There is a negative relationship between

Transcription

Corporate Ownership & Control / Volume 6, Issue 1, Fall 2008
CORPORATE
OWNERSHIP & CONTROL
КОРПОРАТИВНАЯ
СОБСТВЕННОСТЬ И КОНТРОЛЬ
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EDITORIAL
Dear readers!
This issue of the journal Corporate Ownership and Control has a very unique feature – a truly
international focus of corporate governance research. Our contributors made their utmost to deliver
the newest knowledge on corporate governance in many countries such as the USA, Australia, South
Africa, Italy, Portugal, China, Brazil, Jordan. We would like to remark that during last five years of our
activity we published in Corporate Ownership and Control journal papers about corporate governance
in 54 countries of the world.
Authors of the papers were very convincing in delivering the conclusions to the editors and reviewers.
Almost all papers are the result of team working and this fact makes us more than optimistic regarding
the future of research of corporate governance. Academic teams from Australia, Japan, Portugal, Spain,
Germany, Brazil and truly international teams from Jordan and Australia, the USA and Taiwan
demonstrated ability of academic community to unite their efforts toward establishing and further
development of the best standards in corporate governance research. We really enjoyed cooperating
with these researchers during the process of reviewing their papers. Team working contributed
sufficiantly to their ability to be realiable and accurate in revising their papers. Having published in
Corporate Ownership and Control journal papers of more than 1450 authors since 2003 we were sure
about very systematic progress in this sphere of our relationships.
We would like to draw the attention of the reading audience to the issue of progress made by
contributors over the last five years. Their papers improved remarkably from the point of view of the
research methodology and conceptual consideration. Authors are very effective in mixing practice and
theory of corporate governance. Doing so they maximize an outcome from their research. Over last five
years we published in Corporate Ownership and Control journal papers on various issues of corporate
governance, from such widely accepted as corporate ownership to such unique as stock options. Any
field of research in corporate governance was developed by our contributors as much as possible.
The previous issue of the journal Corporate Ownership and Control was a jubilee issue of our journal –
the 20th issue. We outlined a main objective for the next five years - international representation with a
focus on corporate governance issues. With this issue of the journal we start the move in that way and
invite you to join us.
4
CORPORATE OWNERSHIP & CONTROL
Volume 6, Issue 1, Fall 2008
CONTENTS
Editorial
4
SECTION 1. ACADEMIC INVESTIGATIONS AND CONCEPTS
GOVERNMENT CONTROL AND THE HIGHER COSTS OF GOING PUBLIC:
EVIDENCE FROM A NEW STOCK MARKET IN CHINA
9
Nobuyuki Teshima, Katsushi Suzuki
IPO underpricing or the indirect cost of going public is extremely high in China. We hypothesize that
government control over the corporate economy underlies this puzzle. Specifically, bureaucratic
managers in state-owned firms as well as regulatory authorities have incentives to underprice. Using a
sample of a new stock market in China, we find evidence supporting this hypothesis. Underpricing is
higher for state-owned firms and for IPOs before the reform making IPO prices less affected by the
regulator. Furthermore, we find that the reduction in underpricing or indirect cost by the reform more
than offsets the increase in direct costs for compensating underwriters‟ higher efforts. Overall, the
reform making IPO process more market-oriented is beneficial to Chinese firms going public.
SEPARATION BETWEEN MANAGEMENT AND OWNERSHIP:
IMPLICATIONS TO FINANCIAL PERFORMANCE
16
Zélia Serrasqueiro, Paulo Maçãs Nunes
Using panel data, this article shows that agency costs, a consequence of the separation between
ownership and management, are not relevant in explaining the financial performance of Portuguese
companies since, on the one hand, greater size, greater liquidity and higher level of risk do not mean
decreased financial performance and, on the other, greater level of debt does not mean increased
financial performance. The results indicate that the fact of managers being better informed than
owners, about companies‟ opportunities and specific characteristics, does not necessarily mean
behaviour that contributes to diminished financial performance in Portuguese companies.
THE DETERMINANTS OF CAPITAL STRUCTURE:
THE CASE OF LONG-TERM DEBT CONSTRAINT FOR JORDANIAN FIRMS
22
Rami Zeitun, Gary Tian
This paper contributes to the capital structure literature by investigating the determinants of capital
structure of Jordanian companies with the constraint of inadequate long-term debt as their source of
financing and regional risk. We firstly document that Jordanian companies mostly depend on shortterm debt, as a result of the banking credit policy that promotes short-term debt. Our results suggest
that the level of gearing in Jordanian firms is positively related to size, tangibility, and earning
volatility, and negatively correlated to profitability, the level of growth opportunities, liquidity and
stock market activities. The level of gearing measured by short-term debt is, however, negatively
5
correlated to tangibility. The Gulf Crisis between 1990 and 1991 is also found to have a significant but
positive impact on Jordanian corporate leverage.
DIVIDENDS AND INSTITUTIONAL INVESTORS ACTIVISM:
PRESSURE RESISTANT OR PRESSURE SENSITIVE?
38
José María Diez Esteban, Óscar López-de-Foronda
This paper provides new international evidence on the relationship between dividend policy and
institutional ownership by analysing a sample of US and UK and Irish firms characterised by an AngloSaxon tradition and a matching sample of other EU companies from Civil Law legal systems. We find
that while in firms from Anglo-Saxon tradition the relation between dividends and institutional
investors, pension and investment funds, is possitive, in Civil Law countries the relation is negative
where investors are banks or insurance companies with other private interest inside the firm.
INFORMATION SIGNALING AND OWNERSHIP TRANSITION –
VALUE EFFECTS OF SHARE ISSUE PRIVATIZATIONS
44
Martin Ahnefeld, Mark Mietzner, Tobias Roediger, Dirk Schiereck
This paper discusses whether SIPs generate positive announcement returns because of increased
efficiency after the ownership transition. We apply a market model event-study methodology based on
a sample of 134 SIPs in the 1979-2003 period. We identify significantly negative CAARs between 0.125% and -1.766% and find that firm and offering size, the proportion of secondary shares issued
within the SIP as well as the market environment have a negative impact on announcement returns. In
contrast, the negative CAARs are less distinctive for enterprises that had prior SIPs.
