Does corporate governance matter? A crude test using Russian data.

• Author: Black, Bernard
• Position: Symposium on Norms and Corporate Law

Does a firm's corporate governance behavior affect its market value? In most empirical tests in developed countries, firm-specific corporate governance actions have little or no effect on market value. These weak results could reflect limited variation among firms in governance practices.

In contrast, the corporate governance practices of Russian firms vary widely, from quite good to awful. I test whether corporate governance behavior affects the market value of Russian firms using (1) fall 1999 corporate governance rankings developed by a Russian investment bank for sixteen Russian public companies and (2) the "value ratio" of actual market capitalization to potential Western market capitalization for these firms, determined independently at the same time by a second Russian investment bank. The correlation between ln(value ratio) and governance ranking is striking and is statistically strong despite the small sample size: Pearson r = 0.90 (p [is less than] .0001). A one-standard-deviation improvement in governance ranking predicts an 8-fold increase in firm value; a worst (51 ranking) to best (7 ranking) governance improvement predicts a 600-fold increase in firm value. My results are tentative, due to the small sample size. But they suggest that a firm's corporate governance behavior can have a huge effect on its market value in a country where other constraints on corporate behavior are weak.

INTRODUCTION

Does a firm's corporate governance behavior--defined broadly to include both the governance rules that the firm adopts and the behavior of its insiders along governance-related dimensions--affect its market value? For United States firms, evidence that governance practices matter is scarce. Most tests of whether interfirm variations in corporate governance practices affect firms' market value or performance come up empty. When effects are found, they are economically small--often only a percent or two.

And yet, perhaps the problem is with the data, not the proposition that firms' corporate governance behavior affects their market value. The minimum quality of American corporate governance, set by law and by norms so widely accepted that almost no public firms depart from them, is quite high. The variation in firm behavior is small, perhaps too small for us to observe large performance differences due to this variation.

A stronger test of whether and by how much governance behavior affects firms' market value could be possible in a country with weak laws governing behavior by firms and their insiders (managers and large shareholders), weak norms for insider conduct, and weak reputational constraints on insider conduct. In such a country, governance differences between firms will be larger and could have measurable effects on market value.

Across all three dimensions, Russia offers a strong test case. Its corporate and securities laws are unenforced and widely ignored. Behavioral norms reinforce bad behavior--self-dealing and often outright looting. And insiders didn't need to develop reputations for honesty so that their firms could sell shares to the public. Instead, major companies were sold in privatization auctions, letting even disreputable insiders acquire control. The low minimum quality of Russian corporate governance leaves huge room for interfirm variation. Some insiders will simply loot their firms; others will try to attract investors through good conduct; still others will steal some but not all of the firm's profits.(1)

This Article tests the proposition that corporate governance behavior affects the market value of Russian firms (the value that outside, noncontrolling shareholders pay for the firm's shares). I use fall 1999 corporate governance rankings for a sample of sixteen large Russian public companies, developed by Brunswick Warburg, a major Russian investment bank. These estimates were not directly, and their creators believe that they were not indirectly, influenced by the firms' market values.

I combine these governance rankings with data on the actual September 1999 market capitalization of these firms and estimates by Troika Dialog, a second major Russian investment bank, of these firms' potential Western market capitalization at that time. The potential Western capitalization is based on the multiples of assets, capacity, or revenue at which Western firms trade. I see no way for a Russian firm's governance behavior to affect these estimates.

The "value ratio" of actual to potential Western market capitalization offers a measure of the discounts that investors apply to these firms. The variation in discounts is huge--the value ratios vary from 0.48 for Vimpelcom to 0.0001 for Yuganskneftegaz.

The correlation between these firms' value ratios and their corporate governance rankings offers a measure of how important corporate governance behavior is, when investors value Russian firms. The correlation is striking. The Pearson product-moment correlation coefficient between ln(value ratio) and governance ranking is r = 0.90, with a t-statistic of 7.63 (significance level of p [is less than] .0001). These results survive various robustness checks.

My results are tentative because of the small sample size. But they suggest that the governance behavior of Russian firms greatly affects their market value. A measure of how much: a one-standard-deviation change in governance ranking predicts an 8-fold increase in firm value. A worst (51 ranking) to best (7 ranking) change in governance ranking predicts a 600-fold increase in firm value!

This Article proceeds as follows. Part I offers a brief overview of research in the United States on the extent to which corporate governance attributes correlate with firms' market value or performance. Part II describes my research design. Part III presents results. Part IV concludes and discusses policy implications and possible extensions of this research.

1. DOES CORPORATE GOVERNANCE BEHAVIOR AFFECT FIRM VALUE?

   1. Evidence from the United States

      In the United States, efforts to find a correlation between a firm's governance attributes and its market value mostly show weak or no results. For example, the proportion of independent directors on a company's board (or whether the company has a majority-independent board) has no statistically significant effect on performance.(2) Similarly, neither overt activism by institutional investors, nor insider share ownership, nor ownership by outside blockholders, nor a firm's committee structure, has a measurable effect on performance.(3)

      When effects are found, they are usually small--a percentage point or two difference in market value. Effects of this size are found, for example, for a staggered board or other antitakeover provisions,(4) incorporation in Delaware,(5) or use of cumulative voting.(6)

   2. Governance Behavior Should Matter More in Emerging Markets

      The weak observed correlation between the corporate governance practices of U.S. firms and their market value or performance could mean that firms' corporate governance behavior has only a small effect on their market value, compared to other elements such as industry environment, macroeconomic factors, and management skill. But the weak correlation could also reflect the restricted domain of the data. Within a single country, with a well-developed corporate governance system, differences among firms in corporate governance practices may be limited.

      In the United States, the minimum quality of corporate governance, set by securities law, corporate law, stock exchange rules, and behavioral norms so widely accepted that almost no public firms depart from them, is quite high. The variation among firms could be too small for performance differences to emerge from the large amount of "noise" (other factors that affect firm performance) that afflicts empirical studies in this area.

      To conduct a stronger test, we ought to study a country with weaker laws governing behavior by firms and insiders, weaker widely accepted norms for insider conduct, and weaker reputational constraints on insiders. Governance differences among firms will be larger and the effects of interfirm variation on firms' market value or performance will likely be larger as well.

      Across all three dimensions, Russia offers as close to an ideal test case as we are likely to find. It has decent corporate and securities laws, but the laws are unenforced and widely ignored. Cultural norms among managers and large shareholders reinforce bad rather than good behavior. Self-dealing and often outright looting is the norm, not the exception. And insiders didn't need to develop reputations for honesty in order to sell shares to...