Corporate Governance Scores, Tobin s Q and Equity Prices: Evidence from Canadian Capital Markets

Transcription

1 Corporate Governance Scores, Tobin s Q and Equity Prices: Evidence from Canadian Capital Markets Parveen P. Gupta Department of Accounting, Lehigh University, Bethlehem, PA , USA Duane B. Kennedy School of Accountancy, University of Waterloo Waterloo, Ontario, Canada N2L 3G1 Samuel W. Weaver Department of Finance, Lehigh University Bethlehem, PA , USA This draft January 30, 2006 Copyright Material: Not to be reproduced or circulated without authors prior written permission We are grateful for comments received from workshop participants at the European Institute of Advanced Studies in Management, the Annual Meeting of the British Accounting Association, and the American Accounting Association Corresponding author: Duane Kennedy, phone , fax , dkennedy@uwaterloo.ca

2 Corporate Governance Scores, Tobin s Q and Equity Prices: Evidence from Canadian Capital Markets ABSTRACT Recent financial scandals, in U.S., Canada and Europe, involving massive earning restatements, excessive CEO compensation and complete breakdown of the most basic of the corporate governance mechanisms have thrust corporate governance to the forefront in the global capital markets as never before. A number of market participants are asking for summary measures to assess the overall state of corporate governance in order to make better investment and credit decisions. Consequently, a cottage industry of corporate governance information intermediaries has developed all over the globe. In Canada, the investor service of the Globe and Mail annually publishes governance rankings for the 270+ companies represented on the TSX/S&P index. There are four sub-categories that comprise the composite scores and rankings: board composition; board and CEO compensation; shareholder rights; and board governance disclosure. The purpose of this paper is to explore whether within the Canadian capital markets is there any association between composite as well as sub-category corporate governance scores as reported by the Globe & Mail and various measures of firm performance. Using a publicly available data-set for 2002, 2003 and 2004 on the Globe & Mail rankings and correlating it with various financial and market measures, we test for this association. Overall, our study does not find any association between the composite as well as sub-category corporate governance scores and various measures of firm performance. From our findings, it appears that within the Canadian capital markets, at least, the Globe & Mail corporate governance rankings do not appear to have any information content. Since there is no universal template that clearly defines what constitutes effective governance, it is difficult to truly evaluate the representational faithfulness of the holistic governance rankings from the Globe & Mail. More research, over a longer time horizon, is needed to establish the value-relevance of such ratings that are proliferating globally in response to the 2002 crisis faced by the U.S. capital markets in the aftermath of Enron and WorldCom debacles. 2

3 Corporate Governance Scores, Tobin s Q and Equity Prices: Evidence from Canadian Capital Markets I. Introduction Recent financial scandals, in U.S., Canada and Europe, involving massive earning restatements, excessive CEO compensation and complete breakdown of the most basic of the corporate governance mechanisms have thrust corporate governance to the forefront in the global capital markets as never before. In U.S. the Sarbanes-Oxley Act of 2002 which aims to curb some of the most blatant abuses resulting from poor corporate governance was enacted into the law in the shortest possible time in the country s modern legislative history. In Canada, Ontario Securities Commission s proposed Multilateral Instruments No and Certification of Disclosure in Issuers Annual and Interim Filings follow in the footsteps of the Section 302 and 404 of the U.S. Sarbanes-Oxley Act of 2002 which aim to strengthen internal controls over a company s financial reporting systems. Similarly, in United Kingdom, which follows a comply or explain approach to corporate governance, the Turnbull Guidance (which sets out best practices for internal control for U.K.-based companies) is currently under review for possible alignment with the Sections 302 and 404 of the Sarbanes-Oxley Act of Other countries with developed securities markets in Europe and Australasia are also debating similar corporate governance measures and reforms. The purpose of all these international legislative initiatives is to enhance accountability and financial transparency in global capital markets which is based on the presumption that good corporate governance produces better firm performance. Corporate governance, from an agency theory perspective, deals with the problems of information asymmetry, adverse selection and moral hazard that arise due to the separation of ownership from control. As early as in 1776, Adam Smith, in his famous treatise, Inquiry into the 3

4 Nature and Causes of the Wealth of Nations wrote being the managers of other people s money rather than their own, it can not well be expected that (managers) should watch over it with the same anxious vigilance with which (they would watch over their own money). Coase (1937), Jensen and Meckling (1976), and Fama and Jensen (1983a and 1983b) postulated that in the absence of adequate and effective monitoring and control mechanisms (or poor corporate governance), the agents corporate managers work to maximize their own welfare by shirking or otherwise extracting wealth from the principals the shareholders. The resources expended to ensure good governance are generally referred to as agency costs. In the corporate finance literature (Cochran and Wartick, 1988) this problem is commonly referred to as the Berle-Means hypothesis because it was first examined by Adolf Berle and Gardiner Means in a 1932 work entitled, the Modern Corporation and Private Property (p. 7). In a comprehensive survey of corporate governance, Shleifer and Vishny (1997) observe: At first glance, it is not entirely obvious why the suppliers of capital get anything back. After all, they part with their money, and have little to contribute to the enterprise afterward. The professional managers or entrepreneurs who run the firms might as well abscond with the money. Although, they sometimes do, usually they do not. Most advanced market economies have solved the problem of corporate governance at least reasonably well, in that they have assured the flows of enormous amounts of capital to firms, and actual repatriation of profits to providers of finance. (p. 737). It is through effective corporate governance, suppliers of capital attempt to assure themselves not only the return of their initial investment but also an adequate return on their capital. Thus, effective corporate governance not only deals with monitoring and control which owners exercise, but also with the incentives [it provides] for investment, innovation and entrepreneurial activity (Maher and Andersson, 1999, p. 31). As required by various state and federal laws, at least in the U.S., managers have always disclosed the corporate governance mechanisms and processes that their firms have put in place to 4

