University of Rochester

William E. Simon Graduate School of

Business Administration


The Bradley Policy Research Center
Financial Research and Policy
Working Paper No.
FR 10-29


September 1, 2010





Corporate Governance Myths: Comments on
Armstrong, Guay, and Weber



James A. Brickley
Simon School, University of Rochester

Jerold L. Zimmerman
Simon School, University of Rochester





This paper can be downloaded from the
Social Science Research Network Electronic Paper Collection:
http://ssrn.com/abstract=1681030
Electronic copy available at: http://ssrn.com/abstract=1681030
Corporate Governance Myths: Comments on Armstrong, Guay, and Weber
*




J ames A. Brickley
J erold L. Zimmerman
William E. Simon Graduate School of Business
University of Rochester





September 21, 2010





ABSTRACT

This paper argues that academics, politicians, and the media have six commonly held but
misguided beliefs about corporate governance. While Armstrong, Guay, and Weber
(2010) discuss some of these misconceptions, a wider recognition that these beliefs are
actually myths is important. They include: (1) a common definition of corporate
governance exists; (2) a useful distinction is internal versus external governance
mechanisms; (3) outside directors perform two separable roles: to advise and monitor
managers; (4) research has identified good and bad governance practices; (5) a
good governance index can be constructed; and (6) corporate governance best
practices can be deduced from peer data.


Keywords: corporate governance, financial accounting, agency costs, contracting, debt
contracts

JEL codes: D21, D23, J 33, K22, L14, L20, M40, M41

*
We thank Chris Armstrong, Michael Graham, Wayne Guay, Thomas Lys, Eben Moulton, Candy Obourn,
Cliff Smith, J oe Weber, and Mark Zupan for comments on earlier drafts.

1
Electronic copy available at: http://ssrn.com/abstract=1681030
Armstrong, Guay and Weber (2010) (AGW) review research on the role of
information and financial reporting in corporate governance and contracting and offer a
number of compelling insights and suggestions for further work. Rather than providing a
detailed review of their paper (most of which we agree with), we focus our remarks on
some key themes (or myths) inherent in AGWs survey and the literature in general.
AGW and the research literature have recognized some of these myths, while
others have received little or no attention. We first describe six myths that pervade much
of the corporate governance research in not just accounting, but also in finance,
economics, and the legal literatures (section 1). In particular, we highlight six commonly
held, but misguided, beliefs that are reflected in this literature, and then offer some
specific comments on AGW (Section 2). Wider recognition that these beliefs are actually
myths is potentially important, not only for academic researchers but also for politicians,
regulators, the media and general public.

1. Six Common Myths about Corporate Governance
Myth 1: General agreement exists on the definition of corporate governance
Corporate governance, is a frequently used term by academics, business
managers, regulators, the media and the general public. Indeed, it is so commonly used
that commentators often fail to define it. For example, various textbooks on corporate
governance do not define the term explicitly, either in their texts or glossaries.
1

Similarly, while some corporate governance researchers define the term, others do not.
AGW (p. 7) view corporate governance as the subset of a firms contracts that help align
the actions and choices of managers with the interests of shareholders (emphasis added).
Other researchers use different definitions. For example, Larcker, Richardson and Tuna
(2007) define the term more generally as the set of mechanisms that influence the
decisions made by managers when there is separation of ownership and control (p 964).
It is important for researchers, as well as others, to recognize there is no general
agreement on the definition of corporate governance and correspondingly to take care in
defining the term. This choice can have important implications both on the direction and
interpretation of the research AGW being a case in point.

