New Database Captures Widespread Corporate Governance Changes of 1980s, Tracks 30 Years of Governance's Effect on Firm Performance
New Haven, Conn., October 28, 2009 — Professors Martijn Cremers of the Yale School of Management and Allen Ferrell of Harvard Law School have created a new database that tracks firms’ corporate governance from 1978 to 1989, capturing for the first time the period in which most corporate governance changes occurred, M&A activity boomed, and state anti-takeover law was in flux. By combining this new dataset with existing data, Cremers and Ferrell are able to analyze how corporate governance arrangements have affected firm value and stock returns over 30 years.
The Cremers-Ferrell database tracks, from 1978 to 1989, approximately 1,000 firms’ G- and E-Index scores (composite indexes of shareholder rights and anti-takeover measures); the presence or absence of the 24 individual corporate governance provisions that constitute these indexes such as poison pills, compensation plans, and classified boards; and data on M&A activity, firm financials, institutional ownership, and stock returns. They combined this new dataset with the Investor Responsibility Research Center (IRRC) database that covers 1990-2006, creating a comprehensive corporate governance database from 1978-2006.
"The 1980s were characterized by widespread corporate governance changes that largely ceased after 1990," says Cremers, associate professor of finance and a fellow of the Millstein Center for Corporate Governance and Performance at Yale SOM. "Despite the significance of this period, data prior to 1990 hasn’t been available. The database we’ve created allows us to see how corporate governance evolved to where it is today and to re-test existing hypotheses with the benefit of a longer time period."
In investigating the relationship between corporate governance and firm value, Cremers and Ferrell found that poor governance reduced firm value over the 1978 to 2006 time period. According to their analysis, an increase of three points in a firm’s G-Index score (a higher score indicates fewer shareholder rights or more anti-takeover measures) reduces firm value by about a 3.3%.
The authors also discovered that corporate governance affects firm value primarily through a takeover channel rather than through operating performance. Poor governance can reduce firm value by reducing the likelihood of an attractive takeover offer being received and accepted by the target board.
To research this, Cremers and Ferrell looked at how firm value was affected by poison pills, classified boards, and the G-Index both before and after 1985, a year marked by the seminal Moran v. Household International ruling by the Delaware Supreme Court that, for the first time, legally affirmed boards’ use of poison pills as a takeover defense and that was followed by a dramatic increase in the number of firms adopting poison pills. They found that these anti-takeover provisions negatively affect firm value only after 1985. Post-1985, an increase of one point in the G-Index lowers firm value 2% with industry fixed effects, or 1.2% with firm fixed effects; firms with a classified board have an 8.1% lower firm value; and firms with poison pills have an 11.7% lower firm value.
Cremers and Ferrell document that poor governance seems to affect firm value through a takeover channel, as negative effects are greater for firms in an industry experiencing a high level of M&A activity in a given year. Over the full time period, a three point increase in the G-Index is associated with a decrease in firm value of 2.4% for firms in an industry with a low level of M&A activity, and 3.9% for firms in an industry with a higher level of M&A activity.
Good corporate governance resulted in higher stock returns over the full period, according to the authors. Value-weighted portfolios long on firms with good governance and short on those with poor governance produced an annualized return of 3.93%, while equally-weighted portfolios returned 4.58% per year over the full 30-year period. The positive abnormal returns were highest in the beginning of the 1978-2006 time period and tend to decline over time.
"The results suggest that investors learned gradually over time the importance of good governance, which is reflected in the fact that abnormal returns were largest in the beginning of our time period and generally declined thereafter," says Cremers.
Download the paper "Thirty Years of Corporate Governance: Firm Valuation & Stock Returns."