Corporate Governance Changes as a Signal: Contextualizing the Performance Link

Abstract

Promoting “good” corporate governance has become an important concern. One result has been the creation of indexes that purport to measure the quality of a firm’s corporate governance structure. Prior scholarship reports a positive relationship between firms with good corporate governance index ratings and stock-price-based measures of a firm’s ability to create share value, such as Tobin’s Q. Little work, however, explores why we observe this relationship.

We hypothesize one reason for the relationship is that a rating-altering change in corporate governance structure can be a signal concerning the quality of a firm’s management. Changes in governance structures that result in better ratings tend to make a firm’s management more vulnerable to a hostile takeover, or give independent directors or activist shareholders more voice. These effects impose lower costs on high quality managers, who have less to fear, than on poor quality ones. The willingness of a firm’s managers to make such a change thus signals that they are high quality. This positive signal leads to a share price improvement and hence a higher Tobin’s Q.

Our hypothesis suggests that this signal would be particularly strong in a period where there was unusually high uncertainty about the quality of firm managers. We focus on 2001-2002, a period of an unprecedented cascade of corporate accounting scandals, including Enron and WorldCom. This led to reduced confidence in the accounting of all the other firms in the market. Using a fixed effect regression technique, we compare the change in Tobin’s Q for firms that engaged in rating-altering governance changes during this 2001-2002 period with the parallel change in Q for firms making such changes in the years surrounding the accounting scandal period (1992-2000 and 2003-2006). Consistent with our hypothesis, we find that an improved governance index score in the accounting scandal years is associated with a much larger increase in Tobin’s Q than a comparably sized rating improvement occurring in the surrounding years. We empirically rule out that this finding is solely the result of one or both of the finding’s two most likely alternative explanations. One is that having a structure with a higher rating leads over time to a firm having higher quality managers, and that higher quality managers are particularly appreciated in crisis times. A second is that managers, regardless of quality, are better motivated and informed when operating under a more highly rated governance structure, and that these drivers of better performance are particularly valuable in crisis times. Using an OLS regression technique, we compare the cross-sectional relationship between the sample firms’ governance ratings and their Tobin’s Qs for 2001-2002 with the parallel relationship in the years surrounding the accounting scandal period (1992-2000 and 2003-2006). There was no significant difference between the crisis years and the ordinary ones. In other words, in contrast to firms that changed their governance structures in the 2001-2002 period, for firms that did not change, there was no difference between 2001-2002 and other times in the strength of impact on Tobin’s Q from having a good rating versus a bad one.

By enhancing share price accuracy, reducing the asymmetry of information between the market and corporate insiders concerning the quality of management enhances the efficiency of the economy. Our results show how the signaling activities of private actors can help in this regard. They also suggest how sharply asymmetries about management quality can grow if regulatory and gatekeeper failures allow a substantial number of accounting frauds to develop.