1
For example, see Weston, Siu and J ohnson (2001).
2
Electronic copy available at: http://ssrn.com/abstract=1681030
A simple web search reveals many different definitions of corporate governance.
While common definitions focus on the separation of ownership and control at the top of
the corporation, some focus narrowly on the control function of the board of directors,
and others include a wide range of control mechanisms (boards, incentive compensation,
auditors, analysts, credit rating agencies, banks, regulators, courts, media, customers, and
so on). Some commentators take the perspective that the objective of governance is to
maximize shareholder wealth, while others take a broader stakeholder/social perspective.
The choice of definitions is important because it can influence the focus,
structure, and interpretation of the subsequent analysis. For example AGW, who define
the term narrowly, focus their attention in their governance section (section 3) on the
board of directors and executive compensation contracts. While they subsequently
discuss other important contracts, such as debt contracts, except for section 3.2 they do
not stress the governance implications of these contracts on aligning managers and
shareholders interests. In contrast, Larker et al. (2007), who define the term more
broadly, focus not only on the structure of the board and design of compensation
contracts, but also on other governance mechanisms, including active and institutional
investors, debt contracts, and anti-takeover policies.
We think it is useful to employ a broad definition of corporate governance.
Focusing on the separation of ownership and control at the top levels of the corporation is
reasonable. However, limiting attention to just boards and top executives ignores
potential conflicts among various classes of shareholders (see section 4 of AGW).
Separation of ownership and control can also exist among shareholders, since cash flow
and control rights need not be identical. In many corporations, particularly outside the
US and UK, the primary governance problem is controlling incentive conflicts between
inside-majority and outside-minority shareholders (Bebchuk and Weisbach, 2009). Thus,
it is useful to include all three of the firms top-level decision makers in the definition:
shareholders, the board, and key executives.
Corporate law, government regulation, the corporate charter and by-laws, and
corporate policy determine the allocation of decision rights among these three groups
(e.g., consider shareholder voting rights and voting procedures), and thus it is important
to consider the legal/regulatory system, as well as corporate policies, in analyzing how
3
corporations are governed. Moreover, the allocation of decision rights among the
contracting parties varies depending on whether the firm is or is not in financial distress.
To better understand the incentives of the top-level decision makers, one must
look beyond compensation policy and shareholder/board monitoring. Multiple parties
and mechanisms (including, auditors, regulators, credit rating agencies, stock analysts,
courts, the media, monitoring by banks and other creditors, regulation, the markets for
corporate control, product market competition, and corporate policies relating to
takeovers) influence the behavior of the top-level decision makers in the corporation.
Some of these mechanisms are complements, while others are substitutes. To draw
inferences about how top-level decision makers in a particular firm are likely to act in a
particular situation requires a general equilibrium analysis that incorporates all material
contracts.
We find the following very broad definition particularly useful: corporate
governance is the system of laws, regulations, institutions, markets, contracts, and
corporate policies and procedures (such as the internal control system, policy manuals,
and budgets) that direct and influence the actions of the top-level decision makers in the
corporation (shareholders, boards, and executives). Of particular importance in this
system are: 1) the allocation of top-level decision making rights among the three groups,
and the comprehensive set of mechanisms that 2) measure their performance and 3)
provide performance-based rewards and penalties. We refer to these elements as the
firms Top-Level Organizational Architecture (Brickley, Smith and Zimmerman,
2009). The actions of top-level decision makers are a primary determinant of firm value.
This definition focuses attention on these important decision makers, the specific
decisions each is allowed to make, and the comprehensive set of incentives they face in
making these decisions.
Our preferred definition of corporate governance, based on the J ensen and
Meckling view that the firm is the nexus of contracts (also see Coase 1937), includes all
significant formal and informal contracts that affect the behavior of top-level decision
makers, not just those between debt holders and the firm but also between the firm and
4
senior managers.
2
The definition incorporates all potential conflicts of interest including
those between the firm and its customers and between the firm and its suppliers and
employees. While empirically challenging to observe all of the firms contracts (and
other control mechanisms), our definition of corporate governance draws attention to the
potential correlated omitted variables problem inherent in all studies that just focus on a
narrower set of agency conflicts. Stated differently, most studies test hypotheses with
very strong ceteris paribus assumptions. Unless the researcher can observe and hence
take into account the other contracts (both formal and informal) and other mechanisms
described above that affect the behavior of the top-level decision makers, then it is likely
that biased coefficients and incorrect inferences result.

Myth 2: A useful distinction is internal versus external governance
mechanisms
AGW separate the analysis of corporate governance (i.e., corporate boards,
corporate governance, and majority versus minority shareholders) from the outside
agency costs of debt.
3
This approach, common in the literature (e.g., Chew and Gillian,
2005), bifurcates so-called internal governance mechanisms (boards and incentive
compensation) from external governance mechanisms (auditors, security analysts,
regulators, etc.). We have used similar classifications in some of our writings (see
Brickley, Smith, and Zimmerman, 2009).
J ensen and Meckling (1976) in their classic paper warn against this type of
internal versus external distinction. They define the firm as a nexus for a set of
contracting relationships among individuals with conflicting objectives. This perspective
suggests that the behavior of the firm is similar to that of a market the outcome of a
complex equilibrium process (p. 311). As J ensen and Meckling argue, viewed this
way, it makes little sense to try to distinguish those things that are inside the firm from

2
While all contracts potentially can affect the behavior of key decision makers, some are clearly more
important than others. For example, small lease contracts and compensation contracts for rank-and-file
employees unlikely affect the decision-making authority and incentives of shareholders, the board, and top-
level executives.
3
In the Abstract, AGW state, We review recent literature on the role of financial reporting and
information transparency in reducing governance-related agency conflicts between managers, directors and
shareholders, as well as in reducing agency conflicts between shareholders and outside contracting parties,
such as creditors. (Emphasis added.)
5
those things that are outside it (p. 311). For example, in what sense is a contract with
an outside director (often classified as within the firm), different from a contract with an
auditor or creditor (often classified as outside the firm)? Rather than focusing on this
artificial distinction, it is likely to be more productive to focus on the important questions
of why the particular set of contracts arose, the corresponding consequences, and how
exogenous changes (such as tax law revisions, a change in government regulation, or an
unsolicited takeover bid) might affect the organization.
4
An important concern about classifying contracts, as either inside or outside, is
that it tends to divert attention away from potentially important and complex interactions
among the set of key contracts that comprise the firm. For example, AGWs have largely
separate analyses of internal (corporate governance) and external (debt) contracts
(see section 2 below for additional discussion regarding AGWs separate analyses of
corporate governance and debt contracts). Corporate debt, however, is a potentially
important mechanism for mitigating a firms free-cash-flow problem (as AGW briefly
note) and introduces an additional set of monitors (e.g., banks, other private lenders, and
credit rating agencies). The optimal board structure and compensation contracts are
unlikely to be independent of these effects. Separating the analysis into shareholder-
versus-manager and shareholder-versus-bondholder agency problems deemphasizes the
interdependent nature of contractual choice (Begley and Feltham, 1999 and Morellec,
2004).

