Investor Protection and Firm Governance: Substitutes or Complements?

24 August 2007 at 9:57 am Peter G. Klein 4 comments

| Peter Klein |

The new institutional economics often treats the institutional environment and institutional arrangements as substitutes. In countries with stable legal institutions, relatively efficient courts, and reasonable default rules for contract terms, for example, contracts tend to be less complete. If contracting parties can trust the courts to fill in the gaps, why bother to write out every contingency? Likewise, if a country has an efficient external capital market, firms can be small and specialized, relying on the capital markets to allocate resources among business units, but if the external capital market performs poorly, diversified business groups may arise to exploit their internal capital markets.

It is thus surprising to learn, from a new paper by Reena Aggarwal, Isil Erel, René Stulz, and Rohan Williamson, that firms tend to establish better mechanisms for corporate governance in countries that already have strong rules for investor protection. “[O]ur evidence suggests that firm-level governance attributes are complementary to rather than substitutes for country-level investor protection, so that better country-level investor protection makes it optimal for firms to invest more in internal governance.” The better the institutional environment, in this case, the more effort agents put into designing efficient institutional arrangements.

Clearly more work is needed to understand the interactions between “macro” and “micro” institutions. What are some other good papers in this area?

Entry filed under: - Klein -, Institutions, Strategic Management, Theory of the Firm.

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4 Comments Add your own

1. Brian A'Hearn | 28 August 2007 at 9:32 am

I do not know any good papers to recommend, and had been hoping for comments by other readers.

The issue seems an important one to me, related to the Big Question of whether institutions determine only the interesting details of form or have a pervasive impact on the performance of an economy. I like the way you framed the issue in terms of substitutes and complements.

The abstract of the paper you cited says it is based on “an index which increases as a firm adopts more governance attributes”. What does that mean exactly? I thought of governance as being more of a qualitative than a quantitative concept.
2. Peter Klein | 28 August 2007 at 3:04 pm

Brian, that is a good question. The paper constructs a governance index based on data provided by Institutional Shareholder Services (ISS). From the paper: “ISS started providing the Corporate Governance Quotient (CGQ) for U.S. companies in 2002 and for international companies in 2003. The CGQ rankings are a relative measure of a firm’s investment in internal governance, i.e., its adoption of governance attributes, and indicate the firm’s investment in governance relative to firms in its industry or within an index in which the firm is included. To compute these indices (which we do not use in this paper), ISS collects information on governance attributes for a large number of U.S. and foreign companies.” Here are the items used:

BOARD
1. All directors attended 75% of board meetings or had a valid excuse
2. CEO serves on the boards of two or fewer public companies
3. Board is controlled by more than 50% independent outside directors
4. Board size is at greater than five but less than 16
5. CEO is not listed as having a related-party transaction
6. No former CEO on the board
7. Compensation committee comprised solely of independent outsiders
8. Chairman and CEO are separated or there is a lead director
9. Nominating committee comprised solely of independent outsiders
10. Governance committee exists and met in the past year
11. Shareholders vote on directors selected to fill vacancies
12. Governance guidelines are publicly disclosed
13. Annually elected board (no staggered board)*
14. Policy exists on outside directorships (four or fewer boards is the limit)
15. Shareholders have cumulative voting rights
16. Shareholder approval is required to increase/decrease board size
17. Majority vote requirement to amend charter/bylaws (not supermajority)
18. Board has the express authority to hire its own advisors
19. Performance of the board is reviewed regularly
20. Board approved succession plan in place for the CEO
21. Outside directors meet without CEO and disclose number of times met
22. Directors are required to submit resignation upon a change in job
23. Board cannot amend bylaws without shareholder approval or can only do
so under limited circumstances
24. Does not ignore shareholder proposal
25. Qualifies for proxy contest defenses combination points

AUDIT
26. Consulting fees paid to auditors are less than audit fees paid to auditors
27. Audit committee comprised solely of independent outsiders
28. Auditors ratified at most recent annual meeting

ANTI-TAKEOVER
29. Single class, common
30. Majority vote requirement to approve mergers (not supermajority)
31. Shareholders may call special meetings
32. Shareholder may act by written consent
33. Company either has no poison pill or a pill that was shareholder approved
34. Company is not authorized to issue blank check preferred

COMPENSATION & OWNERSHIP
35. Directors are subject to stock ownership requirements
36. Executives are subject to stock ownership guidelines
37. No interlocks among compensation committee members
38. Directors receive all or a portion of their fees in stock
39. All stock-incentive plans adopted with shareholder approval
40. Options grants align with company performance and reasonable burn rate
41. Company expenses stock options
42. All directors with more than one year of service own stock
43. Officers’ and directors’ stock ownership is at least 1% but not over 30% of
total shares outstanding
44. Repricing is prohibited

I’ve seen other governance indexes in the literature too. You can read about them here.
3. Brian A'Hearn | 29 August 2007 at 8:27 am

So “governance” here seems to mean “protection of shareholder interests against management interests”. In that context, it makes sense to talk about a quantity or degree of governance. I had thought the term governance was neutral, and simply meant the arrangements by which a corporation is controlled.

Thanks for the details.
4. Peter Klein | 30 August 2007 at 12:06 pm

That’s a good point. It demonstrates how much the basic framework of agency theory is taken for granted in most of thlis literature.