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Journal of Applied Corporate Finance SPRING 2003 VOLUME 15.3 The Shareholder Wealth Effects of CalPERS’ Focus List by Mark Anson, Ted White, and Ho Ho, CalPERS

THE SHAREHOLDER WEALTH EFFECTS OF CALPERS' FOCUS LIST

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Page 1: THE SHAREHOLDER WEALTH EFFECTS OF CALPERS' FOCUS LIST

Journal of Applied Corporate Finance S P R I N G 2 0 0 3 V O L U M E 1 5 . 3

The Shareholder Wealth Effects of CalPERS’ Focus List by Mark Anson, Ted White, and Ho Ho, CalPERS

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ACCENTURE JOURNAL OF APPLIED CORPORATE FINANCE

THE SHAREHOLDERWEALTH EFFECTS OFCALPERS’ FOCUS LIST

by Mark Anson, Ted White, and Ho Ho,CalPERS*

he decade of the 1990s saw a newdevelopment in public equity investing:shareholder activism. Shareholder activ-ism arose because most public companies

Shareholder activism helps to reduce theseagency costs through the promotion of sound corpo-rate governance principles. In its broadest sense,corporate governance is a process and associated setof procedures that aim to align the interests of themanagers (agents) of a corporation with those of theequity owners of the business (the shareholders). Assuch, corporate governance includes board over-sight and other means by which corporate agents areheld accountable to the corporation’s equity owners.Accountability, transparency, and proper incentivesare the underlying principles of corporate governance.

As an active institutional investor, the CaliforniaPublic Employees’ Retirement System (CalPERS)takes its role in the corporate governance processvery seriously. Among many other initiatives, eachyear CalPERS identifies and publishes its “FocusList”—a list of public companies with poor corporategovernance principles and poor financial perfor-mance. CalPERS’ expectation is that these companieswill be motivated to intensify their managementeffort and improve their financial performance,thereby increasing shareholder value. But whetherthe list is effective is an empirical question, one thatwe try to resolve in this paper by examining its impacton the stock prices of the companies on the list.

In the next two sections, we briefly review howand why corporate governance can break down ina public corporation as well as the prior research onthe effectiveness of shareholder activism. We thenexamine the market impact of CalPERS’ Focus List.We reevaluate the effectiveness of CalPERS’ FocusList in light of the many new corporate governanceinitiatives sweeping the United States. Finally, weprovide some observations regarding shareholderactivism by passive index funds.

T

*The authors thank Peter Nguyen, an equity analyst at CalPERS, for assistancein collecting and refining the data associated with this research. This article reflectsthe insights and opinions of the authors and not the authors’ employer.

have a diverse shareholder base, which facilitatesraising capital to finance a company’s internal projectsbut can interfere with effective oversight of thecompany’s management. In fact, in a large publiccorporation, equity ownership may be so widelydispersed that the owners of the company cannotmake their objectives known to management, orexercise control over management’s actions.

In a corporation, the board of directors and seniormanagement act as the agents for the shareholders.Shareholders, as the owners of the company, delegateday-to-day decision-making to the board and manage-ment with the expectation (or hope) that they will actin the shareholders’ best interests. But the objectives ofsenior corporate management may be very differentfrom those of a corporation’s equity owners. Forinstance, management may be concerned with keep-ing their jobs and presiding over a large corporateempire, whereas shareholders are concerned first andforemost about value creation. The separation ofownership and control of the corporation thus raisesthe issue of agency costs.

Agency costs come in three forms. First, there isthe cost of properly aligning management’s goalswith those of shareholders, including the cost ofstock options, bonuses, and other incentive com-pensation. Second, there is the cost of monitoringmanagement, which includes independent audits offinancial statements and shareholder review of man-agement perquisites. Last, agency costs can includethe erosion of shareholder value from management-led initiatives in the pursuit of individual gain.

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AGENCY PROBLEMS AND THE LACK OFCORPORATE CONTROL

In their seminal paper, Michael Jensen andWilliam Meckling developed the concept of agencyproblems in the management of public corpora-tions.1 Agency problems arise when managers ofpublic companies pursue their own economic self-interest instead of maximizing shareholder wealth.In essence, managers are human beings and arelikely to pursue personal agendas that may have littleto do with shareholder value. This problem isparticularly acute in large public companies wherethe shareholders are widely dispersed and there maynot be sufficient incentives for individual owners touse their own financial or reputational resources tomonitor managerial behavior.