Myth 3: Outside directors serve the interests of shareholders by performing two
distinct and separate roles: to advise and to monitor managers
a. Common View
As AGW state, A large theoretical and empirical literature examines the role of
boards in serving two broad functions: 1) advising senior management, and; 2)

4
This conclusion focuses on the classification of contracts as either internal or external to the firm. For
some other purposes this classification might be useful. For example, from the boards perspective
decisions, such as executive compensation, are internal, while the provisions of the Sarbanes Oxley Act
are external (i.e., beyond the boards control).
6
monitoring senior management (p. 13).
5
Researchers commonly assume that these two
functions are largely distinct and separable and that they potentially compete for a
directors time. For example, Chen (2008) develops a model that shows that higher
advising intensity is associated with lower monitoring quality and higher agency costs
(p.1). Researchers argue that the demands for monitoring and advice, which vary across
firms and time, are likely to be important factors in selecting board members. For
example, Masulis et al. (2010) argue that Despite their monitoring deficiencies, foreign
independent directors may enhance the advisory capability of boards, to the extent that
living or working in foreign countries gives them first-hand knowledge of foreign
markets and enables them to develop and tap a network of foreign contacts (p. 3).
Board members are commonly classified as either inside or outside directors.
Researchers (and others) commonly view outside directors as independent parties who
monitor and advise managers in the interests of shareholders. According to this view, the
primary cost of having outside directors on the board is that they are less informed than
managers about corporate strategy. For example, AGW state that a key advantage of
inside directors is also the key disadvantage of outside directors: specifically the
differential costs and difficulty in ensuring that the director has adequate information
with which to make decisions (p. 16). Similar arguments are made in the case of
separating the roles of the CEO and Chairman of the Board the primary reason for not
having a separate chairman is that the typical CEO is better informed that the outside
chairman (e.g., AGW pp. 28). Much of the governance research focuses on how
informational asymmetries between outside directors and management affect a firms
selection of directors (e.g., the mix between inside and outside directors).

b. Problems with the Common View
The common view has at least three flaws. First, it fails to recognize the most
fundamental role of the board to serve as the agent for shareholders (the ratification role

5
It is common for researchers to ignore the advisory role of boards entirely. For example, Boone, et al.
(2007) view the function of boards as ratifying and monitoring senior managers decisions, and do not
consider the advising/consulting functions in explaining board size and composition.
7
in decision control).
6
Second, it understates the incentive problems related to having
outside directors and independent chairmen. Third, it fails to capture what board
members actually do and how they are selected.
Boards Decision Making Authority
It is inefficient for shareholders to take an active role in decision-making in a
widely held corporation due to information, incentive, and coordination costs. Corporate
law, regulation, and the firms chartering documents assign most of the firms decision
rights to the board of directors. Shareholders elect the board and vote on key items such
as changes in the corporate charter, ratification of auditors, and merger proposals.
However, their power is limited in that they do not have the right to initiate binding
resolutions on corporate policies, such as executive compensation, or to vote on most
firm decisions (e.g., shareholders do not ratify the firms operating budget).
7

In practice, boards delegate substantial decision rights to executive managers
(AGW make this point on p. 90). However, these managers would not have authority to
purchase paper clips with company funds without the implied or expressed authority from
the board. The board also has the right to fire the CEO. In the typical firm, the board
maintains voting rights on key items, such as the annual budget, major capital
expenditures including acquisitions, executive compensation, dividends, and strategic
plans. Boards not only advise executives in their development of strategic initiatives
they also must approve them.
A fundamental principle in agency theory is that it is necessary to separate
decision control and decision management when the executive is not the owner of the
firm (Fama and J ensen, 1983). Without this separation, there would be no control over
the agency conflict between the executive and the owners, and the owners claim would
likely have little value. This separation is important, even if in the limit outside directors
normally play no active role in either monitoring or advising managers. The key point is

6
Fama and J ensen (1983) define decision management as the initiation and implementation of decisions
and decision control as the ratification and monitoring of these decisions.
7
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 grants additional authority
to the SEC to issue requirements that if met permit shareholders to nominate directors to be included in the
firms proxy materials. This law also requires publicly traded companies to conduct shareholder votes on
the compensation plans for named executive officers at least every three years. However, the votes are
nonbinding boards maintain the ultimate decision rights on the design of these plans. Institutional
investors are required to report, at least annually, on how they voted on these proposals.
8
that a board with a majority of outsiders has the latent power to monitor and replace top-
level executives, as well as to change the strategic direction of the firm. Outside
pressures, such as a hostile merger proposal, media/shareholder pressure, legal threats,
and large stock price declines have the potential to stir even an inactive board into action.
Indeed, there are numerous examples of seemingly powerful CEOs who have been fired
by boards when sufficient external pressure to do so exists (Hermalin and Weisbach,
1998). If boards comprised of a majority of insiders are less responsive to these
pressures, then most firms likely have boards comprised of a majority of outside
directors, regardless of their information environment (unless the insiders essentially own
the firm). Even in the pre-Sarbanes Oxley era, most firms had boards with more than 50
percent outside directors (in 1990 the typical percentage was between 60 percent and 65
percent outside directors). By 2004, the typical percentage was closer to 70 percent;
insiders dominated only about 10 percent of the boards (see AGW p. 21).
Incentives of Outside Directors
Individuals make decisions based on both their knowledge and incentives. The
academic literature, regulators, and the public often downplay the incentive issues related
to outside directors. For example, it is often asserted that boards with outside chairmen
are more likely to work in the interests of shareholders.
8
The academic literature, as
summarized by AGW, also tends to abstract from the incentive issues and instead focuses
on asymmetric information between outsiders and insiders as evidenced by their
prediction that when outside directors face greater information acquisition and
processing costs, they are likely to be less effective advisors and monitors, and are less
likely to be invited to sit on boards (p. 17).
In the Federalist Papers (#51), J ames Madison observed that if men were angels,
no government would be necessary and that if angels were to govern men, neither
external or internal controls on government would be necessary. From the shareholders
perspective, outside directors are unlikely to be angels. Outside directors, who typically
own few shares in the firm, have their own agendas and incentives.
9
For example, they
have incentives to shirk and to use corporate resources to increase their utility (e.g., an

