Corporate governance and performance: An indexing approach using the

stochastic frontier analysis

Wided KHIARI ∗
Institut supérieur de gestion de Tunis
E-mail : khiariwided@yahoo.fr

Adel KARAA
Institut supérieur de gestion de Tunis - LIGUE
E-mail : adel.karaa@isg.rnu.tn

Abdelwahed OMRI
Institut supérieur de gestion de Tunis
Unité de recherche - Finance et Stratégies des affaires
E-mail : abomri@yahoo.fr

∗
address : Institut supé rieur de gestion de Tunis, 45, rue de la liberté , cité Bouchoucha, 2000 Bardo, Tunisie. E-
Mail address : khiariwided@yahoo.fr. Tel: 98 58 66 39.

1
 Abstract

In this paper, we study the association between firms’ specific characteristics and
performance for a sample of 320 American firms using a governance efficiency index,
calculated by the Stochastic Frontier Analysis.

The use of a latent classes in the specification of the model, allowed to detect two groups
of firms according to their specific characteristics as: the firm size, the leverage, the dividend
yield and the return on equity (ROE). The results of affectation equation show that the
probability to be in the second group (the most perform) is more important when the firm
size, the dividend yield and the ROE are high, while a high leverage level decreases the
chance to be in the first group (the less perform).

Keywords : governance index, managerial efficiency, performance, corporate governance

mechanisms.

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Corporate governance and performance: An indexing approach using the
stochastic frontier analysis

I. Introduction

Promoted by corporate scandals such as Enron and WorldCom in the United States
(U.S.); France Telecom and Vivendi Universal (France), the Credit Lyonnais or Air
France in 1990; the financial crises of 1998 occurred in Russia and Brazil, corporate
governance has received a lot of attention in the Financial community. Institutional investors
have started evaluating which role corporate governance should play in their investment
policies. The important question whether good corporate governance leads to higher stock
returns and consequently to higher Firm valuations has received limited
attention in the academic literature.

While the revival interest to the corporate governance is recent, the basic problem is
classic. The principal problem is the same in all modern economies and arises when firms’
owners delegate the management to other executives’ directors. In this case, there is a change
in governance value perception, which become a legitimate means allowing the long-term
performance.

A literature review allows to take a census of many works studying the relation
between corporate governance and performance. Most of them examine the individual impact
of every mechanism on performance like the board of directors, its composition, the
managers’ compensation, the ownership structure, the shareholders activism and takeovers
mechanisms. Nevertheless, results seem to be mitigated as the impact of certain mechanisms
differs from one study to another. Besides, those studies don’ t provide an idea on the
interaction between mechanisms. This can be attributed to the concentration on a particular
governance aspect. Consequently, many authors resort to an indicial approach to study the
relation between corporate governance and performance. Firms’ classification according to
this index allows to distinguish firms according to their governance quality.

This study contributes to the literature related to the corporate governance quality as it
takes into account the interaction between different governance mechanisms and integrates
the performance as a concept which has an effect on the governance quality and so on the
managerial efficiency. It takes into account critics addressed to the score computation using
an approach based on the efficiency scores, the stochastic frontier analysis, in order to
calculate governance indexes reflecting the efficiency of the latter. The idea that we try to
exploit, from the model adopted to compute the indexes, is that firms’ specific characteristics
can influence, with governance characteristics, firms’ performance.

The work is divided in two parts. In the first, we present, some studies that used
governance scores to test the relation between corporate governance and performance and
specifically those working with efficiency measures, as well different critics that was
addressed to the governance quantification.

In the second part, we present the statistic model adopted in the gait (approach), as
well as different results obtained.