Jensen and Meckling proposed several solu-tions to the agency problem. One is for managers tohave a significant ownership stake in the company.2

This helps ensure that the managers’ goal of increas-ing their own economic well-being accords withincreasing shareholder wealth. Alternatively, com-pensation schemes can be designed to align themanagers’ interests with those of the shareholders.Compensating managers based on objective mea-sures of shareholder wealth such as share priceperformance can promote the congruence of share-holder and manager goals.

Finally, sound principles of corporate gover-nance can alleviate the agency problem as well asreducing the need for incentive schemes or largeequity stakes by managers. Corporate governanceprinciples are carried out through internal controlsthat monitor and guide management’s performanceand behavior to ensure that shareholders’ bestinterests are upheld.

Unfortunately, the twin problems of humanbehavior and the inability to monitor effectively canlead to a breakdown in a company’s internal controlsystems. Corporate control systems are the respon-sibility of a company’s board of directors, who areelected by the shareholders and are authorized tooversee the company’s managers. But board over-

sight is often weakened when the board is large andunwieldy, when insiders dominate the board, whenthe CEO controls the board agenda, or when the CEOalso chairs the board. As a result, corporate gover-nance often does not work as well in the UnitedStates as it should. The failure of corporations to actin the best interests of shareholders can lead todestruction of shareholder value. This provides anopportunity for investor corporate governance pro-grams—through shareholder activism—to enhancereturns.

Evidence on CalPERS’ Corporate GovernanceProgram

What CalPERS refers to as its Corporate Gover-nance Program is another way of describing share-holder activism. The program chiefly involves exter-nal monitoring of the performance and behavior ofa company’s management to ensure that the share-holders’ best interests are upheld. Over the pastdecade, institutional investors have engaged theexecutive managements of poorly performing com-panies through proxy proposals, direct discussions,and negotiations on corporate goals and vision. Theintent is quite clear: the enhancement of shareholderwealth.

Although investor corporate governance pro-grams are a relatively new phenomenon, there hasbeen considerable research into their financial im-pact. In particular, several studies have examined theeffect of shareholder proposals initiated by CalPERS’Corporate Governance Program. For example, a1994 study found that companies contacted byCalPERS regarding CalPERS-sponsored shareholderproposals experienced positive long-term stock priceperformance in excess of the S&P 500.3 A 1996 studyfound that in a subsample of CalPERS-targetedcompanies, significant positive stock returns wereobserved around the proxy mailing dates for share-holder proposals.4 Another 1996 study found thatCalPERS was successful in changing the corporategovernance structure in almost three-fourths of thecases studied; it further found a positive stock price

1. Michael Jensen and William Meckling, “Theory of the Firm: ManagerialBehavior, Agency Costs and Ownership Structure,” Journal of Financial Econom-ics (October 1976), pp. 305-360.

2. This can also be accomplished through a leveraged buyout (LBO). LBOsfix the problem of a diverse shareholder base by introducing a more concentratedownership structure. In effect, the leveraged buyout firm replaces the diverseshareholder base and provides a measure of active oversight that was lacking with

a fragmented equity ownership structure. For more discussion on this topic, seeMark Anson, The Handbook of Alternative Assets (New York: John Wiley & Sons,2002).

3. Stephen Nesbitt, “Long-Term Rewards from Shareholder Activism: A Studyof the ‘CalPERS Effect,’” The Journal of Applied Corporate Finance (Winter 1994).

4. Sunil Wahal, “Pension Fund Activism and Firm Performance,” The Journalof Financial and Quantitative Analysis, Vol. 31 (1996).

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104JOURNAL OF APPLIED CORPORATE FINANCE

reaction for successful CalPERS shareholder propos-als.5 A 1999 study found that shareholder proposalswere followed by significant corporate governanceactivity and broad changes such as asset sales andrestructurings.6 Finally, a 2000 study showed thatCalPERS’ corporate governance involvement withSears over the period 1989-1992 generated financialimprovement in the company.7

In summary, the empirical evidence demonstratesthat CalPERS-led shareholder proposals have had abeneficial impact on firm performance.8 However,shareholder proposals are just one part of CalPERS’Corporate Governance Program. In the next section,we consider a more targeted form of shareholderactivism and its impact on shareholder value.

THE CALPERS FOCUS LIST

The CalPERS Focus List began in 1992, whenCalPERS publicly identified ten large public corpo-rations as poor performers that should be subjectedto a degree of public scrutiny appropriate to theirunderperformance. CalPERS stated that it wouldcontinue to monitor closely the performance of thecompanies on the Focus List and would considershareholder proposals and other actions necessaryto improve their financial performance. By centering itsattention and resources in this way, CalPERS believesthat it can demonstrate specific and tangible economicresults from its corporate governance efforts.9

In fact, CalPERS takes an active role with thecompanies on its Focus List starting several monthsbefore the list is released. CalPERS begins theprocess in the summer of every year by screening auniverse of approximately 1,200 public companiesacross all industries and levels of market capitaliza-tion. Over the next three to four months, CalPERSreduces this universe to a preliminary list of about 15companies that it believes demonstrate poor finan-cial performance as well as poor corporate gover-

nance principles. These companies become candi-dates for CalPERS’ Focus List.