CEO DUALITY AND FIRM PERFORMANCE—AN ENDOGENOUS ISSUE
58
Chia-Wei Chen, J. Barry Lin, Bingsheng Yi
Whether dual CEO leadership structure is better for corporations is one of the most hotly debated
issues in corporate finance. This paper uses a recent data to re-examine the relationship between CEO
duality and firm performance, controlling for other important variables such as firm characteristics,
ownership structure, CEO compensation, and agency costs. We find a recent trend of increased
number of firms converting from dual to non-dual CEO structure. However, our empirical results do
not show a significant relationship between CEO duality and firm performance nor improvement in
firm performance after change in leadership structure. We find evidence of endogeneity, and we
attribute the insignificance of the relationship between CEO duality and firm performance to the
possibility that CEO duality is endogenously and optimally determined given firm characteristic and
ownership structure.
VALUE BASED FINANCIAL PERFORMANCE MEASURES: AN EVALUATION OF
RELATIVE AND INCREMENTAL INFORMATION CONTENT
66
Pierre Erasmus
This paper investigates the ability of four VB measures to explain market-adjusted share returns and
compare it to that of some traditional measures. Empirical results indicate that the relative information
contents of the VB measures are not greater than that of earnings. The incremental information content
tests indicate that their components add significantly to the information content of earnings, but that
the level of significance is relatively low.
MIGRATION TO ―NOVO MERCADO‖: DOES IT REALLY MEAN IMPROVEMENT OF
CORPORATE GOVERNANCE PRACTICES?
78
Andre Carvalhal, Guilherme Quental
This paper addresses this question by investigating the stock market reaction to the listing on Novo
Mercado without improving governance practices. We provide evidence that firms that list on NM and
improve governance practices earn positive abnormal returns, have higher liquidity and lower
6
volatility. On the other hand, firms that list on NM without improving governance practices do not earn
positive returns, but are rewarded with higher liquidity and lower volatility.
OWNERSHIP AND CONTROL OF ITALIAN BANKS:
A SHORT INQUIRY INTO THE ROOTS OF THE CURRENT CONTEXT
87
Leonardo Giani
This work does a short inquiry into the past experience of the Italian banking law and the ownership
structure of the Italian credit industry. The inquiry is especially focused on the role played by culture
and other historical events (e.g. political ones) in shaping the Italian economic framework. In other
words, this paper wants to trace a short and descriptive outline of the evolution of the Italian banks‟
ownership structure in order to show how political and social factors counted in determining the
present features of the system.
THE EFFECT OF THE SOUTH AFRICAN MARKET CONCENTRATION
ON PORTFOLIO PERFORMANCE
99
Jakobus Daniël (JD) van Heerden, Sonja Saunderson
Portfolio risk is mainly a function of portfolio concentration and covariance between the assets in a
portfolio. This study shows that South Africa experiences a high level of market concentration and that
assets with large weights in the FTSE/JSE All Share Index (ALSI) have large covariances with each
other. Together these two phenomena suggest that a high level of portfolio risk can be expected. Active
portfolio managers in South African generally attempt to decrease portfolio concentration by deviating
from the benchmark‟s weighting structure in order to decrease their portfolio risk. The effect of such a
portfolio construction process on the measurement of relative performance, where the ALSI is used as
the benchmark, was investigated by means of a simulation process. The results indicated that during
times when those shares with larger weights in the index perform well, the probability of outperforming
the ALSI is very small, while the probability of outperforming the ALSI during times when those same
shares perform poorly is very high. These findings suggest that investors need to be educated about the
bias regarding relative performance measurement using broad market indices, while alternative or
additional methods of performance measurement need to be investigated to minimise this bias.
SECTION 2. STOCK OPTIONS
THE IMPACT OF EXPENSING STOCK OPTIONS IN
BLOCKHOLDER-DOMINATED FIRMS. EVIDENCE FROM ITALY
107
Andrea Melis, Silvia Carta
This paper has investigated the economic consequences of recording the cost of stock options at its fair
value, in terms of its impact on the companies‟ reported earnings, and other key financial performance
indicators, such as diluted earnings per share (EPS) and return on assets. The impact of the mandatory
recording of the cost of stock options measured at its fair value has generally reduced the reported
earnings and other key performance measures moderately. Despite some evidence of creative
accounting which was found concerning the elusion of the substance over form principle for the
accounting of stock options plans set up before 7 th November 2002, accounting regulation has
increased the level of disclosure by making companies report the “true” cost of stock options in their
Profit or Loss. Based on 2004 stock-based remuneration disclosures of the value of options given to
directors and employees, the expensing of options have a material negative impact on nearly 30 per
cent of the sample firms‟ reported income and diluted EPS.
IS THERE A FIRM-SIZE EFFECT IN CEO STOCK OPTION GRANTS?
115
Bruce Rosser, Jean Canil
We substitute Hall and Murphy‟s (2002) pay-performance sensitivity metric to detect a firm size effect
in CEO stock option grants. After adjusting for small-firm risk aversion and private diversification
„clienteles‟, we document evidence of a residual small-firm effect impacting on incentive strength
7
principally through grant size. Given lower small-firm deltas, grant size appears to have been increased
by compensation committees to ensure small-firm CEOs are not under-compensated relative to their
large-firm counterparts.
SECTION 3. NATIONAL CORPORATE GOVERNANCE: AUSTRALIA
A PRINCIPLES-BASED ANGLO GOVERNANCE SYSTEM IS NOT A SCIENCE
BUT AN ART
127
Suzanne Young, Vijaya Thyil
This paper through interviewing a number of Australian business executives adds to the academic
literature by providing evidence from the field of the important characteristics of the Australian
governance system, the drivers of change and the effectiveness of the principles-based approach. It
argues that debate needs to move beyond the principles versus rules approach to look at how firms can
be provided with more guidance in operationalising some of the principles that appear to be key to
governance effectiveness. It concludes that there is a need for a holistic model of governance that is
broader than that focusing on the control/legalistic approach; that top management is important in
setting and driving the in-firm governance agenda; that the public needs to be informed and educated
about governance and its importance; and that disclosure still requires an improvement in quality.
THE IMPACT OF CORPORATE GOVERNANCE LEGISLATION ON THE
MARKET FOR CORPORATE OWNERSHIP
138
Joseph Canada, Tanya Benford, Vicky Arnold, Steve G. Sutton
The purpose of this study is to examine how a company‟s decision to shift corporate ownership and/or
corporate control in the face of new corporate governance legislation and regulatory requirements can
alter the traditional markets for ownership and control. In order to examine this issue, the paper first
develops a typology for predicting the type of organizational restructuring that might occur. This
typology incorporates factors from prior research and disentangles the market for ownership from the
market for corporate control. The typology is then used as a basis for an in-depth examination of an
organization whose corporate structure changed in response to mandated changes in corporate
governance. The results provide evidence that corporate governance legislation can potentially induce
incumbent management to voluntarily compete in the market for ownership, notwithstanding the
associated exposure in the market for managerial control.
