Internal Governance Does Matter to Equity Returns but Much More So During “Flights to Quality”

• Date: 01 March 2018
• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/jacf.12276

In This Issue: Corporate Finance Addresses Uncertainty

Eclipse of the Public Corporation or Eclipse of the Public Markets? 8Craig Doidge, University of Toronto, Kathleen Kahle,

University of Arizona, Andrew Karolyi, Cornell University, and

René Stulz, Ohio State University

Fiduciary Duties of Corporate Directors in Uncertain Times 17 Ira M. Millstein, Ellen J. Odoner, and Aabha Sharma,

Weil, Gotshal & Manges

Financial Flexibility and Opportunity Capture:

Bridging the Gap Between Finance and Strategy

23 Stephen Arbogast, University of North Carolina at Chapel Hill,

and Praveen Kumar, University of Houston

Say on Pay: Is It Needed? Does It Work? 30 Stephen O’Byrne, Shareholder Value Advisors

Internal Governance Does Matter to Equity Returns

but Much More So During “Flights to Quality”

39 Peter Brooke, Platypus Asset Management, Paul Docherty,

Monash University, Jim Psaros, The University of Newcastle

and Michael Seamer, The University of Newcastle

Clawbacks, Holdbacks, and CEO Contracting 53 Stuart Gillan, University of Georgia, and Nga Nguyen,

Marquette University

Fundamental Investors Reduce the Distraction on Management from

Random Market “Noise”: Evidence from France

62 Alexandre Garel, Auckland University of Technology, and

Jean-Florent Rérolle, Morrow Sodali

An Improved Method for Valuing Mature Companies

and Estimating Terminal Value

70 David Holland, University of Cape Town Graduate School

of Business

Biomarker of Quality? Venture-Backed Biotech IPOs and Insider Participation 78 Hans Jeppsson, University of Gothenburg

How to Evaluate Risk Management Units in Financial Institutions? 89 Michael Gelman, Ben-Gurion University of the Negev, Doron

Greenberg, Ariel University, and Mosi Rosenboim, Ben-Gurion

University of the Negev

Global Trade – Hostage to the Volatile US Dollar 98 Brian Kantor, Investec

Corporate Finance and Sustainability: The Case of the Electric Utility Industry 106 Steven Kihm, Seventhwave and University of Wisconsin-

Whitewater, Peter Cappers, Lawrence Berkeley National

Laboratory, Andrew Satchwell, Lawrence Berkeley National

Laboratory, and Elisabeth Graffy, Arizona State University

VOLUME 30 | NUMBER 1 | WINTER 2018

APPLIED CORPORATE FINANCE

Journal of

Journal of Applied Corporate Finance • Volume 30 Number 1 Winter 2018

39

Internal Governance Does Matter to Equity Returns

but Much More So During “Flights to Quality”

*Acknowledgements: Financial support provided by Platypus Asset Management and

helpful comments provided by Philip Brown, Philip Gray and John McCormack are grate-

fully acknowledged. We also thank Gareth Hurst for his efforts with collecting the data.

1. Three Australian scholars did just that in a paper published in this journal in 2012

showing the unique Australian setting and concluding that internal governance mecha-

nisms are related to the cost of capital but not cash ows. See Peter K. Pham, Jo-Ann

Suchard, and Jason Zein, “Corporate governance, cost of capital and performance: Evi-

dence from Australian rms,” Journal of Applied Corporate Finance. 24, 84-93; 2012.

2. Examples of these regulatory responses that focus on internal governance, such as

the board of directors and board sub-committees, include the Sarbanes-Oxley Act

(2002) and similar regulations enacted in Canada (2002), Germany (2002), South Af-

rica (2002), France (2003), Australia (2003), India (2005), Japan (2006), Italy (2006)

and the United Kingdom (2012).

3. See Pankaj Jain and Zabihollah Rezaee, “The Sarbanes–Oxley Act of 2002 and

Capital Market Behavior: Early evidence,” Contemporar y Accounting Research, 23,

629–654, 2006; Vidhi Chhaochharia and Yaniv Grinstein, “Corporate Governance and

Firm Value: The Impact of the 2002 Governance Rules; Journal of Finance; 62, 1789-

1825, 2007.

