Corporate Governance and Firm Performance: Theory and Evidence

from Literature
Pallab Kumar Biswas
Ph.D. Candidate, UWA Business School, The University of Western Australia

Md. Hamid Ullah Bhuiyan

Ph.D. Candidate, Department of Economics and Finance, La Trobe University
Abstract: This paper is an attempt to give a short description of the theoretical literature
focusing on different conceptual models of corporate governance and empirical studies
relating to whether good corporate governance leads to better firm performance. Majority
of the literature has been found to focus on the relationship between shareholders,
directors, and management. The findings of these empirical studies are mixed and as a
result, it is often difficult for users to draw any firm conclusion on the relationship. On the
other hand, studies undertaken considering the overall corporate governance mostly
provide evidence of significant relationship between corporate governance and firm
performance. However, whether better corporate governance causes higher firm
performance is still remains a valid research question for reasons like ambiguity regarding
the direction of causality.
Keywords: Agency Theory, Board Structure, Corporate Governance.

Introduction
Prominent examples of corporate scandals like Enron and WorldCom in the US, Marconi in
the UK and many others in different parts of the world, many of which were caused by, or
at least exacerbated by, governance weaknesses, give rise to financial communitys
concerns about the appropriateness of the mere use of firm profitability or growth prospects
in valuing a firm as well as the necessity of effective control mechanisms in ensuring use
of investors funds in value-maximizing projects. However, there is no unequivocal
evidence to suggest that better corporate governance enhances firm performance in
different market settings (Klein, Shapiro and Young, 2005). As a result, investors are still
much skeptic about the existence of the link between good governance and performance
indicators like share price performance and for many practitioners and academics in the
field of corporate governance, this remains their search for the Holy Grail the search for
the link between returns and governance (Bradley, 2004, p. 9). Despite the increasing
volume of cross-country and individual country level evidence mainly suggesting a positive
link between corporate governance and firm performance, many companies still remain
unconvinced and to them, the practical adoption of good governance principles has been
patchy at best, with form over substance often the norm (Bradley, 2004, pp. 8-9).
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This study is an attempt to survey relevant literature to find whether there exists any
relationship between corporate governance and firm performance or not.
The remainder of the paper is structured as follows. Section 2 examines various theoretical
foundation of corporate governance. Section 3 explores the relationship between corporate
governance and firm performance from literature with specific reference from Bangladesh
followed by some of the caveats of governance-performance research in Section 4. Section
5 presents concluding remarks.

Theoretical Foundation of Corporate Governance

Corporate governance lacks any accepted theoretical base or commonly accepted paradigm
as yet (Carver, 2000; Tricker, 2000; Parum, 2005; Larcker, Richardson and Tuna, 2007;
Harris and Raviv, 2008). Citing Pettigrew (1992), Tricker (2000) and Parum (2005) argue
that corporate governance research lacks coherence of any form, either empirically,
methodologically or theoretically, meaning that only piecemeal attempts have been made to
understand and explain how the complex modern organization is run. As a result, a number
of different theoretical frameworks, originating from a broad range of disciplines including
economics, finance, management and sociology, have been used by researchers in
explaining and analyzing corporate governance. Using various terminologies, these
frameworks view corporate governance from different perspectives. Stiles and Taylor
(2002) argue that fragmentation of these various perspectives has led to a lack of consensus
regarding corporate governance and the actual role of the board of directors in the
organization as the nature of boards contribution (and the expectations placed upon it)
depends heavily on which theoretical perspective used. However, these frameworks often
overlap theoretically and do share significant commonalities (Solomon and Solomon,
2004).1 A brief summary of different models is given in table 1.

For example, agency theory and transaction-cost economics share key assumptions and approaches in
conceptualizing boards (Stiles and Taylor, 2002), and it is often difficult to clearly distinguish between the
concept of stewardship and trusteeship (Learmount, 2002).

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Table 1: Summary of Conceptual Models of Corporate Governance

Perspective of Corporate Governance
Key Findings and explanations
Agency Theory
Jensen and Meckling Fundamental corporate governance Solutions to agency problems involve establishing a nexus of optimal
(1976) and Fama and problem deals with how is the principal contracts (explicit as well as implicit) between the owners and management of
Jensen (1983)
(shareholder) able to prevent the agent the company. These contracts, also knows as the internal rules of the game,
(generally
management)
from identify the rights of agents in the organization, performance criteria against
maximizing his own self-interest.
which they will be evaluated and the resulting payoff functions they will tend
to face.
Transaction Cost Economics
Williamson (1979,
The firm itself is a governance structure. Corporate governance deals with identifying internal measures and
1981, 1983, 1984)
The governance problem of a firm are mechanisms to economize the costs associated with contractual hazards as the
perceived to proceed from a number of external market mechanism can not be relied on to mitigate these problems
contractual hazards, including self- because of the fact that it has limited constitutional powers to conduct audits
interested opportunism, information and has limited access to the firms incentive and resource allocation
asymmetries, asset specificity and small machinery (Williamson, 1975, p. 143 in Learmount, 2002).
number bargaining, and the problem of
bounded rationality (Learmount, 2002).
Behavioral Agency Model
Wiseman and
To re-examine the influence of various Decision markers risk preferences are influenced by their framing of
Gomez-Meija (1998) internal
corporate
governance
problems as losses or gains. Positively(negatively) framed problems
mechanisms on executive risk-bearing
increase(decrease) risk bearing, which, in turn, has a negative(positive)
and risk taking behavior and to devise
influence on risk raking.
propositions of enhancing corporate If future base pay is insulated from the threat of loss, agents risk bearing is
reduced and agent may be more willing to pursue contingent pay through
governance.
riskier strategic choices.
Reliance on market based(accounting-based) outcome performance criteria
increases the probability of loss(gain) context.
Use of subjective behavioral criteria for performance evaluation increases
agent risk bearing which subsequently reduces agent risk taking.
Finance Model
Shleifer and Vishny In dealing with agency problems, the Significant legal protection of investor rights and concentrated ownership
(1997)
fundamental question that any corporate through large share holding, takeovers, and bank finance can help investors to
Model

governance system has to answer is how

to ensure suppliers of fund to get a
return on their financial investment.
Demirag (1995) and To identify the financial systems and
Demirag, Clark, and corporate governance structures that
Bline (1998)
resist short term pressures from the
corporate
financial
market
and
encourage
long-term
investment
decisions.