SECTION 4. PRACTITIONER’S CORNER
THE SOX 404 PROCEDURE; IS IT STILL SO REPELLING TO FOREIGN ISSUERS?
147
Marina Stefou
The recent banking crises and the famous financial scandals have revealed the need for strong internal
control mechanisms. However, due to the inherent limitations of internal control achievement of the
financial reporting objectives cannot be absolutely ensured. A great reform in the internal control
mechanism was introduced by the controversial Article 404 of Sarbanes-Oxley Act of 2002. This paper
lays out the internal control provision described in Sarbanes-Oxley Act, presents the extraterritorial
effects on foreign issuers, compares and summarizes overall findings towards ensuring a better
financial environment with regard to the international and European corporate governance framework
applied.
8
РАЗДЕЛ 1
НАУЧНЫЕ ИССЛЕДОВАНИЯ
И КОНЦЕПЦИИ
SECTION 1
ACADEMIC
INVESTIGATIONS
& CONCEPTS
GOVERNMENT CONTROL AND THE HIGHER COSTS OF GOING
PUBLIC: EVIDENCE FROM A NEW STOCK MARKET IN CHINA
Nobuyuki Teshima*, Katsushi Suzuki*
Abstract
IPO underpricing or the indirect cost of going public is extremely high in China. We hypothesize that
government control over the corporate economy underlies this puzzle. Specifically, bureaucratic
managers in state-owned firms as well as regulatory authorities have incentives to underprice. Using a
sample of a new stock market in China, we find evidence supporting this hypothesis. Underpricing is
higher for state-owned firms and for IPOs before the reform making IPO prices less affected by the
regulator. Furthermore, we find that the reduction in underpricing or indirect cost by the reform more
than offsets the increase in direct costs for compensating underwriters‟ higher efforts. Overall, the
reform making IPO process more market-oriented is beneficial to Chinese firms going public.
Keywords: IPO underpricing; Government control; State ownership; Underwriting fee; Shenzhen
SME Board
*Nobuyuki Teshima (teshima@isc.senshu-u.ac.jp) is with School of Commerce, Senshu University, Japan, and Katsushi Suzuki
(kasuzuki@ms.kuki.tus.ac.jp) is with School of Management, Tokyo University of Science, Japan. We are grateful to the
participants of the 4th SMEs in a Global Economy Conference in Shah Alam, Malaysia for their helpful comments. We
acknowledge financial support by “Open Research Center” Project for Private Universities: matching fund subsidy from MEXT
(Japanese Ministry of Education, Culture, Sports, Science and Technology), 2004-2008.
Corresponding author: Nobuyuki Teshima
Address: Senshu University, School of Commerce, 2-1-1, Higashimita, Tamaku, Kawasaki, Kanagawa, 214-8580, Japan.
Tel: +81-44-900-7937
Fax: +81-44-900-7849
Email address: teshima@isc.senshu-u.ac.jp
1. Introduction
The large IPO underpricing in Chinese IPO market
presents us with a puzzle. In Ritter‘s (2003) list of 38
countries, average underpricing in China for 1990–
2000 is by far the largest at 256.9%, followed by
Malaysia at 104.1%.1 IPO underpricing guarantees a
handsome return to investors who have been allocated
IPO shares, while creating an indirect cost to the
firms going public, since they issue shares at prices
1
More recently, Chen et al. (2007) indicate average
underpricing of 213.4% for 1,213 IPOs of state-owned firms
in China during1993–2006.
9
that are lower than what investors in the market are
willing to pay.
The attempts to explain this large underpricing by
traditional and mostly U.S. IPO literature are not
sufficient, since, in the literature, the government
plays no material part, which is obviously not the case
in China. We argue that government control over the
corporate economy underlies the large underpricing in
China. In typical Chinese IPOs, the issuers and the
regulator are the government, and the managers of
issuing firms and the underwriters have close ties with
the government. Those parties share incentives to
underprice IPO shares in pursuit of their respective
interests.2 In particular, we focus on the incentives of
managers and regulators, and hypothesize that the
incentives of both parties cause the large IPO
underpricing in China.
First, managers in state-owned firms are appointed
by the government and have no significant
shareholdings in their firms. It is quite common that
the government appoints government officials as
managers of state-owned firms or, conversely,
appoints managers as government officials (Chen et
al., 2007). In such circumstances, managers are likely
to attach more importance to their bureaucratic
careers than to value maximization of the firms they
manage. In the case of IPOs, they have incentives to
underprice the firms‘ shares in order not to be
penalized for putting the stock market in disarray. 3
Our hypothesis implies that underpricing is higher for
state-owned firms, which can explain the large
average IPO underpricing in China, where stateowned firms are predominant.4
Second, the China Securities Regulatory
Commission (CSRC), which is the regulatory
authority of the stock market, also has incentives to
underprice IPO shares. The CSRC or Chinese
government deliberately underprices so as not to upset
IPO investors. Once investors suffer a loss in IPOs,
they turn away from the stock market and the
subsequent IPOs of state-owned firms are
jeopardized. Since the reopening of the Chinese stock
market in 1990, the CSRC has strictly controlled or
greatly affected IPO share prices. In the beginning of
2005, however, the IPO process was changed to a new
one in which share prices are determined through
bookbuilding. Under bookbuilding, IPO share prices
2
We do not explicitly consider the incentives of
underwriters. Presumably, however, the interests of the
managers of state-owned underwriters are in line with those
of the managers of state-owned issuing firms.
3
Chen et al. (2007) further speculate that managers of stateowned firms pursue promotion in the bureaucratic hierarchy
by allocating underpriced shares to parties that are
important to their careers.
4
Dewenter and Malatesta (1997) compare the underpricing
between state-owned firms and privately owned firms. They
find that underpricing for state-owned firms is higher in
France and in the U.K., but lower in Canada and in
Malaysia. Their sample does not include IPOs in China,
where state-owned firms are predominant.