8
See Lorsch and Zelleke (2005) for a discussion of the conventional wisdom for splitting the CEO and
chairman positions.
9
Bebchuk and Weisbach (2009) review the literature on the incentives of independent directors.
9
outsider might favor social and political objectives over the maximization of share price).
Outside directors can also have different risk preferences than the typical diversified
shareholder (e.g., reputational concerns might motivate outside directors to oppose highly
risky, but positive NPV projects). AGW discuss how Linck et al. (2008) fail to find a
significant relation between information asymmetry and the combined roles of the CEO
and chairman (p. 21). The costs of monitoring the monitor potentially help to explain
why the vast majority of firms do not combine the two positions. That is, if chairmen
provide little additional monitoring of the CEO, then there is no obvious reason to
separate the CEO and chair roles. Stock ownership, incentive compensation, and
reputational concerns in principle can motivate a CEO to be more concerned about
maximizing stock price than the typical outside director or a separate chairman.
What Outside Directors Do and How they are Selected
A more careful consideration of what board members actually do and the criteria
firms use to recruit them is likely to aid in our understanding of board structure.
Rigorous evidence on these issues is limited. However, there is a large descriptive
literature on these topics (see Adams, et al., 2009), as well as publicly available
statements from board nominating committees and executive search firms, concerning
their director-search criteria. These sources, along with our own experience in working
with and serving on corporate boards, suggest that the approach in the accounting
literature of separating a board members activities into two distinct tasks (monitoring
and giving advice to managers) does not reflect either how board members allocate their
time or the criteria used to recruit new directors.
As previously discussed, a primary role of board members is to ratify and monitor
important decisions. To perform this role, directors require knowledge of the firm and
the ability/skill to exercise these decision rights to enhance shareholder value. They
obtain this knowledge primarily by active participation in strategic policy setting and
review of operations. For example, the board must ratify dividend payouts. Assessing
whether the proposed dividend is too high or too low requires the board to understand the
firms investment opportunity set, and the managers incentives to over- or under-invest.
The proposed dividend may be too high because the managers mistakenly under-
estimate the investment opportunity set. Alternatively, the proposed dividend could be
10
too high because the managers are shirking and do not want to exert the extra effort to
undertake positive NPV projects. Directors are simultaneously both advising the CEO on
the optimum dividend policy (and ultimately ratifying the final decision) and monitoring
the CEO as they perform their basic decision-making role (Lorsch and MacIver, 1989).
The two functions are being performed simultaneously and are complementary. They are
not distinct. Directors do not choose separately how much time to spend on the two tasks
of advising and monitoring. J ust because managers have greater firm-specific knowledge
than outside directors does not negate the fact that outside directors can spot decision-
making errors and can add value by being informed of major corporate strategic efforts.
10

Outside directors may have better, or at least different, information on the value of the
firms investment opportunity set given their different industry/firm backgrounds.
As an analogy, thesis advisors (or seminar participants) often offer valuable input
into a research paper and identify problems even though they are not necessarily experts
on the topic. In working with a student, the advisor also obtains information about the
quality of the student and the work. Giving advice and monitoring are jointly conducted
as the advisor performs the basic role of supervising the student. And ultimately, the
thesis advisor must decide whether to recommend whether the thesis is acceptable (the
monitoring role). Thesis advisors do not allocate their time between advising and
monitoring the doctoral student. Rather, these are joint, complementary products that
occur concurrently.
Outside directors prepare for board meetings by reading materials supplied by
managers. During meetings, they listen to various reports and discuss and vote on agenda
items, such as approving the annual operating and capital expenditure budgets. They may
also meet in executive session (without management) and from time-to-time meet with
the CEO individually and with other members of the management team. It is through
these activities that board members gain knowledge to make informed decisions about
strategy, monitor the management team, and develop succession plans (Lorsch and
MacIver, 1989, p. 181).