Davis, Schoorman
and Donaldson
(1997)

Keasy and Wright

(1997)

get their money back.

Short-term pressures appear to present major obstacles to US financial

managers and finance directors in the UK in managing research and
development (R & D) projects. Proper strategy for long-run investment and R
& D, improved communication between major shareholders and the managers,
centralized structure in R & D and inclusion of long term leading indicators
like market share, customer satisfaction, quality improvement in the existing
crude short-term accounting measures are some of the means through which
such pressure can be minimized. Study by Demirag et al. (1998) indicate that
financial managers in the US have somewhat reduced their perceptions of
short-term pressures from the capital markets through improved
communication channels which allow them to take a long-term perspective on
R & D investments and use long-term performance measures in determining
their R & D budgets and projects.
Stewardship Model
To identify different psychological and Managers are more likely to serve organizational rather than personal goals
sociological characteristics antecedents
when (i) their needs are based on growth, achievement and self-actualization;
to the principal-steward relationships
(ii) they identify themselves with their organization and remain highly
and to examine a model based on
committed to the organizational values; and (iii) their philosophy is based on
manager-principal choice rather than a
involvement and trust in a culture based on collectivism and low power
determinism (1997, p. 43).
distance.
Managers choice to behave as stewards or agents, or principals choice to
create an agency or stewardship relationship is contingent on their
psychological motivations and perceptions of the situation.
Two
dimensions
of
corporate The stewardship dimension emphasizes issues like fund misappropriations by,
governance are stewardship and and controlling the behaviours of, non-owner managers; and entrepreneurship
entrepreneurship.
Good
corporate dimension deals with reallocation of economic resources in new combination
governance is as much concerned with involving both innovations and corporate restructuring.
correctly
motivating
managerial
behaviour towards improving the
businesses, as directly controlling the

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behaviour of managers (Keasey and

Wright, 1997, p. 2).
Trusteeship Model
Kay and Silberston Trusteeship model recognizes the The duty of the board of directors as trustee is to preserve and enhance the
(1996)
existence of corporate personality, and value of the assets under their control, and to balance fairly the conflicting
its
economic
and
commercial interests of current stakeholders and additionally to weigh the interests of
importance. It accepts that public present and future stakeholders (Kay and Silberston, 1996, pp. 114-115).
corporation is a social institution, not the
creation of private contract the boards
of directors are the trustees of the
tangible and intangible assets of the
corporation, rather than the agents of the
shareholders (Kay and Silberston,
1996, p. 114)
Stakeholder 2 Model
Freeman (1984)
Unlike production view of the firm, In a stakeholder-serving organization, managers in different functional
managerial view of the firm requires disciplines can be more responsive to the external environment by carrying
the top management to simultaneously forward the notion of internal stakeholders as the conduits to external groups.
satisfy the owners, the employees, and In such an organization, the executives should act as corporate spokesperson,
their unions, suppliers and customers political and social participant and manager of the human resources of the
(Freeman, 1984, p. 6) in order to be firm (Freeman, 1984, p. 247).
successful.
Buchholz (1989)
To ensure participation of a wider Give shareholders increased rights to participate in important management
constituent groups (with economic
decisions.
and/or social stakes in corporate Change in the composition of boards by including more outside directors to
alleviate concern boards are too subservient to management.
activities such as employees, customers,
suppliers,
stockholders,
banks, Employee representation at some level in corporate governance.
environmentalists, government, to name Reinforce of government rules and regulation over issues like insider trading,
hostile takeover.
but a few) in the governance process,
assuring that their wide range of
interests are taken into account by
2

Stakeholder is any group or individual who can affect, or is affected by, the achievement of a corporations purpose (Freeman, 1984, p. vi).

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Donaldson and
Preston (1995)

corporate management and ultimately,

the interests of society as a whole
To critically analyze significant
distinctions, limitations and implications
associated with stakeholder concepts.
Attempt was made to contrast actual or
potential problems experienced by
stakeholders or may experience as a
result of management actions or
inactions and effort was made to explore
the justifications and responsibility of
directors of the firms as trustees for the
stakeholders.

