The Society for Financial Studies

The State of Corporate Governance Research

Author(s): Lucian A. Bebchuk and Michael S. Weisbach
Source: The Review of Financial Studies, Vol. 23, No. 3, Corporate Governance (March 2010),
pp. 939-961
Published by: Oxford University Press. Sponsor: The Society for Financial Studies.
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The StateofCorporateGovernance
Research
Ludan A. Bebchuk
HarvardLaw SchoolandNBER

Michaels. Weisbach
andNBER
Ohio StateUniversity

This article,whichintroducesthespecialissue on corporate governance cosponsoredby

theReviewofFinancialStudiesandtheNationalBureauofEconomicResearch(NBER),
reviewsand comments on thestateof corporategovernance research.The specialissue
featuressevenarticleson corporategovernancethatwerepresented in a meetingof the
NBER's corporate governance project.Each of thearticlesrepresents re-
state-of-the-art
searchin an importantareaofcorporate governance research.Foreach oftheseareas,we
discusstheimportance of thearea and thequestionsit focuseson, howthearticlein the
specialissuemakesa significantcontributiontothisarea,andwhatwe do anddo notknow
aboutthearea.We discussin turnworkon shareholders and shareholderactivism,direc-
tors,executivesand theircompensation, shareholders,
controlling comparativecorporate
governance, investments
cross-border in globalcapitalmarkets,andthepoliticaleconomy
ofcorporate governance.(JELG34)

This specialissue of TheReviewofFinancialStudiespresentssevenarticles

thatwerepresented ata meeting ofthecorporate governance projectoftheNa-
tionalBureauofEconomicResearch(NBER). The articles, whichsubsequent
to theconference wentthrough theusualreviewprocessof TheReviewofFi-
nancialStudies,represent cutting-edge research inimportant areasofcorporate
governance research. This specialissue thus a
provides good opportunity for
taking stockof the stateof corporate governance researchin these areas.
Interestin corporate governance has beenrapidlygrowing, bothinsideand
outsideacademia,together recognition importance. theacademic
with of its In
world,theinterest in corporategovernancehas been trulyinterdisciplinary,
withmuchworkbeingundertaken by researchers notonlyfromeconomics
and
and financebutalso fromlaw,management, accounting. The term"cor-
porategovernance" appears as a key word in the of
abstract 987 articlesover
thepastyear on the Social Science Research Network (SSRN), and,giventhe
huge amount of research being done in the area, SSRN in 2009 startedthe

to
We would like to thankLea Sternforher diligenthelp in preparingthisarticle.Send correspondence
LucíanBebchuk,HarvardLaw School,Cambridge, MA 02138. E-mail:bebchuk@law.harvard.edu.

© The Author2010. Publishedby OxfordUniversity Presson behalfof The SocietyforFinancialStudies.

All rights
reserved. pleasee-mail:journals.permissions@oxfordjournals.org.
ForPermissions,
doi:10.1093/rfs/hhpl21

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 TheReviewofFinancialStudies/v 23 n 3 2010

Corporate Governance Network withtwenty-one different subjectmatter elec-

tronicjournals.
Shleiferand Vishny(1997) definecorporate governance as referringto the
wayin whichsuppliersof financeassurethemselves a return on theirinvest-
ment.Because returns to suppliersof financedependon myriadlegal and
contractualarrangements, theoperationof variousmarkets, and thebehavior
of differenttypesof players,corporategovernance has evolvedintovarious
subliteratures(e.g., Zingales1998; Becht,Bolton,and Röell 2003; Hermalin
forthcoming).
Below,we discussin turnsevenimportant areas of corporategovernance
research,each of whichis represented by an articlein thisspecialissue.For
each of theseareas,we discusstheimportance of thearea and thequestions
thatitposesforresearchers, howthearticleinthespecialissueandotherrecent
researchadvanceourunderstanding of thearea,and thequestionsthatfuture
researchmaydo welltoexamine.Throughout, we stressquestionsconcerning
that
corporategovernance public and private decision makersface; research
thatcan shedlighton thesequestionswill have substantial implications and
payoffs.
Section1 focuseson shareholders and shareholder activism - theactions
thatshareholders may take to protect their interests.Section 2 focuseson
corporate directors, while Section 3 turns to executives and theircompensa-
tion.WhereasSections1-3 focusoncompanieswithout controlling sharehold-
ers,Section 4 considers companies with such shareholders. Sections5 and 6
focuson international corporate governance, with Section 5 considering cross-
country comparisons and Section 6 discussing cross-border investments byfor-
eign investors.Finally, Section7 focuses on the of
politicaleconomy corporate
governance.

1. Shareholders
Berle and Means (1932) identified whatappearedto be a fundamental con-
tradictionin thecorporateformof organization: Whiledispersedsharehold-
ers collectivelyhave incentives to monitor themanagement of thefirmsfor
whichtheyown stock,individually, thefree-rider
problem ruinsuchin-
can
centives,leading to a lack of shareholder involvementin firms.Giventhatthe
distributionof stockownership is importantbecauseof thesefree-riding con-
siderations,Shleiferand Vishny(1986) pointed outthatlargepercentage block
shareholdings aremoreprevalent in theUnitedStatesthanpreviously thought
(no one doubtedtheirexistenceoutsidetheUnitedStates).Morck,Shleifer,
andVishny(1988) andmanyfollow-up studieshavedocumented a robustem-
piricalrelationbetween these and
largeshareholdings corporate performance,
holdingin a widevariety ofsamplesspanning a number ofcountries andtime
periods.