3
II. Corporate governance quantification inadequacy
Many organisations have been interested to search for governance standards that can
militate in favour of an effective working of boards of directors and their specialised
committees, respect of investors rights, improvement of information disclosure, etc.
Consequently, a firm is considered as well governed if it respects these standards. Contrarily,
its governance doesn’ t take into account enough actors interests in the midst of the firm
(Standard & Poor, 2002). For example, the Security Stock Exchange Commission asks for
more reflections on firms’ financial information and the control exerted by the board of
directors in order to insure the accounts clarity and reliability. Consequently, the New York
Stock Exchange (NYSE) draws up, in 2000, a report (Blue Ribbon Committee on Improving
the Effectiveness of Corporate Audit Committees) implementing some recommendations in
order to reinforce audit committees independence. In 2002, the New York Stock Exchange
published a second report fixing governance principles that may be respected by firms. This
report insists on the fact that firms listed in New York Stock Exchange must have, first of all,
boards of directors, nomination and compensation committees where the majority of members
are independent. In addition, audit committees’ members don’ t have to receive other fees
relative to others activities they exerted in the midst of the firm. Also, the manager has to
certify, every year, that he is not noticed and he doesn’ t know about standards violations by
the New York Stock Exchange. This engagement of the manager is a mean to insure that
firms respect standards fixed by the NYSE.

In this strand, some studies show that there are many governance structures that
respect codes of best practices. Consequently, the latter can be synthesized through indexes
reflecting these practices, and put into the disposition of the public, by many organisms, in
order to guarantee a good quality of governance, satisfy investors needs and protect them
from managers manoeuvres.

The Credit Lyonnais Securities Asia (2001) was among organizations having
calculated a governance score. The latter was established for 495 firms from 25 emergent
markets and 18 sectors. The computation is based on 57 binary questions relative to
information transparency, managers’ discipline, audit comity responsibility and boards of
directors working and structure. Noting that 70% of these questions are objectives while the
others necessitate an interpretation of the analyst. Also, this organism selects large firms that
attract institutional investors in order to evaluate their governance. Nevertheless, many studies
( Durnev and Kim, 2003) show that there was a selectivity bias in the CLSA index
computation.

In 2002, Standard & Poor developed an index based on transparency and good
information disclosure. Standard &Poor (2002) supposed that the governance quality could be
studied using ownership structure and its concentration, kind of relations between different
actors, transparency, information disclosure and board of directors’ structure. This index was
computed using a scale from 1 to 10. An index equal to 1 is attributed to firms whose
governance doesn’ t take into account enough actors interest in the midst of the firm, while an
index equal to 10 is attributed to firms whose governance practices are the best.

Recently, the Institutional Shareholders Service (ISS) developed in 2003 a governance

index using 61 variables relative to the board of directors, manager compensation, ownership
structure, poison pills, capital structure and others qualitative factors like meetings of outside
administrators, the administrators retirement’ s age, etc.

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 In the same framework, many authors have tried to quantify the governance using a
score, in order to test the relation between corporate governance and firm performance
(Durnev and Kim, 2003 using CLSA’ s index, 2001 and S&P, 2002). However, many critics
were addressed to the index computation. The classification of firms according to this index
allows to distinguish companies according to governance quality. Nevertheless, this method
calls for recommendations of corporate governance best practices, the flaw resides in the
choice of governance mechanisms forming the score. Virtually all previous studies
concentrated on specific aspects of governance, such as takeover defences (Gompers et al.,
2003), executive compensation (Loderer and Martin, 1997), blockholdings (Demsetz and
Lehn, 1985), board size (Yermack, 1996) or board composition (Hermalin and Weisbach,
1991 and Bhagat and Black, 2002). Nevertheless, it seems crucial to account for the fact that
all these control mechanisms can be adopted alternatively and possibly substituted for each
other to some extent. So, many studies admitted the simultaneity of several governance
mechanisms, suggesting that the use of a particular mechanism is not feasible or efficient.
That is why many authors calculated governance scores using several criteria like
transparency and information disclosure (Black, 2001; Black and al., 2003 and Drobetz and
al., 2003), board of directors’ practices and particular meetings, duality and presence of
outsiders (Black and al., 2003 and Drobetz and al., 2003) and the ownership structure (Black,
2001 and Black and al., 2003). Nevertheless, every study is distinguished from other by
incorporating a specific governance element. For example Black and al., (2003), Drobetz and
al., (2003) incorporated the audit comity as a specific element to their studies. Black (2001)
considered other elements relative to the fusion-acquisition, the bankruptcy risk, the existence
of foreign shareholders and the relation kin between managers and shareholders.

Black (2001) examines the relationship between corporate governance and valuation
for a sample of 21 Russian firms. He constructs firm specific corporate governance ranking
and shows that a one standard deviation change in the governance ranking predicts a seven-
fold increase in firm value. Black (2001) finds a strong correlation between governance and
share prices for Russian firms. However, his sample is very small, and it is unclear whether
these results can be generalized beyond Russia, with its extremely weak country-level
governance.

