If management uses this power judiciously, it could pos-sibly lead to an increase in overall shareholder wealth; ifmanagement, however, uses this power to maintain pri-vate benefits of control, then this provision would dimin-ish shareholder wealth. In either case, it is apparent thatclassified boards enhance the power of managers andweaken the control rights of large shareholders, which isall that matters for constructing the index. (Gompers,Ishii, and Metrick,2003,p. 114)Most provisions other than classified boards can beviewed by the same logic. Almost every provision ena-bles management to resist different types of shareholderactivism, such as calling special meetings, changing thefirm's charter or bylaws, suing directors, or replacingthem all at once. GIM, however, note two exceptions:secret ballots (confidential voting) and cumulative vot-ing. A secret ballot or confidential voting designates athird party to count proxy votes and, therefore, preventsmanagement from observing how specific shareholdersvote.Cumulative voting enables shareholders to concen-trate votes for directors so that a large minority share-holder can ensure some board representation. These twoprovisions are usually proposed by shareholders andopposed by management because they enhance share-holder rights and diminish the power of management.GIM add one point to the Govemance Index when firmsdo not have each of these provisions. For all other provi-sions,GIM add one point when firms do have each ofthem. The Govemance Index is the sum of one point forthe presence (or absence) of each provision.III.Empirical ResultsA. Summary StatisticsExhibit 3 shows the summary statistics for the samplefirms. The full sample is divided into 3 subsamples-industrial, financial, and utility. Firm size is shown in thistable both in terms of sales and total assets. It appearsthat financial firms are considerably larger than industrialand utility firms both in sales and in total assets. I employ
16JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006Exhibit 2. Individual Governance Provisions Employed in the Construction ofthe GovernanceIndexThe detailed explanation for each govemance provision is available in the Appendix of Gompers, Ishii, and Metrick (2003)DelayBlank CheckClassified BoardSpecial MeetingWritten ConsentProtectionCompensation PlansContractsGolden ParachutesIndemnificationLiabilitySeveranceVotingBylawsCharterCumulative VotingSecret Ballot (Confidential Voting)SupermajorityUnequal VotingOtherAnti-greenmailDirectors' dutiesFair PricePension ParachutesPoison PillSilver ParachutesStateAnti-greenmail LawBusiness Combination LawCash-out LawDirectors' Duties LawFair Price LawControl Share Acquisition Lawthe EBIT/sales ratio to measure profitability. Leverage iscalculated as long-term debt divided by total assets as inDefond (1992). Finally, the market-to-book ratio is themarket value of equity (share price times number ofshares outstanding) divided by the book value of equity.