The UK Code of Corporate Governance: Link Between Compliance and Firm Performance

Abstract

Listed companies in the UK are required to comply or give reasons for non-compliance with the recommendations of the UK code of corporate governance called The Combined Code. Prior studies investigating the relationship between compliance and firm performance have found the link to be either non-existent or at best weak. This study, taking a more holistic view of compliance develops an index of non-compliance for a panel of FTSE350 companies for four years (2000-2003). Using total shareholder return (TSR) as the measure of firm performance, we find that the Index is negatively related to TSR, implying that more compliant firms have higher returns. Contrary to the widely held assumption that governance variables are endogenous, our direct test for the endogeneity of the Index finds no evidence of endogeneity. This implies that causation runs from the Index to performance. One reason for the clear contrast of our findings with previous work could be our choice of performance measurement. Assuming that compliance with the Code is a means of signaling to investors that firms are well governed and by implication working in the interests of shareholders, the effects of such positive perceptions can be argued to fall more on market driven measures of firm performance than on measures that rely on accounting based values, such as the various proxies for Tobin's Q. Another reason could be the emphasis on constructing a finely tuned, comprehensive index, incorporating elements of compliance with both the letter as well as the spirit of the Code. Overall, our results suggest that for today's informed and discerning investors, compliance matters not just as a box ticking exercise but as a real change in the governance of large listed companies, for which they are willing to pay a premium.