Durnev and Kim (2003) and Klapper and Love (2003), focus on the factors that
predict corporate governance in emerging markets, and also address briefly whether
governance choices predict firms' market value. Durnev and Kim (2003) find that higher
scores, on both the CLSA corporate governance index and the S&P disclosure index, predict
higher Tobin's q for a sample of 859 large firms in 27 countries. However, they use limited
control variables, their results are barely significant (p values in OLS of 0.04 to 0.06
depending on the governance index), and they do not conduct robustness checks with other
firm value variables or alternate definitions of the governance index. Also, the CLSA and
S&P indices have important limitations. The CLSA index is based in significant part on
analysts' subjective views, which could be biased on their knowledge of stock returns. part on
analysts' subjective views, which could be biased on their knowledge of stock returns. The
S&P index is limited to disclosure, which correlates with other aspects of corporate
governance. This creates an omitted variable problem -- results for a disclosure index will
partly reflect the effect of other, correlated but omitted, elements of overall governance
(Black, 2001)

Notice that the governance scores computation shows that firms with high scores have
high performance. However, those results were criticized by many authors like Klapper and
Love (2002). According to them the stock return used in the CLSA (2001) have limits. The

5
first is linked to the important returns volatility in the emergent market during the latest years
and especially in Asia. The second limit concerns markets inefficiency. Indeed, firms with
low governance scores realise a return which is less important that in the other firms. This can
be explained by market inefficiency rather than the risk due to inadequate governance
practices; so this supplement risk should be remunerated on form of a more important return.
This conclusion was affirmed by many researchers who have developed their own indexes
(Black, 2001 ; Alves an Mendes, 2002 ; Camops and al., 2002 ; Black and al., 2003 ; Bai and
al., 2003 ; Drobetz and al., 2003 ; Mohanty, 2003).

While the index construction takes account the whole governance practices, these
studies bumps into certain conceptual limits. Indeed, we remark, from the literature review,
that the index supposes generally that the different governance components contribute in the
same way in the governance quality improvement. In addition, there is a big divergence
concerning variables used to calculate the governance score.

Because of these limits, many others have tried to adopt new approaches based on
efficiency measures in order to calculate governance indexes.

III. Efficiency measures’ contributions in the governance quantification

The empiric work of Farrell (1957) was the first attempt to measure the efficiency
empirically, and its principal contribution was that the technique efficiency could be analysed
in terms of deviation from idealised frontier efficiency. After a decade, Leibenstein (1966) has
introduced officially the concept of production efficiency. He particularly deals with the fact
that firms can deviate from the optimal efficiency frontier after information, a motivation, a
control or agency problems.

Efficiency scores allow including many inputs and outputs, so they offer synthetic
performance measures. Compared to all other performance measures, efficiency scores
present the advantage of relative scores which take into account direct comparisons with the
best firms.

This efficiency approach focuses the attention on internal management quality and
strategic choices quality. We can consider that it measures the managerial efficiency. It forms
also a “benchmarking” tool since the frontier allows to identify efficient firms which have the
“best practices”, and so can serve as a reference to others. Also, It allows firms to identify the
possible means to access to “best practices”, which lead to a better performance.

To estimate efficiency scores, we use the stochastic frontier analysis (Aigner and al.,
1977) which is frequently appliquated in the bank sector (Berger and Humphrey, 199) and
also in other industries (Lovell, 1993). Compared to other alternative techniques using
efficiency scores on one year, the Data Envelopment Analysis (DEA), this approach present
the advantage to disentangle efficiency and a statistic noise taking account the exogenous
events in the residue (the distance from the efficiency frontier). Also, it allows to control
easier industry specific variables in the efficiency frontier estimation, which is essential to
offer efficiency measures relatively homogenous.