5 protect shareholder interests. It has been up to the investors and the analysts to collect and dissect these disclosures to form an overall opinion about the state of corporate governance at a company. However, given the current corporate climate of earnings restatements, executives and company directors on trial, auditor indictments, and increasing participation by the public in the equity markets, it is understandable why investors and analysts are searching for management tools to measure the vulnerability of firms to dishonesty, fraud and corruption (Sonnenfeld, 2004, p. 108). Consequently, capital market participants are becoming increasingly interested in a single measure that can communicate to them the overall state of corporate governance in a company. Consequently, a cottage industry of information intermediaries has developed all over the globe. For example, in U.S. Standard & Poor s develops and privately distributes such ratings for companies in S&P 400, S&P 500, S&P 600 and Russell 3000 indexes; the Corporate Library, an independent research and governance watch-dog organization, started by noted governance advocates, Nell Minow and Robert A. G. Monks, tracks and provides board effectiveness ratings for more than 2000 U.S. companies and 500 top international companies, the Institutional Shareholder Service (ISS), the leading proxy advisory firm, now rates more than 7,500 U.S. and international corporations on a number of proprietary dimensions and markets its corporate governance quotient (CGQ) to institutional shareholders, and GovernanceMetrics International (GMI), a privately-held firm based in New York City, has developed corporate governance scores for more than 1,600 companies in its data base from over 600 different proprietary governance variables. None of these composite governance ratings are available to the capital markets, at large, and all of providers sell their ratings to the client firms as well as to the institutional and individual investors. Similarly, in Europe Deminor Corporate Governance ratings are published for companies included in the FTSE Eurotop 300 index and in Canada, the investor service of the 5

6 Globe and Mail annually publishes (typically around September/October of each year) the governance ratings for all the companies represented on the TSX/S&P index. Although, the use of these composite ratings is on increase, Sonnenfeld (2004, p. 108) warns that these rating services may cross the line from being independent raters to becoming active consultants for the firms they study in ways which lead to questions about their objective credibility. In spite of the potential for conflict of interest and the limitations of these ratings, many believe that it is dangerous for firms to challenge [these ratings], given the attention paid to them by credit analysts, institutional portfolio managers, and liability underwriters (Sonnenfeld, 2004, p. 108). It should be noted that the Globe & Mail ratings are provided as a public service by the newspaper. Across the globe, these ratings, scores, or grades are being increasingly used by the market participants for investment and credit decisions and by the insurance companies for directors and officers liability insurance purposes. However, from a research standpoint, an interesting question emerges: Are these governance ratings a fad or is there any real value relevance in the information conveyed by these ratings? The purpose of this paper is to explore this question within the context of the Canadian capital markets. We use publicly disclosed Globe & Mail ratings and corporate governance scores of the 270 companies represented on Canada s TSX/S&P index. Using this data-set for 2002, 2003 and 2004, we attempt to ascertain whether firms with overall higher corporate governance scores do consistently out-perform firms with overall lower corporate governance scores? We also test for any association between a firm s performance, and four specific dimensions of corporate governance that comprise the composite corporate governance scores in our sample to better understand whether any one corporate governance dimension associates better with firm performance. 6

7 The remainder of the paper is organized as follows: Section II discusses prior research and develops hypotheses. Section III presents a description of the Globe & Mail data-set and study s research design. Section IV presents empirical results and discusses findings and Section V concludes the paper with a discussion of its limitations and potential for future research in this area. II. Prior Research and Hypotheses Development Does good governance matter or is it just the cost of doing business in today s global capital markets? Is there any association between corporate governance practices employed by a firm and its performance as measured by accounting and market variables? Do the composite governance ratings provide any valuable information to capital market participants in helping them identify better performing firms? These and many others related questions are a matter of study and debate because academic research has not yet provided any conclusive answers on these issues. A series of anecdotal global investor opinion surveys and interviews conducted by McKinsey & Company indicate that good governance has value and a large number of institutional investors are willing to pay significant premium for the stock of a well-governed company. For example, according to the 1996 McKinsey survey, on an average investors were willing to pay a premium of about 16% for a Fortune 1000 company (Felton, et. al. 1996, p. 171) and the same price premium increased to more than 18 percent for a U.S. and U.K. company in a 2000 survey (Coombes and Watson, 2000, p. 75). Surprisingly, the same surveys also concluded that CEOs and executives are willing to pay even higher premiums (24 percent) for the stock of a well-governed company. These findings do indicate that market participants value good governance which, in turn, positively impacts a firm s market value or its overall shareholder return. However, these 7

