If management uses this power judiciously, it could pos-
sibly lead to an increase in overall shareholder wealth; if
management, 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 that
classified boards enhance the power of managers and
weaken the control rights of large shareholders, which is
all that matters for constructing the index. (Gompers,
Ishii, and Metrick,
2003,
p. 114)
Most provisions other than classified boards can be
viewed by the same logic. Almost every provision ena-
bles management to resist different types of shareholder
activism, such as calling special meetings, changing the
firm's charter or bylaws, suing directors, or replacing
them all at once. GIM, however, note two exceptions:
secret ballots (confidential voting) and cumulative vot-
ing. A secret ballot or confidential voting designates a
third party to count proxy votes and, therefore, prevents
management from observing how specific shareholders
vote.
Cumulative voting enables shareholders to concen-
trate votes for directors so that a large minority share-
holder can ensure some board representation. These two
provisions are usually proposed by shareholders and
opposed by management because they enhance share-
holder rights and diminish the power of management.
GIM add one point to the Govemance Index when firms
do not have each of these provisions. For all other provi-
sions,
GIM add one point when firms do have each of
them. The Govemance Index is the sum of one point for
the presence (or absence) of each provision.
III.
Empirical Results
A. Summary Statistics
Exhibit 3 shows the summary statistics for the sample
firms. The full sample is divided into 3 subsamples-
industrial, financial, and utility. Firm size is shown in this
table both in terms of sales and total assets. It appears
that financial firms are considerably larger than industrial
and utility firms both in sales and in total assets. I employ
16
JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006
Exhibit 2. Individual Governance Provisions Employed in the Construction ofthe Governance
Index
The detailed explanation for each govemance provision is available in the Appendix of Gompers, Ishii, and Metrick (2003)
Delay
Blank Check
Classified Board
Special Meeting
Written Consent
Protection
Compensation Plans
Contracts
Golden Parachutes
Indemnification
Liability
Severance
Voting
Bylaws
Charter
Cumulative Voting
Secret Ballot (Confidential Voting)
Supermajority
Unequal Voting
Other
Anti-greenmail
Directors' duties
Fair Price
Pension Parachutes
Poison Pill
Silver Parachutes
State
Anti-greenmail Law
Business Combination Law
Cash-out Law
Directors' Duties Law
Fair Price Law
Control Share Acquisition Law
the EBIT/sales ratio to measure profitability. Leverage is
calculated as long-term debt divided by total assets as in
Defond (1992). Finally, the market-to-book ratio is the
market value of equity (share price times number of
shares outstanding) divided by the book value of equity.