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TheStateofCorporateGovernance
Research

Theunderlying reasons,however, forthisrelationbetweenownership struc-

tureandfirm performance arenotclear.The mainexplanation discussedinthe
Shleifer andVishny(1986) articleis through thepossibility ofhostiletakeover,
becausesuchtakeovers can be moreprofitable fora shareholder who already
ownsa largeblockofsharesthanforonewhodoesnot(see also Grossmanand
Hart1980).Yet,theempirical relation betweenownership andperformance ap-
pears to be too robusttobe explainedby hostile takeovers alone, since the same
relationexistsin countries andtimeperiodsin whichthereis no possibility of
a hostiletakeover.
Another possibilityis thattherelationcouldoccurbecauseofotheractions
takenby blockholders. Most sharesof U.S. firmsare held by informed,
sophisticated institutionalinvestors, manyofwhomhavenonnegligible stakes.
And some outsideshareholders pursue active and sometimes aggressive
strategies- proxyfights andtakeover bidsin thepastandhedgefundactivism
in thepastdecade.
Financialeconomists haveaccordingly beenincreasingly lookingat theef-
fectsof shareholder actions.Therehave been a numberof studiesthathave
examinedtheeffectof publicpensionfundsand otherinstitutional investors
on thefirms in whichtheyinvest(see Del GuercioandHawkins1999,Gillan
andStarks2000,HartzellandStarks2003,as wellas Karpoff 2001 andGillan
and Starks 2007 for surveys). In recent years, the most important playersin
theactivismlandscape have been activist hedge funds. The activities andpay-
offsof suchhedgefunds, which are willing to make substantial investments
in engagement withcompanies,arethesubjectofrecentstudiesbyBravet al.
(2008),GreenwoodandSchor(2009), andKleinandZur(forthcoming).
One keyquestionon whichresearchhas focusedis theeffect ofactivismon
profitability.Areactivists producing value for firms and their fellow sharehold-
ers?Or aretheyhurting theirfellow shareholders? Such questionshavebeen
askedin thepastaboutshareholders mounting proxyfights andtakeoverbids
andhavebeenmorerecently askedabouthedge fund activists. The resolution
ofthesequestionshas important policyimplications for debates on theoptimal
scope of shareholder rightsin publiccompanies(e.g., Bebchuk 2005, 2007;
Bainbridge2006; Strine2006; Liptonand Savitt2007). Whereasa conclu-
sionthatactivismis beneficial providessupport forstrengthening shareholder
rights, for
theoppositeconclusionprovidessupport constraining them.
Unlikeactivistshareholders whomounted proxyfights andtakeover bidsin
thepast,theactivist the
hedgefundsthatattracted limelight in the past decade
do notcommonly seek to acquirethecompanythemselves. Instead,theytry
to affecttheway in whichthecompanyis runor to getthecompanyto be
acquiredby someoneelse. Importantly, thesehedgefundsmostcommonly
contactcompaniesprivately, so it is difficult to gaugethemagnitude of their
intervention usingpublicly available data.It also is not clear what the neteffect
of institutional activism is. Are activists producing a collective good, which
is stillunderprovided, and whoseactionsshouldbe encouraged?Or are they

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TheReviewofFinancialStudiesZv23n3 2010

destroyingvalue at theexpense of otherinvestors?(See Kahan and Rock 2007

fora surveyand discussion of thisissue.)
Unfortunately, informalcontactbetween institutionalinvestorsand firmsis
by its natureprivateand difficultto quantify.Consequently,therehas histori-
cally been only one studyof such activism: Carleton,Nelson, and Weisbach
(1998) gather a sample of lettersbetween Teachers Insurance and Annuity
Association-College RetirementEquities Fund (TIAA-CREF) (a large U.S.
pension fund) and companies. They findthatTIAA-CREF typicallydoes not
ask firmsto make large operationalchanges butis usually successfulat induc-
ing firmsto make the relativelysmall changes they ask for (such as having
a shareholdervote beforeadopting"Blank-Check PreferredStock," or having
women or minorityrepresentativeson theirboard of directors).Yet, it is im-
possible to know exactlyhow representative TIAA-CREF is of otherU.S. (or
international)institutions in termsof its activism.
Becht et al. (2008), a studyincluded in this special issue, utilizes privately
obtained data fromHermes, the fundmanagerowned by the BritishTelecom
Pension Scheme, on engagementswithmanagementin companies targetedby
itsUK Focus Fund between 1998 and 2004. This fundhas been highlyinvolved
withactivismand also has been unusuallysuccessful,earningabnormalannual
returnsnet of fees of 4.9%. Becht, Franks,Mayer, and Rossi have complete
access to the records of all activism by Hermes, including privateinterven-
tions thatwould be unobservablein studiespurelyrelyingon public informa-
tion. Becht, Franks, Mayer, and Rossi document the way in which Hermes
frequentlyseeks and achieves significantchanges in the company's strategy,
includingrefocusingon the core business and returningcash to shareholders,
as well as changes in theexecutivemanagementsuch as thereplacementof the
chiefexecutiveofficer(CEO) or chairman.These authorsestimatethataround
90% of the abnormalfundreturnsis due to the activismprogram.
Becht et al. (2008) is a significantstudybecause it provides a window into
thenatureof "behindthe scenes" activismand shows thatsuch activismcan be
important.The studysuggeststhatfinancialinstitutionscan increase in value
notjust by buyingand selling securitiesstrategicallybutalso by creatingvalue
inside of firmsby providingmonitoringservices. It providesan example of the
way in which it is possible to learn a greatdeal fromthe details of the actions
of a single (particularlyinteresting)financialinstitution.
There are some questions thatfutureresearch should tryto address. If ac-
tivismproduces such large returns,why has Hermes not done it on a larger
scale? Is the abilityto produce such resultsunique to Hermes or a few such
players,or is it somethingthathas been done, or can be done, by otherUK
players with similar success? Note also thatthe large returnsthatthe study
shows raise the question of why more capital does not flowintothiswork,re-
ducingreturns,and in theprocess also possiblyreducingslack in theeconomy.
We need to understandbetterwhat the barriersare to entry,if any, into ac-
tivism.Interestingly, large returnsfromactivismdo not indicatethata system

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 TheStateofCorporateGovernance
Research

is working well.The factthatactivismcan generatesuchlargereturns might

indicatethata highlevelofslackexistspriorto activistintervention.
It willalso be important to understandtheextentto whichthefindings are
duetotheparticular legaland features
institutional oftheUK system.As Becht
et al. (2008) note,legalrulesin theUnitedKingdomgiveshareholders much
morepowerthanU.S. shareholders have.Understanding thewaysinwhichthe
payoffs andeffects of activismdependon legalrulesis an important question
forfinancial economists to investigate.
The financialcrisishas intensified theongoingdebateabouttherole that
shareholders shouldplayin corporate governance.To some,increasing share-
holderpowerandfacilitating shareholderinterventionwhennecessaryarepart
ofthenecessary reforms. To others,activismby shareholderswhopotentially
haveshort-term interestsis partoftheproblem, nota solution.To whatextent
(and when)can shareholder activismimprovefirmvalue and performance?
To whatextent(and when)can shareholder activismproducedistortionsthat
makematters worse?Researchbyfinancial economists thatseeksfurtherlight
on thesequestionswillprovidevaluableinputto thequestionswithwhichde-
cisionmakersarewrestling.