10
are determined after solicitation to institutional
investors, including qualified foreign institutional
investors (QFIIs) presumably skilled in IPO
investment. Since IPO prices after the 2005 reform
reflect more investor demand and less government
intention, our hypothesis implies that IPO
underpricing in China is reduced after the 2005
reform.5
This study is related to those of Datar and Mao
(2006) and Chen et al. (2004), which associate
Chinese IPO underpricing with the nation‘s
institutional features. Using a sample of IPOs for
1990–1996, Datar and Mao (2006) find evidence
indicating that the Chinese government deliberately
underprices IPO shares. Chen et al. (2004) find that
state-ownership is positively correlated with IPO
underpricing during 1992–1997. These two studies
suggest that government control affects underpricing
in China. However, the fact that virtually all the
sample firms in these studies are state-owned makes it
difficult to detect the impact, if any, of government
control on large underpricing. Besides, the IPO prices
were determined by the CSRC in terms of P/E
multiples until March 2001. Thus, it is not certain if
the managerial incentives of state-owned firms had
any effect on underpricing before 2001. Finally, also
until March 2001, the Chinese regulatory authority
imposed stiff quotas on the issuance of IPO shares.
Thus, large underpricing in the previous studies is
possibly attributable to the quota system.
Since the restart of the Chinese stock exchanges in
the early 1990s, most firms listed on them have been
large state-owned firms, and it is no exaggeration to
say that these stock exchanges have served as places
for state-owned firms to raise capital. In June 2004,
the Shenzhen Stock Exchange launched the SME
Board to deal exclusively in securities of small and
medium enterprises (SMEs). Our sample is from this
new market, where the level of underpricing is yet to
be examined. Moreover, due to its SME-oriented
nature, almost equal number of state-owned firms and
privately owned firms are listed on this market, which
is advantageous in studying the effect of state
ownership. Using this market, we detect how
underpricing has been affected by state ownership and
the 2005 reform.6
It should be noted that if the indirect cost of IPOs
(i.e., underpricing) is reduced by the 2005 reform, as
we expect, this does not mean that the total costs of
5
The theoretical model of Benveniste and Spindt (1989) as
well as empirical findings by Ljungqvist et al. (2003)
suggest that bookbuilding method per se does not
necessarily reduce IPO underpricing.
6
Prior to the opening of the SME Board, regulatory reforms
enhancing transparency in IPOs were implemented in
December 2003 and February 2004. Our sample starting
from June 2004 has the merit of being unaffected by these
reforms. Since in China IPOs were suspended in June 2005
for another reform aiming at the elimination of nontradable
shares, we set our test period from June 2004 (the opening
of the SME Board) to June 2005 (IPO suspension).
going public are reduced by the reform. Since the new
procedure requires more effort on the part of
underwriters, they presumably charge higher
underwriting fees to issuers, which is a major
component of direct IPO costs. We examine this issue
after testing our hypothesis above.
In the empirical analysis, we find that
underpricing is significantly higher for state-owned
firms and it is significantly reduced by the 2005
reform. The results support our hypothesis that
government control over the corporate economy
underlies the large underpricing in China. Finally, we
examine how the total costs of going public are
affected by the 2005 reform. We find that the direct
IPO costs are raised significantly, which suggests that
underwriters charge higher fees compensating for
their greater effort. However, the reduction in
underpricing more than offsets the increase in direct
costs. Overall, we conclude that the reform making
the IPO procedure more market-oriented is beneficial
to Chinese firms going public.
The rest of the paper is organized as follows. In
section 2, we develop the hypothesis regarding
government control and IPO underpricing. Section 3
describes our sample and data. Regression results on
underpricing and total costs are presented in section 4.
Section 5 concludes.
2. Hypothesis
IPO underpricing in China is the highest among major
stock markets. The attempts to explain this large
underpricing by traditional and mostly U.S. IPO
literature are not sufficient, because in this literature
the government plays no material part, which is
obviously not the case in China.
We focus on the relation between government
control over the corporate economy and IPO
underpricing. In particular, we hypothesize that
managers of state-owned firms as well as regulatory
authorities have incentives to underprice IPO shares.
First, managers in state-owned firms are appointed by
the government and have no significant shareholdings
in their firms. It is quite common that the government
appoints government officials as managers of stateowned firms, or conversely, appoints managers as
government officials (Chen et al., 2007). In such
circumstances, managers are likely to attach more
importance to their bureaucratic careers than to value
maximization of the firms they manage. In the case of
IPOs, they are concerned more about a personal
penalty for putting the stock market in disarray than
they are about underpricing, which creates indirect
cost for the firms. Consequently, we expect that
underpricing is larger for state-owned firms than for
privately owned firms in China.
Second, the CSRC, which is the regulatory
authority of the stock market, also has incentives to
underprice IPO shares. The authority or Chinese
government deliberately underprices so as not to upset
investors. Once investors suffer a loss in IPOs, they
turn away from the stock market, which could
jeopardize subsequent IPOs of state-owned firms.
Since the reopening of the Chinese stock market in
1990, the CSRC has determined or greatly affected
IPO prices. In the beginning of 2005, however, the
IPO process was reformed, in order to make it more
market–oriented. In the new procedure, issuers and
underwriters commence sales promotion and
bookbuilding, once IPO applications have been
approved by the CSRC. Bookbuilding is divided into
two stages. Issuers and underwriters set a price range
through preliminary bookbuilding, and actual issuing
prices are determined through formal accumulative
bookbuilding. Moreover, the bookbuilding process is
conducted with institutional investors including
qualified foreign institutional investors (QFIIs), who
are presumably skilled in IPO investment. As a result,
IPO prices after this reform reflect more investor
demand and much less governmental intention than
before. Thus, we expect that IPO underpricing in
China is reduced by the reform in 2005.
3. Sample and data
China reopened its stock exchanges in the early 1990s
in Shanghai and Shenzhen. Most firms listed on these
stock exchanges are large state-owned firms, and it is
no exaggeration to say that they have served as places
for state-owned corporate groups to raise capital. In
June 2004, the Shenzhen Stock Exchange launched its
SME Board to deal exclusively in SME securities.
Our sample is from this new market, where the level
of underpricing has not been explored.
Moreover, our sample has the following
advantages as a laboratory of exploring the effects of
government control. First, preceding Chinese IPO
studies use samples consisting predominately of stateowned firms, and this makes it difficult to abstract the
effects of state ownership. On the SME Board,
however, almost equal number of state-owned firms
and privately owned firms are listed due to its SMEoriented nature. Second, since the Chinese IPOs were
conducted under a stiff quota for 1990–2001,
underpricing during this period was more or less
affected by the quota. Finally, Chinese IPOs
underwent material reforms in December 2003 and
February 2004. The SME Board, opened after these
reforms, arguably makes a good IPO laboratory.