CalPERS looks at two financial measures ofperformance: stock price performance and return oncapital. A company’s stock price performance ismeasured relative to its peers over a five-year period;those companies that show significant underperfor-mance are eligible for the Focus List. Return oncapital is measured using the principles of EconomicValue Added (EVA). In brief, EVA includes a chargeagainst profits for the risk-adjusted cost of capital thata company employs.10 This is in contrast to account-ing ratios such as earnings per share or return onequity that can be distorted through noncash charges,early revenue recognition, and capitalized expenses.Capital charges under EVA reflect the return thatinvestors could expect to earn by investing theirmoney in a portfolio of stocks of risk similar to thecompany in question.

Inevitably, all corporations experience periodsof underperformance. However, companies thatalso have poor corporate governance principles aremore likely to experience a prolonged (or even fatal)period of underperformance. For this reason, CalPERSalso reviews each company’s internal corporatecontrols. Issues such as staggered boards of direc-tors, a lack of independent directors, a combinedCEO/Chairman of the Board, board size, and poisonpills are just some of the key governance issues thatmay make a company eligible for the list.

CalPERS contacts companies on the preliminarylist in the late summer or early autumn of each year.Over the course of the next four to six months,CalPERS meets directly with the executive manage-ment and directors of candidate companies to dis-cuss its concerns and to provide management withan opportunity to make a case for exclusion from theFocus List. Sometimes, potential candidates reactimmediately to CalPERS’ initial contact by commenc-ing share buybacks or by implementing new internal

5. Michael Smith, “Shareholder Activism by Institutional Investors: Evidencefrom CalPERS,” The Journal of Finance, Vol. 51 (1996).

6. Diane Del Guercio and Jennifer Hawkins, “The Motivation and Impact ofPension Fund Activism,” The Journal of Financial Economics (June 1999).

7. Stuart Gillan, John Kensinger, and John Martin, “Value Creation andCorporate Diversification: The Case of Sears, Roebuck & Co.,” The Journal ofFinancial Economics (March 2000).

8. However, with respect to shareholder proposals generally, the literature isdivided as to whether they add value. For instance, one study finds no significantstock price reaction to shareholder proxy proposals and no operating performanceimprovement over the one to three years following the shareholder proposal; seeJonathan Karpoff, Paul Malatesta, and Ralph Walkling, “Corporate Governance andShareholder Initiatives: Empirical Evidence,” The Journal of Financial Economics,Vol. 42 (November 1996). Another study finds that shareholder proposals

sponsored by institutional investors receive considerable support from otherinvestors, and have a small but measurable negative impact on stock prices; seeStuart Gillan and Laura Starks, “Corporate Governance Proposals and ShareholderActivism: The Role of Institutional Investors,” The Journal of Financial Economics,Vol. 57 (2000). Finally, there is evidence of a negative stock price reaction whenshareholder proposals are submitted to management, although in a subsample ofsuccessful shareholder proposals, the stock price reaction was positive; see JamesForjan, “The Wealth Effects of Shareholder Sponsored Proposals,” Review ofFinancial Economics (January 1999).

9. See CalPERS’ “Corporate Governance Core Principles and Guidelines,” April13, 1998.

10. The formula for EVA is Net Operating Profits after Tax – (Cost ofCapital)*(Total Capital Employed).

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controls in the hopes of a positive short-term boostto their share price. These changes are made inresponse to the concerns expressed by CalPERS asa large institutional investor, but also to forestallinclusion on the Focus List.

The final Focus List is usually published inFebruary or March of the year following initial contact.Some candidates are excluded because they eitheragree to make changes to their control procedures,have already implemented new controls, or in someother way have addressed CalPERS’ governance issues.The remaining candidates are included due to a lackof either progress regarding internal controls or re-sponsiveness to CalPERS’ shareholder concerns, andan expectation that continued engagement combinedwith public scrutiny can unlock long-term value.

CalPERS has published its Focus List each yearsince 1992. Although the list originally included tencompanies, in recent years it has not been fixed atany specific number so as to allow the CalPERS’investment staff the flexibility to include only themost clear-cut candidates. The list normally includessix to twelve companies.

