Corporate Governance and the Informational Efficiency of Prices

• Author: Kee H. Chung,Choonsik Lee,Sean Yang
• Published date: 01 March 2016
• DOI: http://doi.org/10.1111/fima.12104
• Date: 01 March 2016

Corporate Governance and the

Informational Efficiency of Prices

Choonsik Lee, Kee H. Chung, and Sean Yang∗

We explore the relation between corporate governance and the informational efficiency of prices

(IEP). We find that IEP increases with the quality of corporate governance in a large cross-

section of firms. We show that firms with better governance structures file Form 8-K reports

more promptly and have more accurate analysts’ earnings forecasts, suggesting that corporate

voluntary disclosures and analyst forecasts are channels through which corporate governance

affects IEP. The positive relation between IEP and governance quality cannot be attributed to

reverse causality or other confounding factors (e.g.,analyst following, stock market liquidity, and

institutional ownership). On the whole, our resultsshow that better governance structures lead to

higher IEP by improving the speed and extent of corporateinformation disclosures.

The price of a financial asset is considered informative when it is close to the asset’sfundamental

(intrinsic) value.1Informative price is invaluable to the market economy because it helps allocate

resources efficiently.2We explore whether the informational efficiency of prices (IEP) varies

with the firm’s governance structure and examine possible channels through which corporate

governance affects IEP. The results of our study shed further light on a possible link between

corporate governance and shareholder wealth.

Prior research sheds significant light on the effect of corporate governance on firm value and

profitability. For instance, Gompers, Ishii, and Metrick (2003) show that firms with stronger

shareholder rights have higher share values, profits, and sales growth. Bebchuk and Cohen

(2005) show that staggered boards that insulate the board from removal via a hostile takeover or

a proxy contest reduce shareholder wealth. Cremers and Nair (2005) find a relative underpricing

(overpricing) in shares of companies with a high (low) level of takeover vulnerability. Chung,

Elder, and Kim (2010) show that better corporate governance structures result in higher stock

market liquidity.This study extends the literature by analyzing the effect of corporate governance

on another important attribute (i.e., IEP) of the firm.

The authors thank an anonymous referee, Marc Lipson (Editor), Kenneth Kim, Cristian Tiu, Nitish R. Sinha, Surya

Chelikani, Carl Shen, Eric Higgins, seminar participants at Quinnipiac University and SUNY at Buffalo, and session

participants at the FMA conference for their valuable comments and suggestions. The authors also thank Institutional

Shareholder Services Inc. (ISS) for providing corporate governance data. All remaining errors are our own. This

work was supported by the National Research Foundation of Korea Grant funded by the Korean Government (NRF-

2014S1A3A2036037).

∗Choonsik Lee is an Assistant Professor in the Department of Finance at Quinnipiac University in Hamden, CT. Kee

H. Chung is the Louis M. Jacobs Professor in the Department of Financeat State University of New York at Buffalo in

Buffalo, NY and SKKU FellowProfessor in the School of Business at Sungkyunkwan University (SKKU) in Seoul, Korea.

Sean Yangis a doctoral student in the Department of Finance at State University of New York at Buffaloin Buffalo, NY.

1Changes in fundamental values are unpredictable because they change only when traders learn of new, unexpected

fundamental information. Because prices are close to fundamental values in efficient markets, price changes in efficient

markets are also unpredictable.

2For example,if prices are infor mative,shares of companies run by good managers will be sold at relatively higher prices

than shares of companies run by poor managers. In such a market, shareholders may use share price to compensate good

managers and to remove poorly performing managers.

Financial Management •Spring 2016 •pages 239 – 260

240 Financial Management rSpring 2016

Prior studies have examined the determinants and ramifications of IEP. Chordia, Roll, and

Subrahmanyam (2008) show that smaller tick sizes and narrower bid-ask spreads prompt more

arbitrage trading, which in turn, increases IEP. Boehmer and Kelley (2009) show that stocks with

higher institutional ownership are priced more efficiently. Chang and Yu (2010) analyze how

the firm’s capital structure choice affects IEP and suggest that the firm’s capital structure can

be designed to increase IEP. Our study contributes to the literature by providing evidence on the

relation between IEP and a broadly defined index of corporate governance quality.

Weconjecture that IEP increases with the quality of corporate governance because effective gov-

ernance brings about timely disclosure of value-relevant information by reducing management’s

ability and incentive to withhold such information. Effective governance reduces the likelihood

that management, acting in its self-interest, does not fully disclose value-relevant information to

shareholders. Indeed, Ajinkya, Bhojraj, and Sengupta (2005) and Karamanou and Vafeas (2005)

show that the frequency and accuracy of earnings forecasts increase with board effectiveness.

Byard, Li, and Weintrop (2006) find evidence that stronger corporate governance enhances the

quality of mandatory and voluntary disclosures, which in turn, increases the accuracy of ana-

lysts’ earnings forecasts. Because better disclosure and greater transparency improve the ability

of traders to arbitrage pricing errors and to properly value stocks, better corporate governance

is likely to increase IEP.3Consistent with our conjecture, we find that IEP is higher for firms

with higher governance scores that are constructed from 33 governance standards compiled by

Institutional Shareholder Services (ISS) Inc.

Boehmer and Kelley (2009) show that institutional investors increase IEP, and Chung et al.

(2010) show that stock market liquidity is higher for firms with better governance structures. Prior

studies also show that institutional investors prefer firms with better governance quality (Chung

and Zhang, 2011), and IEP increases with stock market liquidity (Chordia et al., 2008). Hence, the

relation between IEP and corporate governance may be due to their respective correlations with

institutional ownership and stock market liquidity. We show that the relation between IEP and

corporate governance quality is significant even after we control for the effects of institutional

ownership and market liquidity in the regression.

The positive relation between governance quality and IEP may be driven by reverse causality.

Ferreira, Ferreira, and Raposo (2011) find evidence that firms with more informative stock prices

have weakergovernance structures. To address the endogeneity issue, we also employa str uctural

model that includes the two instrumental variables(i.e., f irm age and chief executiveoff ice tenure)

that are likely to be correlated with corporate governance structure but are not directly related

to IEP (i.e., these instrumental variables may affect IEP only through their effects on corporate

governance structure). The two-stage least squares (2SLS) regression results show that IEP is

positively and significantly related to the fitted governance scores, even after controlling for a

possible endogeneity problem.

We analyze possible channels (or mechanisms) through which corporate governance affects

IEP. Asset price is likely to be informative if market participants are promptly provided with

accurate information. Using the mediating variable method (Baron and Kenny, 1986), we show

that analyst forecasts (accuracy) and the firm’s voluntary information disclosures (promptness)

via Form 8-K filings are channels through which corporate governance influences IEP.

3Ferreira and Laux (2007) show that openness to the market for corporate control (i.e., fewer antitakeover provisions) is

associated with higher levels of idiosyncratic risk, trading activity,private information flow, and more information about

future earnings in stock prices. In a similar vein, Michaely, Rubin, and Vedrashko (2014) show that firms with better

governance structure tend to make earnings announcements outside trading hours, which may reduce price volatility and

increase pricing efficiency.