8 survey results should be taken with a grain of salt because there is quite a difference in saying what one would be willing to pay for a good governing company versus what one actually pays. The majority of the empirical 1 research prior to 2000 has focused on understanding the relationship of specific corporate governance variables to firm performance. Significant among these variables are: ownership concentration (owner-controlled firms versus manager-controlled firms, presence of a dominant shareholder versus controlling blockholders), market for corporate control (mergers, acquisitions and hostile takeovers), monitoring of mangers via managerial compensation (salary, bonus, stock options or other equity based) and board composition (presence of outside or independent directors) etc. According to Maher and Andersson (1999), the results of these studies vary from country-to-country and are mixed at best. However, it is only recently, that researchers have begun to explore whether corporate governance as a whole, as measured by a composite score, rating or ranking 2, has any relationship to firm performance. Although a great deal of research has been conducted on the relationship of specific governance practices on firm performance, only a handful of studies have, so far, explored the relationship between the composite measure of corporate governance and firm performance. Potentially, there are two reasons for lack of research in this area: one reason is lack of global consensus on the definition and elements of what constitutes good governance and the other is lack of a recognizable entity that consistently measures corporate governance in a composite sense and makes it available to all capital market participants in a fair and equitable manner. Consequently, academic researchers have attempted to deal with these two issues by creating their 1 For a comprehensive review of this topic, see Corporate Governance: Effects on Firm Performance and Economic Growth by Maher and Andersson (1999). 2 Although, there are several issues (i.e., what individual corporate governance variables should be included in such ratings? Should all the variables be weighted equally? Is the index simply an arithmetic mean of all the individual variables? What data correctly proxy the underlying intent of the variable?) that surround the construction of these indices, as mentioned earlier in this paper, their use by market participants is on the rise. 8

9 own indexes, scores or ratings as proxies for the overall level of corporate governance in a company either by collecting data from the various regulatory filings or through a set of self report surveys. However, in spite of the increasing reliance by the market participants on these composite governance scores, no where else in the world, except Canada, are these composite scores available in the public domain on a regular basis. It is precisely for this reason that we are focusing on Canada to test whether there is any association between the corporate governance ratings and firm performance. One of the earliest U.S. research studies, exploring the relationship between composite governance scores and firm performance was conducted by the Standard & Poor s and is often referred to as S&P Transparency & Disclosure (T&D) study (Patel and Dallas, 2002). Collecting data from the annual reports, 10-Ks, and proxy filings of 460 of the S&P 500 companies, on 98 possible attributes, broadly classified into three major categories (i.e., ownership structure and investor rights, financial transparency and information disclosure, and board and management structure and process), the study concludes that companies can lower their cost of equity capital by providing higher transparency and disclosure to the capital markets. To understand whether T&D study ratings had any information content around the disclosure date, Cheng, Collins and Huang (2003) investigated association between these ratings and market beta, abnormal returns, and earnings response coefficients, and found that S&P T&D rankings provide new information on corporate governance attributes, and the market responds favorably during the event period to firms with stronger corporate governance because stronger corporate governance reduces firm risk by providing for higher earnings quality. At least, preliminarily, these findings can lead one to conclude, that, although, the information on the three major categories was already available to the 9

10 market participants in publicly disclosed filings, aggregation of this information in an index form, does indeed has information content or value relevance. Another recent and widely cited research study in U.S. is by Gompers, Ishii, and Metrick (2003) in which the researchers, once again, construct their own governance index to proxy for the level of shareholder rights at about 1,500 large firms during the 1990s (p. 107). Based on this proprietary index, the study classifies the sample firms into two distinct portfolios: firms with strongest shareholder rights and firms with weakest shareholder rights. Given this classification, the study back-tests an investment strategy that, during the sample period, bought firms with strongest shareholder rights and sold firms with weakest shareholder rights and found that such an investment strategy would have earned abnormal returns of 8.5 percent per year (p. 107). Although, the study establishes a strong relationship between corporate governance and firm performance, within the context of our research paper, it has some important implications: one, the study only focuses on one critical dimension (i.e., shareholder rights) of the overall state of corporate governance in a company. Two, although the shareholder right information was already in the public domain, it was not available to the market in its present composite form, indicating that creation of an index or aggregation of such information, even only on one dimension of corporate governance, may indeed have some value to the market participants. Core, Guay and Rusticus (2004) are however troubled by these findings. According to them (2004, p. 1), a puzzling feature of the [Gompers et al, (2003)] paper is that the authors find persistent stock market underperformance for firms with weak shareholder rights, but they do not find significant underperformance in firm operating performance, which they measure with accounting return on equity. Using analysts forecast errors and earnings announcement returns, Core, Guay and Rusticus (2004) conclude that not only weak governance does not cause poor 10

