Wall Street Journal Online

Two New Studies Could Provide Ammo Vs Governance Backlash

June 29, 2004


NEW YORK -- Investor activists battling a growing backlash against corporate governance reforms have a couple of new weapons to add to their quiver, courtesy of academia.

Two just-off-the-presses scholarly studies offer support for the oft-debated notion that following bedrock corporate governance principles has an impact on corporate behavior and shareholder value.

One of the studies, co-authored by Lucian A. Bebchuk, a Harvard Law School professor and director of the school's corporate governance program, found that companies with staggered board terms deliver less shareholder value than those that hold annual director elections.

The second paper examined connections between governance and the likelihood of corporate fraud, in what is believed by its authors to be the first finding of a direct link between board independence - or lack thereof - and financial shenanigans.

Taken together, the pair of studies could provide a counterweight to the growing backlash coming from companies and their representatives against the cost and burden of complying with a raft of regulations, particularly the provisions of the sweeping Sarbanes-Oxley Act of 2002.

"We have always believed that good corporate governance leads to better performance and management," said Brad Pacheco, a spokesman at the California Public Employees' Retirement System, which has taken some heat for its aggressive governance campaign this year. "It also provides an insurance policy during down cycles in the economy, and leads to greater integrity and openness. These studies validate our position."

With the recent controversies erupting over the cost of complying with Sarbanes-Oxley, "what we need to know is - if there are costs, what are the benefits?" said Samuel H. Szewczyk, an associate professor of finance at Drexel University, who co-authored the fraud study.

Szewczyk and two fellow academics believed they answered the question, in part, by zeroing in on what has become a crucial investor issue following the parade of financial scandals over the past few years and the raison d'etre for the regulations in the first place.

Published in the June issue of Financial Analysts Journal, the study found that as the number of independent, outside directors increased on a board or key committee, the likelihood of corporate wrongdoing decreased. The study, however, did reveal one "troubling" finding, the trio wrote: In general, the presence of a compensation committee increased the likelihood of corporate fraud, which may circle back to issues related to hiring compensation consultants, Szewczyk said.

For the sample, the researchers compared 133 companies accused of fraud from 1978 and 2001 to a sample of similar "no-fraud companies."

An aspect of Szewczyk's work that may resonate with governance activists is his focus on non-management directors who had ties to the companies under review. The issue of board members the paper terms "gray" directors harks back to Enron Corp. (ENRNQ), where critics say ostensibly independent outside directors were tainted by other connections to the former energy giant.

In their study, the academics found, for example, that "fraud companies" in the sample had a higher percentage of "gray" directors on the key audit, compensation and nominating committees.

"The results indicate that board composition and the structure of its oversight committees are significantly related to the incidence of corporate fraud," the authors wrote, adding that their work "supports" new stock exchange requirements strengthening board and committee independence, which became a reality this year for most publicly traded companies.

Staggering Director Terms

The research on staggered boards conducted by Bebchuk and Alma Cohen, a researcher at Harvard Law School and at the Analysis Group, an economic consulting firm, represents the latest entry in the ongoing debate about the wisdom of directors serving staggered three-year terms, a common occurrence in Corporate America.

The increasingly controversial board structure has long been seen as a board entrenchment device by shareholders, who in recent years have urged companies to hold annual elections via shareholder resolutions as a way to make directors more accountable to shareholders. Companies on the other hand argue that staggered board terms are essential for stability and continuity and ultimately in the best interests of shareholders.

Although companies have been more amenable in recent years to go along with shareholders' call to de-stagger the terms, many companies still resist annual elections. According to 2003 proxies analyzed by the Investor Responsibility Research Center, more than 60% of the S&P 500 and S&P 1,500 companies have classified boards.

Bebchuk's research paper, co-issued by Harvard's John M. Olin Center for Law, Economics, and Business and the National Bureau of Economic Research, jumped off from previous research that found that staggered boards was one of about two dozen shareholder-unfriendly provisions that correlated with lower shareholder value.

As it turns out, the presence of a so-called classified board appears to be one of the most important factors negatively associated with corporate value, Bebchuk said.

"A staggered board is not just one among equal, its really quite important in both driving what was already identified in the aggregate and as a stand-alone," Bebchuk said. "We find it to be a pernicious arrangement."

The studies aren't the first to tie practices widely thought of as "good governance" to arguably positive results. A study funded by a grant from Institutional Shareholder Services earlier this year, concluded that companies with relatively poor corporate governance - as measured by the proxy advisory firm's rating system - performed worse than companies with stronger governance.

But over the years, an assortment of academic papers have reached mixed conclusions, with at least one mid-1990s examination finding no connection between market value and board independence.

Some prior studies tried to measure too much by looking for "a single linear relationship between independence and company performance," said Beth Young, a senior research associate at the Corporate Library, an independent governance research firm and corporate watchdog.

While failure to find such a lofty connection is seized by those engaging in "backlash speak," such a phenomenon is unlikely to be documented, she suggested, because of "noise" surrounding the collection of data and given that the optimal director for any given board can depend heavily on a company's particular situation.

The fraud study is significant because it drills down to an individual attribute that is "the holy grail" to shareholders, and empowers investors to focus on the independence issue "at companies where it will make a difference," Young said.

Investors understand that a company could fail in their chosen niche because of a variety of factors, she added. "If you really get down to what motivates investors and what they are most afraid of," she said, "it's a company that has a good product or service but fails because of malfeasance."


Last updated: July 04
Copyright © The President and Fellows of Harvard College.
Comments and questions should be directed to Sigal Bar-Gill at: sbargill@law.harvard.edu