The stakeholder theory is descriptive and instrumental: it can be used as a

framework to test empirical claims, estimations relevant to stockholder
concept, and to examine the connections between corporate performance and
stockholder management.
Descriptive justifications: it is unethical management behavior to focus solely
in the interest of shareowners; statutes have extended the range of permissible
concern by boards to non-shareowner constituencies.
Instrumental justification: success in satisfying multiple stakeholder interests
constitutes the ultimate test of corporate performance, with monitoring devices
that reduce information asymmetry, and enforcement mechanisms including
law, exit and voice, and emphasis of fairness.
The fundamental basis of stockholder theory is normative: stakeholders have
legitimate interest on the intrinsic value of the firm.
Normative justifications: a pluralistic theory of property rights supports various
groups a moral interest or stake in the affairs of the corporation.
The stockholder theory is managerial: recommends attitude, structures, and
practices to constitute stockholder management.
Managerial Implications: managers are responsible to select actions to
maximize the interest of legitimate stakeholder.
Political Model
Pound (1992)
To define political approach where Active and informed institutional investors (including public pension funds)
active shareholders exercise informal use mechanism like shareholder committee, director nominating committee,
and ongoing form of management director nominating petitions, issue campaigns and friendly monitoring to exert
oversight
through pooling their informal pressure on the management of their target corporations. Criticisms of
resources and voting power.
such model, like possibility of institutional investors favour towards shorttermism and undesirable intervention in every management decision, are likely
to fail in the presence of competitive marketplace and diversity among the
institutional shareholders.
Schwab and Thomas To investigate the consequences of Labour unions with large pension funds become one of the most aggressive
(1998)
shareholder activism of unions.
institutional investors who are using their ownership position to tactically push
different corporate governance reforms in order to achieve objectives like more

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Collier and Esteban

(1999)

Charan (1998)

Davies (1999)

accountable management and maximization of return on capital. However, by

aligning themselves with shareholders, unions can reinvigorate inefficient
corporate governance systems.
Participative Model
In order to survive and succeed in Participative governance structures effectiveness relies on the organizations
rapidly changing environment, it is ability to trust freedom, encourage and support the creativity of its members to
important for an organization to pursue flourish in the context of organizational communities of practice, communities
participative governance structure.
of discernment and communities of commitment (Collier and Esteban, 1999,
p. 184). In such an environment, employees are nurtured and encouraged to
carry the attitudes and practices learned through participative governance into
the complex interactions and relationships which shape human existence
(Collier and Esteban, 1999, p. 184).
Strategic Leadership Model
The true potential of the board lies in Boards can provide the reality-checking required by every CEO through
its ability to help management prevent identifying blind spots and overlooked opportunities, offering different
problems, seize opportunities, and make perspectives and insights into the external environment, and providing an
the corporation perform better than it objective view of the industry landscape and alternative views of people. They
otherwise would (Charan, 1998, p. 5).
can achieve these by using structure advantageously, recruiting talented
directors, cultivating multiple perspective, assuring information needs,
ensuring learning, CEO evaluation and succession planning.
Nature and size of the body of the Effective board: (key competences of directors): strategic perception, decisionconcerned sectors (public or social) are making, analytical and communication skill, effective interaction, ability to
the variables on which a model of plan, delegate, appraise and develop others, achievement through risk taking,
corporate governance depends. Effective resilience, integrity, independence.
board
leadership
rather
than Shared strategic direction: establish a vision and values which set the target of
management is the key focus at times of the company; decide strategy through a process involving people who have to
deliver it; involve external stakeholders and develop stakeholder value as well
their (boards) lower performance.
Key foundations for strategic leadership as shareholder value.
Strategic management process: be certain that strategies are effectively
are:
Sound and effective board of delivered, boards prepare the strategies, monitor the implementation, and
directors;
control through empowerment.
Shared strategic direction and
commitment to pursue it; and

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 Strong strategic management process.

To develop a system of controls in an Four control levers are important for managers attempting to harness the
organization that demands flexibility, creativity of the employees. These are diagnostic control systems (to ensure
innovation and creativity.
effective and efficient achievement of goals), beliefs systems (for empowering
and encouraging individuals to search for new opportunities), boundary
systems (for determining rules of the games) and interactive control systems
(for enabling top-level managers to deal with strategic uncertainties and
opportunities). Effective use of these control systems ensure managers that the
benefits of creativity and innovation are not achieved at the expense of control.
Forbes and Milliken To develop a model of boards strategic Board effort norms (ensuring preparation, participation and analysis),
(1999)
decision-making effectiveness through
cognitive conflict (leveraging differences of perspective), presence and use of
identifying critical processes and
knowledge and skills will be positively related to board task performance.
outcomes which serve as mediators of Board cohesiveness will be related to board task performance in a curvilinear
manner and will be less likely to detract from board task performance in the
the relationship between commonly
existence of high level of cognitive conflict.
studied aspects of board demography
and firm performance (Forbes and Job-related diversity on the board will be positively related to the presence of
functional area knowledge and skills and cognitive conflict on the board but
Milliken, 1999, p. 490).
negatively related to the boards cohesiveness and its use of its knowledge
and skills.
Policy Governance Model
Carver (2000)
To develop a model that will give Policy governance model requires board to be sure about its performance
organizations true owners competent expectations, to assign these expectations clearly and to check to see that the
servant-leaders to govern on their expectations are being met to be accountable for the working of the
behalf (Carver and Carver, 2001).
organization. Under this model, the governing board is obligated to serve as a
link in the chain of command between owners and operators. The boards
owner-representative authority is best employed when the board operate the
organization as an undivided unit, prescribe organizational ends, make all its
decisions using the principle of policies descending in size. The model enables
extensive empowerment to the staff while preserving controls needed to ensure
accountability. It also provides a values-based foundation for discipline, a
framework for precision delegation, and a long term focus on what the
organization is for more than what it does.
Source: Adapted from Ho (2005)
Simons (1995)

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Table 1 suggests that through different models, researchers have tried to examine the
subject from different perspectives of financier or other stakeholders. Despite various
challenges from different models, agency theory remains the most frequently used
theoretical approached followed in corporate governance research (Spira, 2002).

