Recent changes in the corporate governance environment in the UK and its relation to firm value: has it become stronger? T. van den Berg

Recent changes in the corporate governance environment in the UK and its

relation to firm value: has it become stronger?

T. van den Berg

University of Groningen

Faculty of Economics and Business

MSc Business Administration: Finance

March, 2013

Supervisor

Abstract

This study aims at the changes in the field of corporate governance from 2004 to 2011 in the UK and their relation to firm value. A large history of regulatory changes in the corporate governance environment of the UK exists already prior to this period, which shall also be discussed in this paper. It is tested within the corporate governance environment, by creating five subindices based on specific categories, but also in relation to firm value of firms listed on the FTSE 100. This study adds to the current literature to evaluate a unique and broad set of corporate governance variables over a recent period, with inclusion of the financial crisis. This study shows that the last 8 years have caused a great increase on the field of transparency and public disclosure of corporate governance mechanisms. It shows that several fields of corporate governance are closely related to each other in the implementing process of corporate governance mechanisms, rather than one section having a priority over another. The results show that a higher score on the total corporate governance index is positively and significantly related to higher firm value, measured as Tobin’s Q. Of the five subindices, only board functioning is significantly related to higher firm value. Profitability, measured as return on assets, is however of stronger influence.

JEL-classification: G01, G30, G38

1. Introduction

Corporate governance is a field of finance which has been getting more attention over the last few years. Public debate on the efficiency of corporate governance has started to develop since worldwide scandals in 2000 and increased even more in the light of the recent crisis. Corporate governance is aimed at controlling the people who have power in the firm, making sure the people in charge do not take advantage of their power and make decisions which increase their personal benefits instead of the benefits for the firm and shareholders. Described by the UK Corporate Governance Code of 2012, it has the following explanation: “Corporate governance is therefore about what the board of a company

does and how it sets the values of the company, and is to be distinguished from the day to day operational management of the company by full-time executives.” This description originates from an

early and influential report on national corporate governance in the UK. The purpose of the first UK Corporate Governance Code, in the Cadbury Report of 1992, was to “review those aspects of

corporate governance specifically related to financial reporting and accountability” (Cadbury Report,

1992).

In corporate governance, the board of directors is an essential element. The board of directors is the highest authority on decision making and therefore should be separated from control to make sure that for example the CEO will focus on maximizing the firms wealth and not his own wealth (Boyd, 1994). The choice of compensation for the CEO was traditionally decided on by the board of directors (Conyon, 2009). During recent years however, it has become highly common to have separate remuneration committees or external consultants which decide on the level of compensation. Already 15 years ago, Conyon (1997) finds that remuneration committees have become the most common thing to pay setting arrangements in the UK. This was one of the first innovations in corporate governance.

There are several aspects in the field of corporate governance which make it an interesting and diverse subject to research. There is a fine line between too much control and too little control on corporations. On the one hand, too much control will limit managers in their feeling of freedom and their decisions on investing, growing and probably even adding value (McDonald and Westphal, 2010); while on the other hand, too little control can cause great problems with risk taking and allows for acting in the interest of the own individual benefit of the managers (Jensen and Meckling, 1976). So there exists an interesting balance problem between the levels of control in the world of corporate governance. In this paper I will focus on the changes in the UK in corporate governance structures since the financial crisis and whether this has led to more effective structures and higher levels of board control.

before and it seems more important than before to keep a close eye on the ones leading companies. Several causes are commonly assigned to have an influence in causing the crisis. Greed from top managers, made possible by lack of regulation and “poor” corporate governance, described as a weak control on the executives, are argued to be the causes of the financial crisis (Ettorre, 2009). The financial crisis has done enormous harm to almost everything, including employment rates, wealth destruction and extreme debt levels, and I think this makes for a very interesting, diverse and omnipresent subject. In a comparable situation, several corporate governance variables have a significant influence on the performance of firms during the East Asian financial crisis in 1997 to 1998, showing it does indeed matter (Mitton, 2002).

Also, it might be that the executive pay design contributed to conditions leading to the financial crisis (Nyberg, Fulmer, Gerhart and Carpenter, 2010). Over the last few years, cash bonuses for CEOs and CEO pay have become an increasing point of interest in the media and literature. Critics state that since the board of directors is influenced by the CEO, their choice for CEO compensation is not maximizing firm value. Especially with the recent financial crisis, it is interesting to see how the structure of corporate governance of firms is influenced and changes.

As said, it is argued that weak governance structure is to some extent one of the causes of the financial crisis, next to a lack of regulation (Ettorre, 2009; Kirkpatrick, 2009). Only much more regulation and increase in the level of control of corporate governance can restore order. Another factor is that corporate governance arrangements did not suffice to protect against excessive risk taking in financial companies (Kirkpatrick, 2009). There were high concentrations in mortgage-related securities, which violates one of the basic principles of risk management, the principle of diversification. This violation, also one of the causes of the crisis, is a result of the agency theory problems which should be avoided by modern risk management systems (Lang and Jagtiani, 2010). For example, in the banking sector, Beltratti and Stultz (2009) find evidence that banks with higher Tier 1 capital ratios outperformed banks with low ratios during the crisis. Looking at the level of leverage of financial institutions, Nielsen (2008) shows that leverage ratios of financial institutions have increased in the years 1980-2008 from 1 to 10, to over 1 to 30 and even 1 to 50. However, it could also be that the crisis would have been even worse if there was no alignment at all between managers and owners (Nyberg et al., 2010)

governance systems, since it provides the most protection for shareholders (La Porta, Lopez-De-Silanes, Shleifer and Vishny, 1997). In that same study, common law countries provide companies with better access to equity finance than civil law countries. Finally, common law countries have much more listed companies and IPOs per million people than civil law countries, which led to a belief that common law is the best practice. Another study investigates whether common law provides the best investor protection, implying that eventually international governance standards should converge into the UK standards, but that happens only on some parts of corporate governance (Cicon et al., 2012).