2. Boards ofDirectors
An alternativeto directmonitoring byshareholders is governance through the
boardof directors, who are electedby shareholders. Yet, as has been recog-
nizedat leastsinceSmith(1776) and Berleand Means (1932), directors'in-
terestsmaynotfullyoverlapwiththoseof shareholders. The complexthree-
wayrelationship amongshareholders, boards,and topmanagement has been
thesubjectof a substantial literature(see Hermalinand Weisbach2003 and
Adams,Hermalin, andWeisbachforthcoming forsurveys).
How do we makeboardsworkbetter? One recipethathasbeenincreasingly
suggestedby public and privatedecision makersis to have independent
boards(see Gordon2007 on the rise of independent directors).Indeed,a
commonpolicyresponseto observed"governance crises"has been to adopt
reformsdesignedto strengthen the independenceof boards.For example,
following theEnronandWorldComscandalsin 2002,theexchangesincreased
independence requirements, and the Sarbanes-OxleyAct of 2002 required
theindependence of auditcommittees. The financialcrisishas similarlyled
to theconsideration of legislationaimed at bolstering the independence of
compensation committees.
Whyimposeregulatory limitson thecomposition of theboard?Hermalin
andWeisbach(1998) presenta modelin whichdirectors imposedon thefirm
by regulations are likelyto be less effectivethanthosepickedthrough the
endogenousselectionprocessthatwouldoccurin theabsenceof regulation.
At thesametime,regulators are typicallyconcernedthat,without regulation,
opportunism byinsidersmightlead to insufficient independence ofdirectors.

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 TheReviewofFinancialStudies/v 23 n 3 2010

Nonetheless, given the growing importance of independent directors,

whetherdue to regulationor to choices made by firms,it is importantto
studyempiricallytheeffectsof directorindependence.Initialworkon the sub-
ject failed to finda link between board independence and higherfirmvalue
(Hermalinand Weisbach 1991; Bhagat and Black 1999, 2002). However,there
is a growingbody of empiricalresearchindicatingthatdirectorindependence
is associated with improveddecisions with respect to some specifictypes of
decisions (e.g., Byrd and Hickman 1992; Shivdasani 1993; Brickley,Coles,
and Terry1994; Cotter,Shivdasani,and Zenner 1997; Dann, Del Guercio, and
Partch2003; Gillette,Noe, and Rebello 2003). In particular,it has been shown
that directorindependence has an impact on CEO turnover(e.g., Weisbach
1988), executivecompensationdecisions (e.g., Core, Holthausen,and Larcker
1999; Chhaochhariaand Grinstein2008), the incidence of fraud(e.g., Beasley
1996; Dechow, Sloan and Sweeney 1996; Beasley et al. 2000), and on the in-
cidence of opportunistictimingof stock option grants(e.g., Bebchuk, Cohen,
and Fen-ell2009).1
An important,and necessary,conditionfordirectorsto be able to be effec-
tive is the amountand natureof informationthattheyhave. If directorsonly
have access to publicly available information,it is hard to imagine thatthey
will be able to evaluate managementbetterthanan outside shareholder.In ad-
dition,the mere factthatdirectorsdo not have superiorinformationwould in
itselflikely be the consequence of a strainedrelationshipwith management,
since presumablyno information of value would have been transmitted during
board meetings.The informationaladvantage of directorsover outsidersthus
presumablyprovidesa measureof thepotentialforthesedirectorsto add value.
Ravina and Sapienza (2009), in this special issue, adopt a novel strategyto
estimatethe magnitudeof this informationaladvantage. These authorscom-
pare the tradingperformanceof independentdirectorswith thatof otherof-
ficersof the firm.Their interestingfindingis thatindependentdirectorsearn
positive and substantialabnormalreturnswhen theypurchase theircompany
stock, and thatthe differencewith the same firm'sofficers'personal trading
returnsis relativelysmall at most horizons. Executive officersand indepen-
dent directorsboth earn higherreturnsin firmswiththe weakest governance.
In addition,independentdirectorswho sit on the audit committeeearn higher
returnsthanotherindependentdirectorsat the same firm.Finally,independent
directorsearn significantly higherreturnsthan the marketwhen theysell the
company stock in a window beforebad news and aroundearningsrestatements.
The authorsview theirresultsas consistentwiththe view thatindependentdi-
rectorshave an informationaladvantage over outsidersand thus can perform
theirjob well.

1 Recentwork(ChhaochhariaandGrinstein2006) also documents thatreforms somefirms

to increase
requiring
theiruse ofindependent wereassociatedwithincreasesin thefirmvalueofsuchfirms.
directors

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 Research
TheStateofCorporateGovernance

WhileRavinaand Sapienza(2009) stresstheimplications of theirfindings

fortheabilityof independent directorsto perform theirrolewell,one could
also drawinferencesfromitconcerning theirincentives to do so. In particular,
to theextentthatindependent directors on
rely management forthereceiptof
information,independentdirectorswho made largertrading profits mighthave
beenindividuals thatwereclose to management or whoseperformance ofthe
oversightfunctionmight have been more favorable to management. Bebchuk,
Cohen,andFerrell(2009) findthatindependent directors havebeenrecipients
timedstockoptiongrants,
ofopportunistically andtheyshowthatthedirectors'
benefitsfromsuchluckytimingwereassociatedwithsubstantial benefits to
theCEO. In particular,
they find for
that, anygiven firm and CEO, theodds
of a CEO grantbeingluckyweresignificantly higherwhentheindependent
directorsof thefirmreceivedgrantson thesame dateand thatdirector grant
eventsnotcoincidingwithawardsto executivesweremorelikelyto be lucky
whentheCEO receiveda luckygrantin thesameorprioryear.
TheRavinaandSapienza(2009) studyandtheotherrecentworksdiscussed
thevalueoftheworkbyfinancial
inthissectionhighlight economists on inde-
pendent who a
directors, play major role in corporate decision making.Finan-
cial economistsshouldnot generally assume thatindependent directors seek
to maximizeshareholder value;rather,the decisions of independent directors,
likethoseof othereconomicagents,mightwell be influenced by theirincen-
tives,whichin turnare a productof variousfeaturesof theenvironment in
that
whichtheyoperate.The information independent directors have should be
similarlyrecognizedto be endogenously determined by corporatestructures
and processesratherthanto be exogenouslygiven. Additional workon the
incentivesandinformation ofindependent directors would be worthwhile.