The Impact of Corporate Governance Disclosures on Firm Performance

Better corporate governance is likely to improve the performance of firms, through more
efficient management, better asset allocation, better labour practices, or similar other
efficiency improvements (Claessens, 2006). Drobetz et al. (2004) argue that agency
problem, the foundation of agency theory, is likely to exert impact on a firms stock price
by influencing expected cash flows accruing to investors and the cost of capital. Firstly,
low stock price result from the investors anticipation of possible diversion of corporate
resources. Theoretical models by La Porta, Lopez-de-Silanes, Shleifer and Vishny (2002)
and Shleifer and Wolfenzon (2002) also predict that in the existence of better legal
protection, investors become more assured of less expropriation by controlling bodies and
hence, they pay more for the stocks. Secondly, through reducing shareholders
monitoring and auditing costs, good corporate governance is likely to reduce the expected
return on equity which should ultimately lead to higher firm valuation.
There exists a well number of anecdotal evidence of a link between corporate governance
practices and firm performance. But the empirical studies mainly focus on specific
dimensions or attributes of corporate governance like board structure and composition;
the role of non-executive directors; other control mechanisms such as director and
managerial stockholdings, ownership concentration, debt financing, executive labour
market and corporate control market; top management and compensation; capital market
pressure and short-termism; social

responsibilities and internationalization. Table 2

provides a summary of some of the major studies over the last couple of years, showing
the mixed findings on the relationship between specific attributes of corporate
governance and corporate performance.
Though the relationship between shareholders, directors and management has been the
central topic of corporate governance research for a long time, focusing merely on the

legal company and the firm as the agent of the shareholder seems no longer sufficient and
time has come to view the governance of the firm as a whole (Van den Berghe, 2002).
Moreover, as Ho (2005) argues, evaluating corporate governance on individual
dimension or attribute may not capture the total effect of corporate governance as much
as the case where all the attributes are considered collectively.3 Hence, researchers often
attempt to measure overall corporate governance and try to identify the relationship
between corporate governance and firm performance. A summary of their findings are
shown in table 3.

Citing degaard and Bhren (2003), Bauer, Frijns, Otten and Tourani-Rad (2008) also argue that relating
corporate performance to a particular aspect of corporate governance may not capture the true
relationship except when specific aspect is controlled for other aspects of governance.

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Table 2: A Summary of Major Corporate Governance Studies

Positive findings
Neutral or negative findings
1. Board Structure and Firm Performance
1.1 Independent Directors
By analyzing 75 fraud and 75 non-fraud firms, Beasely (1996) find Several surveys of empirical studies find no convincing evidence
that no-fraud firms have boards with significantly higher that more outsiders on the board improves firm performance
percentages of outside members than fraud firms. Moreover, the (Fosberg, 1989; Hermalin and Weisbach, 1991; Lin, 1996; Bhagat
likelihood of financial statement fraud decreases when outside and Black, 1999, 2002), but they were negatively related to
director ownership in the firm and outside director tenure on the performance (Agrawal and Knoeber, 1996), and they directed
board increase and the number of outside directorships in other management effort in maximizing short-term profits (Baysinger and
firms by outside directors decrease. Survey of 515 Korean firms by Hoskisson, 1990). Haniffa and Hudaib (2006) argues that market
Black et al. (2006) show that firms with 50% outside directors have perceives multiple directorship as unhealthy and do not add value to
0.13 higher Tobins Q (roughly 40% higher share price) which is corporate performance.
consistent with the view that greater board independence causally
predicting higher share prices in emerging markets. Brickley, Coles
and Terry (1994) find a positive relation between the portion of
outside directors and the stock market reaction to poison pill
adoptions; and Anderson, Mansi and Reeb (2004) show that the
cost of debt, proxied by bond yield spreads, is inversely related to
board independence. Similarly, Ho (2005) and Brown and Caylor
(2004) find strong and positive correlation between non-executive
directors and corporate performance.
1.2 Separation of chairmanship and CEO role
Baliga, Moyer and Rao (1996) find weak evidence that duality of Finlestein and DAveni (1994) find that board vigilance is
board chairman and CEO affect long term performance of US positively associated with CEO duality, and association is stronger
companies. On the other hand, Rechner and Dalton (1991) find that when both informal CEO power and firm performance are low.
firms opting for independent leadership consistently outperform
those relying upon CEO duality. By analyzing 347 Kuala Lumpur
Stock Exchange (KLSE) listed companies, Haniffa and Hudaib
(2006) provides evidence that companies with role duality seem not
to perform as well as their counterparts with separate board
leadership. Yermack (1996) and Brown and Caylor (2004) also
support the notion that firms are more valuable when the CEO and

board chair positions are separate.

1.3 Board Committees
Abbott, Park and Parker (2000) report that in the US, firms with
audit committees which follows the minimum thresholds of both
activity (at least two meetings in a year) and independence are less
likely to be sanctioned by the SEC for fraudulent or misleading
reporting. Klein (2002) finds a negative relation between audit
committee independence and abnormal accruals. For US large
public companies, a nomination committee displays better
performance under both market-based and accounting-based
measures over companies without such committee (Wallace and
Cravens, 1993). After surveying the international companies, Ho
(2005) reports that (a) audit and nomination committee are
significantly and positively related with corporate competitiveness;
(b) Strong and positive relationships between the average return on
equity for 1997-1999 and several mechanism in deciding top
executive remuneration; and (c) The market does attach weights to
board structures or measures that assure the independence of the
board. Brown and Caylor (2004) provide evidence in this respect by
showing that solely independent audit committees are positively
related to dividend yield, but not to operating performance or firm
valuation.
1.4 Director or Managerial Ownership
Hambrick and Jackson (2000) find outside director holdings to be
associated with subsequent corporate performance and directors
with a meaningful stake in the organization are pivotal factor in
improving corporate governance. Chen, Guo and Mande (2003),
however, report a monotonic relation4 between Tobins Q and
managerial ownership. Using 123 Japanese firms-level data from
1987 to 1995, they find that Q increases monotonically with
4

Ezzamel and Watson (1997) do not find strong relationship between

pay and performance among the UK companies with remuneration
committee and other governance variable. Similarly, Klein (1998)
finds no apparent correlation between share prices and the
composition of specific oversight board committees.