In this strand, El Mir and Khanchel have tried to identify efficient governance using
ownership structure and the efficiency of the control exerted by the board of director. Based
on a sample of 331 American listed firms from 994-2001 for which they collected information
relative to financial and governance characteristics, they synthesize governance practices by

6
an index computed according to a non parametric method, the Data envelopment analysis,
which allows to take account of the relation (linear or not, endogenous or exogenous) between
inputs (control system) and outputs (performance). This method is based on recommendations
provided by codes of best practices and those provided by certain organization in order to
determine a “good governance”. Indeed, the primary object of codes of best practice is the
improvement of management and control quality, which lead to the improvement of firms
performance level. Given that the final aim is the firm performance, authors used the latter to
reach the same objective as previous studies: identify a “good governance” and try to look for
its characteristics. They show that the majority of firms are efficient. Adding that they were
able to provide evidence on the sensibility of efficient governance to best practices using the
means comparison test. In addition, they identified correspondences between governance
efficiency degree and financial characteristics. Finally, they established a decision rule
allowing firms to know about their governance system reliability.

Also, Bottasso and Sembenelli (2002) provide empirical evidence on the relation
between the identity of ultimate owners and technical (in)efficiency by estimating stochastic
production frontiers on Italian firm level panel data for twelve manufacturing industries over
the 1978-93 period. Privately-owned independent firms are used as reference group and their
efficiency is assessed against three alternative forms of ownership: subsidiaries of (privately
owned) national business groups, subsidiaries of foreign multinationals, and state owned
firms. Even if cross-industry differences obviously exist a common pattern can however be
identified. Overall, subsidiaries of foreign multinationals (state owned firms) are found to be
more (less) efficient than the reference group. On the contrary, no systematic difference is
found between independent firms and subsidiaries of national business groups.

IV. Firms distinction according to their specific characteristics using the

stochastic frontier analysis
In this part, we are trying to appreciate, empirically, governance practices of a sample
of American firms using an index, which will be considered as a governance index. The latter
is an efficiency score, calculated according to the stochastic frontier analysis which express,
for every firm, the distance that separate it from a frontier reflecting corporate governance
“best practices”. The idea we try to exploit, from the model adopted in the indexes
computation, is that firms specific characteristics can influence, with governance
characteristics, firms performance.

IV. 1. Sample characteristics

The study explores a sample of 320 large Americans firms (belonging to Frotune 500)
for a period of 8 years from 1994 to 2001. The accounting data and those related to
governance variables were collected from the site www.edgarscan.com. The stock data was
extracted from the site www.yahoofinances.com.

Firms belong to eleven different sectors. Indeed, 17.5% of them belong to service
sector, 17.18% to the production sector, 15.62% to roughly and detailed sales, 12.5% to
consumption service, 10.625% to technology sector, 6.25% to energy sector and the rest is
constituted by firms belonging to financial sector, health, paper and publication, chemistry
and transport.

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 IV. 2. Variables used in the analysis

At this stage, we tried to list different variables to incorporate in the model: these are
relative to performance, used as dependent variable, and to corporate governance. The latter is
approached by a set of variables relative to ownership structure, board of director structure
and audit committee structure. The measures adopted for these variables and for control
variables are indicated in annexe I.

A literature review shows that the majority of previous works concentrated on a

unique corporate governance aspect, like managerial ownership level, ownership structure or
board of director structure. As for us, we concentrate on the interdependence between these
mechanisms.

The Non Linear Factorial Analysis (NLFA) appears, in our case, as an appropriate
method. Indeed, it provides us with the description of the whole firms governance practices,
according to the set of governance variables kept. From a statistic plan, the fact of keeping
factorial axes rather than initial variables allows us to avoid problems of multicolinearity.

Factorial axes construction rest on significant association between initial variables

modalities and factorial components. In the interpretation of every axe, we consider only
associations between initial modalities which are highly correlated to it. On a practical plan,
we keep in every axe variables where correlations between them are greater than 0.4.

The exam of correlation coefficients value between initial variables and factorial axes
bring out six axes: inside control efficiency, managerial discretion, ownership concentration,
dominance of the board by the CEO, manager entrenchment and inside financial control
efficiency (Annexe I).

IV. 3. Model Presentation

The construction of the model used in this study is based essentially on works of
Green (1990) and Orea et Kumbhakar (2003).