3. ExecutiveCompensation
In theordinary courseof events,publicfirmsare managedby executives, not
directorsorshareholders. Executives'decisionsareinfluencedbythedirectors'
oversight, as well as by shareholders'
monitoring. Executives'decisionsare
also affected,however, by theincentives providedto themby theirexecutive
compensation arrangements. Thesecompensation arrangements havebecome
thesubjectofa largeliterature(see Murphy1999andCore,GuayandLarcker
2003 forsurveys).
Thereare at least two views of executivecompensation in theliterature.
One view("theoptimalcontracting view")sees executivepayarrangements as
theproduct ofarm'slengthcontracting betweenboards and executives,which
leads to contractsthatprovideefficientincentives forreducingagencyprob-
lemsas muchas possible(e.g., Holmstrom 1979). An alternativeview ("the
managerial powerview") questionswhether pay arrangements theprod-
are
uctof arm'slengthcontracting and sees such payarrangements as partof the

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TheReviewofFinancialStudiesZv23n3 2010

agency problemitselfratherthanas a solutionto it (Bebchuk and Fried 2003,

2004).
One part of the debate on executive compensation concerns compensa-
tion levels (Kaplan 2008). Are the levels of executive compensation,which
have grownconsiderablyrelativeto rank-and-file compensationin recentyears
(Jensen,Murphy,and Wruck 2004; Bebchuk and Grinstein2005), a reflection
of supply and demand in the labor marketforexecutives? Or do theyreflect
rentseekingby powerfulmanagers?Given theattentionthatpay levels receive
fromthe media, the public, and policy makers,a betterunderstandingof the
factorsaffectingthemis clearlyan importantresearchtopic.
The second dimensionto the debate concernsthe structureof pay arrange-
ments. Under the optimal contractingview, the design of pay arrangements
is presumed to be (second-best) efficient.In contrast,the managerial power
view allows forthepossibilitythatpay arrangementswill be structured subop-
timallyin ways thatlead to dilutedor even perverseincentives.While Jensen
and Murphy(1990) arguedthatpay is insufficiently tied to performancedue to
outside social pressures,the managerialpower view suggests thatsuboptimal
pay-performancesensitivitycould itselfbe a productof executive influence.
To financialeconomists,thequestionof incentives,and in particulartheextent
to which incentivesprovidedby pay arrangementsshould be presumedto be
optimal,is of significantimportance.
Some recentwork by financialeconomists,includingthe work by Kaplan
and Rauh (2009) in thisspecial issue, seeks to explain the growthof executive
pay withinthe arm's lengthcontractingparadigmby suggestingthatit reflects
an increase in the value of executives' marginalcontributionsand improve-
mentsin theiroutside options. Murphyand Zabojnik (2007) suggest thatthe
growthin pay reflectsa shiftin the importanceof "managerial ability"(skills
transferableacross companies) relativeto "firm-specific humancapital" (valu-
able only withinthe organization),which operated to strengthenexecutives'
bargainingposition by improvingtheiroutside options. Gabaix and Landier
(2008) develop a model in which the marginalproductof an executive of a
given qualityis proportionalto the marketcapitalizationof the firmand argue
thatthe growthof pay has been due to the increase in the marketcapitaliza-
tion of firms.The extentto which these theoriescan explain the time-series
variationin executive compensation is questioned on empirical grounds by
Dew-Becker and Gordon (2007), Cremersand Grinstein(2009), and Frydman
and Saks (2010).
Kaplan and Rauh (2009) examine thequestionof whetherthegrowthof pay
can reflectmarketforces in a creativeway. The idea is thatif executive pay
reflectsmarketforces,thenits growthshould parallel thatof otherhighlypaid
professions.Kaplan and Rauh gatherdata on compensationfromhigh-paying
fieldssuch as financialservice sectoremployees frominvestmentbanks,hedge
funds,privateequityfunds,and mutualfunds(Wall Street),as well as corporate
lawyers,professionalathletes,and celebrities.

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 TheStateofCorporateGovernance
Research

The estimatesof Kaplan and Rauh (2009) lead themto conclude thatnonfi-
nancial public company CEOs and top executivesdo not representmore than
6.5% of any of the top adjusted gross income (AGI) brackets(the top 0.1%,
0.01%, 0.001%, and 0.0001%). Individuals in the Wall Streetcategorycom-
priseat least as higha percentageof thetop AGI bracketsas nonfinancialexec-
utivesof public companies. Kaplan and Rauh argue thatthisevidence suggests
thatthegrowthof executivepay is notreflectiveof suboptimalcontracting,but
ratheris mostconsistentwiththeoriesof superstars,skill-biasedtechnological
change, greaterscale, and the interactionof these effects.
Although Kaplan and Rauh (2009) suggest that the growthof pay levels
could be consistentwith the optimal contractingview, they do not attempt
to test directlywhethercompensation is indeed the productof arm's length
contracting.A full defense of this view would have to address the empirical
evidence thatcompensationlevels are higher(as well as less sensitiveto per-
formance)when governanceis weaker (see Bebchuk and Fried 2004, Chapter
6 fora survey).Among otherthings,thereis evidence thatCEO pay is higher
whenoutsidedirectorsserveon multipleboards,when theboard has interlock-
ing directors,when more of the outside directorshave been appointed under
this CEO, when thereare no large outside blockholders,when a smaller per-
centage of sharesis held by institutionalinvestors,and when antitakeoverpro-
tectionsare more significant(e.g., Borokhovich,Brunarski,and Parrino1997;
Hallock 1997; Core, Holthausen,and Larcker 1999; Cyert,Kang, and Kumar
2002; Hartzell and Starks2003).2
Whereas Kaplan and Rauh (2009) defend the optimal contractingview
against claims thatpay levels have been excessive, some otherrecent work
seeks to defend this view against claims that compensation structureshave
been inefficiently designed. In particular,Edmans, Gabaix, and Landier (2009)
presenta model in which optimalpay lines up closely withempiricalobserva-
tions on actual executive compensation.And while many public officialsex-
pressed concernsthatstandardpay arrangementsprovideexcessive incentives
to focus on the short-term (an argumentstressedin Bebchuk and Fried 2004,
Chapter14), Fahlenbrachand Stulz (2009) argue thatthereis no empiricalev-
idence that such incentiveshave played a role in the run-upto the financial
crisis.
Althoughinterestin executive pay has been high for quite some time,the
Financial Crisis of 2008-2009 has further intensifiedthisinterest.Public atten-
tionto thecompensationlevels of top officialsappears to be at an all-timehigh.
Regulators around the world are examining measures to improve the struc-
ture of compensationand not to make thingsworse throughill-thought-out
provisions.And authoritiesin the United States and elsewhere are consider-
ing measuresto improvethe corporategovernanceprocesses thatproduce pay
2 Thereis also evidencethatweaker is associatedwithlowersensitivityof pay to perfor-
corporate
governance
mance(Bertrand 2001) andopportunistic
andMullainathan compensation practicessuchas thosemanifestedby
optionbackdating (Bebchuk,Cohen,andFerrell2009; Bizjak,Whitby, andLemmon2009).