10
Bowen (2008) describes boards role in policy setting as (Boards) raise questions, debate policy choices,
and eventually adopt or reject recommendations brought to them by them by the president or CEO (p. 22).
11
Adding an outsider to a board does not necessarily imply an increase in the
amount of managerial monitoring or produce better decisions, since all outside directors
are given the same basic reading material and attend many of the same meetings.
Potentially more important than the absolute or relative number of outside directors are
their backgrounds. Bowen (2008) argues that the right people to add to the board
possess the traits of integrity, competence, reliability, good judgment, independence of
mind, and dedication to the cause (p. 136), and diversity of both backgrounds and
perspectives (p. 142). Adding a director with very similar backgrounds and experience
to the board is unlikely to produce new insights after reviewing the same material, either
for monitoring or advising. This suggests that there is no one person who would be an
ideal director for all firms, since being ideal depends on the backgrounds of the other
board members and top managers. The ideal next director also depends on the specific
circumstances facing the firm. Having the right mix of outsiders can promote
productive discussions and monitoring in a confidential setting.
11
Consistent with this discussion, evidence from board nominating committees and
executive search firms indicates that firms focus their attention on getting the right mix
of board members (e.g., in terms of experience, age, training, and geography). In contrast
with much of the academic literature, practitioners primary emphasis in selecting new
board members is not on monitoring skills, but on obtaining the right mix of individuals
to promote useful discussions and decisions on corporate strategy. Nominating
committees and search firms appear to believe that the primary differentiating factor
among prospective board members is their potential contribution to strategy -- not
differential abilities to monitor managers or to perform other board tasks.
12
Consistently,
the descriptive literature, which is largely based on fieldwork and surveys of board
members, suggests that many board members view their role in strategic decision making
as being more important than their role in monitoring managers.
The evidence on board member roles and selection is limited, and our discussion
of these topics is largely conjectural. We suggest, however, that deeper insights

11
There is likely to be a limited set of outsiders with the appropriate backgrounds and skills to be
productive board members for any given firm. Observed board structures suggest that many firms consider
individuals with prior CEO experience as particularly useful board members.
12
Some firms have added financial experts to their boards in response to requirements in the Sarbanes
Oxley Act of 2002.
12
concerning board structure will be obtained through a more careful consideration of the
boards role in strategic decision-making and what it means for a given firm to get the
right mix of board members.

Myth 4: Research has taught us much about corporate governance, including what
are good and bad governance practices
13
There is a substantial body of theoretical and empirical work on corporate
governance. As summarized in AGW, accountants have published numerous papers on
the roles that information and financial reporting play in the contracting process (e.g., in
board design, executive compensation, and debt contracts). Armed with selected results
from this research, prominent academics have expressed strongly worded opinions on
what are good versus bad governance practices and have provided correspondingly
assertive prescriptions to corporate leaders, politicians, and regulators on how to improve
corporate governance via books, op-eds, congressional testimony, and consulting
engagements. But have we really learned enough from our study of corporate
governance to provide well-founded normative advice to either managers or policy
makers? We think that the answer is no; a heavy dose of skepticism is warranted when
academics, consultants, or regulators unconditionally classify a particular governance
practice as good versus bad, or weak versus strong.
The firm consists of a nexus of contracts that are jointly designed and change
through time. A firms corporate governance system is largely defined by these various
contracts. Unfortunately, there is no well-developed theory that encompasses the multi-
dimensional, inter-temporal nature of the contract design problem. Existing theory
focuses on specific, limited issues, often utilizing many simplifying assumptions. While it
has provided useful insights, our understanding of the overall problem is extremely
limited.
Empirical researchers, in turn, have produced a large body of research that
documents various correlations and associations in the data. Frequently, the authors of
these studies stress how their results are consistent with some model or conjecture about
corporate governance. Upon more careful reflection, however, most of these results are

13
AGW (Section 3.4) discusses in greater detail many of the same points we make in this myth.
13
also consistent with alternative explanations. Moreover, causality often is impossible to
infer (Adams, et al., 2009). For example, Core et al. (2006) document a statistical
association between firms with weak governance and stock market underperformance
but conclude that other factors likely explain this association (e.g., time-period specific
returns or differences in expected returns).
In general, it is difficult to draw strong conclusions from this work because of the
joint endogeneity of the observed features of the firms contracts including the
characteristics of the firms information and accounting system. For example, Lehn et al.
(2003) study 81 publicly traded U.S. firms surviving over the period of 1935 through
2000. They conclude that board size and composition evolve endogenously as firms
grow and their investment opportunities change.
Without a more comprehensive theory, it is difficult to ascertain whether an
observed association (e.g., between board structure and characteristics of the firms
financial reporting system) is driven by cause and effect (and if so in which direction) or
omitted exogenous factors that jointly determine both variables. Without additional
assumptions, it is even impossible to tell whether two governance design features are
complements or substitutes from the sign of their cross-sectional correlation (Holmstrom
and Milgrom, 1994).
While we know much more about the basic principles and descriptive facts
pertaining to corporate contracting and financial reporting than we did 20 years ago, we
still have very limited ability to explain or predict the specific organizational design of
any given firm, let alone categorize whether a specific firm has good or bad
governance.
14
We expect and encourage continued research on this important topic.
AGW (section 3.4) offer some specific research guidance. Ideally, theoretical work will
advance to the point where more structured empirical work can be conducted.
Unfortunately, due to the overall complexity of the problem, we do not expect substantial
developments in the foreseeable future.