The literature on the structure of corporate governance as well as the role of the CEO and the bonus and payment structure has kept increasing a lot during the last decade, with numerous scandals in 2001 and 2002 (Chhaochharia and Grinstein, 2009). These scandals were one of the factors leading to the establishment of the Sarbanes-Oxley Act in 2002 in the United States, with new board requirements for firms. These new regulations were based on the belief that a board of outside directors is good for every firm and forced firms to increase number and involvement of outside directors in the board. However, Wintoki (2007) finds results suggesting that such a uniform governance regulation can be harmful to some firms, especially young, infant firms that operate in changing and uncertain business environments. Also, these new rules are less beneficial to firms that have high costs and low benefits from outside monitoring. Another study shows that, since the implementation of this act, there has been an increase of firms filed for deregistration, called going dark (Leuz, Triantis and Wang, 2008). This deregistration makes those firms no longer have to comply with reporting requirements. Apparently, the new and increased regulations on corporate governance are not beneficial for all type of companies, while they are designed to make control more efficient and lead to maximizing firm value. In the next section I will elaborate more on the timeline and the history of theses codes in the UK, why they were introduced and what changed.

For the research in this paper I will use data from the FTSE 100 companies over the period 2004 to 2011. I collect the data from Datastream and my dataset consists of data on equities but also on board composition and many other corporate governance variables. I create a unique corporate governance index (CGI) of 59 variables. These variables are corporate governance provisions and selected based on an extensive research of current literature. Next to that, I also look at variables which cannot be included in the index for statistical reasons. This way, I want to make sure every aspect of corporate governance is still described and taken into account. The data will be analysed using regression analysis to find out which variables cause the biggest influence on firm value and which variables change the most the last decade. A more extensive description of the data, corporate governance variables and the construction of the index will follow later in section 3 and 4.

This study adds to current literature since it is a quantitative research on recent corporate governance innovations and held against the light of the financial crisis. I use panel data and a self-created, extensive corporate governance index. A higher score on this corporate governance index means a better governance practice. As said, corporate governance is aimed at aligning interests of the managers and the shareholders to maximize shareholders wealth. Efficient corporate governance should be related to the highest firm value, so I test for a relation between firm value and corporate governance index. This combination of extensive variables, a self-created index and panel data with the inclusion of the crisis makes this study a unique contribution to current literature. I find that total corporate governance index is positively related to firm value. Of the five different subindices, only board functioning is positively related to firm value. The other subindices are not significantly related to firm value. The inclusion of the dummy for the crisis is significant in each regression and shows it has a negative relation to firm value.

This paper has the following structure. In the next section fundamental and recent literature on corporate governance and the developments in the field of corporate governance will be reviewed and analysed. Section 3 contains the hypotheses, methodology and the construction of the corporate governance index. Section 4 shows and describes the data, while section 5 has the descriptive statistics. In section 6, I will show the results for the non-CGI variables and the results from the regression analysis. Finally, in section 7 I present the conclusion, compare my results to results from current literature, and show limitations of my research.

2. Literature Review

important when the ones that make the decisions, the managers, are not the ones that have a financial interest and share in the wealth generated by these decisions, the owners. When asymmetry of information exists, owners and managers, the principal and the agent, act in their own interest and there is friction between these two parties. This problem is already pointed out in the 1930s when Berle and Means (1932) suggest that managers can show behavior in which they maximize their own wealth instead of the wealth of the shareholders. This suggestion is based on the idea that there exists information asymmetry between the managers and the shareholders, where the shareholders are unable to effectively control the manager. Managers are more likely to take actions in their own interest when there is no effective control. This effective control should be independent and separated from the management that takes the decisions.

After that, in 1976, Jensen and Meckling find that managers might be inclined to only publish positive information, since their employment is influenced by the information that is being brought out. In that same paper, the link between pay and performance is made through ownership. If a manager’s ownership falls, “his incentive to devote significant effort to creative activities, such as searching out

new profitable ventures, falls” (Jensen and Meckling, 1976). This behavior is logical, since not

participating in profitable ventures hurts the manager more when he has more ownership. Therefore more ownership for managers is desirable by shareholders, since this leads to a higher incentive for the manager to engage in profitable activities to increase their personal wealth.

managers should be designed to align these interests (Conyon, 1997). It follows directly from the agency theory that owning stocks as a member of the board is an incentive to correctly exercise control on a company. A recent study finds that there are two components which should be realigned between owners and agents: financial alignment (by compensation) and alignment of actions (by monitoring) (Lang and Jagtiani, 2010). To realign these interests, agents should get compensation based on equity ownership (Nyberg et al, 2010). However, shareholder return can be only a noisy signal for managerial effort. It should be linked to economy and industry wide benchmarks, to make sure the good performance is the result of the actions of the manager (Conyon, 1997).

CEOs find greater control by an outside board on their own strategic decisions a lack of respect and this outside judgment is only appropriate in case of a crisis.

More recently, broader aspects of corporate governance have become more important. Many studies have looked at combinations of corporate governance and firm value, corporate governance and stockholders returns or corporate governance and executive compensation. Stronger corporate governance is most important in case of an exogenous shock such as a crisis (Mitton, 2002). There are many articles which focus on an index of corporate governance provisions to capture all relevant variables. One of the most important lists of provisions is list with the IRRC-provisions, set up by the Investor Responsibility Research Centre to monitor corporate governance of firms. The IRRC was founded in 1972 and is considered to be an independent and unbiased research center focusing on the field of corporate governance. Their list consists of 24 provisions which were said to influence shareholders rights. Later, all these 24 rules are divided into five subcategories and a Governance Index (G-Index) was created for research and analysis. This index gives all these provisions an equal weight and relates it to firm value, measured as Tobin’s Q. It shows firms with higher shareholder rights have higher firm value, but the index is negatively related to shareholder returns in the 1990s (Gompers, Ishii and Metrick, 2003).

After that, Bebchuk et al. (2009) argue that not all of those provisions should have equal weight, since not all have the same influence on firm value. They create an Entrenchment-Index (E-Index), which consists of 6 of the 24 IRRC-provisions, which they claim to be the most influential provisions with respect to firm value. This index consists of: staggered boards, limits to shareholder bylaw amendments, poison pills, golden parachutes and supermajority requirements for mergers and charter amendments for a research in the period of 1990-2003. They find results of a rise in their E-index leading to lower firm value and large negative abnormal returns, while the other eighteen IRRC provisions are uncorrelated with firm value or abnormal returns. Since then, this index has gained wide recognition and has been used in over 150 studies.1 However, there is still no complete agreement on which corporate governance measure is best and it can be different for each situation. A study focusing on the changes caused by the implementation of the Sarbanes-Oxley Act, which I consider similar to the change in corporate governance environment and regulations caused by the financial crisis, shows inconsistent results with their indices (Bhagat and Bolton, 2009). These inconsistent results with indices are also one of the reasons why I decide to create my own corporate governance index and include variables which I seem fit, keeping the current corporate governance environment in mind.