Using heteroscedasticity robust residuals to account for nonlinearity of insider ownership, Short and Keasey (1999) report a
cubic form of relationship between managerial ownership and firm
performance for UK companies, due to possible effects of
alignment (Jensen and Meckling, 1976, convergence of interest)
and entrenchment (Morck, Shleifer and Vishny, 1988, high level of
managerial ownership).

While higher managerial ownership causes higher Q; higher-Q firms also inspire managerial ownership (Chen et al., 2003).

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managerial ownership, thus, suggesting greater alignment of

managerial interests with those of stockholder with the increase in
ownership.
1.5 Foreign Directors
Oxelheim and Randy (2003) study show that firms in Norway and Black et al. (2006) provide evidence that for Korean firms, the
Sweden with foreign directors have higher Tobins Q.
presence of foreign director does not predict higher market value
1.6 Board Size
Limiting board size is believed to improve firm performance
because the benefits of larger boards (increased monitoring) are
outweighed by the poorer communication and decision making of
larger groups (Lipton and Lorsch, 1992; Jensen, 1993). Consistent
with this notion, Yermack (1996) documents an inverse relation
between board size and profitability, asset utilization, and Tobins
Q. Anderson et al. (2004) show that the cost of debt is lower for
larger boards, presumably because creditors view these firms as
having more effective monitors of their financial accounting
processes. Brown and Caylor (2004) add to this literature by
showing that firms with board sizes of between 6 and 15 have
higher returns on equity and higher net profit margins than do firms
with other board sizes. Conyon and Peck (1998b) also conclude that
the effect of board size on corporate performance (return on equity)
is generally negative.
2. Ownership and Other Control Mechanisms
2.1 Insider Ownership
Agrawal and Knoeber (1996) and Ho (2005) find greater insider Holderness, Kroszner and Sheehan (1999) report a rise in
ownership to be positively related to performance. Morck et al. managerial ownership from 13% in 1935 to 21% in 1995. In
(1988) also find a positive relationship between board ownership comparison to Morck et al. (1988) finding with 1980 data, the
and firm performance in the 0-5% ownership range, but a negative relationship with this 1995 sample was weaker. Brown and Caylor
relationship between 5-25% indicating as ownership convergence (2004) find no evidence of positive relationship between operating
of interest, and a positive influence of management ownership performance or firm valuation and either stock option expensing or
beyond 25% level. In similar vein, McConnell and Servaes (1990) directors receiving some or all of their fees in stock.
report a curvilinear relationship between Tobins Q and the fraction
of common stock owned by corporate insiders. But unlike Morck et

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al. (1988) study, the curve in their study slopes upward until insider
ownership reaches approximately 40% to 50% and then slopes
slightly downward.
2.2 Ownership Concentration
Cross-sectional analysis of Wruck (1989) indicates that the change
in firm value at the announcement of a private sale is strongly
correlated with the resulting change in ownership concentration
after the sale and the purchasers current or anticipated future
relationship with the firm.

2.3 Family Ownership

McConaughy, Mathhews and Fialko (2001) find that family
controlled firms in America have greater value, operate more
efficiently, carry fewer debts than other firms.
2.4 Institutional Investor Ownership
Short and Keasey (1997) show that in the absence of other large
external shareholders, institutional investors have a significant
positive effect on the firm performance. Management tends to
become entrenched at higher levels of ownership in the UK since
they do not enjoy the same freedom as their US counterparts to
mount takeover defenses, and institutional investors in the UK are
more likely to coordinate their monitoring activities. Ho (2005)
reports that significant institutional investors holdings raise board
vigilance, which in turn has a positive effect on firm performance.
Lehmann and Weigand (2000) find positive impact of ownership
concentration on profitability for firms with financial institutions as

Thonet and Poensgren (1979) report that manager-controlled firms

in Germany significantly outperform owner-controlled firms in
terms of profitability, but owner-controlled firms has higher growth
rates. Agrawal and Knoeber (1996) find no significant relationship
between performance and stockholdings of block-holders.
Holderness and Sheehan (1988) argue that the frequency of
corporate-control transactions, investment policies, accounting
returns and Tobins Q are similar for majority owned and diffusely
held firms. On the other hand, cross-sectional analysis of Lehmann
and Weigand (2000) indicates significantly negative impact of
ownership concentration on profitability as measured by the return
on total assets which supports the view that large shareholders
inflict costs on the firm.
Studies like Jacquemin and de Ghellinck (1980) and Prowse (1992)
find no relationship between performance and family ownership in
French and Japanese firms.
Agrawal and Knoeber (1996) find no significant relationship
between performance and institutional stockholding.