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 TheReviewofFinancialStudiesZv23n3 2010

The examination
arrangements. of pay arrangementsand thepay-setting
pro-
cessesbypublicandprivatedecisionmakers, we hope,willbe informed
from
theongoingandfutureresearchoffinancialeconomists.

4. ControllingShareholders
The natureofgovernance problemsdiffers greatly betweenpubliccompanies
withand without a controlling shareholder (La Porta,Lopez-de-Silanes, and
Shleifer1999; Bebchukand Hamdani2009). Withcontrolling shareholders,
themarket forcorporate controlthatplayssuchan important rolein theanal-
ysisof companieswithout a controllercannotprovidea sourceof discipline.
Witha controlling shareholder, thefundamental governance problemis notop-
portunism by executivesand directorsat the of
expense publicshareholders at
large but rather opportunism by thecontrolling shareholder at the expense of
theminority shareholders.
The Becht,Franks,Mayer,and Rossi; Ravinaand Sapienza; and Kaplan
and Rauh articlesin thisissue all focuson companieswithouta controlling
shareholder - thecommonstructure amongpubliclytradedfirms intheUnited
Statesand theUnitedKingdomand theone on whichmostresearchhas fo-
cused.Butas theworkoncomparative corporate governance has shown(Becht
and Röell 1999; La Porta,Lopez-de-Silanes, and Shleifer1999; Franksand
Mayer2001),companieswitha controlling shareholder arethedominant form
amongpublicly traded firms in most countries.Holderness (2009) shows that
controlling shareholders are more common even in the United States thanis
usually assumed.
One important typeof controlling shareholders are thoselabeled "con-
trollingminority shareholders" by Bebchuk,Kraakman,and Triantis(2000).
Theseareshareholders whoownonlya minority (and sometimes a smallmi-
nority)of the company's cash flow rightsbut controla majority of thevotesand
thushavea lockon control. An ownerofa minority ofthecashflowrights can
controla majority of thevoteswhencash flowrightsand votesare separated
duetotheuse ofdual-classstock,corporate pyramids, orcross-holdings. Such
structuresarequitecommonin manycountries and
(Claessens,Djankov, Lang
2000; Faccio andLang 2002). Bebchuk,Kraakman, andTriantis(2000) show
thatsuchstructures havethepotential tocreateverylargeagencycoststhatare
an orderofmagnitude largerthanthoseassociatedwithcontrolling sharehold-
erswhoholda majority of thecash flowrightsin theircompanies.Bertrand,
Mehta,andMullainathan (2002) present evidenceaboutthesignificant amount
oftunneling thattakesplace in suchfirms.
In theUnitedStates,controlling minority shareholder structures commonly
occurthrough theuse of dual-classshares.In suchfirms, multipleclasses of
stockswilltrade,typically withthesamedividendrightsbutdifferent voting
rights.This arrangement ensures thatcontrolis keptin thehandsof a small
groupof individuals, usuallythefounderand/orhis family, eventhoughthe

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 TheStateofCorporateGovernance
Research

companycan be tradedpubliclywithmanyshareholders. The wedgebetween

thepricesofthedifferent classesofstockreflects theprivate benefitsofcontrol
enjoyedby the high-vote shareholders. There have been a number of articles
the of
documenting patterns ownership, prices the ofdual-class stocks,and the
valueofvotingrights insuchfirms bothintheUnitedStatesandinternationally
(e.g.,Zingales1994,1995;Nenova2003). Yet,thesestudieshavetypically had
relativelysmall samples that limittheirabilityto answer important questions
aboutdual-classfirms, suchas theincremental effectof dual-classownership
on valuation.
Gompers, Ishii,andMetrick(2009), in thisissue,considertheissueofgov-
ernancewhencashflowrightsandvotingrightsareseparated. Theyassemble
a comprehensive listof dual-classfirmsin theUnitedStatesand use thislist
toinvestigate therelationship betweeninsiderownership andfirmvalue.Their
data(whichareavailableattheReviewofFinancialStudieswebsite)havetwo
usefulfeatures forthisvaluationanalysis.First,sincedual-classstocksepa-
ratescash-flow rightsfromvotingrights, theycan separately identifytheim-
pact of each. Second,they address endogeneity concerns byusingexogenous
predictors ofdual-classstatusas instruments.
In single-stageregressions, Gompers,Ishii,andMetrick(2009) findstrong
evidencethatfirm valueis increasing ininsiders'cash-flow rightsanddecreas-
in
ing insidervotingrights. In instrumental-variableregressions, pointes-
the
timatesremainthesame sign and magnitude, but the significance levelsare
lower.This workillustrates of
theimportance ownership structurefor valua-
tion.Because of its instrumental variableapproach, it has a relativelyclean
wayof measuring theimpactof controlling shareholders thatcan appropriate
private benefitsfromminority ones.
The Gompers,Ishii,and Metrick(2009) articlethusmakesa contribution
to theaccumulating empiricalevidencethatcontrolling minority shareholder
structuresare associatedwithincreasedagencycostsandreducedfirmvalue.
The questionthenarises why such structures developand are maintained
and whatshouldbe thepublicpolicytowardthem.Giventheimportance of
companieswithcontrolling minority shareholders in manycountriesaround
theworld,thesequestionsshouldbe partof theresearchagendaof financial
economists.

