twitter misled him about the fundamental value of the company
• False SEC filings could enable Elon Musk to counter-sue under SEC
Rule 10b-5 for loss or damage suffered due to being misled
https://financemark.substack.com/p/can-elon-musk-terminate-the-
twitter
Compensation
16
Highest paid CEOs in Australia
15.97
13.87
13.38
10.6
10.08
8.99
8.38
7.89
7.48
6.93
0 2 4 6 8 10 12 14 16 18
Macquarie Group
CSL
Goodman Group
Newcrest Mining
BHP Group
Kogan.com
Woolworths
Sims Metal Management
Brambles
Wesfarmers
Total 2020 reported pay ($m) Total 2021 reported pay ($m)
https://www.afr.com/work-and-careers/leaders/revealed-australia-s-50-highest-paid-ceos-20211117-p599rf
Shareholder
votes against
compensation
(% voting
against)
https://www.afr.com/work-and-careers/leaders/revealed-australia-s-
50-highest-paid-ceos-20211117-p599rf
Compensation
Executives aim to maximize their utility
Utility increases with wealth (at a decreasing rate), but decreases with
effort and risk
• Salary ~ has not increased much in recent years. Median pay up 1% in Australia over the last
year ; Average decreased by 1.3% over last year
• “Cash” Bonus
• Stock
• Options
Compensation components
• Clawbacks
• “say on pay”
Other considerations
Designing compensation
Salary
Fixed salary is generally necessary – CEOs need cash
to be able to live
Drawback is that it is not sensitive to firm
performance
Bonus Additional cash compensation for meeting a target of some kind
Stock grants
Can be granted as a bonus
Can form part of compensation
Make the CEO’s compensation directly sensitive to
stock price movements
Option grants
Similar to stock
Encourage additional risk taking
Often long-dated
Designing compensation
Clawbacks
•These enable the
company to obtain
compensation back from
the CEO, in certain
circumstances, after
he/she leaves
Say on pay
•Give shareholders the
power to reject
compensation plans that
the board implements
• In Australia
•Shareholders vote on
compensation plans. If
more than 25% of
shareholders reject the
plans on two
consecutive occasions,
there is a board spill.
• Introduced in 2012
Golden parachutes
•Compensation if the CEO
leaves the company
under specified
circumstances (i.e., target
of a takeover)
Say on Pay – evidence
How would you investigate whether Say on Pay
is helpful?
What would your experimental design be?
Dependent variables?
Say on pay – evidence
• Borthwick et al: https://doi.org/10.1111/acfi.12381
• What factors increase the likelihood of shareholder dissent?
[firm year panel from 2005 – 2015]
• How does the market react to shareholder dissent?
• How did the market react to the introduction of say on pay
rules
24
Issues?
Issues?
25
Market
reaction to
two strikes
rule coming
in
Market
reaction to
receiving a
pay strike
Anti-takeover
Provisions
Example: Twitter’s Poison Pill
https://www.businessthink.unsw.edu.au/articles/twitter-poison-pills-shareholders
How does the market generally react to firms
adopting poison pills?
30
In July 2018: Papa John’s adopted a poison pill over the weekend ostensibly to prevent
its former Chairman/founder buying the firm. The shares fell around 7% on the Monday
after trade resumed
Why are
takeovers
important
to
governance
The threat of takeovers thus encourages managers to
act in shareholders’ best interests
But, managers would rather not get fired [CEO
positions are quite lucrative]
Bidders could observe this, and believe they could
improve target value by firing poor quality managers
and replacing them with good quality managers
If managers are low quality, then share prices decline
to reflect the lack of management acumen
Major
types of
anti-
takeover
provisions
Poison Pills
Staggered (or classified) boards
Golden Parachutes
Supermajority voting provisions (i.e. for a
takeover of the company to be approved)
Plus
• Limits to amendments to charters
• Limits to amendments to by laws
Governance
Metrics
• Focus on what ATPs do to managers’ incentives (not how they
influence the takeover offer that a target receives)
• Key research :
• Gompers, Ishii & Metrick (GIM, 2003) – used by the IRRC:
24 anti-takeover provisions (ATPs)
• ATPs → lower firm value
• Bebchuk, Cohen & Ferrell (BCF, 20089): 6 significant ATPs
• ATPs → lower firm value; 6 key ATPs make the
difference
• Bebchuk & Cohen (2006): 1 ATP (SBOARD, staggered
Boards)
• Classified board and Poisson pills lead to lower firm
value
• Masulis, Wang and Xie (2007): GIM index is associated
with acquirers doing worse takeovers
• Harford, Humphery-Jenner, and Powell (indicator for
having more than 10 anti-takeover provisions)
• Entrenched managers do takeovers that destroy
more value
• Entrenched managers avoid takeovers that might
increase outside monitoring (i.e. targets with
blockholders)
• Entrenched managers use overvalued equity to
acquire expensive targets
• Staska and Waller: very useful summary of the prior literature
(in the appendix table)
Could ATPs
have some
specific
benefits?