14
For example, researchers and corporate activists often classify staggered boards as bad governance
because they potentially reduce the threat of a hostile takeover. Yet Mayers and Smith (2005) find that
mutual insurance companies often have classified boards. Since it is impossible to acquire a mutual
company, there must be other motives for staggered boards that are not currently well understood.
14
Myth 5: A good governance index can be constructed
A firms governance system consists of multiple components (board structure,
compensation structure, auditors, the corporate charter, debt contracts, government
regulation, etc.). Presumably, the quality of a firms governance does not depend on just
one component, but its overall system of governance. Following Gompers et al. (2003),
many researchers have constructed indices to rank firms based on their overall quality of
governance. Consultants and the media have produced similar indices.
15
But can a
meaningful measure of good governance really be constructed? We think the answer is
no.
To construct an index of good governance, the typical researcher or consulting
firm selects a set of key governance variables and classifies each in terms of contributing
to good or bad governance (e.g., large board size is often classified as bad, while a
high percentage of outside directors is classified as good). The variables are then
weighted and summed to form the index. A common practice in this literature is to
express each of the governance characteristics as a dummy variable; the index is then
formed by their simple sum (e.g., if there are ten variables the index would range from 0
to 10). The index is then used as the key explanatory variable in testing whether the
quality of governance is related to performance or economic outcomes, such as an
accounting restatement. Or, consulting firms estimate the weights by regressing some
performance measure (stock returns or accounting return on assets) on the governance
variables (board composition, board size, number of meetings, etc.).
These approaches are highly problematic for at least three reasons. First, as we
have already discussed, a firms entire governance system is endogenous (see AGW,
especially section 3.4). Without additional structure, the driving forces behind any
observed associations among endogenous variables (such as a governance index and
performance) are impossible to determine. Second, the current state of knowledge is not
sufficient to allow us to classify meaningfully any specific governance feature (or
combination of features) as either good or bad. Third, extant research similarly does not
allow us to select a meaningful set of weights (i.e. we do not know the relative

15
For example, see RiskMetrics Group (formerly Institutional Shareholders Services), Governance Metrics
International (GMI), and The Corporate Library (TGL).
15
importance of various governance mechanisms and how the weights might vary across
firms).
Larcker, et al. (2007) discuss the potential problems caused by arbitrarily
weighting a limited set of government mechanisms to form a governance index. They
collect a variety of structural measures of corporate governance on a large sample of
firms and use principal components analysis to identify numerous dimensions of
governance. Based on past work, they rate each of these dimensions as either increasing
in bad or good governance. These variables are then used as explanatory variables to
determine if there is an association between good and bad governance and firm
performance (and outcomes, such as accounting restatements).
While Larker et al. (2007) is arguably an improvement over past work, it is
subject to many of the same criticisms. Curiously, after critiquing the existing literature
as being potentially biased, they turn around and rely on this literature to classify their
indices as reflecting either good or bad governance. As one example, they classify board
size as increasing in bad governance based on Yermack (1996). Interpreting
Yermacks results in this manner, epitomizes succumbing to Myth #4 believing that
governance features can be meaningfully rank ordered, as either good or bad, based on
existing empirical work. In reflecting on the documented board size/performance
association, Hermalin and Weisbach (2002) question why so many large boards continue
to exist in a competitive marketplace if they are as inefficient as claimed in much of the
governance literature. They reasonably conclude that the observed negative relation
between performance and board size potentially reflects an equilibrium phenomenon
not cause and effect.
16
Similar concerns can be expressed for all the other classifications
made by Larcker et al. (2009). As these authors note, they are also unable to address
entirely concerns about the joint endogeneity of firm governance and performance.

Myth 6: Corporate governance best practices can be deduced from peer data
Practitioners and researchers often assess a firms corporate governance relative
to a peer group. For example, managers and analysts try to infer best practice from the

16
In fact Lehn et al. (2007) conclude that firm performance (measured by market-to-book ratios) causes
popular governance indices (GIM and BCF) to increase, not vice versa.
16
governance practices used by the preeminent firms in the economy or a particular
industry. Compensation committees use peer-group comparisons to make decisions on
the level and form of executive compensation, while the SEC requires firms to present
peer-group comparisons in proxy statements. The Department of Treasury, the Federal
Reserve Board, and the Federal Deposit Insurance Corporation intend to actively
monitor the actions being taken by banking organizations with respect to incentive
compensation arrangements and will review and update this guidance as appropriate to
incorporate best practices that emerge (emphasis added).
17
Provisions of the Dodd-
Frank Act of 2010 are based on popular notions of best practices (e.g., those relating to
incentive compensation and board committees). Some academics have concluded that
specific governance practices are good or bad based on estimated associations
between industry-adjusted performance and firm-specific governance features, such as
the structure of executive compensation (e.g., see Bebchuk, et al. 2009).
We do not argue that all benchmarking of governance practices is useless or that it
should never be performed. It is a myth, however, to assume that best practices can be
deduced readily from peer data. In fact, benchmarking can be highly misleading and can
lead to erroneous inferences.
The basic problem in deducing best practices from benchmarking exercises
arises from using an inappropriate peer group. Valuable benchmarking exercises require
identifying a peer group with similar agency problems and corporate structures that can
offer meaningful comparisons. However, basic economics suggests it is not easy to
identify homogeneous peers. Profit-maximizing firms often adopt differentiating
business strategies. The more successful (and profitable) a firm, the less likely it faces
perfect competitors. Flourishing firms face few direct competitors and have evolved
optimal governance structures that allow them to implement successfully their
differentiating business strategies. For example, the firms business strategy drives its
optimal investment, capital structure, outsourcing, and vertical integration policies. A
firm jointly chooses these policies, along with its governance structure, endogenously.
Emulating the governance structure of a best of breed firm is unlikely to prove useful
to other firms in the same industry. Without copying the peers business model (which

