In the paper, Corporate Governance and Innovation, which was recently made publicly available on SSRN, we examine the effect of corporate governance on innovation as measured by firm research and development (R&D) expenditures. Two different perspectives dominate the academic literature on corporate governance. One perspective emphasizes principal-agent problems and suggests that executives who are protected from shareholder pressure become entrenched. Entrenched executives pursue their own interests at the expense of shareholders. If executives prefer less-risky corporate strategies then an entrenched executive might reduce risky R&D expenditures. An alternative perspective emphasizes that the threat of takeovers forces executives to focus on short-term results so long-term investments such as R&D may suffer. An executive concerned about a takeover threat may reduce R&D expenditures, which are not expensed, to increase short-term profits and stock prices to discourage a hostile takeover. This perspective suggests that entrenched executives who are free from the pressure of hostile takeovers may pursue more R&D expenditures.
Our results do not support either of these views. Simple regression techniques do indicate that entrenched executives perform less R&D. However, it is unclear whether entrenched executives lead to less R&D or that firms which perform less R&D chose to adopt governance procedures that entrench executives. When we use techniques that allow for the possibility that low R&D leads to more entrenched executives, we find very little evidence that entrenched executives reduce R&D expenditures. We interpret this as evidence that the quality of corporate governance has little effect on the level of R&D expenditures. Instead, it looks like firms that choose to perform little R&D also choose governance provisions that entrench executives and protect executives from hostile takeovers.
Our results come with one important qualification. The level of R&D spending is relatively easy for boards to observe so entrenched executives may not be able to reduce the level of R&D spending. However, the quality of R&D projects is more difficult for boards to monitor so entrenched executives may alter the type of R&D projects while keeping the level of R&D spending unchanged. In particular, an entrenched executive may chose to pursue low-risk/low-return projects rather than high-risk/high-return projects. This is an important qualification to the results in our paper and we do examine this possibility in related research.
We believe that our findings have important implications for corporate governance research in general. We measured corporate governance using indices compiled by the Investor Responsibility and Resource Center (IRRC) from filings with the Securities and Exchange Commission. The IRRC tracks governance features such as whether the firm has adopted a poison pill, has staggered boards, or is incorporated in a state with anti-takeover laws. This is one of the most common measures of corporate governance in the academic literature. However, many studies do not use techniques which account for the possibility that this measure of corporate governance responds to the phenomenon of interest. As a result, some existing studies may overstate the effect of corporate governance on firm investment strategy and firm value.
The full paper is available for download here.