Editor’s Note: This post is by Brian R. Cheffins of the University of Cambridge.
In my paper Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown? The Case of the S&P 500, a draft of which is currently available here, I provide the first detailed empirical analysis of the operation of U.S. corporate governance during the stock market turmoil of 2008. The study focuses on a sample of companies at “ground zero” of the stock market meltdown, namely the 37 firms removed from the iconic S&P 500 index. The results indicate that, despite U.S. stock markets experiencing their worst year since the 1930s, corporate governance performed tolerably well. This in turn implies it would be premature for policymakers to overhaul existing arrangements.
As the paper describes, over the past few decades U.S. corporate governance has been re-oriented towards the promotion of shareholder value. The sharp decline in share prices that occurred in 2008 implies this shareholder-focused corporate governance model “failed” and that reform is correspondingly justified. However, corporate governance is not the primary determinant of share prices, as reflected by the fact academic testing of the hypothesis that good corporate governance improves corporate financial performance has yielded inconclusive results. It therefore is possible that in 2008 corporate governance in public companies generally functioned satisfactorily amidst general market trends that inexorably drove share prices downwards. The paper examines whether this in fact might have been the case by examining corporate governance in companies removed from the S&P 500 index.
Over the next while there likely will be numerous studies of how corporate governance functioned during the recent financial crisis. However, the 37 companies removed from the S&P 500 in 2008 provide an apt starting point. One reason is that big public companies are markedly more important from an economic and investment perspective than their smaller counterparts — the S&P 500 index covers approximately 75% of the total value of the U.S. equities market. Another is that among any sample of publicly traded firms “troubled” companies will likely be the center of the action with respect to corporate governance controversies (e.g. Enron), and companies dropped from the S&P 500 index are apt to fall into this category. Among the 37 companies removed in 2008 20 can be categorized as “at risk”, with 13 of the companies having been dropped due to a dramatic fall in their market value, six due to “rescue mergers” (i.e. mergers where the company would have likely otherwise ended up bankrupt) and one due to Chapter 11 bankruptcy. Of the 10 industrial sectors represented in the S&P 500, firms from the “financials” sector dominated both the overall sample (15 out of 37 firms) and the “at risk” cohort (12 out of 20).
The primary search strategy I used to assess the operation of corporate governance in the 37 companies removed from the S&P 500 during 2008 was a thorough analysis of press and newswire coverage. A wide-ranging set of searches was conducted for each of the sample companies using Factiva, which offers extensive coverage of newspapers, business magazines and trade journals. The searches were structured to find out what corporate governance mechanisms were activated in the six months before and six months after a company’s removal from the S&P index, with the objective being to assess how responsive and effective corporate governance was during the stock market turmoil.
Due to the prominence of companies that are part of the S&P 500, the Factiva searches should have brought to light most material corporate governance developments concerning the sample companies. Nevertheless, the Factiva searches were supplemented by analysis of Georgeson’s 2008 Annual Corporate Governance Review, the Stanford Law School Securities Class Action Clearinghouse database and an AFL-CIO website offering data on CEO pay for 2007.
The key findings of the study are as follows:
• There was little evidence of Enron-style fraud
• Only a minority of the sample companies experienced overt criticism of the board or publicized boardroom turnover, with the firms involved almost exclusively being in the “at risk” category
• A sizeable minority of “at risk” companies experienced publicized turnover of senior management
• The executive pay policies of a sizeable minority of the sample companies were criticized, with the controversies being restricted to at risk companies and companies that paid their CEOs more than the S&P 500 average
• Private equity went AWOL in a difficult climate for public-to-private buyouts
• Institutional investors (i.e. mutual funds and pension funds) were largely silent
• Hedge fund activism affected only a small minority of the sample companies, though the interventions produced results when they occurred
To the extent that corporate governance did “fail” among the companies removed the S&P 500, the difficulties were restricted largely to the financials sector. Boards of a number of banks and thrifts were subjected to intense criticism and bonus-driven executive pay may well have provided senior managers of major financial companies with incentives to take risks that were ill-advised due to the hit their firms would take if things went wrong. The corporate governance challenges financial companies pose, however, are likely to diminish over the next while, with the entire sector retrenching due to a combination of market trends and regulatory factors.
Once the financials are removed from the equation, the case in favor of a regulatory overhaul of corporate governance is weakened considerably. Based on what happened with the companies removed from the S&P 500 during 2008, corporate governance performed tolerably well. Moreover, while the U.K. already has in place a number of the features of corporate governance popular among those who advocate reform in the U.S., the stock market meltdown was worse in Britain than in America. Future studies perhaps will uncover damning evidence of corporate governance breakdowns during the stock market meltdown of 2008. However, at this point the case for radical reform has not been made out.
The paper is available here.