5. InternationalComparisons
Untilthemid-1990s, mostoftheworkon corporate governance hasbeeninthe
contextofU.S. firms. Buttheinfluential workofLa Porta,Lopez-de-Silanes,
andShleifer (1999) andLa Portaetal. (1997, 1998,2000a,b, 2002) has stimu-
lateda largebodyofworkon international comparisons (see Levine2005 and
La Porta,Lopez-de-Silanes,andShleifer2008 forsurveys).
Muchofthisworkhas focusedon differences betweencountries'legalsys-
tems(including theirsystemsofenforcement) andhas studiedhowsuchdiffer-

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 TheReviewofFinancialStudiesZv23n3 2010

eneesrelateto differences in howeconomiesandcapitalmarkets perform. La

Portaet al. (1997, 1998) putforward an anti-director indexformeasuring the
legal protection accordedto investors, and thisindexhas been subsequently
used by morethanone hundredstudies(Spamann2009). How bestto mea-
suretheextentto whicha particular country's legalsystemprotects therights
ofpublicinvestors is an activeareaofresearchin whichrecentworkseeksto
provideimproved indicesforthispurpose(Hail andLeuz 2006; La Porta2006;
Djankovetal. 2008; JacksonandRoe 2008).
Whileresearchon comparative corporate governance has in thepastmainly
focusedon cross-country differences in governance,a substantial body of
researchaboutU.S. firms has beenshowingthatcross-firm differences in gov-
ernancehavesubstantial effecton firm valueandperformance. Gompers, Ishii,
and Metrick(2003) haveshownthata governance index(theG-index)based
on twenty-four provisionsis negatively correlated withfirmvalue.Bebchuk,
Cohen,and Ferrell(2009) pointout thatsix of theseprovisionsfullydrive
theGompers-Ishii-Metrick resultsand proposean alternative entrenchment
indexbasedon them(theE-index).A particularly important component ofthe
G-indexand theE-indexis whether boardsare staggered(Bebchuk,Coates,
and Subramanian2002; Bebchukand Cohen 2005). A significant number
of subsequentstudieshave identified manyways in which the G-index, the
E-index, and the existence of staggered boards are associated with firm
performance and behavior(e.g., Masulis,Wang,and Xie 2007; Kedia and
Philippon2009).
Giventhemagnitude of firm-level differences in governance, it is a nat-
ural nextstepfortheliterature on international comparisons tryto look
to
beyondcross-country differences and incorporate intotheinvestigation firm-
leveldifferences. Aggarwal et al. (2008), in thisissue, take this stepusinga
new databaseof firm-level governance provisionsputtogether by RiskMet-
a
rics, global shareholder advisory firm.3 Bruno and Claessens (2007) and
Chhaochharia andLaeven(2007) also usethisdatasettoinvestigate thesubject.
Withdata on bothcountry-level and firm-level an
governance, important
questioninvestigated byAggarwaletal. (2008) is howthesetwotypesofgov-
ernancechoicesinteract. Does havinga good legal systemact as a substitute
forfirm-level choices?Or does itfacilitate firm-level governance, makingthe
twotypesofgovernance complements? Theoretically, either is possible,so the
can
question only be answered by examining data on firm- and country-level
governance.
GiventhattheUnitedStatesis knownforitshigheconomicdevelopment
and stronginvestor protection, theauthorsexaminewhether comparablenon-
U.S. firms choosehigherorlowerlevelsofprotection thansimilarU.S. firms.
They construct a firm-level governanceindexthatincreaseswithminority

3 At thetimeof the thedatabasewas ownedby theInstitutional

Shareholder Services(ISS) and is conse-
study,
toas theISS databasebyAggarwal,Erel,Stulz,andWilliamson(andotherauthors).
quentlyreferred

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 Research
TheStateofCorporateGovernance

shareholder protection. ComparedtoU.S. matching firms, only12.68%offor-

eignfirms havea higherindex.The valueof foreignfirms fallsas theirindex
decreasesrelative totheindexofmatching U.S. firms, implying thatthegover-
nanceattributes examinedin thestudyarerelevant forshareholder value.The
authorsviewthesefindings as consistent withthe"complements" viewunder
whichlowercountry-level investor protection makesitsuboptimal forforeign
firms to investas muchin governance as U.S. firms do.
As done by Aggarwalet al. (2008), futureresearchon comparative cor-
porategovernance should strive to take firm-level governance into account.
Theuse oftheRiskMetrics datasetforthispurpose,however, has somelimita-
tions.Bebchukand Hamdani(2009) pointoutthattheRiskMetrics datasetis
U.S.-centric in thatitfocuseson features thatareimportant forthecompanies
without a controlling shareholder thataredominant in theU.S. capitalmarket
butnotin mostothercapitalmarkets aroundtheworld.Indeed,thefinding of
Aggarwal et al. (2008) that firm-level governance is betterin U.S. firmsthan
in firms fromothercountries is likelyto be at leastpartially due to theU.S.-
centricnatureofthedatasetusedbythisstudy.
The BebchukandHamdani(2009) analysissuggestsa direction thatwould
be worthpursuing by work on international comparisons. Much of thework
thusfarhas soughttodevelopandemploya singleglobalgovernance standard
formakingeithercountry-level or firm-level comparisons around the world.
However,governance arrangements that are optimal forinvestor protection in
a
companieswithout controlling shareholder could be for
suboptimal compa-
nieswithsucha controller and vice versa.Consequently, thequestfora sin-
gle globalgovernance standard shouldbe replacedwithseparatestandards for
evaluating governance infirms withandwithout a controlling shareholder. The
development andapplication ofsuchstandards is potentiallyan important task
forfuture research.