Our sample consists of 50 firms that were listed
on the SME Board from its opening in June 2004 to
June 2005 when IPOs were suspended in China. All
data used in our analysis are obtained from
prospectuses available on the Shenzhen Stock
Exchange website. Table 1 shows the summary
statistics for our full sample as well as for subsamples
of 24 state-owned firms and 26 privately owned firms.
Firms are classified as state-owned if they have the
government or another state-owned entity as
shareholders.
[Insert Table 1 about here]
11
Underpricing or the indirect cost of an IPO is
measured as the initial return, using the offer price
and the aftermarket price (the closing price of the first
trading day). The mean (median) underpricing is
60.7% (48.6%) for our full sample, which is smaller
than the levels previously reported for Chinese IPOs
but is still larger than other major markets. The mean
(median) is 76.9% (55.1%) for state-owned firms and
45.9% (28.4%) for privately owned firms. The
difference in mean is statistically significant at the
10% level.7 The mean gross proceeds (the issue price
multiplied by the number of new shares) are
significantly smaller for state-owned firms.
Interestingly, however, the average number of new
shares (in 10 millions) is almost identical between
state-owned firms and privately owned firms (2,735
and 2,767 respectively, with a t-value of −0.134),
while the average issuing price is lower for stateowned firms than for privately owned firms
(RMB8.47 and RMB9.83 respectively, with a t-value
of −1.425). Thus, the smaller gross proceeds for stateowned firms are possibly a result of larger
underpricing.
We measure firm size by total assets and sales
revenues in the year preceding the IPOs. Total assets
are not significantly different, while the sales
revenues are larger for privately owned firms at the
10% significance level. Finally, about three quarters
of the sample firms conducted IPOs before the 2005
reform, and the ratio is almost identical between the
two subsamples.
4. Regression analyses
4.1 Underpricing
In order to test our hypothesis that large underpricing
in China is associated with government control over
the corporate economy, we regress underpricing on
dummy variables for state-owned firms (STATEOWNED) and for IPOs conducted before the 2005
reform (PRE-REFORM). We expect the coefficients
of the two dummy variables to be positive, which
indicates that underpricing or the indirect IPO cost is
higher for state-owned firms and for IPOs before the
2005 reform.
Control variables are included in the regressions
based on previous IPO literature. Both issue size and
firm size are expected to be negatively related to
underpricing, since the larger an IPO, the smaller the
informational asymmetry and uncertainty (Beatty and
Ritter, 1986). We use the natural logarithm of the
gross proceeds (LN (proceeds)) to control issue size
effect. The natural logarithm of total assets (LN
(assts)) and sales revenue (LN (sales)) are used to
control firm size effect.
As Ritter and Welch (2002) suggest, market
conditions are also associated with underpricing.
7
Hereunder we use a t-test assuming unequal variance in
comparing state-owned firms and privately owned firms.
12
Traditional IPO literature documents that higher
market returns are associated with larger underpricing
(e.g., Derrien and Womack, 2003). However, under
our hypothesis that bureaucratic managers and the
government put a higher priority on their own
interests than on the firm‘s value, they may well
underprice more when the market is moving
downward and difficult IPOs are expected. We use
the buy-and-hold return of the Shenzhen Stock
Exchange A-Share Index for the 15 days before
listing (MARKET) as the proxy for market
conditions.8
Table 2 shows regression results. The
coefficients of STATE-OWNED and PRE-REFORM
are positive, and they are significant at the 10% and
1% level, respectively. These results support our
hypothesis. In addition, the negative (not statistically
significant) coefficients of MARKET, which are
unusual in IPO studies, suggest that underpricing in
China is caused by the incentives of bureaucratic
managers and regulators to avoid unpopular IPOs.
The insignificance of the size variables suggests that
for Chinese underpricing, informational asymmetry is
less relevant than institutional features.
4.2 Direct and total IPO costs
The results in the previous section show that the
indirect IPO cost (i.e., underpricing) for Chinese firms
is reduced by the reform in 2005. The results support
our hypothesis that large underpricing in China is
associated with government control, and thus, it is
reduced by the reform making IPO process more
market-oriented.
Now, we turn to the issue of total IPO costs for
Chinese firms going public. Other than the indirect
cost of underpricing, firms assume direct costs in
IPOs (Ritter, 1987). Direct costs include underwriting,
auditing, and reviewing fees. In particular,
underwriting fees paid to investment banks make up a
substantial portion of the direct costs. 9 The new IPO
process introduced by the 2005 reform requires more
effort on the part of underwriters who are supposed to
conduct deliberate bookbuilding. Thus, it is quite
natural if the underwriters charge higher fees to
issuers (Ljungqvist et al., 2003).
We collect the data of direct costs (in RMB
10,000) for the 50 IPOs from the prospectuses and
calculate the ratio of the direct costs to the gross
proceeds (direct cost ratio). The results are
summarized in Table 3. The mean of the ratio is
8
Ma and Faff (2007) document that underpricing in China
is influenced much more by market conditions before the
listing than those before offering.
9
Chen and Ritter (2000) report that underwriting fees
cluster around 7% of gross proceeds in the U.S., where
bookbuilt IPOs are predominant.
significantly higher for IPOs after the reform,
supporting our conjecture that Chinese underwriters
are charging higher fees.
Next, we examine the change in total IPO costs
caused by the reform. In the regressions, the
dependent variable is defined as the sum of
underpricing and the direct cost ratio. The variable
indicates the ratio of total costs to gross proceeds or
funds raised by the firms. We use the same
independent variables as in the regressions of
underpricing. Table 4 shows the results. The
coefficients of PRE-REFORM are positive and
statistically significant, which suggests that the total
costs of going public in China are reduced by the
reform. Overall, the move to the more marketoriented IPO process is beneficial to Chinese firms
going public.
5. Conclusion
The Chinese IPO market has exhibited large IPO
underpricing. We argue that government control is
behind this puzzle. First, in China, most listed firms
are large state-owned firms and managerial
shareholdings are insignificant. The managers attach
more importance to their bureaucratic careers than to
value maximization of the firms they manage. In such
circumstances, managers have incentives to
underprice IPO shares, in order to avoid being
penalized for conducting unpopular IPOs, which will
stand in the way of successive IPOs. Second, the
CSRC, the regulatory authority of the stock market,
also has incentives to underprice IPO shares. The
CSRC or Chinese government deliberately
underprices so as not to upset investors. If investors
suffer a loss in IPOs, they turn away from the stock
market and subsequent IPOs of state-owned firms are
jeopardized. Using a sample from a new stock market
in China, we find evidence supporting this hypothesis.