In this study I use an extensive index of 59 corporate governance variables, based on combinations of the IRRC-provisions, the G-Index and the E-Index, but also including recent innovations which appear to change, for example sustainability committees and succession plans for board members. I create this broad index to see on the one hand what has changed in the field of corporate governance during the last 8 years, but on the other hand also to see which are related to firm value. This study is therefore not so much only a firm value investigation, but more of a governance-wide investigation on different practices in relation to the crisis.

2.1 Development of corporate governance regulations and codes

Over the last years there has been much development in the field corporate governance, the structure of it and the effectiveness of different structures. As said in the introduction, in this section I will give a short summary of the last decades on corporate governance and how it developed into the most recent UK Corporate Governance Code.

The first time disclosing information about remuneration of executives was required by law was after the Companies Act of 1967. It requires companies to show data on the aggregate compensation (except pension payments) and shareholdings of the chairman or the highest-paid director (when other than the chairman). This requirement made it possible to study the interrelationships between the ownership and remuneration of top management in the United Kingdom and the performance of their companies (Cosh, 1975). His study shows that company size is the biggest determinant of remuneration, while profitability is significant in only some industries. Since then, the Companies Act has been changed a lot of times, but still exists and this can be seen as the fundament of the current UK Corporate Governance Code.

from this report have later been used in constructing corporate governance systems in large and economically important countries, such as the United States and Germany (Sheridan, Jones and Marston, 2006). One of the recommendations for companies is to use a remuneration committee for executives. After that, the majority of publicly traded companies in the UK established remuneration committees, with a majority of non-executive directors (Ozkan, 2011). Other important points in the Cadbury Report focus on the structure of the board of directors. First of all, the CEO and chairman of the board of directors should not be the same person. Since the Cadbury Report, positions of the CEO and chairman of the board were separated more often (Hillier and McColgan, 2006). Next to that, to avoid agency problems, on the board of directors there should be a majority of independent executive (outside) directors. There should also be an Audit Committee with at least three non-executive directors (Ow-Yong and Kooi Guan, 2000). These recommendations led to changes in the structure of the board by increasing the number of non-executive and outside directors. However, there has not been found much evidence of a real increase in effectiveness as result of these changes (Ozkan, 2007). The report also stated that this code should be part of the requirements of being listed on the London Stock Exchange, which got a lot of resistance at first. However, Cadbury pointed out that those who have a doctrinaire approach of business and do not understand the business well, will not adopt this code if it is not required (Jones and Pollitt, 2004). With this reasoning, Cadbury won the discussion of the Confederation of British Industry (CBI) and the London Stock Exchange accepted this code and required firms to comply with it in November 1992. At this time, the Cadbury Report stated that “corporate governance is system by which companies are directed and controlled” (Cadbury Report, 1992). The definition of corporate governance was going to be adjusted, improved and extended throughout the next years.

The following report arrived in 1995, the Greenbury Report. This report was a response to a public concern on high compensation packages of executives and thus placed a focus on compensation policies to be more performance linked and for compensation for executive directors to be determined by non-executive directors (Conyon and Murphy, 2000; Ow-Yong et al., 2000; Sheridan et al., 2006). Shareholders should approve on these compensation packages. However, this pay for performance link should not be linked to share prices, since these can rise for the industry as a whole or reflect inflation, not through actions of the manager (Conyon, 1997; Ozkan, 2011). Also, total compensation should be disclosed in the financial statements in detail (Ow-Yong et al., 2000). Another rule it emphasizes is releasing price-sensitive information at a single moment to the whole market (Sheridan et al., 2006). This report encouraged companies to replace their option plans with long term incentive plans. As a result, the government placed more restrictions on option rewards and reduced the amount that could be awarded. With this discouragement of large share option grants, the pay for performance link is diminished (Conyon and Murphy, 2000).

disclose more information on compensation packages. As already said earlier, compensation should be constructed in such a way that incentives for performing are highest. Linking pay to long term performance and increasing commitment through option plans was one of the implementations of the Hampel Report (Ozkan, 2011). But also, it emphasizes to add textual explanation and extra information on the practice of corporate governance within the firm in the annual report (Sheridan et al., 2006). Thus the report focused on more transparency, but gave companies more freedom in choosing different corporate governance practices, as long as they explained why to the public. This principle is known as the “comply or explain”-principle. The outcome of the Hampel Report was to set up a Combined Code. Together, all these reports led to significantly more corporate news announcements and therefore did indeed cause increased transparency (Sheridan et al., 2006). Finally, these 3 reports led to the London Stock Exchange Combined Code on Corporate Governance, to which all companies listed on the LSE must comply, which came in practice on December 31st, 1998. In the Turnbull Report in 1999, there were some minor changes considering amongst others the quality of financial reporting. The result of all these reports was the adoption of the national code of corporate governance in the UK in 2000. France was two years earlier with the actual adoption of a national code, but already since 1992 the UK were stressing the importance of a national corporate governance code and began forming it, which makes the UK indeed an early adopter of a national corporate governance code (Cicon et al., 2012). National corporate governance codes generally focus on two subjects: improving the quality of governance of boards on companies and to increase accountability and transparency towards shareholders while maximizing shareholder value (Aguilera and Cuervo-Cazurra, 2004).

environment changed significantly. However, many auditors felt the management still has the final decision in disputes with auditors and only about half of the auditors felt they really could influence the management (Cohen et al., 2010).

The follow-up in the UK to the Sarbanes-Oxley Act in the US came with the Higgs Report in 2003, which was titled “Review of the role and effectiveness of non-executive directors”. The UK government was not entirely sure on what to do at that time. On the one hand, the UK government wanted to react quickly to the situation in the US, but on the other hand, it wanted to wait and see how the regulations from the Sarbanes-Oxley Act would turn out to be and the UK government has probably negotiated with the US on this topic. Also, there was much more governmental influence and an international element of corporate governance in the Higgs Report than in the Cadbury Report (Jones and Pollitt, 2004). But next to the non-executive directors, the report also focuses on remuneration, with a recommendation for a policy on a pay to performance link for executive directors’ compensation and fixing the remuneration for individual directors (Ozkan, 2011).