A TEST OF CALPERS’ FOCUS LIST

Our main purpose here is to determine whetherthe Focus List has had a beneficial impact onshareholder value. If corporate underperformance isthe result of either a lack of effort or poor decision-making that can be corrected through public scrutinyor improved corporate controls, then inclusion onthe Focus List might be expected to reinvigorate thecompany with regard to its management effort andhence improve its financial performance. This wouldbe a positive signal to the market and result in increasedshareholder value as reflected in higher share prices.

To conduct our analysis, we performed an eventstudy, which has become a standard tool of empiricalfinance. Its objective is to measure the differencebetween the actual returns on an investment and thereturns that would be expected to occur in theabsence of an observed event, such as an acquisition

announcement. The difference between the actualand expected returns is called the “excess return.”Excess returns are measured around the event date,and conclusions are drawn as to whether the eventhad an economic impact. In measuring the expectedor normal return, we used a market model—thefamiliar “beta” model—in which the expected returnis a stable (and linear) function of the return to amarket index. We estimated the parameters for themodel using daily market data over the one-yearperiod prior to our test periods.

Examining a company’s stock price perfor-mance before inclusion on the Focus List, at the timeof announcement of the Focus List, and after inclu-sion on the Focus List might provide some evidenceon the economic value of corporate governanceprograms. Excess returns can be accumulated over aperiod of time to form a cumulative excess return,which can then be tested for economic significance.11

We examined five periods of stock price perfor-mance for companies that appear on CalPERS’ FocusList. The first period runs from 180 trading daysbefore publication of the Focus List to 91 days beforerelease of the list. The second period is 90 daysbefore publication to one day before publication.The third period is the publication date of the FocusList plus the next four trading days, which is meantto capture the initial impact of publication on equityperformance.12 CalPERS has total control over therelease of its Focus List and guards this informationjealously. Consequently, there is no “slippage” ofinformation prior to the publication date. The fourthperiod is five trading days after publication of the listuntil 94 trading days after publication, and the fifthperiod is 95 days after publication of the Focus Listto 184 trading days after publication. Examining thepost-publication periods helps to determine if thereis a continuing economic benefit to shareholders.

As noted previously, one of the criteria forFocus List inclusion is poor stock price performance.Consequently, we might expect to see negative stockprice performance leading up to the announcementdate. On the other hand, since companies have

11. We test the shareholder wealth effects for the portfolio of companiesconstituting each Focus List, instead of looking at individual company returns. Inan event study, it is generally assumed that there is no correlation across theabnormal returns of different securities. This assumption is justified if there is noclustering of the event dates. For the purposes of this paper, however, the eventsare clustered in time around the release of each Focus List. The clustering problemcan be solved by aggregating a portfolio of abnormal returns dated around theevent periods, as we do in our study. For a description of this solution, as well asthe econometrics for testing cumulative excess returns, see John Campbell, Andrew

Lo, and A. Craig MacKinlay, The Econometrics of the Financial Markets (Princeton,NJ: Princeton University Press, 1997).

12. This five-day window around publication of the Focus List is consistentwith an event study of the Council of Institutional Investors’ Focus List by GaryCaton, Jeremy Goh, and Jeffrey Donaldson, “The Effectiveness of InstitutionalActivism,” Financial Analysts Journal (July/August 2001); the authors do not,however, appear to have corrected for the clustering problem described above infootnote 11.

Over the past decade, institutional investors have engaged the executivemanagements of poorly performing companies through proxy proposals,

direct discussions, and negotiations on corporate goals and vision.The intent is quite clear: the enhancement of shareholder wealth.

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already been contacted by CalPERS, they mightmake a concerted effort to improve their stock priceperformance in attempt to avoid inclusion in theFocus List. This could lead to positive stock priceperformance over the period immediately leadingup to the publication of the Focus List.

Table 1 contains the results for the full sample.Each of the five test periods indicates positivecumulative excess returns. The 90-day period begin-ning five days after publication demonstrates signifi-cant positive economic performance of 11.99%. Thatis, we can state with 95% confidence that inclusionin CalPERS’ Focus List is associated with an addi-tional (excess) return to shareholders of about 12%on average over the three months after release of thelist. Furthermore, this wealth increase does not dissi-pate. The period 95-184 days after publication demon-strates additional positive cumulative excess returns of5.37% (although this is not statistically significant).

The second panel of Table 1 contains only thosecompanies that did not have any competing orconfounding corporate announcements (such asmanagement changes or new business ventures) atthe time of the release of CalPERS’ Focus List. Theresults are the same; there is a significant positiveshareholder impact from the release of CalPERS’Focus List. Contemporaneous announcements werealmost equally divided between positive and nega-tive announcements. Consequently, we would not

expect a material impact one way or another on ourresults. For our remaining tests, we also screened forconfounding/contemporaneous announcements anddid not find that they changed our conclusions(results not reported).

