Editor’s Note: This post is from René Stulz of Ohio State University.
With my co-authors Reena Aggarwal (Georgetown), Isil Erel (Ohio State) and Rohan Williamson (Georgetown), I have recently completed a revision of the paper “Differences in Governance Practices between U.S. and Foreign Firms: Measurement, Causes, and Consequences.” The paper is available at SSRN. The paper is now forthcoming at The Review of Financial Studies. The paper shows that foreign firms invest less in firm-level governance and that this lower investment is associated with lower valuations.
Using the well-known definition of Shleifer and Vishny (1997), governance consists of the mechanisms which insure that minority shareholders receive an appropriate return on their investment. Governance depends both on country-level as well as firm-level mechanisms. The country-level governance mechanisms include a country’s laws, its culture and norms, and the institutions which enforce the laws. Firm-level or internal governance mechanisms are those that operate within the firm. Firm-level governance mechanisms that increase the power of minority shareholders to receive a return on their investment are costly, so that the adoption of such mechanisms by a firm is an investment. The payoffs from that investment differ across countries and across firms.
The U.S. is recognized to have extremely high financial and economic development, to have strong investor protection, and to protect property rights well. Consequently, we would expect the internal governance of firms in the U.S. to come as close as possible to what the optimal internal governance of a firm would be in a foreign country if it were not constrained by weaker institutions and lower development than in the U.S. The internal governance of firms in the U.S. therefore provides a benchmark that can be used to evaluate the impact of different institutions and different development from the U.S. on governance choices and, through these choices, on firm value.
On theoretical grounds, it is not clear whether the characteristics of the U.S. make firm-level investment in governance mechanisms that increase the power of minority shareholders more or less advantageous for U.S. firms relative to firms from countries which do not have the same high level of development and investor protection. One possibility is that foreign firms would invest less in firm-level governance if they were in the U.S. because firm-level governance and country-level investor protection are substitutes. An alternative possibility is that investment in firm-level governance is less productive in countries with poor economic development and weak investor protection than it is in the U.S., implying that firm-level governance and investor protection are complements.
We find strong evidence that foreign firms invest less in internal governance mechanisms that increase the power of minority shareholders than comparable U.S. firms do. In other words, investment in firm-level governance is higher when a country becomes more economically and financially developed and better protects investor rights. Further, to the extent that institutional and development weaknesses reduce a foreign firm’s investment in corporate governance compared to a U.S. firm, we would expect the value of the foreign firm to be lower. As expected, we find that the value of foreign firms is negatively related to the magnitude of their governance investment shortfall relative to U.S. firms.
To conduct our investigation, we need information about firm-level corporate governance attributes that increase the power of minority shareholders for a large number of firms across a large number of countries and we would like individual governance attributes to be assessed similarly across all these firms. We use the corporate governance attributes recorded by Institutional Shareholder Services (ISS). By doing so, we can analyze 44 common governance attributes for 2,234 non-U.S. firms and 5,296 U.S. firms covering 23 developed countries. We create a governance index making sure that the governance attributes included are relevant both for U.S. firms and foreign firms. We call it the GOV Index.
To evaluate the governance a foreign firm would have if it were in the U.S., we use a propensity score matching method in order to match each foreign firm with a comparable U.S. firm. We then show that foreign firms generally have a lower GOV index, so that they give less power to minority shareholders, than if they were U.S. firms. We define the governance gap to be the difference between the governance index of a foreign firm and the governance index of a comparable U.S. firm. A firm with a positive governance gap has a higher value of the GOV index than its matching U.S. firm. Only 12.7% of foreign firms have a positive governance gap. Strikingly, 86.1% of these firms come from Canada and the U.K., so that firms from countries with similar investor protection as in the U.S. are the ones that are the most likely to invest more in governance than comparable U.S. firms. Such a result is inconsistent with the hypothesis that investor protection and internal governance mechanisms are substitutes.
Having compared the governance of foreign and U.S. firms, we turn to the question of whether the governance gap helps explain a firm’s valuation. We find that the value of foreign firms is increasing in their GOV index. More importantly, perhaps, the lower the GOV index of a foreign firm compared to its matching U.S. firm, the lower the value of that foreign firm. We find that this result holds controlling for firm characteristics known to affect q and controlling for the endogeneity of the choice of governance mechanisms.
If firm-level governance is more costly for foreign firms than for U.S. firms, we expect that the foreign firms comparable to the U.S. firms that benefit the most from investing in internal governance will find it optimal to invest less in governance than matching U.S. firms do and will suffer a loss of value as a result. We can therefore use regression analysis to investigate whether a foreign firm’s q is negatively related to the governance index value it would have in the U.S. We find that this is the case. Such a coefficient is not subject to an endogeneity bias because we are measuring the governance of a U.S. firm and the valuation of a foreign firm.
In addition to investigating the value relevance of differences in the aggregate governance index between foreign firms and comparable U.S. firms, we also consider the value relevance of specific governance provisions. We focus on provisions that have attracted considerable attention in the literature and among policymakers. We find that firms that have an independent board, auditors that are ratified annually, and an audit committee comprised solely of outsiders, have a higher value when their U.S. matching firm has these governance attributes. In contrast, neither board size nor separation of the chairman and CEO functions are value relevant.