11 stock returns but also note that any stock return differential reverses in the period after the initial sample period (p. 1). Following the Gompers, Ishii, and Metrick (2003) approach, Bauer, Gunster, and Otten (2004) also construct good governance portfolios (or top 20% of the companies with highest corporate governance ratings) and bad governance portfolios (or bottom 20% of the companies with lowest corporate governance ratings) using the Deminor corporate governance ratings for companies included in the FTSE Eurotop 300 index. Given the zero investment strategy, the study finds positive correlation between firm valuation (as measured by Tobin s Q) and corporate governance scores. However, the authors suggest that this relationship weakens substantially after adjusting for country differences (p. 1). Contrary to the Gompers, Ishii, and Metrick (2003) findings, this study finds a negative relationship between governance standards and earnings based performance ratios (p. 1). Drobetz, Schillhofer, and Zimmermann (2003) construct a broad corporate governance index, based on 30 governance proxies divided into five distinct categories (e.g., corporate governance commitment, shareholder rights, transparency, management and supervisory board matters, and auditing) from data obtained from survey and other archival sources, for German public firms. The study presents mixed evidence on whether there is any relationship between good governance and firm performance. Following the Gompers, Ishii, and Metrick (2003) approach, the authors back-test the investment strategy and conclude that buying high corporate governance index firms and shorting low corporate governance index firms during the sample period would have earned abnormal returns of around 12 percent on an annual basis (p. 1). However, findings suggest that although expected stock returns are negatively correlated with firm-level corporate governance when dividend yield are used as proxies for the cost of capital (p. 11

12 1) firms with better governance practices tend to be large, have higher average returns and lower dividend yield, and generally receive higher valuations, as measured by Tobin s Q and the marketto-book-ratio (p. 13). Similarly, von Nandelstadth and Rosenberg (2003) construct an index of corporate governance for the firms traded on the main list of the Helsinki Stock Exchange and find that firms characterized by a high (efficient) level of corporate governance have delivered greater stock returns, are higher valued based on the measure of Tobin s Q, and exhibit higher ratios of cash flow to assets, on average, in comparison to their counterparts characterized by a low (inefficient) level of corporate governance (p. 1). Black, Jang, and Kim (2003) construct a corporate governance index for 525 companies listed on the Korean Stock Exchange. The data is collected through a survey on five key dimensions of the corporate governance: shareholder rights, board structure, board procedure, disclosure to investors, and ownership parity. Using ordinary least squares regression, the authors find that a worst-to-best change in [their corporate governance index] predicts a 0.48 increase in Tobin s Q (about a 160% increase in share price). This effect is statistically strong (t = 6.11), robust to choice of market value variable (Tobin s Q, market/book, and market/sales), robust to specification of the corporate governance index, and robust to inclusion of extensive control variables (p. 1). Although the studies discussed above lean more towards establishing a positive association between either a composite or a single measure of the corporate governance and firm performance, all of these studies attempt to self-construct a corporate governance index and then hypothetically back-test various investment strategies to determine whether good governance firms yield higher firm performance. Interestingly, in none of the capital markets covered by the above mentioned 12

13 studies, the corporate governance ratings or the index (comprised from publicly available information) is disclosed publicly to the capital markets. Thus, based on the findings of these studies, although, one may conclude, with some reservations, that there is a positive association between corporate governance and firm performance, it is not possible to determine whether there is any value-added from focusing on the composite governance ratings or whether there is any new information that is communicated by these composite governance ratings. Interestingly, Canadian capital markets provide a fertile ground to test, in real-time, for any association between corporate governance ratings and firm performance, because the Globe & Mail, a prominent national newspaper, publishes annually the corporate governance scores for the all the companies traded on the Toronto Stock Exchange that are part of Canada s benchmark S&P/TSX index. Rather than back-testing a contrived investment strategy, based on the constancy of corporate governance and various macro-economic environment variables and the market psyche, our study explores whether there is any association between the publicly disclosed corporate governance scores and firm performance based on a three-year time series. We also explore whether any one of the four dimensions that comprise the composite Globe & Mail ratings are associated with firm performance. We measure firm performance along three dimensions: relative market valuation as measured by the Tobin s Q and price-to-book ratio, financial performance as measured by return on assets, and market reaction as measured by the 11-day and 2-day reaction. Since many firms included in the study are cross-listed on U.S. stock exchanges as well, we also explore whether cross-listing matters while explaining association between corporate governance scores and firm performance. Consequently, at the macro-level we test following null hypotheses: H 0 There is no relationship between Globe & Mail s composite corporate governance ratings and firm performance. 13