After that, there have been continuous improvements and reports on specific areas of corporate governance, for example Sir David Walkers Review on corporate governance of financial institutions and the banking industry in the UK. Finally in 2010, the UK corporate governance code (known as “the Code”) replaced the LSE Combined Code and summarizes all earlier reports in the following six points: separate chairman and chief executive, a balance of executive and independent non-executive directors, strong independent audit and remuneration committees, annual evaluation by the board of its performance, transparency on appointments and remuneration, effective rights for shareholders2.

Just recently, in late 2012, the UK Corporate Governance Code was updated again. It gets regular updates and currently the definition of corporate governance is the following:

“Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves than an appropriate governance structure is in place. The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board’s actions are subject to laws, regulations and the shareholders in general meeting.”3

2

See “The UK Approach to Corporate Governance” by the Financial Reporting Council, 2010.

This study focuses on data from the period of 2004 to 2011, so this last report not of influence on this study, but it gives a view of what is going on in the field of corporate governance today and shows that it is a constantly changing and developing subject. The Code still operates on the basis of the “comply or explain”-principle and is regularly reviewed with involved companies and investors. This principle means these corporate governance codes are not legally binding. Companies can deviate from the practices in the code, but then they would have to explain why they cannot comply. This principle is seen as an important foundation of the code. However, since almost all stock exchanges require companies to follow the code to be listed on the exchange, this is not so much a free choice after all (Cicon et al., 2012).

Summarizing, this section shows the problems that are present in the corporate governance environment and what research has been done. It shows corporate governance is an ever-changing, broad subject and different aspects should be taken into account for different situations. Better corporate governance should better align interests of the managers and the owners, leading to higher firm value.

3. Methodology and hypotheses

In this article I will look at the changes in corporate governance over the period 2004 to 2011. The main model relates corporate governance structure to firm valuation. As already explained in the literature review, a more efficient corporate governance structure better aligns interests of managers and owners and therefore leads to higher value. Also, better corporate governance should be more profitable and therefore investors expect higher future returns, which should cause an increase in firm valuation (Black, Jang and Kim, 2006). To take all different aspects of the corporate governance into account, I combine many different variables into an index. This is done in many comparable studies, such as Gompers et al. (2003), Black et al. (2006), Bebchuk et al. (2009) and Connelly et al. (2012). The index in this paper is created in light of the recent events in the corporate governance environment and the literature on the causes and effects of the financial crisis. In this section, I shall discuss the index extensively and describe the construction of the index and the included variables. I will use this index to investigate my main research question:

Has corporate governance of firms increased since the financial crisis and is this related to higher firm value?

As said, the FTSE works with the Combined Code, which uses the “comply or explain” principle. Since the Code is updated and extended regularly, I expect the disclosure or transparency on elements of corporate governance to increase. In these hypotheses, transparency is measured as the number of observations throughout the years. Corporate governance codes are gaining more and more attention and this is reflected in the demand for transparency, disclosure and accountability (Cicon et al., 2012). Also, during the East Asian financial crisis higher disclosure quality and greater transparency are related to better performance (Mitton, 2002). Many high-leverage institutions which are part of the cause of the financial crisis have too little transparency (Nielsen, 2010). Since the development of corporate governance structure 70 years ago, it has never been more important for boards to focus on transparency and accountability (Ettorre, 2009). These articles support the following hypotheses 1a and 1b:

H1a: Transparency on corporate governance variables, not included in the corporate governance index, has increased from 2004 to 2011.

H1b: Transparency on corporate governance mechanisms, measured in the corporate governance index, has increased from 2004 to 2011.

From this hypothesis follow the expectations of the next two, which focus on the value of a variable instead of the number of observations. These variables will be explained more thoroughly in section 3.1 for variables included in the corporate governance index and in section 4.3 for variables not in the corporate governance index. They will be tested based on descriptive statistics.

H2a: Values for corporate governance variables, not included in the corporate governance index, have increased from 2004 to 2011.

H2b: Values of corporate governance mechanisms, measured in the corporate governance index, have increased from 2004 to 2011.

Since I am using such a broad list of corporate governance variables, I have the possibility to look at how the improvements are divided amongst the several subindices. I expect companies to focus on the complete picture of corporate governance, and not on just a specific index. As said before, the SOX Act led to more attention on corporate governance as a broad field of interest and because of that, forced companies to enhance their corporate governance mechanisms in all fields at the same time, rather than just one field at a time (Bhagat and Bolton, 2009). Comparable studies find similar results with correlation between subindices (Gompers et al., 2003; Black et al., 2006; Connelly, Limpaphayom and Nagarajan, 2012). I test this general corporate governance approach by looking at the correlation of the subindices and this leads to the following hypothesis:

The next hypotheses are all focusing on variables in the corporate governance index and support for these hypotheses is in the next section, 3.1.

H4: There is a positive relation between firm value and the total corporate governance index

H4a-4e: There is a positive relation between firm value and a subindex of the corporate governance index4

Finally, I will look at the influence on of the financial crisis, which had its outburst in 2007 and caused reduced value for companies (Goddard, Molyneux and Wilson, 2009; Lang and Jagtiani, 2010; Nielsen, 2010). In the East Asian financial crisis, corporate governance structure of a company influenced the performance (Mitton, 2002). I include a dummy variable with value 1 for the years 2007 to 2011. These articles support and lead to my last hypothesis:

H5: The financial crisis, measured as a dummy variable with value 1 from 2007 to 2011, is negatively related to firm value.

In the next section, hypotheses 4a-4e will be extensively explained based on current literature.