Underpricing is higher for state-owned firms and for
IPOs before the reform which made IPO prices less
affected by the regulator. Furthermore, the reduction
in underpricing by the reform more than offsets the
increase in direct costs involved in compensating the
increased efforts of underwriters.
In sum, we find evidence showing that
government control over the corporate economy
raises the cost of going public. We expect that in the
future, IPO underpricing as well as the cost of going
public in China will decline further as the
liberalization of the corporate economy proceeds.
References
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Beatty, R. P., and Ritter, J. R. (1986). Investment
banking, reputation, and the underpricing of initial
public offerings. Journal of Financial Economics 15,
213–232.
Benveniste, L. M., and Spindt, P. A. (1989). How
investment bankers determine the offer price and
allocation of new issues. Journal of Financial
Economics 24, 343–361.
Chen, G., Firth, M., and Kim, J. -B. (2004). IPO
underpricing in China‘s new stock markets. Journal of
Multinational Financial Management 14, 283–302.
Chen, H. -C., and Ritter, J. R. (2000). The seven
percent solution. Journal of Finance 55, 1105–1131.
Chen, Z., Choi, J. J., and Jiang, C. (2007). Private
benefits in IPOs: evidence from state-owned firms.
Working Paper, Temple University.
Datar, V., and Mao, D. Z. (2006). Deep underpricing
of China‘s IPOs: sources and implications.
International Journal of Financial Services
Management 1, 345–362.
Dewenter, K. L., and Malatesta, P. H. (1997). Public
offering of state-owned and privately-owned
enterprises: an international comparison. Journal of
Finance 52, 1659–1679.
Derrien, F., and Womack, K. L. (2003). Auctions vs.
bookbuilding and the control of underpricing in hot
IPO markets. Review of Financial Studies 16, 31–61.
Ljungqvist, A., Jenkinson, T., and Wilhelm, W.
(2003). Global integration in primary equity markets:
the role of U.S. banks and U.S. investors. Review of
Financial Studies 16, 63–99.
Ma, S., and Faff, R. (2007). Market conditions and the
optimal IPO allocation mechanism in China. PacificBasin Finance Journal 15, 121–139.
Ritter, J. R. (1987). The costs of going public. Journal
of Financial Economics 19, 269–281.
Ritter, J. R. (2003). Investment banking and securities
issuance. In G. Constantinides, M. Harris, and R.
Stulz (eds.), Handbook of the Economics of Finance,
Vol. 1A, Corporate Finance. Amsterdam: NorthHolland, pp. 255–306.
Ritter, J. R., and Welch, I. (2002). A review of IPO
activity, pricing, and allocations. Journal of Finance
57, 1795–1828.
13
Appendices
Table 1. Descriptive Statistics
Full sample
State-owned
firms
Privately
owned firms
t -value
Underpricing
mean
median
st. dev.
60.7%
48.6%
56.8%
76.9%
55.1%
63.0%
45.9%
28.4%
44.3%
1.956
*
Gross proceeds
(RMB 10,000)
mean
median
st. dev.
23,945
21,105
8,577
21,419
20,007
5,892
26,276
24,489
9,761
-2.106
**
Assets
(RMB 1)
mean
median
st. dev.
386,483,261
282,728,029
410,762,607
357,651,087
242,675,443
537,454,326
413,097,575
342,293,190
223,316,865
-0.460
Sales
(RMB 1)
mean
median
st. dev.
479,537,595
263,536,736
865,239,854
254,469,966
216,122,546
151,194,657
687,292,330
327,406,568
1,140,121,133
-1.880
Pre-reform dummy
mean
median
st. dev.
0.760
1.000
0.427
0.750
1.000
0.433
0.769
1.000
0.421
-0.156
50
24
26
Observations
*
The full sample consists of all 50 firms that conducted IPOs on the Shenzhen SME Board during 2004–2005. Sample firms
with government and/or state-owned entity shareholders are classified as state-owned firms.
Underpricing = (closing price of the listing day – offer price) / offer price.
Gross proceeds = offer price multiplied by the number of shares offered in the IPO.
Assets = total assets at the end of the fiscal year before listing.
Sales = sales during the fiscal year before listing.
Pre-reform dummy = a dummy variable taking the value of one for the IPOs before the 2005 reform.
**, * denote statistical significance of the difference at the 5% and 10% levels, respectively, for two-tailed tests assuming
unequal variance.
Table 2. Regression Results of Underpricing
Model 1
Model 2
Constant
542.84
(2.11)
**
402.62
(1.30)
STATE-OWNED
30.08
(1.67)
*
33.52
(1.93)
*
PRE-REFORM
36.56
(2.72)
***
44.73
(3.17)
***
LN (proceeds)
-19.01
(-0.86)
-36.99
(-1.19)
MARKET
-349.79
(-1.39)
-358.34
(-1.31)
LN (assets)
14.86
(0.89)
LN (sales)
1.55
(0.89)
Adjusted R2
0.12
0.10
Observations
50
50
The dependent variable is underpricing [(closing price of the listing day – offer price) / offer price].
STATE-OWNED = a dummy variable taking the value of one for the firms with the government and/or state-owned entity
shareholders.
14
PRE-REFORM = a dummy variable taking the value of one for the IPOs before the 2005 reform.
LN (proceeds) = natural logarithm of the gross proceeds (offer price multiplied by the number of shares offered in the IPO).
MARKET = buy-and-hold return of the Shenzhen Stock Exchange A-Share Index for the 15 days before listing.
LN (assets) = natural logarithm of total assets at the end of the fiscal year before listing.
LN (sales) = natural logarithm of sales during the fiscal year before listing.
White heteroskedasticity consistent t-values are in parentheses.
***, **, * denote statistical significance at the 1%, 5%, and 10% levels, respectively, for two-tailed tests.
Table 3. Direct IPO Costs
Direct cost ratio
Full sample
Before reform
After reform
t -value
6.43%
6.13%
2.14%
6.01%
6.01%
1.46%
7.79%
7.37%
3.24%
-2.672
50
38
12
mean
median
st. dev.
Observations
***
The full sample consists of all 50 firms that conducted IPOs on the Shenzhen SME Board during 2004–2005. Sample firms
are divided into those that used the IPO procedure before the 2005 reform and those that used the procedure after the reform.
Direct cost ratio = the ratio of direct IPO costs to gross proceeds. The direct IPO costs include underwriting, auditing, and
reviewing fees.
