Irrelevance of Governance Structure

The central theme in corporate governance is that allocating more control rights to shareholders will allow them to hold disloyal managers accountable and reduce agency costs. The common empirical prediction that follows is that a “weak governance structure” will be associated with “weak firm value and performance” due to high agency costs. However, a review of empirical studies of the last forty years reveals that every aspect of corporate governance that was studied yielded conflicting empirical findings as to its effect on firm value and performance. For instance: the level of cash flow rights held by management; dual-class firms; anti-takeover defenses, such as poison pills, staggered boards, and protective state legislations; hedge-fund activism; and the strength of corporate governance as measured by several indices.  

Interestingly, despite the inconclusive empirical evidence, institutional investors with common ownership are consistently pushing toward strong governance structure for publicly traded firms, via, for instance, destaggering boards, limiting the use of poison pills, excluding dual-class firms from the indices, demanding mandatory sunsets for dual-class firms, and supporting hedge funds’ governance initiatives.

What explain the conflicting empirical findings in the studies of corporate governance? And why, given the inconclusive empirical findings, institutional investors with common ownership are consistently pushing toward strong governance structures in public firms?

To answer these questions, we develop a model in which, a priori, corporate governance can either increase or decrease firm value. Our main result shows that in a competitive equilibrium corporate governance is irrelevant to firm value. Importantly, different from the “no transaction costs” model of Modigliani and Miller (1958), the irrelevance result in our model does not arise because there is “no conflict” between shareholders and managers. It is trivial that without a conflict the allocation of control rights is irrelevant, as the manager will always resign to make room for a better manger. Indeed, for long it was assumed that with conflict (i.e., “agency costs”) governance structure is relevant. Instead, following the spirit of Miller (1977), who shows that capital structure remains irrelevant even with taxes, we show that governance structure is irrelevant even with agency costs. Our model allows us to identify the conditions under which corporate governance is relevant, thereby informing the design of future empirical studies and explaining institutional investors' strong-governance-strategy and the anti-competitive consequences of common ownership.