14 H 0 There is no relationship between any one of the components of the Globe & Mail s composite corporate governance ratings and firm performance. III. (i) Data Description and Research Design Data Description Our study utilizes the data on corporate governance scores and rankings, and related stock price and financial statement data on companies included in Canada s benchmark S&P/TSX composite index. The corporate governance scores and rankings are obtained from the Globe & Mail website. 3 These scores and rankings are published each year in the Globe & Mail s Report on Business, which is made available to public at no cost. The 2002 scores and rankings were published on October 7, 2002 for the entire set of 270 companies then in the S&P/TSX index. The 2003 rankings covered 207 companies and were published on September 22, The 2004 rankings included 218 companies and were published on October 12, We focused on the companies that are common to all three years leading to a sample consisting of 178 companies with three years of time series data on corporate governance scores. The data to develop the composite governance scores and rankings is collected by the Globe & Mail from the proxy circulars filed by the Canadian companies to the Ontario Securities Commission. There are four sub-categories that comprise the composite scores and rankings: board composition, board and CEO compensation, shareholder rights, and board governance related disclosures. The maximum composite score that a company can achieve is 100 points. Out of the total 100 possible points, during 2002, on the board composition dimension a company could score There are two reasons for different number of companies being reported by the Globe & Mail in their Report on Business each year. One reason is the restructuring of the index that took place from May 2002 to December The TSX 300 was renamed on May 1, 2002 to the S&P/TSX composite index. The index went through a transition that was designed to reduce the number of constituent companies because the bottom 100 companies were too small, collectively representing only two percent of the index. The second reason is the cut-off date of the Report on Business study, which affects the number of proxy circulars available to the Globe & Mail reporters who compile this data. The Globe & Mail excludes companies that are in bankruptcy protection. 14

15 maximum 40 points, 23 points on the board and CEO compensation dimension, 22 points on the shareholder rights dimension and 15 points on the disclosure of board related structure and process dimension. During the ensuing two years, the newspaper made some adjustments to each of the three sub-categories except the board composition dimension, which remained at the 40 point level. 5 Appendix 1 reproduces the 22 questions along with the Globe & Mail scoring scheme. (ii) Research Design Firm performance is the independent variable and composite as well as sub-category governance scores are the dependent variables in our overall research design. We measure firm performance through three separate sets of metrics: (1) relative market valuation as measured by Tobin s Q and price-to-book ratio, (2) firm s operating performance as measured by its return on assets, and (3) market reaction as measured by the 11-day stock returns and 2-day stock returns around the publication date of the Globe & Mail rankings. We use Tobin s Q as one of the measures of firm performance because it has been used in corporate governance studies since the work of Demsetz and Lehn (1985) and Morck, Shleifer, and Vishny (1988) (Gompers, Ishii and Metrick, 2003, p. 126). According to White, Sondhi, and Fried (1998, p. 1041), The relationship between a company s market and book values can be measured by Tobin s Q ratio, defined as the market value of the firm divided by its book value on a replacement cost basis. Q values below 1 (price less than replacement book value) imply that the firm earns less than the required rate of return; a (marginal) dollar invested in the firm s assets results in future cash flows whose present value is less than a $1. Based on the definition provided by Gompers, Ishii and Metrick (2003), we obtained data from Compustat Research Insight to calculate Tobin s Q. Specifically, Tobin s Q equals the market 5 The first note in Table 1 details the maximum score for each sub-category over the three-year time period. The board and CEO compensation and board related structure and process sub-categories declined respectively by 4% and 2% while the shareholder rights sub-category picked up an additional 6% weight in the overall composite scores and rankings. 15

16 value of assets divided by the book value of assets where the market value of assets is computed as the book value of assets (variable AT for the most recent fiscal year end) plus the market value of common stock (variable MKVALM at month end) minus the book value of common stock (variable CEQ for the most recent fiscal year end) minus deferred taxes from the balance sheet (variable TXDB for the most recent fiscal year end). As a sensitivity check, we use price-to-book ratio as an alternative measure of firm performance. The price-to-book ratio is obtained from Compustat Research Insight (variable MKBK for the month end). Both Tobin s Q and the price-tobook metrics measure firm performance based on book vis-à-vis market-based measures. For our research study, the measures are highly positively correlated (greater than 0.85 in each year). We also measure firm performance as return on assets. In our study, return on assets is a proxy for operating performance. It is calculated as income (variable IB for the most recent fiscal year end) divided by the book value of assets (variable AT) using data obtained from Compustat Research Insight. After analyzing the corporate governance scores and the measures of firm performance through univariate statistical measures, three econometric regression models are developed. The three regressions are estimated using companies common to all three years ( ) for which data on the variables are available from COMPUSTAT. Econometric Model 1 The first regression model regresses Tobin s Q and price-to-book ratio against the composite governance scores as well as against each one of the four sub-categories (board composition, board and CEO compensation, shareholder rights, and board governance related disclosures) to investigate whether any one sub-component of the overall corporate governance scores is more 16