The model proposed is presented as follows:

qit = αt It +ϑ + β'xit +ε it ; i =1,2,..., N et t =1,2,...,Ti

With :

ε it = vit − u i ; ui ≥ 0 ; (1.1)
vit → N(0, σ v) ;

f(ui) = Θ u iλ -1 exp{- Θ u i } , u i ≥0, Θ >0 et λ > 0

λ
u i → GAMMA(λ, Θ)
Γ(λ )
;
ϑ → dF(ϑ) ;

And :
• q it, Tobin Q level of the firm i during the year t ;
• xit, explicative variables vector associating governance characteristics of the firm i
during the year t ;

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 • It, indicator variable of the year t ;
• ϑ, non observable inter-firm heterogeneity capturing random effects specific to firms;
• αt et β, vectors of parameters to estimate ;
• vit, symmetric error component ;
• εit, composite error ;
• u i, asymmetric error component which measures managerial inefficiency. It reflects
the gap between the Tobin Q observed (q it) and the maximum value which can be
reached once we situate on the efficiency frontier ( αt It +ϑ + β' xit + vit ). It follows a
semi-normal distribution (the absolute value of a normal distribution( µi, σµ2)).

Following Green (1990), we establish the conditional density function εit knowing ϑ
as follows :


f (ε it(ϑ )) = Θ expΘ ε it(ϑ )+
λ
(Θσ v )2  +∞ 1 x λ-1exp− x + εit(ϑ )+Θσ v2 ( ) dx
2

Γ(λ ) 2 ∫0 σ v 2π  (1.2)

2σ v
2
  

We kept, in the model, the variable in order to control the heterogeneity of

observations in their individual dimensions. Indeed, it refers to non observable inter-firms
heterogeneity factors able to influence firm performance process. These factors correspond to
firms specifics characteristics (firm size, leverage, dividend yield, etc). Moreover, the model
structure shows a temporal dimension, expressed in (1.1) by αtIt, which reflects the dynamic
of firms performance process of the sample during the time.

Like green (1990), we propose that is distributed according a discreet probability

function which is define on a set of points m, vk ; k=1,2,…,m. We make the random process
which generate these different points depending on certain firms specific observable
characteristics, like firm size, leverage level, return on equity (ROE) and dividend yield.

Formally, we write:

( )
Pit ϑk =
(
exp γ Zit
k
) ; k = 1, 2, ... , m-1 et ( )
Pit ϑm = 1 (1.3)
( ) ( )
m −1 m −1
1+∑exp γ Zit j
1+∑exp γ j Zit
j =1 j =1

With :

Zit, variables vectors associated to observable characteristics (others than governance

variables) of the firm i during the year t ;
γ k ; k = 1, 2, …, m-1, estimated parameters.

In order to estimate different parameters of the model, we write the likelihood function as
follow:

( )
N Tim 
()
L β, α t, γ, λ, Θ =∏∏∑ Pit ϑ j Θ expΘ ε it ϑ j +
Θσ v
( ) ( ) ∫
2
+∞
1 
λ −1
X exp−
(it j v
( ) ( ))
 X + Θε ϑ + Θσ 2 2  
 
 Γ(λ ) dX 
Θσ v 2π 2σ v
2
 2
  
0
i =1 t =1 j =1
  
(1.4)

9
For identification problems, we pose Θ = 1.

The estimated parameters can be used to compute the conditional posterior class
probabilities. Following the steps outlined in Greene (2002), the posterior class probabilities
can be written like that:

( ) 
( )(
pit ϑ j Θ expΘ ε it ϑ j +
Θσ v ) 
2
+∞  ( ( ) ( ))
 X + Θε ϑ + Θσ 2 2 

∫0
1 λ −1
X exp− it j v

Γ(λ )  2  Θσ v 2π 2σ v
2
  (1.5)
π ( j / i, t )=

( )
m 
( )( )
Pit ϑ j Θ expΘ ε it ϑ j +
Θσ
2
 +∞  ( ( ) ( ))
 X + Θε ϑ + Θσ 2 2 

∑ Γ(λ )
v
∫0
1 λ −
X exp−
1 it j v

 Θσ v π σv
2
 2
j =1 2  2 

This expression shows that the posterior class probabilities depend not only on the
parameters γ of (1.3) but also parameters σv, λ et Θ, the parameters characterizing efficiency
process. This allows us to consider our model as a latent class model, since the process of
groups belonging is governed by a non observable endogenous random.

It’ s clear that the determination of classes depends both on individual characteristics
and firms efficiency level.