3.1 Construction of the corporate governance index

As said earlier, this research is mainly based on a corporate governance index which is created specifically for this research. I do not use existing indices such as the G-Index or E-Index, since these are not specified on the financial crisis and show inconsistent results with other studies on changes caused by corporate governance (Bhagat and Bolton, 2009). Also, recent research on corporate governance shows that choosing own corporate governance indices can be better at assessing the governance practices (Connelly et al., 2012). Even more, they say the link between governance and value is only visible when using a broad range of corporate governance variables, not with individual mechanisms. A downside of using an index is that variables can only be counted as present or not present. This way of measuring reduces precision, but is necessary to create an index (Gompers et al., 2003). I will not use such variables in the index, since it is too hard to distinct between ranges of numbers that would get a point and which would not, which would lead to randomized results. However, the variables that cannot be included in the corporate governance index for this reason, are not completely omitted. I will elaborate more on these variables in section 4.3 and look at the descriptives in section 5.

4

In this governance index I include 59 variables. First of all, I divide the variables into five subcategories of different items. Some aspects of corporate governance will show up in all subcategories. For example, transparency is not a subsection on its own, but it is measured in each subsection with corresponding variables. This division is also because transparency is needed in every field, from ownership to performance and from financial statements to corporate governance practices. These subcategories are not the same as the UK Corporate Governance Code distinguishes, but all aspects are in there and divided as follows: board structure (12 variables), board functioning (7), compensation policy (10), shareholder rights (20), vision and strategy (10). The number in parentheses is the number of variables in that specific category. In a subcategory, a company gets one point for having the best corporate governance practice for a certain variable. The best corporate governance practice means the practice which causes an increase of alignment between owners and managers. If variables for a company were “not available”, this means the provision is not present, and therefore results in a negative answer and does not add points to the corporate governance index. However, if companies have none of the variables available throughout the period, and thus have a corporate governance score of 0/59, they are omitted from the final sample as being not available. In the next subsections I will explain some more on the most important variables; the full list can be found in Appendix B.

3.1.1 Board structure

chairman, with no connection to the company (Ettorre, 2009). If the CEO does not chair the board, it means his influence is supposed to be lower and the company gets one point on the corporate governance index.

The next structural component is the presence of a nomination committee. As already said in the introduction, this has been common for more than a decade, so I do not expect to find many companies that do not have a nomination committee. Another common item, which is included in both the Governance-index of Gompers et al. (2003), as well as the E-index of Bebchuk et al. (2009), is the aspect of having a staggered board structure. This structure means the board is divided into different levels, where each level entails a number of board members that entered at a specific time. All levels have thus different times at which they started and also only one level can be reelected, or not reelected, each term. This way, terms of members will always overlap and it is impossible to completely change the board each time and an outsider who wants to gain control of the company has to wait a few years before being able to gain control of the board (Gompers et al., 2003). In case of proxy fights, where shareholders do not agree on the directors or managers and might even want to completely remove them, this is a powerful defense, since only a fraction of the directors can be replaced (Bebchuk et al., 2009). Since this is an increase in managerial power and a reduction in power of shareholders, not having a staggered board structure adds a point to the corporate governance index.

Next to these variables focusing on board size and its members, there is also a group of variables that focuses on the willingness of the company to commit to certain corporate governance instruments for a balanced board. For each company, six policy elements are included in the total score. These policy elements state whether a company has a policy on for example board size or gender diversity. This variable measures purely whether the company has a policy on this element, not whether they comply with it. Carter, Simkins and Simpson (2003) find that firms that are committing to diverse boards show a positive relation between firm value and board diversity, in terms of women and minorities. I expect these policy elements to have risen the last years and each element is an increase in efficient corporate governance. A higher score on this subindex means better corporate governance in a company and more efficient corporate governance should be related to higher firm value. This relation leads to the following hypothesis:

H4a: There is a positive relation between firm value and the board structure section of the corporate governance index

3.1.2 Board functioning

to reach an efficient corporate governance structure and to control the functioning of the board of directors. An example is a general corporate governance committee. This committee focuses purely on the effectiveness of corporate governance and adds in the monitoring function. Other committees a company can have are an audit committee and a compensation committee. These four committees are, just as the board of directors itself, controlling the functioning of the company and therefore fit in this category. These committees support the board of directors and have to be independent as well. I include one extra variable for the audit committee, which focuses on audit committee expertise. This variable focuses on the size of the audit committee (whether it has three or more members) and the background of those members (whether at least one of them is a financial expert according to the Sarbanes-Oxley Act5). Audit committees play an important role in monitoring internal controls and the quality of reporting and they need sufficient expertise to be able to exercise this control efficiently (Cohen et al., 2010). Inefficiency and shortage of expertise of audit committees are also related to causes of the crisis (Kirkpatrick, 2009).

Another element in board functioning is aimed at the meetings of the board and the attendance of board members. In the next section I will look at the number of board meetings and the board meetings attendance average, but these are not included in the index. In the corporate governance index I include a variable which measures whether companies state what members attended a meeting and which did not, just as Black and Jang (2006) and Connelly et al. (2012), measured by board attendance. Rules for attendance were already described in the Cadbury Report in 1992 and in 2003, the Higgs Report recommends disclosing numbers on the individual attendance of directors at board meetings. Disclosing individual attendances of course adds to the transparency of a company’s practices, which is also seen as important.

Another element which is much criticized was the extremely high figures companies paid to external consultants. It was argued that doing this resulted in doing each other favors and getting them back also, instead of only hiring external consultants when needed and for a right price, for example for compensation (Conyon, 2009). However, the board of directors must have the ability to hire them if they think it is important for the company. Therefore I include the variable external consultants, which measures as yes or no. Practically, this means whether the board of directors can hire external consultants if they see fit, and can do so without the approval of the management. The focus has to be on controlling the management and therefore it should be possible for the board to hire external consultants without their approval. If the management has the power of approval, they can decline the

5 _{According to the Sarbanes-Oxley Act someone is a financial expert when the person has experience with}

proposed consultants and with that avoid being looked into by external advisors or consultants. When the management has the chance to hire external consultants without approval, this can be in their own benefit (Kostiander and Ikäheimo, 2012).

Not being able to look forward enough was another point of criticism. Having short-term plans and only focusing on what was going to happen in the next few months is said to be one of the many faults of companies. To solve this, companies need to have a succession plan for key members of the executive board, supported by a nomination committee (Higgs Report, 2003). Although this sounds logical, being prepared in case something unexpected and bad happens, it appeared to be missing for a lot of companies in the early 2000s. This succession plan is also necessary to keep a good balance between skills, experience and refreshment on the board, according to the most recent UK Corporate Governance Code. For this subindex, just as for board structure, this leads to the following hypothesis.

