THE IMPACT OF CORPORATE GOVERNANCE ON STOCK PRICES

The Impact of Corporate Governance on Stock Prices

Abstract

The purpose of this paper was to analyse the impact of corporate governance on the stock price and for this we constructed a governance index based on several attributes known to be associated with good corporate governance. After checking that the index is positively associated with standard indicators of firm performance, we use it to evaluate the returns on governance-sorted portfolios. Our main finding is that poorly governed firms significantly outperform better-governed firms. However, this result derives from the greater risk exposure of poorly governed firms. After adjusting for size and book-to-market, excess returns become insignificant across all portfolios. We verify that neither the sample period nor the behavior of specific industries is responsible for this outcome. Consistent with market efficiency, stock prices appear to fairly reflect the higher (lower) risk associated with poor (good) corporate governance.

Controls — Internal & External18

Systemic Problems20

Conclusion26

References28

Appendix30

Introduction

The increasing number of corporate scandals in the last five years have stained corporate governance reputation and questioned the effectiveness of its current structure. As a result, corporate governance has received attention from policymakers, investors, corporate boards and rating agencies. During this period, many top executives of giant corporations such as WorldCom Inc. ENRON Corporation, Tyco International Ltd. Adelphia Communications Corporation, Credit Suisse First Boston, to name a few have been convicted of conspiracy, orchestrating schemes to hide their company’s debt and exaggerate profits while embezzling millions of dollars. Shareholders as well as legislators have been appalled at such intolerable actions. These actions and practices have created an urgent need for corporate governance assessment and rating systems.(Lawrence, 2004)

Corporate governance is as old issue as the venture itself. In the nineteenth century, state corporation law enhanced the rights of corporate boards to govern without the consent of shareholders in exchange for statutory benefits like appraisal rights, in order to make corporate governance more efficient. Since that time, concerns of shareholders over administration pay and stock losses periodically have led to more frequent calls for corporate governance reforms.(Bhojraj, 2003)

Corporate governance cannot be dealt with in an abstract model, as it is a product of hierarchal, cultural, and political systems. Also, any model or a governance structure must entail the four basic ingredients namely: accountability, independence, transparency, and integrity. It is evident that these components are interdependent and cannot be.