The CalPERS Focus List occasionally contains“repeat offenders.” That is, some companies areincluded on the Focus List two years in a row if theircorporate governance principles, in the view ofCalPERS, have not improved. This may dampen theimpact of the Focus List because these companieshave already been identified by CalPERS to be poorperformers. To account for this effect, we screenedrepeat offenders and included them only the firsttime they appear on the Focus List. The results arepresented in Table 2.

We note from Table 2 that the cumulative excessreturns for the period 91-180 days prior to publica-tion are now slightly negative. This is consistent withCalPERS’ choosing corporate laggards. In Table 1,the repeat offenders may generate positive excessreturns resulting from their first nomination to theFocus List that offset the negative excess returnsassociated with first-time offenders. What’s more,after screening for first-time corporate nominees, thelevel and significance of the cumulative excessreturns over the period 5-94 days after publicationwere higher. The average cumulative excess returnto shareholders over this period is now 13.3%.

TABLE 1

TABLE 2

T–180 to T–91 T–90 to T–1 T to T+4 T+5 to T+94 T+95 to T+184

FULL SAMPLEMean CAR (%) 0.89 6.47 0.26 11.99 5.37T-Statistic 0.23 1.64 0.33 3.05** 1.50

FULL SAMPLE WITH ADJUSTMENT FOR CONFOUNDING EFFECTMean CAR (%) 1.51 8.46 0.17 11.34 4.98T-Statistic 0.37 2.05* 0.21 2.74** 1.32

*, ** represent significance at 10% and 5% levels of confidence, respectively.

T–180 to T–91 T–90 to T–1 T to T+4 T+5 to T+94 T+95 to T+184

ADJUSTMENT FOR REPEAT OFFENDERSMean CAR (%) –0.32 7.69 0.33 13.31 5.72T-Statistic –0.08 1.86* 0.40 3.22** 1.48

*, ** represent significance at 10% and 5% levels of confidence, respectively.

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We also considered whether there are differ-ent shareholder effects for companies with smallmarket capitalization values versus companieswith large market capitalization. As discussedpreviously, large public corporations have a morewidely dispersed shareholder constituency thatmakes monitoring by shareholders especially diffi-cult. Consequently, we expect that inclusion inCalPERS’ Focus List should have a greater effect onlarge-cap companies than on small-cap companieswith their more concentrated equity ownership,because the dispersed shareholders associated witha large corporation now have a vigilant monitorlooking after their economic interests.

We divided our sample into large-cap (S&P 500)versus small-cap (non-S&P 500) companies. Table 3demonstrates that the economic impact for large-capcompanies is much greater than for small-cap com-panies. For large-cap companies, the average cumu-lative excess return for the period 5-94 days afterpublication of the Focus List is almost 24% (signifi-cant at the 5% level), as compared to 10.5% (signifi-cant at the 10% level) for small-cap companies.Therefore, we conclude that inclusion in CalPERS’Focus List has a greater shareholder wealth effect for

those companies with a large, widely dispersedshareholder base, as predicted.

We also divided our sample according to WallStreet analyst coverage. Our hypothesis was thatcompanies with greater Wall Street coverage wouldexperience a greater shareholder wealth impactbecause the information associated with CalPERS’Focus List would be better interpreted and morebroadly disseminated. We found that small-cap stocksare covered by 9.81 analysts, on average. Therefore, wedivided our sample into those Focus List companiesthat were covered by more than ten market analystsand those covered by ten or fewer analysts.

Table 4 presents our results. Focus List compa-nies with broader analyst coverage experienced anaverage cumulative excess return over the period 5-94 days after publication of 17.1%, compared to10.6% for companies with more limited analystcoverage. Additionally, the cumulative excess re-turns associated with greater analyst coverage weresignificant at the 5% level, while the returns withlower analyst coverage were not significant even atthe 10% level. We conclude that CalPERS’ Focus Listhas a greater shareholder wealth impact on thosecompanies with greater Wall Street analyst coverage.

TABLE 3

TABLE 4

T–180 to T–91 T–90 to T–1 T to T+4 T+5 to T+94 T+95 to T+184

ALL LARGE-CAP COMPANIESMean CAR (%) –2.10 16.38 1.94 23.93 4.40T-Statistic –0.21 1.63 0.99 2.38** 0.46

ALL SMALL-CAP COMPANIESMean CAR (%) –5.05 1.91 0.12 10.49 0.96T-Statistic –0.90 0.34 0.11 1.88* 0.17

*, ** represent significance at 10% and 5% levels of confidence, respectively.

