Differences in Governance Practices between U.S. and Foreign Firms : Measurement, Causes, and Consequences

In this paper, we compare the governance of foreign firms to the governance of comparable U.S. firms using propensity scores. We find that it is quite important, when comparing the governance of foreign firms and U.S. firms, to do so by comparing apples to apples, namely firms with similar characteristics. Comparisons based on country averages of firm-level governance indices understate the magnitude of the differences in investment in internal governance across countries because small firms, which typically invest less in internal governance, are over-weighted in the U.S. We call the difference in governance between a foreign firm and its matching U.S. firm the governance gap. For the typical foreign firm, the governance gap is negative in that the foreign firm invests less in internal governance than its matching U.S. firm. A foreign firm is much less likely to have a negative governance gap in a country with good investor protection, so that there is clear evidence that investment in internal governance and investor protection are complements rather than substitutes. We find that the governance gap is strongly related to firm value. Firms which invest less in internal governance than their matching U.S. firm are worth less and their value shortfall increases with their internal governance investment shortfall. We conclude that a firm's underinvestment in governance compared to its matching U.S. firm cannot be explained by unobserved firm characteristics which would make it optimal for the foreign firm to invest less in internal governance. Country characteristics play an extremely important role in explaining why the typical foreign firm invests less in internal governance than its matching U.S. firm. However, neither investor protection nor other country characteristics completely explain the relation between a firm's internal governance investment and its value. It is quite likely that firms typically underinvest in internal governance because doing so is optimal for their controlling shareholder and suboptimal for their minority shareholders. An increase in a typical foreign firm's investment in internal governance would make minority shareholders better off, but would not make its controlling shareholder better off. Further, in countries which place greater weight on the interests of stakeholders, an improvement in internal governance might also adversely affect these stakeholders