6. Cross-BorderInvesting
A substantial partof theworkon international comparisonsabstractsfrom
themovement of firmsand capitalacrossborders.It takesas giventhateach
countryhas a givensetoffirms anda givenamountofcapitalinvested in these
andit focuseson howfirmsin different
firms, countries varyin howtheyare
governed.In ourincreasingly globalizedworld,however, thereis in factmuch
movement acrossborders, andthereis someresearchthatseeksto understand
thecausesandconsequencesofsuchmovement.
One important elementof cross-border movements concernsdecisionsby
firmsheadquartered andoperating in a givencountry to subjectthemselves to
thegovernance rulesof othercountries.Coffee(1999) and Stulz(1999) have
suggestedthatfirms can therefore
"bond"themselves to good governance by
incorporatinginanother countryorbylistingon a foreign exchange.Thereis a
lineofworkexamining
significant whyfirms "migrate" to foreign governance

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 TheReviewofFinancialStudiesZv23n3 2010

systemsandtheextentto whichsuchmigration is due to a desireby firms to

"bond"themselves togovernance arrangements thatprovidetighter protection
to publicinvestors (Reese and Weisbach2002; Pagano,Röell, and Zechner
2002; Doidge,Karolyi,andStulz2004; Siegel2005; Doidgeet al. 2009).4
Another important elementof globalcapitalmarkets is cross-border move-
mentofcapital.In contrast to classicalportfolio theory, investors tendto have
a "homebias" in favorof investing in firmsof theinvestor's country of resi-
dence.Recently, however, investors havebeenincreasingly allocatingpartof
theirequityinvestments to foreign companies.As it is naturalto ask howthe
migration of firms acrossbordersis influenced bygovernance considerations,
itis also naturaltoaskhowcross-border investing flows are influenced bysuch
considerations.
The levelofinvestor protection is likelyto be particularly important forin-
vestorsconsidering purchasing securities issued a
by company from another
country. Foreigninvestors tendtohaveless information aboutcompaniesthey
investin thandomesticinvestors andalso tendto havefewerpoliticalconnec-
tionsorlong-term relationships withthefirm thatcanpotentially substitute for
governance. Under this the of
hypothesis, quality governance in a firm should
be correlated withtheforeignstockholders in a company.In particular, since
strong governance makes a firm relatively more attractive to foreigners tothan
domesticinvestors, foreigners should have a higherpercentage ownership in
firms whereinvestors arebetter protected.
The studyby Leuz, Lins,and Warnock(2008), in thisissue,teststhishy-
pothesis.Therehas been muchworkdocumenting thatincreaseddisclosure
makesa firm moreattractive toall investors (see Hermalin andWeisbach2009
andthereferences and
therein), Leuz,Lins, and Warnock show thatsuchopen-
nessis particularly in
important attracting foreign investors. The authorsstudy
4,409 firms from twenty-nine countries to assess whether and whyconcerns
aboutcorporate governance result in fewer foreign holdings. Their resultssug-
gest that foreigners invest less in firms that reside in countries with poorout-
siderprotection and disclosureand have ownershipstructures thatare con-
duciveto governance problems.This effectis particularly pronounced when
are
earnings opaque,indicating that the information asymmetry and monitor-
ingcostsfacedbyforeign investors likelydrivetheresults.
The findings of Leuz, Lins,and Warnock(2008) confirm thatgovernance
problemsimpede firms' ability to attract capital from foreigninvestors even
morethanit impedestheirabilityto raisecapitaldomestically. Poor gover-
nancecan thuslimitcapitalflowsandtheintegration ofcapitalmarkets in the
globaleconomy. These are
findings especiallyimportant given that some of
thecountries whoseinvestor is
protection especially weak are also those coun-
triesforwhomcapitalinvestment fromabroadis especiallysignificant. Thus,
4 This workis relatedto thesubstantial on regulatory
literature
naturally amongstatesseekingto
competition
attract (Romano1985;Bebchuk1992;Romano1997;Daines2001; BebchukandHamdani2002;
incorporations
BebchukandCohen2003; Kahan2006; Bar-Gill,Barzuza,andBebchuk2006).

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 Research
TheStateofCorporateGovernance

governance reforms mightproduceconsiderable

in suchcountries benefitsfor
theireconomies.Whether suchreformswill in factoccurdependsin parton
thepoliticaleconomyofgovernance reforms, whichis thesubjectof thenext
section.

7. Politics

Corporate governance is inparta productoflegalsystems putin place andthe

legalinfrastructure accompanying them. Throughout the earlierdiscussion, we
havetalkedaboutthepotentialsignificance of differences amongsystemsof
corporate governance in different countries.Such systems differ considerably
aroundtheworldand,foranygivencountry, overtime.
Thereis a lot of researchthateithertakesthelegal rulesas givenand ex-
amineshowagentsmakechoicesgiventhem,oraskswhatlegalarrangements
are desirableassumingthatpublicofficialsgenerallyseek to adoptwhatever
rulesare optimal.But whythenwouldcountriesthatare in a similarstage
of theireconomicdevelopment havelegalrulesthatare so different and why
do so manycountries in
persist havingsystems that seem to providepatently
insufficientlegalprotection to publicinvestors?
One important strandseeksto relatecross-country differences to somein-
nate,long-standing differences among countries. This line of work suggests
thata country's levelofinvestor protectionmaybe influenced bylong-standing
factorssuchas thecountry's legal origin(La Portaet al. 1998; Glaeserand
La
Shleifer2002; Porta,Lopez-de-Silanes, and Shleifer2008), itscultureand
ideology(Bebchuk and Roe 1999; Roe 2003; Allen2005), or thereligionof
itspopulation (Stulzand Williamson 2003), all of whichlie outsidetherealm
ofcurrent politicalchoices.
But giventhatcountries do changetheirinvestor protection arrangements
considerably overtime,thelevelof suchprotection at anygivenpointin time
mayalso resultat leastpartlyfromrecentdecisionsby publicofficials. And
thequestionis howthesedecisionsare determined. The theoryof regulatory
capture(Stigler1971) suggeststhatthedecisionsbypublicofficials mightbe
influenced and sometimes distorted bytheinfluence activities ofrent-seeking
interestgroups.Whatcan be said aboutthewayin whichinterest grouppol-
iticsis playedout in thearea of corporategovernancepolitics?In a recent
JournalofEconomicLiterature survey,Morck,Wolfenzon, andYeung(2005)
stresstheimportance of developingformalpoliticaleconomymodelsof cor-
porategovernance arrangements andviewthistaskas "a fascinating uncharted
territoryforcreativetheorists."
Bebchukand Neeman(2009), in thisissue,tryto help fillthisvoid and
developa formalpoliticaleconomymodelofhowlobbyingbyinterest groups
affectsthelevelof investor protection. In theirmodel,threegroups - insiders
in existingpubliccompanies,institutional investors (financial intermediaries),
who
andentrepreneurs plan to take companiespublicin thefuture - compete