T–180 to T–91 T–90 to T–1 T to T+4 T+5 to T+94 T+95 to T+184

COMPANIES WITH MORE THAN TEN ANALYSTSMean CAR (%) 0.97 6.29 0.52 17.12 4.82T-Statistic 0.14 0.92 0.39 2.51** 0.97

COMPANIES WITH TEN OR FEWER ANALYSTSMean CAR (%) –0.18 2.10 –0.73 10.61 4.34T-Statistic –0.03 0.36 –0.63 1.81 0.71

*, ** represent significance at 10% and 5% levels of confidence, respectively.

We can state with 95% confidence that inclusion in CalPERS’ Focus List is associatedwith an additional (excess) return to shareholders of about 12% on average over the

three months after release of the list.

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As a final refinement to our analysis, we dividedour sample according to the market’s perception ofcorporations before their inclusion in CalPERS’ Fo-cus List. There may be competing economic effectsat the time of publication by CalPERS of its Focus List.On the one hand, there might be a negative stockprice impact as investors react unfavorably to theidentification of CalPERS’ target firms. This should betrue for companies that the market had previouslybelieved to be good performers before their appear-ance on the Focus List. On the other hand, manyinvestors may react favorably to a company’s appear-ance on CalPERS’ Focus List because of CalPERS’underlying commitment to work with such compa-nies to improve their corporate controls. This shouldbe true for companies that the market had previouslyperceived to be poor performers. Therefore, wereviewed all news releases for each company in oursample for a period of six months before publicationof the Focus List and divided our sample into thosecorporations that the financial media had identifiedas poor performers and those identified as goodperformers.

Table 5 contains the results. Consistent with ourhypothesis, companies that had been previouslyidentified as laggards experienced greater share-holder wealth effects than those companies previ-ously believed to be good performers. Laggardsexperienced an average cumulative excess returnover the period 5-94 days after publication of 19.2%(significant at the 5% level), while “good performers”experienced an average cumulative excess return of9.5% (significant at the 10% level).

As a final test, we looked to see whether theeconomic impact of the Focus List has changed overtime. In other words, we were curious whetherCalPERS’ Focus List remains as valuable today aswhen it was originally introduced. To determine this,

we ran a simple regression of the cumulative excessreturns of CalPERS’ Focus List against time. Theregression coefficient was not significantly differentfrom zero, indicating that the economic impact ofthe CalPERS Focus List has not diminished in valueover time.

CORPORATE GOVERNANCE IN THE “NEW AGE”

The deluge of corporate accounting scandalsand the mounting number of corporations that havesuccumbed to some form of governance malfea-sance since the collapse of Enron in late 2001 havecreated a “new age” of corporate governance. In thisnew age, sound principles of corporate governancehave been pushed to the forefront of investorconsciousness. We briefly summarize four newcorporate governance initiatives and then considertheir impact on the shareholder value effect ofCalPERS’ Focus List.

New York Stock Exchange Corporate Account-ability and Listing Standards Committee. In Febru-ary 2002, then-SEC Chairman Harvey Pitt asked theNYSE to review its corporate governance listingstandards. The NYSE established the CorporateAccountability and Listing Standards Committee toreview the NYSE’s current listing standards alongwith recent proposals for reform, with the goal ofenhancing the accountability, integrity, and trans-parency of corporations listed on the NYSE. TheCommittee has made several recommendations tothe NYSE that are primarily designed to permithonest and well-intentioned directors, officers, andemployees to effectively perform their functionsand to allow shareholders to more easily andefficiently monitor the performance of corpora-tions and their directors. Several specific recom-mendations include:

TABLE 5 T–180 to T–91 T–90 to T–1 T to T+4 T+5 to T+94 T+95 to T+184

COMPANIES WITH POSITIVE NEWSMean CAR (%) 0.81 14.55 0.50 9.47 8.68T-Statistic 0.17 3.00** 0.52 1.96* 1.92*

COMPANIES WITH NEGATIVE NEWSMean CAR (%) 10.19 –7.38 0.87 19.20 3.50T-Statistic 1.73 –1.25 0.76 3.26** 0.60

*, ** represent significance at 10% and 5% levels of confidence, respectively.

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Independent directors must constitute a majorityof a company’s board.

Listed companies must have an audit committee,a nominating committee, and a compensation com-mittee, all composed of independent directors.

Listed companies must adopt corporate gover-nance guidelines as well as a code of businessconduct and ethics.