*** denotes statistical significance at the 1% level, for two-tailed test.
Table 4. Regression Results of Total IPO Costs
Model 1
Model 2
Constant
549.82
(2.21)
**
STATE-OWNED
27.99
(1.55)
PRE-REFORM
34.86
(2.47)
LN (proceeds)
-14.97
(-0.69)
-34.07
(-1.13)
MARKET
-392.14
(-1.52)
-417.86
(-1.56)
**
397.57
(1.34)
31.12
(1.79)
*
45.17
(3.24)
***
LN (assets)
20.20
1.20
LN (sales)
-1.84
(-0.14)
Adjusted R2
0.11
0.09
Observations
50
50
The dependent variable is total IPO costs (underpricing + direct cost ratio), where underpricing is (closing price of the listing
day – offer price) / offer price, and direct cost ratio is the ratio of direct IPO costs to gross proceeds.
STATE-OWNED = a dummy variable taking the value of one for the firms with the government and/or state-owned entity
shareholders.
PRE-REFORM = a dummy variable taking the value of one for the IPOs before the 2005 reform.
LN (proceeds) = natural logarithm of the gross proceeds (offer price multiplied by the number of shares offered in the IPO).
MARKET = buy-and-hold return of the Shenzhen Stock Exchange A-Share Index for the 15 days before listing.
LN (assets) = natural logarithm of total assets at the end of the fiscal year before listing.
LN (sales) = natural logarithm of sales during the fiscal year before listing.
White heteroskedasticity consistent t-values are in parentheses.
***, **, * denote statistical significance at 1%, 5%, and 10% levels, respectively, for two-tailed tests.
15
SEPARATION BETWEEN MANAGEMENT AND OWNERSHIP:
IMPLICATIONS TO FINANCIAL PERFORMANCE
Zélia Serrasqueiro*, Paulo Maçãs Nunes**
Abstract
Using panel data, this article shows that agency costs, a consequence of the separation between
ownership and management, are not relevant in explaining the financial performance of Portuguese
companies since, on the one hand, greater size, greater liquidity and higher level of risk do not mean
decreased financial performance and, on the other, greater level of debt does not mean increased
financial performance. The results indicate that the fact of managers being better informed than
owners, about companies‟ opportunities and specific characteristics, does not necessarily mean
behaviour that contributes to diminished financial performance in Portuguese companies.
Keywords: Agency Costs, Financial Performance, Information Asymmetry, Managers, Owners, Panel
Data
* Management
and Economics Department, Beira Interior University and CEFAGE Research Center Évora University, Évora,
Portugal
**Corresponding author: Universidade da Beira Interior, Departamento de Gestão e Economia, Estrada do Sineiro, 6200-209
Covilhã, Portugal, Phone Number.:+351 275 319 600; Fax Number:+351 275 319 601; E-mail address: macas@ubi.pt
1.
Introduction
Until the mid 70s, economists viewed the firm as a
unit transforming inputs in outputs, not bothering to
study its organizational structure, nor the possible
implications of its agents‘ behaviour for performance.
From the mid 70s, economists begin to concern
themselves with studying the organizational structure
of the company, and in this context appears the work
of Galai and Masulis (1976) and Jensen and Meckling
(1976), originating Agency Theory. Agency Theory is
based on construction of the utility functions of the
agents involved in the organizational relationships
established in the company, the main question being
the possibility of the utilities of the different agents
involved in its functioning being divergent.
Galai and Masulis (1976) and Jensen and
Meckling (1976), conclude that the existence of
information asymmetry limits the functioning of the
company, since the different agents do not all have
the same amount of information. Based on different
levels of information, agents try, in particular
circumstances, to maximize their individual utility,
conflicts of interest being inevitable. The theoretical
and empirical development of Agency Theory has
tried to analyse the conflicts of interest among the
various agents who make up the company, also trying
to find ways of minimizing those conflicts.
One of the most relevant aspects of Agency
Theory in the context of business organizations deals
with the conflict of interests between managers and
owners, a consequence of information asymmetry
existing in their relationship. According to Galai and
Masulis (1976), Jensen and Meckling (1976), Fama
16
and Jensen (1983), Jensen (1986), and Stulz (1990),
managers are better informed than owners about
certain specific aspects of company management, for
example, about investment possibilities. The fact that
owners have less information leads managers to try to
maximize their utility, to the detriment of owners‘
utility, investing in projects that contribute to
improving their personal benefits but harm financial
performance.
In this study, using panel data, the research
question is to find out if agency costs, a consequence
of the separation of management and ownership, limit
the financial performance of Portuguese companies.
An increase in company size can contribute to
greater separation of management and ownership, a
consequence of information asymmetry, affecting
financial performance. Higher levels of debt, and
lower levels of liquidity, can help to mitigate agency
costs, a consequence of the separation of management
and ownership, since managers must make periodic
payment of debt charges, having less finance available
for investments that may contribute to diminished
financial performance. A higher level of risk can
contribute towards managers investing in projects
with a currently negative net value, without the
owners realizing, contributing to diminished financial
performance. Therefore, we intend to test empirically
if size, debt, liquidity and level of risk limit the
financial performance of Portuguese companies, as a
consequence of aggravated agency costs resulting
from the separation of management and ownership.
With this aim, we divide this study as follows: in
section 2 we present the hypotheses for investigation
according on the expected relationship between
explanatory variables and financial performance,
based on agency costs resulting from the separation of
management and ownership; in section 3 we present
the methodology used; in section 4 we present the
results obtained; and in section 5 we present the
conclusions of this study.
on the arguments set out, we formulate the following
hypothesis:
H2: Higher company debt means increased financial
performance, as a consequence of diminished agency
costs resulting from the separation of management
and ownership.
2.
2.3. Liquidity
Hypotheses for Investigation
Next we present the relationships expected between
the variables already mentioned and financial
performance, based on agency costs resulting from
the separation of management and ownership.
2.1. Company size
Jensen and Murphy (1990), conclude that company
size is negatively related to financial performance
since managers, taking advantage of the lesser
possibility of control by owners, given the greater size
of companies, invest in projects that allow them to
obtain better personal benefits, rather than increase
management efficiency and consequently financial
performance. Gardner and Grace (1993) and
Cummins et al. (1999) reinforce the arguments of
Jensen and Murphy (1990), concluding that the
possible existence of less ownership control over
managers‘ actions can lead to the latter investing in
projects that give them greater prestige, such as those
which contribute towards maximising company
market share, something that can cause diminished
financial performance. Larger companies are subject
to an aggravation of agency costs resulting from the
separation between management and ownership.