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 TheReviewofFinancialStudies/v 23 n 3 2010

forinfluenceover the politicians settingthe level of investorprotection.The

authorsidentifyconditionsunderwhichthislobbyinggame has an inefficiently
low equilibriumlevel of investorprotection.
Factorspushinginvestorprotectionbelow its efficientlevel include the abil-
ity of corporateinsidersto use the corporateassets theycontrolto influence
politicians and the inabilityof institutionalinvestorsto capturethe full value
thatefficient investorprotectionwould produceforoutsideinvestors.The inter-
est thatentrepreneurs (and existingpublic firms)have in raisingequitycapital
in the futurereduces but does not eliminatethe distortionsarisingfrominsid-
ers' interestin extractingrentsfromthe capital thatpublic firmsalready pos-
sess. The entrepreneurs preferan efficient
level of investorprotection,and their
introduction intotheBebchuk and Neeman (2009) model thereforemoderates,
but is shown not to eliminate,the bias in favorof excessive privatebenefits
of control.While entrepreneurs do internalizethe interestsof those public in-
vestorswho buyinitialpublic offeringshareswhentheytaketheirfirmspublic,
theydo not internalize,and neitherdoes anyone else at the lobbyingtable, the
interestsof individualswho directlyor indirectlyhold sharesin existingpublic
firmsand who are not at the table.
The essentialpointis that,in an economywithexistingpublic firms,choices
of investorprotectionlevels affectnot only the allocation of cash flowsfrom
thecapital to be raised frompublic investorsin thefuturebutalso theallocation
of rentsfromthe capital that public firmsalready have (Bebchuk and Roe
1999). When those lobbyingon behalfof insidersand outside shareholdersdo
notfullyinternalizethecosts and benefitsof theirchoices on outside investors,
the fightover these rentsproduces suboptimalinvestorprotectionlevels even
in thepresence of entrepreneurs lobbyingforefficientrules.
The insightsgeneratedby the Bebchuk and Neeman (2009) model comple-
ments those developed by Rajan and Zingales (2003, 2004) and Perottiand
Volpin (2008), who argue thatincumbentfirmsseekingto retainmarketpower
lobby forweak investorprotectionthatwould make it difficultforotherfirms
to raise capital to enter.Bebchuk and Neeman focus on anotherconflictamong
interestgroups- the strugglebetween public firms'corporateinsiders,who
seek to extractrentfromthe capital under theircontrol,and the outside in-
vestorswho providedthemwithcapital.5
One importantpatternestablishedby theevidence is thepositivecorrelation
betweenhigh levels of investorprotectionand good economic outcomes such
as well-developed stock marketsand higherlevels of economic growth(e.g.,
5 Note thatboth the Bebchukand Neeman (2009) and the
Rajan, Zingales,Perotti,and Volpin line of
workfocuson lobbyingby interestgroups,in contrastto earlierworkthathas focusedon how investor
protectionis shapedby thecitizens'votingdecisionsand thepreferences of themedianvoter(Pagano and
Volpin2005a, b; Perottiand vonThadden2006). Bebchukand Neemanarguethat,in theordinary courseof
events,mostcorporate issuesare intensely followedby theinterestgroupswithsufficientstakeand expertise
butare notsufficiently
understood and salientto mostcitizens.Buttheyrecognizethattheordinaryproinsider
operationofinterest
grouppoliticscan sometimes be interrupted reforms
byproinvestor resultingfromcorporate
scandalsor a stockmarket crashthatmakesvotersmoreattentive to corporate
governance problems,and they
allowforthispossibility
in theirmodel.

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 TheStateofCorporateGovernance
Research

La Portaet al. 1998,2002; La Porta,Lopez-de-Silanes,and Shleifer1999).

One possibleinterpretation of thiscorrelationis thathigherlevelsof investor
protectionbringaboutsuchgood economicoutcomes.The resultsgenerated
bytheBebchukandNeeman(2009) modelindicate, however, thatsomeofthe
causalitymaygo in theoppositedirection: a highlevelof investor protection
maybe, at leastpartly, theproduct- rather thanthecause- ofhigheconomic
growth,a developedstockmarket, oran advanced-stage economy.
The modelprovidespredictions relatingdifferences in investorprotection
(bothovertimeand aroundtheworld)to thestructure of politicaland legal
decisionmaking, thedevelopmental stageoftheeconomy, thecorporate struc-
turesdominant in theeconomy,as well as to scandalwavesand stockmarket
crashes.Whilesome of theseresultscan help explainpatterns identifiedby
a numberof existingempiricalstudies,it also providesnewpredictions that
futureempiricalworkmayseekto test.
More generally, to improvetheunderstanding of existinggovernancear-
rangements and how they could be it is
improved, important forfuture work
totakeintoaccountandstudyhowsucharrangements areinfluenced by inter-
estgrouppoliticsandhowitcan impedegovernance reforms. The framework
offeredbytheBebchukand Neeman(2009) modelmightbe helpfulforsuch
work.

8. Conclusion
ThisissueofTheReviewofFinancialStudiescontainssevenarticlesthatwere
presentedin a meetingof theNBER's corporate governance project.Each of
thearticlesmakesa significantcontribution
to an importantarea of corporate
governance. For each of theseareas,we discussits importance and current
stateof research,how thearticlein thisspecial issue makesa contribution,
and some of theworkthatremainsto be done. We hope thatthearticlesin
thespecialissue,and theadditionalworkthatwill follow,will advanceour
understanding abouttheseimportantareas.

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