Does Corporate Governance Matter?

After the collapse of Bear Stearns, Countrywide, Lehman Brothers, GM and AIG(AIG Quote) last year, and with Citigroup(C Quote) and Bank of America (BAC Quote) greatly diminished in stature, corporate governance has once again become a popular topic in government, the mainstream business press and on corporate boards.

Although most people intuitively think that it's a good thing for the performance of a company and its own risk management to have a strong and independent board of directors overseeing it, last year a group of Stanford professors published a working paper in which they questioned this basic assumption.

The professors examined the three largest firms that assign governance ratings each year for American public companies: RiskMetrics(RMG Quote), GovernanceMetrics International and The Corporate Library -- and concluded that none was correlated with better current performance, and few of the ratings predicted better future company performance.

Some corporate governance critics pointed to the paper's results as demonstrating their deeply held view that corporate governance is a crock and has no bearing on whether a company will have better or worse financial performance in the future.

Before we collectively toss aside the notion that the quality of corporate governance impacts a company's performance and risk management, let's examine the facts around the professors' research:

• This is still a "working paper" and is not yet published in a peer-reviewed journal, suggesting there are still kinks being worked out in the research.
• They found that none of the governance ratings firms' ratings were linked to how a company was currently performing. Yet, if you're thinking of making an investment in a company or writing a D&O insurance policy or making a commercial loan, you have no interest in this type of correlation; you only want to know if there's a link between today's governance structure and future performance.
• They found that The Corporate Library's governance scores predicted a company's future operating performance and future earnings' multiples. Unfortunately, the metrics they used to find this relationship are common in the academic world (e.g., Tobin's Q) but almost never used by investors, banks, or insurance companies.

So, even with several problems, the study did still find that better corporate governance led to better future financial and stock performance. However, the study still raises the question of, if this link exists, why hasn't corporate governance become more widely used by investors as a variable to consider when making investment decisions?