Shareholders must be given the opportunity tovote on any equity-based compensation plans.

The CEO must certify annually that the companyhas established and complied with procedures forverifying the accuracy and completeness of financialinformation provided to investors.

The Sarbanes-Oxley Act of 2002. On July 30,2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, a far-reaching piece of legislationintended to hold corporate executives and outsideauditors more accountable to the shareholders ofpublic companies. The act contains four mainprovisions:

CEOs and CFOs must make extensive certificationsregarding the accuracy and completeness of theirannual and quarterly financial statements. Penalties forfalse or incomplete statements can be an individual fineof up to $5 million and imprisonment of up to 20 years.

A new Public Company Accounting OversightBoard will oversee independent auditing firms.

Public companies must disclose material changesin their financial condition or operations on a rapidand current basis.

Corporate loans to executives and directors areprohibited.

Association for Investment Management andResearch (AIMR) Research Objectivity Standards.On July 17, 2002, AIMR released its Research Objec-tivity Standards, whose purpose is to create anenvironment that promotes objective securities re-search and analyst independence. The standards aredesigned to regulate the behavior of both “sell side”firms (brokerage houses and investment banks) and“buy side” firms (investment management firms) inthe production, use, and distribution of analystrecommendations. Among the more notable pro-posed requirements are the following:

Analyst compensation must be commensuratewith the quality of the research and the accuracy ofthe analyst recommendations.

Investment banking must be segregated frominvestment research and must not be allowed toinfluence analyst research or recommendations.

All conflicts of interest on the part of both theanalyst and the firm must be fully disclosed.

The research analyst may not take a stock positionthat differs from his or her recommendation to thepublic.

The Investment Protection Principles. At thebeginning of July 2002, the Attorney General of theState of New York, the Comptroller of the State ofNew York, the Treasurer of the State of NorthCarolina, and the Treasurer of the State of Californiaall implemented new Investment Protection Prin-ciples (IPP) in their dealings with broker/dealers andinvestment banks. These principles were set forth inthe agreement reached between the New York StateAttorney General and Merrill Lynch in connectionwith Merrill’s $100 million settlement for deceptiveanalyst recommendations. Upon the motion of theTreasurer of the State of California, the CaliforniaPublic Employees’ Retirement System and the Cali-fornia State Teachers’ Retirement System have alsoadopted the IPP in their business dealings withbroker/dealers and investment firms, and it is likelythat other institutional investors will follow suit. TheIPP are very similar to the AIMR Research ObjectivityStandards (indeed, they contain nearly identicalprovisions) in that their purpose is to restore cred-ibility, investor confidence, and integrity in analystrecommendations regarding public corporations.

These various recommendations and proposalsshould generally serve to reinforce and enhance theshareholder value effect of CalPERS’ Focus List. TheSarbanes-Oxley Act, for example, makes key corpo-rate “players” more accountable to shareholders,although it does not specifically provide for en-hanced shareholder power. To the extent that the actencourages and empowers competent and ethicalpeople serving as directors and managers of publiccorporations, shareholders will expect corporateofficers and directors to devise more effective re-sponses to deficiencies in corporate governance,which should enhance the price impact of the FocusList. This enhancement should be greatest in largerpublic corporations, where corporate accountabilityhas been the most lacking. Similarly, the provisionsin the AIMR’s Research Objectivity Standards and theInvestment Protection Principles have one purpose:to restore credibility, confidence, and integrity inanalyst recommendations. Greater analyst indepen-dence and credibility should lead to an enhancedunderstanding of CalPERS’ Focus List and thereforea greater shareholder value impact upon and follow-

Many investors may react favorably to a company’s appearance on CalPERS’ FocusList because of CalPERS’ underlying commitment to work with such companies to

improve their corporate controls.

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110JOURNAL OF APPLIED CORPORATE FINANCE

ing its publication. On the other hand, the variousproposals tend to place more voting power inshareholders’ hands. We found above that theshareholder wealth impact of CalPERS’ Focus List isgreater for large public corporations whose sharesare widely held. Perversely then, the recommenda-tions might somewhat reduce the financial impact ofCalPERS’ Focus List because empowered sharehold-ers may be less in need of a large institutionalinvestor like CalPERS to champion their cause.

THE CASE FOR SHAREHOLDER ACTIVISM BYPASSIVE INDEX FUNDS

Many institutions have a passive investmentapproach through index funds. Equity index invest-ing is a popular strategy with both institutional andretail investors. The size of this market is huge—it isestimated that the industry total for all index provid-ers approaches $2.5 trillion.13 The sheer size of theequity index market makes it a fertile breedingground for shareholder activism. This is especiallytrue for institutional investors who have sufficientresources to pursue a corporate governance pro-

gram. However, institutional investors may questionthe value of shareholder activism because of the“free rider” problem—other shareholders contributenothing to the corporate governance initiative yetreceive just as much benefit as the investor whoactively pursued the governance plan of action.