4. For example, compared to rms with stronger corporate governance, rms with

weaker corporate governance have been shown to be more likely to experience manage-

ment perpetrated fraud (Mark S. Beasley, “An Empirical Analysis of the Relation between

the Board of Director Composition and Financial Statement Fraud,” The Accounting

Review. 71, 443-465, 1996), be subject to SEC enforcement action (Patricia Dechow,

Richard Sloan, and Amy Sweeney, “Causes and Consequences of Earnings Manipulation:

An Analysis of Firms Subject to Enforcement Actions by the SEC,” Contemporar y Ac-

counting Research. 13, 1-36, 1996) or manipulate nancial disclosures (K.V. Peasnell,

P.F. Pope, and S. Young, “Board Monitoring and Earnings Management: Do Outside Di-

rectors Inuence Abnormal Accruals?” Journal of Business Finance and Accounting. 32,

1311-1346, 2005). Studies have also reported a positive association between rm

corporate governance environments and the quality of management forecasts (B.

Ajinkya, S. Bhojraj, and P. Sengupta, “The association between outside directors, institu-

tional investors and properties of management earnings forecasts,” Journal of Account-

ing Research. 43(3), 343-376, 2005); accounting conservatism (Juan Manuel García

Lara, Beatriz García Osma, Fernando Penalva, “Accounting Conservatism and Corporate

Governance,” Review of Accounting Studies. 14, 161-201, 2009) and the informative-

ness of disclosures (Wendy Beekes and Philip Brown, “Do Better-Governed Australian

Firms Make More Informative Disclosures,” Journal of Business, Finance & Accounting.

33, 422-450, 2006).

ew businessmen or scholars doubt that good

internal governance helps rms perform better.

Nevertheless, it turns out that demonstrating

that empirically is tricky because the positive

eects of good corporate governance matter much more so at

some times than others. e statistical link is strongest during

“ights to quality,” when market sentiment turns bearish and

pessimistic but weakens for long periods of time during bull

markets and low market volatility. Using more than ten years’

evidence from a hand collected database of Australian rms,

we show that internal governance is related to both rm value

and performance and that rms with stronger governance are

less risky, generate higher equity returns and perform signi-

cantly better during market downturns. When risk aversion

is high, demand for well-governed rms increases and inves-

tors discount the value of rms with potential agency conicts.

is time-varying relationship between internal governance

and returns may explain both the limited explanatory power

of governance on rm value and the mixed empirical evidence

reported in previous studies. Our proposition of a time-vary-

ing relationship between corporate governance and returns

provides a new framework for considering the impact of

agency conicts on shareholder value.

Background

Corporate governance is the key mechanism for controlling

agency costs, acting through two channels: internal gover-

nance, such as the board of directors, and the external market

for corporate control. Although Australian rms adopt Anglo-

Saxon board structures, the market for corporate control is not

nearly as active in Australia as compared with the US and the

UK. is allows researchers to assess the relative importance

of internal corporate governance specically by studying the

evidence from Australia.1 e distinction between internal

and external (hostile take-overs, proxy battles etc.) corporate

governance is important because the most signicant inter-

national regulatory responses to corporate governance failures

have focused on improving internal governance mechanisms

rather than addressing the market for corporate control.2

As such, any exam ination of whether strong internal

governance improves shareholder value is a lso an indirect

test of whether these legislative response s were appropriately

targeted. Some studies have reported that key regu latory

interventions, such as the Sarba nes-Oxley Act, have a positive

impact on rm value, but these studies foc us on short-run

stock price reactions to legislative e vents, rather than the

longitudinal relationship bet ween corporate governance and

rm va lue.

3

By examining the eect of internal governance

on equity returns in Aust ralia, we can examine t his relation-

ship across time.

Agency theory sug gests that rms with strong corporate

governance should have lower agency costs, hence super ior

operating performance and rm value. And, indeed, a large

body of empirical evidence shows that e ective internal

corporate governance reduces agency c osts.4

But if eective corporate governance can reduce agency

costs and thereby decrease the cost of capital and/or increase

expected future cash ows of the rm, it follows that there

F

by Peter G. Brooke, Platypus Asset Management, Paul Docherty Monash University, Jim Psaros,

The University of Newcastle and Michael Seamer, The University of Newcastle*