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largest shareholders which is consistent with the view that banks are
better (more efficient) monitors to lower the agency costs.
2.5 Takeover Control
Brickley and James (1987) and Schranz (1993) argue that outside Agrawal and Knoeber (1996) report a negative relation between
directors might be effective monitoring mechanism in case of greater corporate control activity (number of takeovers within a
restricted takeovers as the proportion of outside directors is firms industry) and performance.
negatively correlated with salary expenditures, or takeovers might Study by Franks and Mayer (1996) suggests that hostile takeovers
be good control mechanism when there are few outside directors on do not perform a disciplining function in the UK in 1985 and 1986
the board.
as high board turnover does not derive from past managerial failure.
2.6 Other Control Mechanisms
Berger, Ofek and Yermck (1997) report that entrenched CEO Agrawal and Knoeber (1996) find that more debt financing is
avoids debt financing; leverage levels are low when the CEOs are negatively related to performance. Moreover, they do not find
long in office and does not face pressure from either ownership and significant relationship between performance and executive labour
compensation incentives or active monitoring of the board.
market control.
Study by Ho (2005) shows that more debt financing is positively
related to rigorous risk assessment of the board and negatively
related to environmental protection policy, competitive potential
and average price-book value ratio for 1997-1999.
Study by Florackis (2005) report that debt-maturity structure is
significantly related to performance, meaning that debt-maturity can
help align interests of managers with that of shareholders and,
therefore, enhance firm value.
3. Managerial Compensation
3.1 Relationship with Governance Structure
Core, Holthausen and Larcker (1999) report that CEOs can earn Using panel data on large, publicly traded UK companies gathered
greater compensation from firms with weaker governance between 1991 and 1994, Conyon and Peck (1998a) document that
characteristics like CEO being the chair of the board, large board board monitoring, measured in terms of the proportion of nonsize, greater percentage of outside directors being appointed by the executive directors on a board and the presence of remuneration
CEO, relaxed retirement age for outside directors and presence of committees and CEO duality, do have only a limited effect on the
increasing proportion of outside directors serving three or more level of top management pay.
other boards.
Hall and Liebman (1998) and Main, Bruce and Buck (1996) find Analysis of 199 of the Times Top 1000 listed firms by Ezzamel and
that when stock options are included, a stronger pay-performance Watson (1997) confirms that changes in executive pay are more

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link can be identified. Aggarwal and Samwick (1999) report that closely related to external market comparison of pay levels than to
executives pay-performance sensitivity for executives at firms with changes in either profit or shareholder wealth. Core, Holthausen
the least volatile stock prices is greater than that at firms with most and Larcker (1999) report that excess CEO compensation has a
volatile stock prices. Examining the relation of managerial rewards significant negative association with subsequent firm operating
and penalties to firm performance in Japan, the US and Germany, performance as well as stock returns. Similar negative relationship
Kaplan (1994a, 1994b) reports that poor stock performance and between excess director compensation and firm performance is
inability to generate positive income increases the likelihood of top reported by Brick, Palmon and Wald (2006). Recently, Duffhues
management turnover in these countries. In another study, using and Kabir (2008) questions about the conventional wisdom of using
time series data from the UK and Germany, Conyon and Schwalbac executive pay to align managers interest with those of shareholders
(2000) report a significant positive association between cash pay after finding no systematic evidence that executive pay of Dutch
and company performance in both countries.
firms is positively related to corporate performance.
4. Social Responsibility and Firm Performance
Verschoor (1998) and Ho (2005) argue that companies committed Study by Coffey and Wang (1998) shows that managerial control
to ethical behaviour have higher overall financial performance than with more insider directors tend to be more supportive of corporate
those without such explicit undertakings.
philanthropic behaviours than broad diversity of having more
outsiders.
5. Competitive or Collaborative Board Politics
Simmers (1998) finds that quality speed of board strategic decision Wahal (1994) analyzes 9 activist funds over a 9 year period and
process and the outcomes are strongly related to collaborative their holdings in different companies and finds no evidence of longpolitics but goal achievement and unrestricted funds are weakly term stock price performance improvement of targeted firms.
associated with collaborative politics.Ogden and Watson (1999) Besides, performance continue to decline even three years after
report considerable improvement in the customer service and higher targeting.
resulting shareholder returns since privatization of UK water supply
industry in 1989.
6. Impact of Internationalization
Sanders and Carpenters survey of a sample of large US firms
(1998) suggests that the proportion of outside directors on the board
is positively associated with the degree of internationalization.
Similar finding is also reported by Ho (2005).
7. Compliance with the code of compliance
Using a sample of big German listed corporations, Goncharov,
Werner and Zimmermann (2006) conclude that the firms with
extended compliance with the Code are priced with a premium of

- 16 -

3.23 EUR on average and the stock performance of the firms with
higher compliance is 10 percentage points higher.
Source: The above table is prepared following Ho (2005)

Table 3: Effect of Overall Corporate Governance on Firms Performance

Study
Korea:
Black et al. (2006)
Durnev and Kim (2005)

Germany:
Drobetz et al. (2004)

The US:
Gompers, Ishii and
Metrick (2003)

Russia:
Black (2001a, 2001b)
Japan:
Bauer, Frijns, Otten and
Tourani-Rad (2008)

Norway:

Key Research Findings

Country-level Evidence
The authors report strong OLS and instrumental variable evidence that overall corporate governance index is an
important and likely causal factor in explaining the market value of Korean Public Firms.
Firms with greater growth opportunities, greater needs for external financing, and more concentrated cash flow
rights practice higher quality governance and disclose more. Moreover, firms that score higher in governance
and transparency rankings are valued higher in the stock market.
Constructing a broad corporate governance rating (CGR) Drobetz et al. (2004) document a strong positive
relationship between the quality of firm-level corporate governance and firm valuation. Using dividend yields
as proxies for the cost of capital, they also report negative correlation between expected stock returns and firmlevel corporate governance. Finally, during the sample period they document that an investment strategy (that
bought high-CGR firms and shorted low-CGR firms) earned abnormal returns of about 12 percent on an annual
basis.
Corporate governance is strongly correlated with stock returns during the 1990s in the US. At the beginning of
the sample, each one-point of the decade, each one-point increase in G (Governance Index) is associated with
decrease in Tobins Q of 2.2 percentage points. By the end of the decade, this difference has increased
significantly, with a one-point increase in G associated with a decrease in Tobins Q of 11.4 percent points. The
results clearly support the hypothesis that well-governed companies have higher equity returns, are valued more
highly, and their accounting statements show a better corporate performance.
Firms can greatly improve their own share values, and thus reduce the cost of raising equity capital, through a
determined effort to improve their corporate governance practices.
Employing a unique data set provided by Governance Metrics International, Bauer et al. (2008) find that wellgoverned firms in Japan significantly outperform poorly governed firms by up to 15% a year. Governance
provisions dealing with financial disclosure, shareholder rights, and remuneration do affect stock price
performance. However, they report limited impact of provisions that deal with board accountability, market for
control and corporate behavior.
Using data from Oslo Stock Exchange firms, degaard and Bhren (2003) report that corporate governance

- 17 -

degaard and Bhren

(2003)
India:
Bhattacharyya,
Raychaudhuri and Rao
(2008)
La Porta et al. (2002)
Klapper and Love
(2004)

De Nicol, Laeven
and Ueda (2008)

Karpoff, Marr and

Danielson (2000)

matters for economic performance, insider ownership matters the most while outside ownership concentration
destroys market value, direct ownership seems superior to indirect ownership and that performance is inversely
related to board size, leverage, dividend payout and the fraction of non-voting shares.
Using event study methodology with quasi-experimental research design, Bhattacharyya et al. (2008) find that
increased information disclosure and better corporate governance mechanism resulting from the regulation
enforced by the Securities and Exchange Board of India (SEBI) reduce cost of capital of Indian listed
companies.
Cross-Country Evidence
Using firm level data from 27 developed countries, La Porta et al. (2002) find better shareholder protection to
be associated with higher valuation of corporate assets.
Using firm level data from 14 emerging stock markets, the authors conclude that firm-level corporate
governance is highly correlated with better operating performance and market valuation, as measured by ROA
and Tobins Q, respectively.
Using country level data from 10 Asian, 7 Latin American, 22 developed and 2 emerging countries, De
Nicol et al.(2008) report that corporate governance quality in most countries has overall improved in
varying degrees with few notable exceptions. They also document a positive, significant and quantitatively
relevant impact of improvements in corporate governance quality on traditional measures of real economic
activity like GDP growth, productivity growth, and the ratio of investment to GDP. The growth effect is found
to be particularly pronounced for industries that are most dependent on external finance.
Results Using Specific Database
Using ISS database, Karpoff et al. (2000)find that cross-sectional performance in related to a simple index of
restrictiveness of a firms governance structure. Consistent with the management entrenchment hypothesis,
their result show that firms with the fewest restrictive provisions relative to other firms in the industry have the
best industry-adjusted performance measured by return on assets and market-book-value ratio.

- 18 -

In contrary to the above findings, somewhat different result is reported by Bauer,

Guenster and Otten (2004) for Europe and the United Kingdom. Their empirical results
suggest a negative relationship between governance standards and earnings based
performance ratios (net profit margin and return on equity). In an event study, De Jong,
DeJong, Mertens and Wasley (2005) do not detect any price effects following actions
taken by the Netherlands private sector self-regulation initiative (The Peters
Committee). In a recent study, Cheung, Jiang, Limpaphayom and Lu (2008) also find no
statistically significant correlation between corporate governance practices and market
valuation in China in the year 2004.

What about Bangladesh:

In Bangladesh, the journey of corporate governance has started very recently. The first
initiative regarding corporate governance was taken in August 2003 by a private
consulting firm, Bangladesh Enterprise Institute (BEI), which conducted a diagnostic
study and published a report, A Comparative Analysis of Corporate Governance in
South Asia: Charting a Roadmap for Bangladesh followed by the publication of The
Code of Corporate Governance for Bangladesh in April 2004. Afterwards, in November
2004, The Institute of Chartered Accountants of Bangladesh (ICAB) prepared a Draft
Code of Corporate Governance-Bangladesh. The regulatory attempt taken by The
Securities & Exchange Commission (SEC) of Bangladesh in January 2006 by issuing an
order requiring companies listed on a stock exchange in Bangladesh to comply with a
number of governance provisions is also noteworthy. Other than these developments,
corporate governance activities are limited to academic discussion in seminars and
conferences and the publication of a small number of academic studies (e.g. Reaz and
Arun (2006), Al Farooque et al. (2007), Imam and Malik (2007), Bhuiyan and Biswas
(2007), Uddin (2008)). As a result, literature relating to corporate governance and firm
performance is not so rich like other countries. Imam and Malik (2007) examines firm
performance and corporate governance through ownership structure in Bangladesh. By
analyzing all listed non-financing firms from the Dhaka Stock Exchange from two

sample points of 2000 and 2003, they provide evidence that foreign holding is positively
and significantly related to firm performance and the relationship is a monotonic one.
Moreover, firms with high institutional ownership and firms with concentrated ownership
pay high and less dividend respectively. However, the finding of Al Farooque, van Zijl,
Dunstan and Karim (2007) is mixed. While their ordinary least square (OLS) regression
analysis indicates a linear as well as non-linear relationship between board ownership and
performance, this relationship disappears when they conduct a two stage least square (2SLS) estimation of a simultaneous equation model.