17 value relevant than the others. The following two equations capture the overall governance score regressions: Tobin s Q = α + β Composite Governance Score + γ ln(sales) + δ Return on Assets + ζ Cross-listing status+ ε (1) Price-to-book ratio = α + β Composite Governance Score + γ ln(sales) + δ Return on Assets + ζ Cross-listing status+ ε (2) where Tobin s Q for 2002 (2003) (2004) was calculated using the market value of common stock at the end of October 2002 (September 2003) (October 2004) 6 and book values at the most recent fiscal year end on or before October 2002 (September 2003) (October 2004). Following two equations capture the sub-category score regressions: Tobin s Q = α + β Sub-category Score + γ ln (Sales) + δ Return on Assets + ζ Cross-listing status+ ε (3) Price-to-book ratio = α + β Sub-category Score + γ ln (Sales) + δ Return on Assets + ζ Cross-listing status+ ε (4) Econometric Model 2 The second regression model regresses return on assets against the composite governance scores as well as each one of the four sub-categories. The following two equations respectively capture each one of the regressions: Return on Assets = α + β Composite Governance Score + γ ln(book-to-market) + δ ln(sales) + ζ Cross-listing status+ ε (5) Return on Assets = α + β Sub-category Score + γ ln(book-to-market) + δ ln(sales) + ζ Cross-listing status+ ε (6) Econometric Model 3 The third and the final regression model tests whether there is any stock market reaction around the announcement date of the Globe & Mail rankings. We investigated only the short-window stock returns as measured by the two-day 7 and eleven-day 8 event period. The cross-sectional analysis at the firm level over a three year time period is based on the following equation: 6 The reason to choose month-end market value of the common stock was due to the timing of the release of the corporate governance scores: for 2002, the governance scores were published on October 7, 2002; for 2003 the governance scores were published on September 22, 2003, and for 2004 the governance scores were published on October 12, Two-day event period for each of the three years was as follows: for 2002, close of trading on Friday, October 4, 2002 to close of trading on Tuesday, October 8, 2002; for 2003, close of trading on Friday, September 19, 2003 to close of trading on Tuesday, September 23, 2003; for, 2004 close of trading on Monday, October 11, 2004 to close of trading on Wednesday, October 13, Eleven day event period for each of the three years was as follows: for 2002, close of trading on Monday, September 30, 2002 to close of trading on Tuesday, October 15, 2002; for 2003, close of trading on Monday, 17

18 R it = α + β Governance Score + γ ln(sales) + δ Cross-listing Status+ ε (7) R it = α + β Governance Category sub-scores + γ ln(sales) + δ Cross-listing Status+ ε (8) where R it is the aggregate excess return over period t of individual firm i for each one of the three years. Excess returns were calculated by subtracting the Canadian Financial Markets Research Centre (CFMRC) equally-weighted market index for the appropriate period. While running various regressions, we controlled for the size of the firm as measured by total sales as a proxy, because there was a significant negative correlation between sales and a number of firm performance measures (see Panel B Table 2). We also constructed quartile-based portfolios as determined by the composite governance scores to test for the robustness of our findings. IV. Findings and Discussion Sample Demographics In Table 1, we present descriptive statistics for our sample companies for each one of the three years for which the Globe & Mail ratings were released to the Canadian capital markets. INSERT TABLE 1 ABOUT HERE As mentioned earlier, a Canadian company can achieve a composite score anywhere from 0 to 100 in the annual Globe & Mail corporate governance survey. A review of the Table 1, Panel A reveals that, from 2002 to 2004, although, the mean composite governance scores increased by approximately 10 points and standard deviation declined by approximately 1 point, the range of the scores has remained relatively stable for the same period. This does not tell us a lot about what structural changes might be occurring in the composite governance scores of the sample firms over a three year period. However, the coefficient of variation which is the ratio of standard deviation to September 15, 2003 to close of trading on Monday, September 29, 2003; for 2004, close of trading on Monday, October 4, 2004 to close of trading on Tuesday, October 19,

19 the mean indicates that relative to the mean governance score for each year the variation in the yearly composite governance scores is declining. In spite of the stability in the range, which is the result of few outliers 9, this suggests that year-over-year composite governance scores are getting into a tighter band. However, same is not true for the four sub-categories. Although, three out of four sub-categories exhibit an increase in their average sub-scores, the Board Composition subcategory shows the largest amount of improvement followed by the Board Governance Related disclosure sub-category and Shareholder Rights sub-category. Interestingly, the sub-scores for the Board and CEO compensation category were approximately equal in spite of the maximum score dropping from 23 to 19. Overall, the data presented in the Table 1 Panel A suggests that some structural shifts are occurring in the corporate governance structure and processes within Canadian companies as measured by the Globe & Mail survey. However, what is not clear is whether these changes are driven by the firms desire to improve their reported ratings in the media or these changes are genuinely intended to improve the overall state of corporate governance in these companies. In order to better understand this phenomenon, we divided our sample into cross-listed vs. not cross-listed firms. Since a large number of Canadian companies are cross-listed on the U.S. stock exchanges we would normally expect the cross-listed firms to score higher in total as well as on each one of the four sub categories. The basis for our belief is the passage of the Sarbanes- Oxley Act in July 2002 which mandated many corporate governance reforms for all U.S. listed companies. Additionally, during the same period, the New York Stock Exchange (NYSE) and NASDAQ stock exchange substantially revised their listing standards for all public companies raising capital in the U.S. equity markets. Consistent with our expectations, the findings presented 9 There is only one governance score that looks like an outlier. In 2003, Investors Group had a score of 34 and the next lowest score was 39. In all other cases (top and bottom), the most extreme score was close to the next most extreme. 19

