Home -> Law Blog Directory -> Corporate Governance Blogs -> The Harvard Law School Corporate Governance Blog

Corporate Governance

: The Harvard Law School Corporate Governance Blog

Does corporate governance matter in competitive industries?

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes from Xavier Giroud and Holger M. Mueller of New York University.)

We examine whether corporate governance has a different effect on a firm?s operating performance in competitive and non-competitive industries in our forthcoming Journal of Financial Economics paper entitled Does corporate governance matter in competitive industries? We use exogenous variation in corporate governance in the form of 30 business combination (BC) laws passed between 1985 and 1991 on a state-by-state basis to address this question. By reducing the fear of a hostile takeover, these laws weaken corporate governance and increase the opportunity for managerial slack. Typically, BC laws impose a moratorium on certain kinds of transactions, including mergers and asset sales, between a large shareholder and the firm for a period ranging from three to five years after the shareholder?s stake has passed a prespecified threshold. This moratorium hinders corporate raiders from gaining access to the target firm?s assets for the purpose of paying down acquisition debt, thus making hostile takeovers more difficult and often impossible.

We obtain three main results. First, consistent with the notion that BC laws create more opportunity for managerial slack, we find that firms? return on assets (ROA) drops by 0.6 percentage points on average after the laws? passage. Second, the drop in ROA becomes increasingly stronger the less competitive the industry is. For example, ROA drops by only 0.1 percentage points in the lowest Herfindahl quintile but by 1.5 percentage points in the highest Herfindahl quintile. Third, the effect is close to zero and statistically insignificant in highly competitive industries. This last finding, in particular, is supportive of the view expressed by many economists, going back to Sir John Hicks in the 1930s and even Adam Smith, that competition in the product market mitigates managerial slack.

Besides showing that competition mitigates managerial agency problems, we also examine which agency problem competition mitigates. We find no evidence for empire building: Capital expenditures are unaffected by the passage of the BC laws. By contrast, input costs, wages, and overhead costs all increase after the passage of the BC laws, and only so in non-competitive industries. Overall, our findings are consistent with a ?quiet-life? hypothesis whereby managers insulated from hostile takeovers and competitive pressure seek to avoid cognitively difficult activities, such as haggling with input suppliers, labor unions, and organizational units demanding bigger overhead budgets. We also conduct event studies around the dates of the first newspaper reports about the BC laws and compute CARs separately for low- and high Herfindahl portfolios. We find that the average CAR for the low-Herfindahl portfolio is small and insignificant, whereas the average CAR for the high-Herfindahl portfolio is ?0.54% and significant.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on June 05, 2009 (boomark / email).