H4b: There is a positive relation between firm value and the board functioning section of the corporate governance index

3.1.3 Compensation policy

Category three focuses on maybe the most important factor of causing the financial crisis and the one factor that also got the most media attention by far: compensation policy. As already described extensively in the introduction and literature review, high compensation packages caused by greed of managers can be said to be one of the causes of the financial crisis (Ettorre, 2009; Kirkpatrick, 2009). Next to that, compensations were extremely high for top managers, while companies itself did not make much profit or performed well. There was hardly any link to performance, which gave managers little incentive to make their companies perform well, as explained by Berle and Means (1932). Golden parachutes, high compensation for top managers if they were to be fired, were omnipresent and extremely high (see 4.4). Transparency of the whole pay setting process must improve to give shareholders a better view of the tradeoffs being made (Kostianer and Ikäheimo, 2012). This whole subcategory focuses on the fact that compensation for managers should be lower, control should be higher and the compensation should be linked more to performance instead of a fixed high salary (Fama and Jensen, 1983; Conyon, 1997).

High compensation packages without a link to performance led to high costs for a company, even in times of financial distress and therefore this linked should be present. The variable CEO compensation links to total shareholder return measures this. Shareholder return is considered to be an appropriate measure for profitability and should always be at the center of attention of a manager, since this is in the interest of the owners. After the SOX-Act in 2002, there has been a significant increase in director’s stock ownership to link their compensation more to performance (Bhagat and Bolton, 2009). In another study focusing on future operating performance, stock ownership of board members is said to be the most important aspect in improving corporate governance (Bhagat and Bolton, 2008). I expect this link to results to have been increased even more in the sample period. Shareholders’ approval of stock option plan makes sure that stock option plans cannot be implemented by management directly. Stock option plans are also linking compensation to performance and are plans where employees get the opportunity to buy stock at a certain strike price for a certain time frame. This plan gives employees the chance to make a profit if the company does, but even more it gives employees ownership of their company. This ownership should then make them more committed and therefore increases motivation and productivity. However, the stock option plan has to be at the right price, otherwise employees have an unfair advantage. One of the elements that should be considered in stock option plans is the vesting period of stock options. A vesting period is a period of usually at least three years, in which the stock options can be exercised. This vesting period makes it impossible to exercise all options at a specific moment in time, but only a part of the total plan per year.

Board stock ownership can be positively related to firm value (Yermack, 1996). I include a variable compensation structure which measures whether the compensation is divided into several parts. Instead of just having a fixed salary, there can also be bonuses and stock option plans. Fixed salary should then be lower and be compensated with bonuses related to performance or stock option plans which also focus on the overall performance of the company.

In the field of transparency, there is one variable, measured as individual compensation. This variable measures whether a company states what the individual compensation of all executives and board members is. Another public pressure point has been the environmental policy of a company and the focus on social engagement. I will elaborate more on that later, but in the compensation section there is one variable which focuses on this: compensation linked to sustainability. This variable measures whether executives’ pay is linked to several social targets and sustainability, such as health and safety and their corporate social responsibility.

the company performs badly. A general look at compensation is measured by a summarizing variable compensation controversies, which tells whether there have been any problems with compensation in that company in the years. Not having any controversies adds a point to the corporate governance index, while having one does not. I expect the total score for this subsection to be related to firm value, leading to the following hypothesis:

H4c: There is a positive relation between firm value and the compensation policy section of the corporate governance index

3.1.4 Shareholder Rights

As already mentioned several times, shareholder rights have become more important too and they should be protected by good corporate governance mechanisms. The UK uses a common law system, which protects shareholder rights the most (La Porta et al., 1997). In the corporate governance environment, protection of shareholder rights is a constantly developing field and these practices are continuously improved (Aguilera and Cuervo-Cazurra, 2004). La Porta, Lopez-De-Silanes, Shleifer and Vishny (2002) show that rights of minority shareholders relate to higher firm value. Next to that, Gompers et al. (2003) show that firms with stronger shareholder rights have higher firm value. Also, when shareholders rights are better protected, outside investors do not mind to pay more for financial assets, leading to higher firm value (La Porta et al., 2002). There are a lot of provisions which focus on shareholder rights. Many of these provisions are related to the voting power of shareholders, since voting power is the most important source of power for shareholders (Clark, 1986). When owning shares of a company, you are partly owner of the company and with that you get some rights. However, this differs amongst companies. If you have more rights, this means you have more power, because you can, in theory, influence decision making. There are a lot of ways for companies to decrease the voting power of a majority of shareholders. Since this limits shareholder rights and increases managerial power, there is wide resistance to these provisions (Bebchuk, 2009). Firms with weak shareholder rights have lower profitability and lower sales growth than other firms in their industry with strong shareholder rights (Gompers et al., 2003). For my corporate governance index I give every provision that limits or diverges from normal voting rights or constructions in the field of takeover defenses 0 points, since these are restricting shareholder rights (Gompers et al., 2003).

in some cases prevent the majority of shareholders of having it their way (if they are just short of a supermajority). These requirements are usually 66.5%, 75% or 85% of all shareholders, which regularly exceeds attendance at meetings (Gompers et al., 2003). The variable voting cap measures if a company places boundaries on the power a shareholder has, given their number of shares. There are several options when there are not equal voting rights. For example, in a time-phased voting, it depends on how long the shareholder is an owner of the shares and if it exceeds a certain period the shareholder gets more votes per share (Gompers et al., 2003). Next to that, it can depend on the number of shares someone holds and in this case not every shareholder can always vote. Therefore I include the variable minimum number of shares required to vote to take this into account. With this provision you need a certain amount of shares before you are able to vote and therefore reduces basic shareholder rights (Gompers et al., 2003). There can also be a difference between shares, such as double voting rights or non voting rights. In the first case, this share is sold at a premium since you have double voting rights, while in the second case the owner does not have the ability to vote. The final variable on voting is equal voting rights, which is answered with yes if all shares of a company have equal voting rights.

