SUMMARY

As in the article Corporate governance and equity prices by Paul Gompers, Joy Ishii and
Andrew Metric. The rights of shareholders vary across the firm. They used 24 unique
provisions to construct their article. In that they proved that firms which have stronger rights
of shareholders had outperformed with the firms which doesn’t value the rights of
shareholders. They built models to examine the relationship between the shareholders’ right
and the company performance and proposed 3 hypotheses, following with some evidence to
support them.

The authors created a “Governance Index” to represent the extent of shareholder’s right. For
each presence of the provision in the company which can limit the right of shareholders, they
simply added one point in that case to build the index. However, for the Cumulative Voting
and Secret Ballots provisions, they added one point when these provisions do not appear in
the firm. Therefore, the sum of one point makes up the Governance Index (G). If the value of
G is greater than or equal to 14, the companies will be included in “Dictatorship Portfolio”,
while “Democracy Portfolios” consists of the firms with the lowest value of G. The
dictatorship means the managers are more powerful and shareholders’ right is more limited.
The democracy is the opposite.

They selected the data of 24 provisions for about 1500 companies from the publications of
the Investor Responsibility Research Center during the period from September 1990 to
December 1999, while screening out the companies which issued dual-class common stock.
The provisions were divided into five groups: Delay, Voting, Protection, Other, and State,
which construct the subindices. Then they examined how G and subindices are related to
company characters such as book-to-market ratio, firm size, Tobin Q etc. The descriptive
statistics aim to provide a background of the following research.

They also chose the top ten companies with the largest capitalization in the Democracy and
Dictatorship Portfolios as extreme groups. Based on the two extreme portfolios, they built a
regression model with abnormal return as dependent variable and four independent variables
which indicate risk, firm size, BM and momentum. In the model, the intercept “alpha”
explains the excess return of the company. The regression results show that alpha of the
Dictatorship Portfolio is negative and significant, while the democracy portfolio earns a
positive and significant return.
Next, they conducted another model to find the relationship between Tobin Q that represents
the value of the firm and G. The result indicates that the relationship between Q and G is
significantly negative in nine years from 1990 to 1999. Generally, both results show that the
more democratic company outperform the dictatorial company.

Because there is no causality between governance provisions and operating performance,

they constructed three hypotheses to explain the empirical results. In first hypothesis they
discussed about how week shareholder rights attracted huge costs. A discount in share-holder
rights causes associate degree unexpectedly massive increase in agency costs through some
combination of inefficient investment, concentrated operational potency, or self-dealing. If
shareholders find it troublesome or expensive to exchange managers, then managers might be
more willing and ready to do things from which they’ll get personal not gains. This is the
standard justification for takeover threats because the strongest form of social control
discipline.

Turning to II hypotheses, governance will not influence performance. However, there should
be a perception that governance provisions are actually made for protecting management.
During this case, the stock in these corporations would are comparatively overvalued in 1990.
once the poor operational performance happens, the market is shocked. However, the
managers don't seem to be. The protecting provisions then offer a protect, real or fanciful, for
social control jobs and compensation. On other hand, if governance provisions were place in
place by discerning managers, these same managers may well be internet sellers of the stock
in their companies.

In III hypothesis, institutional possession, or alternative firm characteristics can be related

each with Governance and with abnormal returns. Governance provisions can be totally safe,
with no influence either on social control power or on agency prices.