17
Department of Treasury et al. (2010), p. 17.
17
seems unlikely because successful firms remain successful precisely because they have
erected meaningful entry barriers such as patents or brand name), the benchmarking firm
very likely follows a different business model/strategy. There is little reason to believe
that the benchmarking firms business model generates exactly the same set of agency
problems as the best of breed, and therefore it is unlikely that both share exactly the
same set of optimal governance methods. Stated differently, the more a firm can
differentiate itself from its competitors, the less benchmarking will prove useful in
assessing that firms governance structure.
On the other hand, if all firms in the industry are identical in terms of following
identical business strategies, competing for the same customers, and operating in the
same regulatory environment, then they face very similar (identical) agency problems.
But if these firms are identical in all dimensions, they are likely to evolve through
competition to similar governance practices, unless alternative practices are neutral
mutations (value irrelevant). In either case, benchmarking industry best practices is
unlikely to be prove useful. It is of course possible for identical firms to adopt inefficient
governance practices (due to imperfect information or an environmental change that
makes a long-standing practice inefficient). It is within very homogeneous industries
(i.e., one or two firms have successfully innovated best governance practices) where
industry benchmarking is likely to prove productive. However, it is still important to
consider carefully whether the change is appropriate for a given firm. For example,
Armour and Teeces (1978) study of diffusion of the multidivisional form of organization
in the oil industry suggests while this innovation was value-increasing for most firms in
the industry, some firms were better off not changing (smaller and less complex firms).
Boards of directors have an advantage in industry benchmarking compared to
academics, regulators, and consultants. Boards typically know which peers employ
similar business models, strategies, and customer bases, and thereby share a common set
of agency problems. Hence, boards likely are able to assess better than researchers and
regulators why different governance structures exist within a peer group and whether
adopting a particular governance mechanism is value enhancing for their firm.
Absent detailed knowledge of each firms competitors, academics, regulators, and
outside consultants typically rely on pre-defined industries to construct peer groups such
18
as the Standard Industry Classification (SIC), North American Industry Classification
System (NAICS), Global Industry Classifications Standard (GICS), or Fama and French
industries (1997). It is well known that such pre-defined industry classifications
misclassify firms.
18
For example, heavy equipment producers for the oil and gas
industry, producers of video games, manufacturers of lawn mowers, and makers of
personal computers share the same two-digit SIC code (Bernard and Skinner, 1996),
while SIC code #53 contains a mix of low and high-end retailers, including Wal-Mart,
Target, Kohls, and Neiman Marcus. Dopuch, et al. (2008) document that these four
firms, even though classified in the same two-digit SIC industry, have significantly
different cash generating processes and operating cycles.
Bhojraj, et al. (2003) report the average R
2
between a firms monthly stock return
and the monthly return of an equally weighted portfolio of all the firms in its industry is
at most about 26 percent when using any of the common industry classification schemes
(SIC, NACIS, GICS, or Fama-French industries). Likewise, industry sales growth,
leverage, and price-earnings ratios are able to explain on average no more than 15 to 20
percent of the variation in the same variable at the individual firm level.
19
Hence, three
quarters of the variation in monthly stock returns, sales growth leverage, and PE ratios is
NOT explained by industry-wide events. This evidence suggests that considerable
heterogeneity exists among firms even in the same standard industry classification.
Given that substantial firm-specific heterogeneity exists within most standard
industry classifications, firms within these industries likely have evolved very different
optimal governance structures. It is hard to envision that Wal-Mart, Neiman Marcus, and
Kohls share a common optimal governance structure. Hence, any inferences regarding
the optimality of any given firms corporate governance structure based on industry
benchmarks are likely to be incorrect. A significant deviation in some governance
practice from the industry average is just as likely to be the result of a difference in the
firms business model from the average business model in the industry as it is a
difference from an optimal governance structure. In turn, cross sectional variation in

18
For example see, Clarke (1989), Guenther and Rosman (1994), Kahle and Walkling (1996), Fan and
Lang (2000), Ramnath (2001), Krishnan and Press (2003), and Bhojraj, et al. (2003).
19
In particular, Bhojraj, et al. (2003) estimated time series models at the firm level where firm-level sales
growth, leverage, and PE ratios were regressed on the same equally weighted industry variable.
19
performance among firms within an industry may well be driven by differences in
competitive advantage, rather than by differences in governance practices.
Several studies reach similar conclusions regarding a single optimal governance
structure. Linck, et al. (2008) find pronounced differences in the determinants of board
structure between small and large firms (p. 326) and go on to conclude that our results
show strong relations between board structure and firm characteristics, suggesting that
any regulatory framework that imposes uniform requirements on board structure could be
ill-conceived ( p. 327). Likewise, Coles, et al. (2008) posit that boards provide both
monitoring and advising roles (see Myth 3 above). They conclude that complex firms
(i.e., diversified firms, large firms, or highly leveraged firms) likely have greater advising
requirements) and are more likely to benefit from a larger board of directors, particularly
from outside directors who possess relevant experience and expertise, while firms for
which the firm-specific knowledge of insiders is relatively important, such as R&D-
intensive firms, are likely to benefit from greater representation of insiders on the board
(p. 351).
20