Priority shares or non-transfer shares are also possible different types of shares which reduced shareholder rights. The same goes for pre-emptive rights, which mean that existing shareholders have the option to buy newly issued shares at a reduced rate before anyone else can. All of these types of shares are examples of anti-takeover devices, since it limits the owner’s ability to sell his shares in case of a bid. A final variable is the poison pill, which is a device where the owner of shares gets extra options which make the shares less attractive to a potential buyer. There are several options here. In one case the current owner of shares allows existing shareholders to buy shares at a discount of the target company. In another case, the current owner of shares is allowed to buy shares of the bidding company after the takeover at a discount, which both makes acquiring less attractive. Poison pills are part of the so called “delay”-strategy of defensive tactics, which are designed to slow down the takeover of a hostile bidder (Gompers et al., 2003). Poison pills are also known as shareholder rights plans and can also give the director shareholder the right to not sell their shares when they are still in office. Having such a pill in place signals to potential buyers that the board will not surrender easily and the board will try to maintain their positions (Bebchuk et al., 2009). All these options make the shares less attractive for a buyer.

incentives to perform for the manager are directly lowered by this phenomenon, since performing badly does not have that many consequences. A golden parachute lowers the economic cost of a director losing control and might increase slack on the part of managers, since they are less subject to the market of control (Bebchuk et al, 2009). Most of all, it is a decrease in shareholder rights, since shareholders should have the right to fire a manager without incurring extra costs (Gompers et al., 2003). Therefore this is mostly a restriction of shareholder rights than a compensation policy and I include it in this subcategory. Having a golden parachute used to be common in the early 2000s, however now I expect fewer companies to have this construction. Share structure is answered with yes if the company only has common stock, since this increases shareholder rights; it is answered with no if the company also has for example preferred stock. Higher shareholder rights are thus expected to be positively related to firm value, leading to the following hypothesis:

H4d: There is a positive relation between firm value and the shareholder rights section of the corporate governance index

3.1.5 Vision and strategy

The last category of corporate governance variables is vision and strategy. This subsection focuses on long-term objectives of companies and whether they act socially responsible and are committed to the general environment. Not only the extreme payments or risk-taking behavior of companies has been criticized by media, also their responsibility of doing business while keeping the environment in mind. It has become a real trend for companies to focus on their corporate social responsibility (CSR) and companies have even turned it into a value-creating marketing strategy which can improve stock returns (Edmans, 2012). While some companies took it on right away, others were almost obliged to follow, since customers also chose for companies with a focus on the environment. Having a consistent and carefully built CSR-strategy, relates to better performance (Tang, Hull and Rothenberg, 2012).

This section is measured with ten variables. Having a corporate social responsibility committee deals with all matters in fields as society, environment, employment and political. Next to having a committee which oversees all related activities, there should also be a corporate social responsibility report. This report also includes health and safety and sustainability as items. Having such a report in their annual report or as a separate report, results in one point for the corporate governance index. Then there are several aspects this report should cover, for example whether this report includes all global activities. Next, the report should be checked by someone for truth, best by an external auditor.

responsibility index. This public attention puts pressure on companies to keep up with other companies and also requires a company to regularly look at their achievements in this field. As already said in the previous section on shareholder rights, shareholders are more and more engaged in decision making and are getting more power. An important aspect of contact with shareholders is measured as shareholder engagement and if the company reports on how they provide the engagement.

Then there are two more variables focusing on economic, social and governance (ESG) issues. The first is whether a company has a policy for handling ESG-issues and implementing them into the main strategy of the company. If a senior manager has made a public commitment to make ESG-issues a part of daily strategic decision making and the company’s overall strategy, a company gets one more point for the index. The last variable focuses on the transparency of the vision of the company of integrating all CSR and ESG issues in their strategy. If a company openly states their concerns, doubts and their grounds for making strategic decisions on these issues, both financial as non-financial, that company gets one more point for the index. The more transparent a company is and the more information it discloses, the higher its value should be, leading to the last hypothesis in this section:

H4e: There is a positive relation between firm value and the vision and strategy section of the corporate governance index

Finally, the total corporate governance index is a sum of the scores of all the separate subindices. As explained, I compose all subindices in a way that higher scores increase alignment between shareholders and managers and should lead to higher firm value. The total corporate governance index is the combination of these subindices and shows the relation between the complete corporate governance environment and firm value. So logically, the final hypothesis, which focuses on this combined influence of the subindices on firm value, is:

H4: There is a positive relation between firm value and the total corporate governance index

4. Data

study possible. As said, this is an interesting period, with years before the financial crisis (until 2007) and years afterwards.

This yearly data on the list of companies of the FTSE 100 are collected from Datastream, which has an up to date list of FTSE 100. The FTSE 100 is a list of the 100 most highly capitalized companies listed at the London Stock Exchange. The full list of companies can be found in Appendix A. As said in the introduction, the UK has an extensive history and focus on corporate governance; therefore there is good data availability. I choose to use the FTSE 100 instead of for example the FTSE 350, because the companies in the FTSE 100 have been getting more media attention and therefore I expect them to be more aware of corporate governance policies and the national corporate governance code and more active in the field of corporate governance. Wintoki (2007) already shows that a national corporate governance code is most appropriate for large firms and small firms need other regulations which keep their specific characteristics in mind and are therefore not comparable. Finally, the FTSE 100 has good data availability.

This leads to a total 4742 corporate governance observations and 2986 control variables observations over the period 2004 to 2011. I remove values higher than ±5 for Tobin’s Q (26 observations) and 0 for TCGI (58 observations) as outliers, in line with Black et al. (2006). Since this is converted into an index score, this leaves a total of 683 company observations used in the final model. Not available items due to lack of data and outliers in the database lead to the removal a total of 26 observations in the final model. I will use panel data with fixed effects. Fixed effects are necessary to investigate the changes of the variables over time and it is tested in section 6.

As said in section 3, I count corporate governance variables in the index simply to be present or not present. Although this reduces precision and I cannot include all variables, this is necessary to create an index (Gompers et al., 2003). If companies have none of the variables available throughout the period, and thus have a corporate governance score of 0/59, they are omitted from the final sample. In the next section, I will first describe the control variables and provide literature support. After that, I will describe the variables which I not include in the corporate governance index, due to not being able to get scored 0 or 1, but are still interesting to look at.