20 in Table 1 Panel B clearly indicate that for each of the three years, cross-listed companies demonstrate higher overall corporate governance scores than the non-cross-listed companies. The differences in scores are statistically significant at p-value of However, when we analyze our sample by cross-listings at the sub-category level, we do not find across the board statistically significant difference in the sub-scores of the two groups of firms. For each year, the most statistically significant difference is found with respect to the Board Composition sub-category (at p-value of 0.01 for 2002 and 2003 and p-value of 0.05 for 2004) which indicates that cross-listed firms (1) have higher proportion of independent directors on their boards with lesser number of them in the directors interlocks, (2) tend to conduct more executive sessions, and (3) regularly conduct overall board and director performance evaluations. Although, cross-listed firms score higher on the Board Governance Disclosure sub-category, differences between the two groups of firms are not as significant (p-value of 0.01 for 2002 and 0.10 for 2003 and 2004) as the Board Composition sub-category. However, the most surprising finding from the data presented in Table 1 Panel B is that there is little difference between the cross-listed and not cross-listed firms when it comes to the Shareholder Rights sub-category (except for 2004 at p- value of 0.10) and the Board and CEO Compensation sub-category (except for 2004 at p-value of 0.01). To understand why might this be the case, we reviewed the measurement metrics used by the Globe & Mail (and as presented in Appendix 1) to compute scores for each one of the four subcategories. A review of these metrics (or questions) suggests to us that for firms to score higher on the Board and CEO compensation sub category and on the Shareholder Rights sub-category, they need to make more substantive changes in their governance structure and processes than the other two sub-categories. As a rational market participant, believing that Canadians pay attention to the 20

21 Globe & Mail ratings, the firms may have chosen the path of least resistance to raise their ratings by instituting changes in less challenging categories. Table 2 provides univariate statistics and Spearman correlation coefficients for each year for the following variables: Governance score, Tobin s Q, Price-to-Book Ratio, Sales, Return on assets, 11-day stock return and 2-day stock return. The sample size varies from firms due to missing values for some variables in Research Insight. INSERT TABLE 2 ABOUT HERE A review of the univariate statistics shows a gradual increase in the median values of Tobin s Q and the price-to-book ratio over the three years. There is a large increase in the mean and maximum values of Tobin s Q and price-to-book ratios from 2002 to This increase is caused by a substantial increase in market value for three companies. If these three observations are deleted, the mean and maximum values for Tobin s Q and the price-to-book ratio are similar across the three years. Table 2 Panels B, D, and F show significant positive correlation between composite corporate governance scores and firm size as measured by sales. This statistically significant positive correlation across all three years clearly indicates that large firms have higher composite corporate governance scores. Interestingly, Tobin s Q and the price-to-book ratios for each one of the three years are significantly negatively correlated with total sales, implying that larger firms, comparatively, have a lower market capitalization relative to book values. Since most proxies for Q are poor (Erickson and Whited, 2001), we also used price-to-book ratio as another measure of the market valuation of a firm. Panel B, D, and E indicate that the price-to-book ratio is significantly (p-value = 0.01) positively correlated (0.862 for 2002, for 2003, and for 2004) with Tobin s Q. In spite of this strong positive correlation between the two measures, it is 21

22 only the Tobin s Q that is significantly (p-value = 0.01) positively correlated, for all the three years, with accounting measure of firm performance as measured by return on total assets. This suggests that firms with higher Tobin s Q have higher return on assets in our sample but not necessarily higher price-to-book ratio. These findings suggest that in spite of such high positive correlation between the two, the Tobin s Q and the price-to-book are not perfect substitutes for each other because each appears to capture a somewhat different aspect of market valuation of the firm. Now we present and discuss our results and findings for each one of the hypotheses presented earlier. Test of Hypothesis One: Is There an Association Between Globe & Mail s Composite Corporate Governance Scores and Various Firm Performance Measures? As mentioned earlier in Section II, the first null hypothesis explores association between the Globe & Mail s composite corporate governance scores and three broader measures of firm performance: (1) market valuation measures as measured by Tobin s Q and price-to-book ratio (see Table 3), (2) operating performance measures as measured by accounting return on assets (see Table 5), and (3) market reaction measures as measured by 2-day and 11-day stock returns around the event date (see Table 6). Discussed below are our findings for each one of these firm performance related variables. A. Are Tobin s Q and Price-to-Book Associated with Globe & Mail s Composite Corporate Governance Scores? Table 3 presents results of our first econometric model which comprises of the following two regression equations: Tobin s Q = α + β Composite Governance Score + γ ln(sales) + δ Return on Assets + ζ Cross-listing status+ ε (1) Price-to-book ratio = α + β Composite Governance Score + γ ln(sales) + δ Return on Assets + ζ Cross-listing status+ ε (2) INSERT TABLE 3 ABOUT HERE 22