Initially, the stochastic frontier classic approach leads to the construction of a unique
stochastic frontier which serves as an efficiency reference to the whole firms sample.
However, the specification used in latent class models leads to estimate as many frontiers as
classes. In those conditions, Orea and Kumbhakar (2003) propose to establish (in)efficiency
level of every firm in this manner:

J
INEF =∑π( j i,t).INEFit (j) (1.6)
j =1

Where π(j/i, t) is the posterior probability to be in the j class for a given firm i, and INEFit(j)
represents (in)efficiency level of the firm i according to governance norms characterizing the
class j.

Formally, INEFit (j ) is presented as follow:

+∞ (
 X + Θε it (ϑ j )+(Θσ v )2 2  )
∫0 Θσ v 2π 1
X λ -1
exp −
 2σ v
2 

( )
INEFit (j ) = (1.7)
+∞  X+ Θεit (ϑ j )+(Θσ v ) 
2 2

∫0 Θσ v1 2π Xλ exp− 2σ v
2 



IV. 4. Results of stochastic frontier model estimation using the likelihood method

To progress, we have estimated the previous model on the whole sample by the
likelihood method. Estimation results are given by the table I:

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 Table I – Results of the efficiency frontier estimation

Estimations Std.Err.
Results relative to governance axes
Constant 2.7643 0.1354***
Inside control efficiency 0.1168 0.0505 **
Managerial discretion -0.1061 0.0484 **
Ownership concentration -0.0588 0.0232 **
Dominance of the board by the CEO -0.0349 0.0421*
Manager entrenchment -0.1209 0.0366***
Inside financial control efficiency 0.2109 0.0508***
Results relative to control variables
Dividend yield -0.9920 0.3276***
Leverage 0.0664 0.0308 **
Return on equity -0.1342 0.0181***
Firm size -0.0373 0.0225*
V 4.0543 0.1097***
Log de vraisemblance -6058.3592

Globally, estimation results show a significant effect of the governance on

performance. The second column of the previous table gives the coefficient relative to the
effect of governance axes on Tobin Q. So, a significant and positive (negative) coefficient
different from zero associate a positive (negative) effect of governance mechanisms on firm
performance.

Indeed, results show a significant and positive effect of inside control efficiency and
inside financial control efficiency on performance. However, we emphasize a significant and
negative impact of managerial discretion, ownership concentration, dominance of the board
by the CEO and manager entrenchment on performance.

The object of the use of a non observable latent class structure in the specification of
the model is to establish many efficiency levels (or efficiency frontiers) for every firm,
according to their specific characteristics. The idea that we try to exploit here is that some
characteristics like size, leverage, dividend yield and return on equity can influence, with
governance characteristics, firms performance.

Model equations in (1.5), (1.6) and (1.7) allow to indicate the belonging to different
groups. Variables introduced in affectation equations have to capture significant effects which
are translated by a difference in governance efficiency between groups.

In the second column of the table I, we find results associated with the groups
affectation. A significant and positive (negative) coefficient shows a tendency to be in the
first group (second group). Noting the importance of the whole variables used: the probability
to be in the second group is all the more important that the size, the dividend yield and the
return on equity are high. However, a high leverage level increases the probability to be in the
first group.

11
 The study of firms specific characteristics shows a positive impact of the size, the
dividend yield and the ROE on the performance. However, the relation is negative between
leverage and performance.

The positive relation between Tobin Q and firm size gives to the latter an important
effect which can affect the performance. Several authors consider that large firms have means
and capacities to invest in most efficient and sophisticated governance systems. They are also
motivated to do it because they want to keep their competitive position and their reputation on
the stock market. In this strand, Short and Keasy (1999) show that firm size affects positively
the performance basing on two effects: potential financing effect and economies of scale.
According to them, the first effect allow large firms, to generate easily inside funds and to
access to these funds from outside sources. So, these firms will have a higher performance
than small firms. The second argument given by these authors stipulate that economies of
scale which accompany the size allows firms to create entry barriers which affect performance
positively. However, Demsetz and Lehn (1985) showed that the size is negatively linked to
the ownership concentration. According to them, capital fraction necessary for an effective
control decreases when firm size increases, which generate a negative relation between firm
size and performance.