4.1 Control variables

Firm Value – Firm value is my dependent variable. Consistent with a lot of other relevant literature I use Tobin’s Q as a proxy for firm value (Yermack, 1996; Palia, 2001; Gompers et al., 2003; Black et al., 2006; Bebchuk, 2009; Ozkan, 2011; Connelly et al., 2012). Tobin’s Q predicts a firm value based on the difference between its book and market value of assets and is considered an efficient way to compare companies’ value over a period of time. Tobin’s Q is my main dependent variable, since I will test whether the CGI influences firm value. There are results of the G-Index being negatively related to firm value measured as Tobin’s Q (Gompers et al., 2003). As is common, I use market value of assets divided by the book value of assets as the measure for Tobin’s Q (Yermack, 1996; Palia, 2001; Gompers et al., 2003; Bhagat and Bolton, 2008); Bebchuk, 2009). Tobin’s Q is not readily available from Datastream. I calculate it as the market value of assets divided by the book value of assets, which symbolizes the replacement value of current assets:

Tobin’s Q = Market Value of Assets_{Book Value of Assets} 6

In this equation, market value of assets is calculated as book value of assets (Datastream item WC02999) plus market value of common stock (which is book value of common stock (Datastream item WC03501) times the market to book value (Datastream item MTBV)) minus book value of common stock (Datastream item WC03501) minus deferred taxes (Datastream item WC03263). Book value of assets is readily available.

CGI score - This is the score on the corporate governance index the company has. This score is, as said, between 0-59, since there are 59 variables measured. I will also use the scores on the separate subindices in some regressions to compare their individual influence on Tobin’s Q.

Firm size – This is measured as the log of the assets and is a control variable for the size of a company, since these large companies are usually paying more (Ozkan, 2007). Also, size is a measure of organizational complexity (Core et al., 1999). Early studies around 1990 find size to be negatively related to firm value, but in later studies firm size has a significant and strong positive relation with firm value (Palia, 2001). There is evidence that companies have larger boards relative to their size (Cosh and Hughes, 1997). It is usually measured in assets, so I use a log of total assets (Datastream item WC02999) in line with Black et al. (2006), Bhagat and Bolton (2008), (Bhagat and Bolton, 2009), Bebchuk (2009) and Connelly et al. (2012).

Firm profitability - Measured as return on assets (ROA) just as Yermack (1996), Bhagat and Bolton (2008), Bhagat and Bolton (2009) and Connelly et al. (2012), and is a common control variable in

6 _{In this equation, Market Value of Assets = Book Value of Assets + Market Value of Common Stock – Book}

Value of Common Stock – Deferred Taxes.

Tobin’s Q regressions (Bebchuk, 2009). I also use return on assets instead of return on equity since the firms in my sample are from different sectors and therefore have a different capital structure and different leverage ratios, which would make interpreting results difficult. Return on assets is calculated as the net income bottom line (Datastream item WC06151) divided by total assets (Datastream item WC02999).

Board size - Black et al. (2006) use a model in which they include board size as a control variable. In one case, it measures the number of members on the board, in the other it uses a dummy variable equal to 0 if a firm has 8 members, 0.5 if it has 9-12 members and 1 if it has more. Yermack (1996) finds a negative relationship between board size and performance while using the log of total members of the board. I use the total number of members (Datastream item CGBSDP060) as a control variable in line with Palia (2001), Ozkan (2007), Bhagat and Bolton, (2008), Ozkan, (2011).

In the model I use a dummy variable for the year 2007 and later. In the corporate governance environment, this is seen as the burst of the bubble leading to the financial crisis (Goddard et al., 2009; Lang and Jagtiani, 2010) and thus an important point in the corporate governance history of the last years. Finally, εit is an error term.

4.2 The model

All together, I will use the following model. I will do several regressions but the base OLS-regression will be:

Firm valueit = α + β1CGI it+ β2Firm size it + β3Firm performance it + β4Board size it + β5Crisis it + εit (1)

In this model firm value is the dependent variable, measured as Tobin’s Q; α is a constant; CGI consists of different scores on the corporate governance index; control variables are log of total assets, return on assets, and board size; crisis is a dummy with a value of 1 for the years of 2007 to 2011 and εit is an error term.

I will use the following regressions to measure the impact of the different variables:

Firm Valueit = α + β1 TCGI it+ β2 control variables it + β3 Crisisit + εit (2)

Firm Valueit = α + β1 CGIBS it+ β2 control variables it + β3 Crisisit + εit (3)

Firm Valueit = α + β1 CGIBF it+ β2 control variables it + β3 Crisisit + εit (4)

Firm Valueit = α + β1 CGICP it+ β2 control variables it + β3 Crisisit + εit (5)

Firm Valueit = α + β1 CGIVS it+ β2 control variables it + β3 Crisisit + εit (7)

Firm Valueit = α + β1 CGIBS it + β2 CGIBF it + β3 CGICP it + β4 CGISR it + β5 CGIVS it + β6 control

variables it + β7 D07 it + εit (8)

In these models TCGI is the score for the total corporate governance index, CGIBS is the score for the board structure subsection, CGIBF for board functioning, CGICP for compensation policy, CGISR for shareholder rights and CGIVS for vision and strategy.

4.3 Variables not included in the corporate governance index

As already explained, not all variables are measured in a way that they can be assigned points and thus be included in the corporate governance index. However, some of these variables are still an important part of the corporate governance environment and can provide some more clarification on how the corporate governance environment has changed the last years. A full list of these variables can be found in Appendix C.

4.3.1 Board structure

First of all, in the category of board structure, there are six variables not included in the index. Board size is argued to be one of the most influential variables for a strong corporate governance structure. It is associated with higher firm value, although in some countries there are results it does not (Connelly et al., 2012). In studies on data from the 1990s or earlier, you see evidence that larger boards (over 7 to 8 people) are related to lower firm value, due to communication problems and they are easier for a CEO to control (Jensen, 1993; Yermack, 1996). Other studies find similar results (Core et al., 1999). However, with the improvements in communication possibilities since then, larger boards do not suffer from those problems anymore and are therefore now positively related to firm value. Already in an early study on data from 1970 until 1989 board size increased for some companies, while the ratio of non-executive directors increased for other companies where the board size did not increase (Cosh and Hughes, 1997). In a more recent study on the period around the Sarbanes-Oxley Act, it showed that board size stayed relatively constant, while an increase is expected (Bhagat and Bolton, 2009). Since this is a very important variable in my opinion and other studies use it as a control variable, I also include board size as a control variable in my analysis.