Innovative or “hard to value”
firms
• Humphery-Jenner (2014):
http://dx.doi.org/10.1002/smj.2121
Labor-market “bonding”
Supply chain relationships
• Jonson et al (2015):
10.1016/j.jfineco.2015.03.008
How might you test the relationship
between ATPs and “firm value”
• Regression of the presence of ATPs onto
value measure for each year in a firm-year
panel: , = + ,−1 +
σ=1
,−1
+ ,
• Examine how the market reacts to
investments made by firms with more ATPs
(an “event study”)
• Explore whether firms with ATPs do
genuinely achieve higher takeover
premiums
Governance & Firm Value - Bebchuk
& Cohen, JFE 2005
• Do ATPs reduce firm value? (Bebchuk & Cohen, JFE 2005)
• Examine one ATP: Staggered or classified board – proxy for
entrenched boards
• From 1995 the majority of US firms (>60%) had a staggered
board in place
• They argue that it reduces the likelihood of a proxy contest or
hostile takeover
Issue: “off the shelf” poison pills
Regression methods
• How do we deal with the panel sample. Here, there are firms, with observations for years
(obviously some firms fall out of, or enter the sample, but roughly speaking)
• “Pooled OLS” – firm year panel sample:
, = + , +෍
=1
,
+ + + ,
• Fama-Macbeth regression
• Run a cross-sectional regression each year ∈ 1, :
= +
+෍
=1
+
• Calculate the Fama-Macbeth
• Coefficient:
=෍
=1
• Standard error (basic version):
=
1

෍
=1

−
2
=
Governance & Firm Value
• Pooled OLS regression of industry-adjusted Tobin’s q on staggered board
dummy and controls (see Table 2)
• As expected, staggered boards result in lower firm value
Table 3: Annual regressions
What is being done about ATPs?
• Institutional
investors
pressuring
boards to
remove them
40
External Monitoring
from Institutions
Example 1
• Institutional investors can play an important role in influencing corporate
decision-making:
• See e.g. Loeb’s push for Sony to separate its entertainment arm
• http://www.bloomberg.com/news/print/2013-08-05/sony-rejects-loeb-s-request-to-
sell-part-of-entertainment-unit.html
42
Example 2
43
From: http://www.smh.com.au/business/carnegie-perpetual-turn-up-heat-on-brickworks-soul-patts-20131023-2w1yt.html
External
Monitoring
from
Institutions
• Institutional investors can play an
important role in monitoring managers
• Can potentially push for board
positions (with a large enough
holding, see e.g. Mike Cannon-
Brookes with AGL)
• Can influence managers with proxy
votes (i.e. to remove anti-takeover
provisions; remove directors)
• Can influence voting at
shareholders’ meetings
• Can convey a signal to managers
through a pattern of selling/buying
in response to managerial decision-
making
• Good ‘survey’ paper on institutional
investors is Edmans (2013):
“Blockholders and Corporate
Governance”
The Evidence
• Related to Voice:
• McCahery, Sautner and Starks (2011)
• Survey institutional investors
• Blockholders do actively engage at AGMs, initiate discussions
with the board or (in the Netherlands) contact the supervisory
board to seek management change
• Hedge funds more likely to be activist than other institutions
• Brav et al (2008)
• 13D filings (which an insto must file to engage in activism) are
associated with abnormal returns of 7-8% over a (-20,+20)
window
45
The Evidence
• Related to Exit:
• Theoretically established in Edmans (2009): Theory model
to show that exit can convey information
• McCahery et al (2011): exit is primary method of discipline
employed by blockholders
• Gallagher, Gardner and Swan (2013): Blockholder trading
→ increases in price efficiency and improvements in future
performance
• Gorton, Huang and Kang (2013): multiple blockholders →
better price informativeness
• Edmans et al (2013): increased liquidity → greater block
acquisition: consistent with idea that they will be more
likely to buy into a company if they can exit
• Chang et al (2013): blockholder trading → higher firm
value and less value-destruciton/ agency conflicts
46
Conclusions
Firms with weaker shareholder rights (poorly governed) have lower
performance
But, the market appears to reward good governed firms with higher
returns
In efficient markets, only unexpected news gets priced.
Methods of improving governance
• Internal governance
• Removing ATPs
• External governance