Yet consider the following example. An institu-tional investor holds 1% of the stock of XYZ Com-pany, currently worth $100 million, in its passiveindex fund. The management of XYZ Company haspursued costly “empire-building” strategies that havedone nothing to increase shareholder wealth. As aresult, the company has declined in value by 5% eachyear for the last three years.

Unfortunately, the institutional investor cannotsell the stock because it must pursue a buy-and-holdstrategy in its index fund. Passive index investingimposes a significant constraint on an investor—theinability to sell an underperforming stock. Indexinvestors achieve a breadth of equity exposurecheaply and efficiently. However, they must acceptthe poor financial performance of any underachiev-ing companies that are contained in their chosenindex.

A Focus List Case History

In the fall of 1999, CalPERS approached A.G.Edwards & Sons, a regional broker/dealer andfinancial services firm based in St. Louis, Missouri,as a candidate for its annual Focus List. Thecompany was flagged through CalPERS’ screen-ing process due to poor financial performanceand corporate governance issues. CalPERS’ re-search indicated that A.G. Edwards was signifi-cantly underperforming the financial market andits peer group, despite a tremendous stock marketboom—over the previous two years, the companyhad underperformed the S&P 400 Midcap Indexby 53% and the S&P Midcap Diversified FinancialServices Index by 17%.

CalPERS believed that the market had lostconfidence in management’s ability to run thecompany effectively because of poor governancepractices. Chief among these concerns were thelack of an independent board of directors, aconflict of interest in establishing the pay of the

CEO, and the inadequacy of director compensa-tion. Through meetings and correspondence withCalPERS, the company agreed to:

Restructure the board to include a majority ofindependent directors;

Establish a nominating committee consisting ofindependent directors and the CEO;

Make director compensation more competitive,and make part of compensation equity-based; and

Eliminate any involvement of executive man-agement in establishing the compensation of theCEO.

These were important and significant im-provements in A.G. Edwards’ corporate gover-nance policies, as demonstrated by their financialimpact. For the two-year period after appearingon CalPERS’ Focus List, A.G. Edwards outper-formed the S&P 400 Midcap Index by 25% and theS&P Midcap Diversified Financial Services Indexby more than 65%.

13. See Anson (2002), cited earlier.

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111VOLUME 15 NUMBER 3 SPRING 2003

If the management of XYZ Company continueson its current path, the institutional investor canexpect next year to lose another 5%, or $5 million,on its investment. Under these circumstances, theinstitutional investor would be better off if it pursueda program of intervention in the corporate gover-nance of XYZ Company. In fact, the institutionalinvestor has an incentive to spend up to $5 millionto curtail management’s empire-building strategy.

CONCLUSIONS

CalPERS’ strategy is to pursue a course of actionaimed at improving the overall performance of publiccompanies in its investment funds. Corporate gover-nance programs can have an impact not only ontargeted companies, but on the broader stock mar-ket—the lessons made public and learned by onecorporation can influence the performance of otherpublic corporations. Alternatively, an investor mightchoose to concentrate its efforts on a single company.

We have demonstrated that over the period1992-2001, CalPERS’ Focus List created significantvalue for the shareholders of targeted corporations.This wealth-enhancing effect was greatest for large-cap stocks with diverse shareholder bases. Addi-tionally, the shareholder value effect was greater forcorporations with more extensive Wall Street ana-lyst coverage. Last, the shareholder wealth effectwas greater for companies that the market hadpreviously identified as laggards, as compared tocompanies that the market had previously identi-fied as good performers. Nonetheless, inclusion onCalPERS’ Focus List significantly enhanced share-holder value in every case. We conclude thatCalPERS’ corporate governance program is suc-cessful in changing corporate behavior, and weencourage passive index investors to pursue similarprograms when it is in their interest to do so. Thenew era of corporate governance and responsibilityin the United States makes shareholder activismeven more important.

MARK ANSON

is Chief Investment Officer of CalPERS.

TED WHITE

is Director of Corporate Governance of CalPERS.

HO HO

is Quantitative Equity Portfolio Manager of CalPERS.

To the extent that the Sarbanes-Oxley Act makes key corporate “players” moreaccountable, shareholders will expect corporate officers and directors to devisemore effective responses to deficiencies in corporate governance, which should

enhance the price impact of the Focus List.

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