1. Comments on AGW
While discussants can always quibble about a survey papers organization and the
papers included and excluded in the review, we begin by stressing that we agree with
much of AGW. In particular, we endorse AGWs call for more careful consideration
(and more research) of endogeneity and causality issues by accounting researchers
studying corporate governance issues. In addition, we echo their major theme that
informal contracts are important, and often overlooked components of corporate
governance. Nonetheless, this argument should be extended to include managerial
reputation and repeat business as likely significant policing mechanisms that constrain
managerial rent seeking behavior. Consider the following experience of a retired CEO,
Most of our products were custom-made. Customers called in their orders over the
phone. The customers word alone was enough. In my 20-year stint as CEO, not once

20
One consulting firm that eschews the existence of best practices is Grahall. This firm states, There is
no such thing as best practices. The only best practices are those that work best for your company.
(Grahall 2009, p. 23)
20
did a customer go back on it. Unusual? Not at all. Without such trust, business couldnt
be conducted.
21
Besides the preceding observations, we have two additional comments on AGW.
First, as discussed under Myth #2 (A useful distinction is internal versus external
governance mechanisms), AGW have largely separate discussions of how financial
reporting is used in corporate governance (section 3) and debt contracting (section 5).
22

We appreciate the enormity of the task AGW have assumed in writing their survey and
understand the pedagogical advantages of structuring their review around corporate
governance and debt contracting. However, these two major sections of the paper are not
well integrated, and are written as almost standalone papers. While section 3.2.6 (how
outside directors mitigate agency costs of debt) and section 3.2.8 (how debt acts as a
commitment device for financial reporting transparency) are a good start to integrate their
two major themes, the remainder of section 3 ignores the interaction between the agency
costs of the separation of ownership and control and the agency costs of debt. Section 5
only references governance four times. AGW (p. 55) conclude that few studies exist
on how financial reporting by creditors influences the agency problem between directors
and managers and how financial reporting substitutes or complements monitoring by the
firms creditors. Nonetheless, we believe that a productive line of inquiry would involve
the interaction among financial reporting and other mechanisms designed to control
manager-shareholder conflicts and shareholder-debt holder conflicts. Stated differently,
instead of examining just the role of financial reporting in mitigating managerial
opportunism or examining the role of financial reporting in mitigating agency costs of
debt, future research should explore how financial reporting complements or substitutes
for other mechanisms to control both agency problems in a more general equilibrium
setting.
Second, one important governance mechanism excluded by AGW in their review
is how competition in a firms product markets affects corporate governance and debt
contracting. On the one hand, managers facing very competitive product markets have
little free cash flow to expropriate, and hence strong governance mechanisms are less

21
Aaron (1994) p. A14.
22
Section 4 of AGW is a terse, but interesting review of the agency problems between majority and
minority shareholders.
21
important.
23
On the other hand, surviving firms in highly competitive product markets
must adopt cost minimizing production methods, including governance and organization
costs. Therefore, these firms require effective governance systems. Hence, it strikes us
that the role of product market competition in corporate governance is an empirical issue.
While the role of product market competition has been explored in the theoretical
and empirical executive compensation and incentives literature (for example, see Raith,
2003 and Karuna, 2003), accounting-based corporate governance research has generally
ignored this potentially important implicit governance device. This omission is
particularly important to accounting researchers studying corporate governance because
various characteristics of the financial reporting system such as transparency, timeliness,
and conservatism likely affect both the ability of the board and shareholders to monitor
managers and entry by potential competitors. For example, the voluntary disclosure
literature usually views proprietary costs (entry by potential competitors) as a constraint
on firms voluntary disclosures (Darrough and Stoughton, 1990 and Verrecchia, 1990).
Without controlling for the correlated-omitted-variables-problem of potential entry (i.e.,
product market competition), researchers might erroneously conclude that an observed
statistical association between an endogenous financial reporting characteristic and a
corporate governance measure is causal.

2. Conclusions
To explain all nature is too difficult a task for any one man or even for any one
age. Tis much better to do a little with certainty, and leave the rest for others that
come after you, than to explain all things. Isaac Newton
24
While Newton was addressing research in the natural sciences, we believe his
views apply equally to social science research in general and specifically corporate
governance research. As reviewed by AGW, accountants (and other researchers) have
produced a large body of research on corporate governance. We have discussed six
commonly held beliefs that are reflected in this literature, which we believe are
misguided. Our intent is not to criticize past researchers for failing to develop a

23
Firms in competitive product markets can still have quasi rents (i.e., firm-specific investments) that short
horizon managers can expropriate.
24
Statement from unpublished notes for the Preface to Opticks (1704) quoted in Never at Rest: A
Biography of Isaac Newton (1983) by Richard S. Westfall, p. 643.
22
comprehensive model and understanding of the complex topic of corporate governance.
Echoing Newton, to explain all of corporate governance is too difficult a task for any
one man or even for any one age. Nonetheless, since Berle and Means (1932)
researchers have improved our understanding of agency problems and the associated
control mechanisms. AGW offer a number of specific suggestions for advancing our
understanding of the role of financial reporting in mitigating agency problems. Our
intent is to emphasize the conceptual and empirical impediments that require attention.
Greater sensitivity to the view that these beliefs are myths potentially could lead to
more productive future research, as well as more careful interpretation of existing work.
It could also prove useful in the regulatory process and to other audiences. Meanwhile, it
is important not to make overly strong or misguided claims about how a given firm
should design its governance system. Tis much better to do a little with certainty, and
leave the rest for others that come after you, than to explain all things.

23

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27