23 A review of the results presented in Table 3 Panels A and B indicates that after controlling for firm size (as measured by sales) neither Tobin s Q nor price-to-book ratio are related to the composite governance scores as reported by Globe & Mail. What is surprising is not only the lack of statistical significance for each of the three years, but also for 2003 and 2004 the negative sign associated with the composite governance score coefficients indicating that higher governance score leads to decline in the market valuation measures of our sample firms. Although insignificant, these findings are counter intuitive. Higher corporate governance scores, assuming no measurement error, 10 a priori, should lead to higher market valuation because adoption of good governance practices by a firm leads to higher transparency in its financial and non-financial disclosures and communicates to the capital markets that the boards of directors are serious about management accountability which in turn reduces the uncertainty created by the separation of ownership from control leading to lower cost of capital and higher overall return for shareholders. This was the rationale provided by many respondents in the earlier mentioned McKinsey surveys which documented that market participants were willing to pay a premium for better governing companies. As a sensitivity check, we replicated the regressions after deleting 7 observations with Tobin s Q values greater than 6.0 in each of the three years. The results remain unchanged in all respects Although, these results indicate that composite governance score is not a robust predictor of Tobin s Q and price-to-book, our regression models (1) and (2) assume a linear relationship between the dependent and independent variables. B. Is Return on Assets Associated with Globe & Mail s Composite Corporate Governance Scores? 10 There is no universal definition of what constitutes good governance and how it can be measured for empirical validation but our review of the literature suggests that Globe & Mail scores are developed using commonly accepted measures of good governance. Other research studies cited in the literature review section of this paper also use similar measures. 23

24 Table 5 Panel A presents the results of our second econometric model which comprises of the following regression equation: Return on Assets = α + β Composite Governance Score + γ ln(book-to-market) + δ ln(sales) + ζ Cross-listing status+ ε (5) INSERT TABLE 5 ABOUT HERE Once again, we find that Globe & Mail s composite corporate governance scores are not associated with a firm s return on assets. Consistent with the Tobin s q and Price-to-Book findings, the coefficient of the composite corporate governance scores is once again negative for years 2003 and 2004 indicating that firms with higher corporate governance scores tend to report lower return on their assets. Although, a firm s total sales is a significantly positive predictor of its return on assets, the negative coefficients for all the three years (significant only for 2002 and 2004 at p-value = 0.05) indicate that higher Book-to-Market ratio firms have lower return on assts. These findings are perplexing. However, juxtaposing the negative coefficients for the composite corporate governance score (from Table 3 Panels A and B) with the significantly negative association between book-to-market and return on assets (from Table 5 Panel A) could also suggest that for firms in our sample cost of corporate governance outweighs the benefits produced by it. In other words, Canadian investors expect a certain level of corporate governance from firms raising capital in their equity markets and the costs incurred by these firms to meet those expectations, consequently, create a negative drag on the firm s earnings which in turn depresses their accounting as well as market measures of firm performance. C. Is there a Market Reaction around the Event Date to Globe & Mail s Composite Corporate Governance Score Disclosures? Table 6 Panels A and C presents the results of our short-window event study which comprises of the following regression equation: R it = α + β Governance Score + γ ln (Sales) + δ Cross-listing Status+ ε (7) 24

25 INSERT TABLE 6 ABOUT HERE Consistent with the previous two measures of firm performance, we do not find any significant market reaction around the 2-day as well as the 11-day window. Although the composite governance score coefficients are significant (p-value = 0.10) and positive for 2002, close to zero coefficient values suggest that whatever little market reaction our model appears to be catching is probably due to the hype that might have been created by the first time disclosure of these scores in a major Canadian newspaper. Also, we should not forget that 2002 was the year during which Enron and WorldCom imploded and the Sarbanes-Oxley Act was passed. Overall, based on these findings, we are unable to reject the first null hypothesis of no association between Globe & Mail s composite corporate governance scores and firm performance. Now we present and discuss our results and findings on the second null hypothesis. Test of Hypothesis Two: Is there Any Association between Globe & Mail s Corporate Governance Sub-category Sub-Scores and Various Firm Performance Measures? The Globe & Mail s composite corporate governance scores are a sum total of the scores achieved by the Canadian firms in the following four sub-categories: Board Composition, Board and CEO Compensation, Shareholder Rights, and Board Governance Disclosures (see Table 1, Panel A). In an effort to understand whether any of these sub-categories exhibit greater association to firm performance for our sample companies, we replicated our econometric models by incorporating each one of the four sub-categories in our individual regressions as described below. A. Are Tobin s Q and Price-to-Book Associated with any one of the Globe& Mail s Four Corporate Governance sub-category scores? Table 4 presents results of our first econometric model (as it relates to sub-categories) which comprises of the following two regression equations: Tobin s Q = α + β Sub-category Score + γ ln (Sales) + δ Return on Assets + ζ Cross-listing status+ ε (3) 25