Caveats of Governance-Performance Research

The issue of endogeneity often creates a problem for researchers while conducting
research on corporate governance. In the past, researchers often do not consider this issue
with reasonable care. For example, studies like Morck et al. (1988), McConnell and
Servaes (1990) have not addressed the endogeneity problem as they treated ownership
structure as exogenous in explaining the relationship between ownership structure and
corporate value. However, as Demsetz and Lehn (1985) argue, ownership structure is
endogenously determined in equilibrium.5 Murphy (1985) also finds that executive
compensation is strongly positively related to corporate performance, suggesting that
ownership structure can represent an endogenous outcome of the compensation
contracting process (Cho, 1998, p. 106). In similar vein, Kole (1996) argues that
managerial ownership is endogenous. She provides evidence of a reversal of causality in
the ownership-performance relationship, from performance to ownership rather than from
ownership to performance. Taken together, these corporate governance literature suggest
that both ownership structure and firm performance may be regarded as endogenous
variables (Rose, 2005). In such situation, OLS will yield inconsistent results as OLS

The problem of endogeneity was also noted by Jensen and Warner (1988) by stating A caveat to the
alignment/entrenchment interpretation of the cross-sectional evidence, however, is that it treats ownership
as exogenous, and does not address the issue of what determines ownership concentration for a given firm
or why concentration would not be chosen to maximize firm value (Jensen and Warner, 1988, p. 13).

- 20 -

parameter estimates are biased.6 Besides, treating ownership structure an independent

variable in ownership-performance regression can confuse the direction of causality (see
Cho, 1998, p. 106 for details).

To deal with the problem of endogeneity, researchers often estimate simultaneous

equation system using the two-stage least squares (2-SLS) or three-stage least squares (3SLS) method (Agrawal and Knoeber, 1996; Loderer and Martin, 1997; Cho, 1998;
Demsetz and Villalonga, 2001; Bhagat and Black, 2002; Lins, 2003; degaard and
Bhren, 2003; Rose, 2005; Zheka, 2006; Bhagat and Bolton, 2008; Black and Kim, 2008)
or instrumental variable in the regression (Hermalin and Weisbach, 1991; Himmelberg,
Hubbard and Palia, 1999) or a fixed-effects estimator with panel data (Himmelberg et
al., 1999; Bhagat and Bolton, 2008; Black and Kim, 2008).7 Using simultaneous equation
system, Loderer and Martin (1997) examine the relationship between acquisition
performance and managerial equity holdings. They find no evidence that large
stockholdings lead to better performance. However, they report that performance
negatively affects managerial ownership. On the other hand, estimating a three-equation
simultaneous equation system using the 2-SLS method, Cho (1998) finds that investment
affects corporate value, which, in turn, affects ownership structure, but finds no reverse
causality from ownership to corporate value. Similarly, 3-SLS analysis of Rose (2005)
shows that increased firm performance results in higher managerial ownership stake, not
the other way around. As opposed to reverse causality, using panel-data vector
autoregression, Himmelberg et al. (1999) find evidence that both ownership and
performance are endogenously determined by a common set of characteristics (observed
and unobserved) in the firms contracting environment. However, in analyzing the
governance effects in the framework of standard production function approach, Zheka

OLS assumes that the regressors are uncorrelated with the residual term, but this assumption is violated
when endogenous variables in one equation appear to be regressors in other equations (Rose, 2005).
7
In simultaneous equation system, equations are estimated using instrumental variables. By definition,
instruments are unrelated to the dependent variables and hence, variables that are thought to be exogenous
and independent of the disturbance or error term can be treated as instruments (Rose, 2005). However, it
is often difficult to find natural instrumental variables (Himmelberg et al., 1999).

- 21 -

(2006) does not find significant evidence of reverse causation or other endogenous
effects.
Besides the issue of endogeneity, there exists some other caveats in governanceperformance research. For example, Roche (2005) argues that a longer time horizon is
necessary to demonstrate any impact of good corporate governance on shareholder value.
Bhagat and Bolton (2008) are also of the opinion that companies with strong shareholder
rights may not have exhibited higher return performance during the current decade of
2000s as the results could be sample-period specific. Moreover, as Roche (2005)
suggests, the legal origin of a country may be more important factor, making the role of
corporate governance secondary, in influencing firm performance. Finally, as there is
possibility of some sort of correlation between governance factor and some unobservable
risk factor(s), it is also important to account for risk-adjustment (Bhagat and Bolton,
2008).

Concluding Remarks
Though the proponents of good corporate governance have never been failed in providing
arguments that whats good for corporate governance is good for the share price
(Roche, 2005, p. 244), The effect of corporate governance on share price performance
used to be something of a contentious issue (Roche, 2005, p. 244). This is because, for a
long time, researchers failed to find empirical support for the notion that well-governed
firms should be well-managed as well with (as a result) higher shareholder value (Roche,
2005). In recent times, researchers from different parts of the world are mostly coming
forward with strong correlation between these two variables. Rather than examining the
impact of a complete set of governance standard on firm performance, these studies
mostly investigate impact of single governance characteristic on firm performance. But
focusing merely on specific attribute of governance often fails to capture the total effect,
which ultimately leads to questionable result. Moreover, failure to consider properly the
issue of endogeneity often causes confusion in identifying the direction of causality
between corporate governance and firm performance and makes the research findings
futile. As a result, future research in governance-performance area should take into

- 22 -

account the issues like endogeneity, sample-period specificity, country legal origin and
risk-adjustment.

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