The positive relation noted between dividend yield and Tobin Q, on the one hand, and
the ROE and Tobin Q on the other hand joins some previous studies, which consider the
governance as an element contributing to firm performance and also one of American
investors preoccupations. Indeed, the latter are interested firstly in governance systems
deployed in firms before placing their funds in order to insure that their interests are protected
and their wealth won’ t be expropriated. For example, using performance accounting
measures, Core and al., (1999) prove that firms with inefficient governance structure have
more important agency problems, CEO are well compensated and announce less performance.
At this stage, we can join previous studies to affirm that a good governance structure is
associated with a best firm performance.

In fine, we find in the negative relation between leverage and Tobin Q Myers’ (1977)
works. He consider that a high debt level risks to cause high agency costs because of interests
divergence between shareholders and creditors. Indeed, moral hazard problems lead to
negative relation between leverage and performance. That is why Majumdar and Chhibber
(1999) observe a significant and negative relation between leverage and performance.
However, Harris and Raviv (1991) consider debts as a means to decrease agency costs. As
for, Jensen (1986), he considers it as a contractual engagement from the manager in order to
refund cash flows to creditors and so, it’ s a means to resolve free cash flows problems.
According to him, failure risk inherent in debt contract incites the manager of indebted firm to
be more perform and to adopt a better management. In addition, the existence of these
contracts make managers consume little gratifications and become more efficient to avoid the
loss of their controls and their reputations. Consequently, firms which are more indebted are
in a position to be more perform.

These results lead to describe different profiles of firms belonging to each group. The
first group is composed essentially of less perform firms. Indeed, the belonging to the second
group seems to show a better performance, in means, since the corresponding mass point
takes a significant value of 4.0543 which is more than zero, the value of group mass point.

According to these results, we are convinced of the interest in declining many

governance referential, which take into account inter-disparities firms. In other words, it’ s a

12
matter of adapting, for every group, an efficiency measure which takes into account firms’
characteristics that constitute it, in terms of governance and performance.

IV. 5. Index profile

The determination of the frontier represented by the best practices allow to evaluate
corporate governance firms efficiency. It’ s a matter of regress, according the stochastic
frontier analysis logic, performance on governance variables. The proposed Governance index
is an efficiency score which reflects, for every firm, the distance that separate it from an
efficiency frontier expressing corporate governance best practices.

After calculating efficiency score, we obtain the following results:

Table II – Governance indexes

Number of Means Standard

efficient deviation
firms
1994 45 10.22 0.50
1995 52 10.24 0.52
1996 42 10.28 0.53
1997 36 10.28 0.52
1998 41 10.30 0.52
1999 27 10.34 0.48
2000 11 10.49 0.48
2001 11 10.51 0.47

According to this table, we can notice a net increase of the (in)efficiency index during
the time. This increase occurs between 1999 and 2001 and can be explained by spectacular
falls of American large firms. Indeed, most of these bankruptcies are attributed to a
governance systems weakness and precisely to a dangerous management strategy, for
manager benefice and often fraudulent like in Enron and Worldcom.

The brought out index allows us also to operate a disparity between firms according to
governance system quality. In other words, it allows us to identify most perform firms
operating on the market and to classify them in a decreasing order annually. In our case, we
kept perform firms which have an index value lower than tenth percentile. Noting that during
2000 and 2001, the number of efficient firms reaches the lower value (11 firms). However,
this value became maximum in 1995. The efficiency deterioration was followed by a
performance degradation, and consequently by the disappearance of certain firms from the
market. Indeed, we note that only two firms have succeed to keep a high performance level
during the whole period: « Philips Morris » and « Schering Plough Corp ». However, others
were able to keep their performance on seven years, like, « Parker Hannifin » and « General
Electric », and on six years like, « Merck », « Sears », « United Pacific », « Abbott
laboratories », « Bellsouth » and « Merck », « Sears », « United Pacific », « Abbott
laboratoires », « Bellsouth » and « Chubb ».

13
V. Conclusion
The objective of this paper is to study the association between firms specific
characteristics and their performance, using a governance efficiency score computed
according to the stochastic frontier analysis.

From a theoretical point of view, a literature review allows to bring out certain limits
relative to the governance indexes construction. Indeed, we note that the index computed in
the previous studies supposes generally that the different governance components contributed
in the same manner in the improvement of the quality of the latter. In addition, there is a big
divergence concerning variables used to compute governance index.

On the procedure level, this work is a demarcation in relation to previous works

studying corporate governance quality, and particularly the relation between governance and
performance by the fact that it has as object to develop a synthetic index to evaluate corporate
governance firms practices, wedged on performance level achieved by different firms. Index
construction takes as a departure point the idea according to which there exists a real willing
from the firms to conform to the international governance standards and to combine,
consequently governance best practices. Once the index is calculated, it’ s a matter to show
that firms specific characteristics can influence, with governance characteristics, firms
performance.

The use of non observable latent class structure in the model specification aims to
establish many efficiency levels for firms according to their specific characteristics like firm
size, leverage, dividend yield and return on equity (ROE). This structure allows to discern two
groups of firms. Results of equation affectation to different groups show that the probability
to be in the second group (the most perform) is all the more important that the dividend yield,
the firm size and the ROE are high, while a high leverage level seems to increase the
probability to be in the first group (the less perform).

Indexes computation show a net increase of the (in)efficiency index during the time.
This increase occurs between 1999 and 2001 and can be explained by spectacular falls of
American large firms. Indeed, most of these bankruptcies are attributed to a governance
systems weakness and precisely to dangerous management strategy, for favour manager and
often fraudulent like in Enron and Worldcom.

Like all research works, our study is not exempt from some limits. From a
methodological point of view, the sample choice present a selectivity bias. Indeed, our sample
is extracted from Fortune 500, which includes mainly large firms. The latters, present some
particularities in relation to other American firms, which limits our study generalisation. This
study can also be the object of replications in other contexts.

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 Annexe I – Recapitulative Table of variables and axes used in the estimation

Axes Governance Proper Loading

mechanisms value Variables and measures
- board of directors size: Ln(administrators total
number) ; 0.474
- number of independent executives : (independents
members/ total of administrators) ; 0.516
- audit committee size : Ln (auditors total number) ; 0.495
- number of independents in audit committee 0.486
- existence of compensation committee: dummy variable
1 if it exists and 0 if not ; 0.846
Axe 1 Inside control 4.730 - existence of nomination committee : dummy variable,
efficiency 1 if it exists and 0 if not ; 0.846
- nomination committee meetings : Ln(meetings
number/ year) ; 0.860
- compensation committee meetings : ln (meetings
number/ year) ; 0.860
- executive ownership level ; -0.475
- managerial ownership level : % of capital hold by the
CEO. -0.437

- existence of compensation committee: dummy variable

1 if it exists and 0 if not ; 0.417
- CEO in compensation committee : dummy variable , 1
if he belong and 0 if not; 0.520
- existence of nomination committee : dummy variable,
1 if it exists and 0 if not ; 0.417
Axe 2 Managerial 2.935 - CEO in nomination committee : dummy variable, 1 if
discretion he belong and 0 if not ; 0.520
- Executive ownership : 0.411
- Board of directors size ; -0.498
- number of independent executives ; -0.517
- Audit committee size ; -0.567
- Number of independent in audit committee. -0.576

- Ownership of the first majoritaire :% of majoritaire

shareholders holding more than 5% of the capital ; 0.700
Axe 3 Ownership 1.860 - Institutional ownership : % of the capital hold by
concentration institutional. 0.993

- CEO in compensation committee : variable dummy, 1

Axe 4 Dominance of the if he belong and 0 if not; 0.694
board by the CEO 1.669 - - CEO in nomination committee : dummy variable, 1 if
he belong and 0 if not ; 0.694

Manager - CEO tenure : Ln(number of year spent as a manger) ; 0.603

Axe 5 entrenchment 1.445 - CEO ownership : % of capital hold by the CEO. 0.435

- Audit committee meetings : Ln(meetings total

Axe 6 Inside financial 1.239 number/year) ; 0.566
control efficiency - Existence of a charter : dummy variable , 1 if it exists
and 0 if not. 0.722

Control and performance variables

Variables Measures
Tobin Q Market value of liabilities on equity replacement value
Firm size Log of the total equity
Leverage Accounting value of long term debts on total equity.
Dividend yield Market adjusted return for the period of 12 months (Rt – Rm)
ROE Net profit on total equity

17