Based on the arguments set out, we formulate the
following hypothesis:
H1:
Greater company size means diminished
financial performance, as a consequence of increased
agency costs resulting from the separation of
management and ownership.
2.2. Debt
Fama and Jensen (1983), Jensen (1986), Berger et al.
(1995), Wells et al. (1995) and Adams (1996), based
on agency costs resulting from the separation of
management and ownership, conclude that debt can
positively influence the financial performance of
companies. On one hand, owners resort to debt with
the purpose of disciplining managers‘ actions,
reducing free cash flows, since managers must make
periodic payment of the debt capital and interest. On
the other hand, increased debt means increased
probability of bankruptcy which also contributes
towards to increased discipline among managers.
Improvement in management efficiency, a
consequence of increased debt, means, according to
Fama and Jensen (1983), Jensen (1986), Berger et al.
(1995), Wells et al. (1995) and Adams (1996), an
increase in companies‘ financial performance. Based
Fama and Jensen (1983) and Jensen (1986) conclude
that greater levels of company liquidity can mean
lower financial performance, a consequence of
increased agency costs resulting from the separation
of management and ownership, since managers are
better informed than owners about the functioning and
investment possibilities of companies. Managers,
given the greater ease of meeting the short-term
responsibilities of companies, a consequence of a
higher amount of free cash flows, can invest in
projects with a negative liquid current value that
allow them to increase their personal prestige, but
which mean diminished financial performance. Based
on these arguments, we formulate the following
hypothesis:
H3: Higher levels of company liquidity mean
diminished financial performance, a consequence of
of management and ownership.
2.4. Risk
According to Galai and Masulis (1976), Jensen and
Meckling (1976), Lamm-Tennant and Starks (1993),
Oppenheimer and Schlarbaum (1993) and Adams and
Buckle (2003), we can expect a negative relationship
between the level of volatility of companies‘
operational results and their financial performance, a
consequence of increased agency costs resulting from
the separation of management and ownership. The
authors state that greater volatility of operational
results has, in many situations, its root in the greater
competition companies face, which causes
considerable volatility in receipts. Managers, better
informed than owners about the functioning of
companies, realize the greater level of risk and try to
maximize their personal benefits, something which
can imply diminished financial performance. Based
on the arguments set out, we formulate the following
hypothesis:
H4: Higher levels of company risk mean diminished
financial performance, as a consequence of increased
management and ownership.
3. Methodology
3.1. Database
In this study we use a database of the Exame Review
that publishes annually (from 1991) a database of the
500 biggest companies in Portugal, with data
17
collected by the local filial of the Dun & Brad Street
Consulters Multinational. The companies included in
the database were selected on basis of total value of
sales and excludes companies that don‘t send their
financial documents to be analyzed. We study a panel
data of firms from 1999 to 2003. First, to avoid
selection issues we study a balanced panel data of 162
during 5 years. Finally, we selected the companies
with separation between ownership and management
to period from 1999 to 2003. Based on the criteria
mentioned above, we selected 141 companies for the
period 1999-2003, and so we have a panel made up of
705 observations.
3.2. Variables
According to the literature, and previously defined
hypotheses for investigation, we consider as possible
variables that can influence the performance of
Portuguese companies: size, debt, liquidity, and level
of risk. The following table gives us a description of
the variables used and their corresponding
measurement.
(Insert Table 1 About Here)
3.3. Method of Analysis
Companies‘ specific characteristics are distinct in the
majority of situations. The data assessment methods
using panel models have the great advantage of
measuring those different characteristics, called nonobservable individual effects. A regression by the
ordinary least square method does not allow for
measurement
of
companies‘
non-observable
individual effects, and so normally the assessed
parameters do not evaluate correctly the relationships
between variables. Consideration of non-observable
individual effects has the great advantage of
mitigating the problem of the absence of possibly
relevant variables not included in explaining the
dependent variable. In this study we use initially three
distinct forms of assessment: 1) regression by the
ordinary least square method; 2) panel model
admitting the existence of random non-observable
individual effects; and 3) panel model admitting the
existence of fixed non-observable individual effects.
We can present the assessment model in the following
way:
yit    X ít   uit ,
with
i  1,...,162; t  1,...,5 ,
in which i represents each of the companies and t the
periods, y it is the vector of the explained variable,
Xít is the vector of the explanatory variables of
each company in each period,  is the vector of the
assessed parameters, u it is the error vector given by:
uit  vi  eit ,
18
vi is the non-observable individual effect of
each company and eit is the error which assumes
in which
normal distribution.
After evaluation, we test the relevance of
companies‘ non-observable individual effects,
applying the LM test. The LM test verifies the null
hypothesis that non-observable individual effects are
not relevant in explaining the dependent variable,
against the alternative hypothesis that non-observable
individual effects are relevant. If we reject the null
hypothesis, we can conclude that a simple regression
by the ordinary least square method is not the most
correct form of assessment, given the relevance of
non-observable individual effects.
If we conclude that non-observable individual
effects are relevant, we proceed to comparison of the
panel model assuming the existence of random nonobservable individual effects, with the panel model
assuming the existence of fixed non-observable
individual effects. The random non-observable
individual effects model assumes that non-observable
individual effects are not correlated with the
explanatory variables. On the other hand, the fixed
non-observable individual effects model assumes the
existence of correlation between non-observable
individual effects and the explanatory variables. With
the aim of testing which model is most appropriate,
we use the Hausman test. The Hausman test verifies
the null hypothesis that there is no correlation
between non-observable individual effects and the
explanatory variables, against the alternative
hypothesis that there is correlation between nonobservable individual effects and the explanatory
variables. If we cannot reject the null hypothesis, the
panel model assuming the existence of random nonobservable individual effects is seen to be more
appropriate. If we reject the null hypothesis, given the
existence of correlation between non-observable
individual effects and explanatory variables, the panel
model assuming the existence of fixed non-observable
individual effects is more appropriate.
We test for the existence of error
autocorrelation. If autocorrelation exists, it is
necessary to proceed to an assessment of the most
appropriate model considering its existence.
We used annual dummy variables so as to
remove the impact of possible macroeconomic
alterations on the financial performance of Portuguese
firms.
4. Results
In table 1 we present the results of the descriptive
statistics to variables.
Results of the descriptive statistics of the
variables indicate that companies‘ financial
performance presents some volatility, since the
standard deviation is above the mean, the same
occurring with the proxy measuring the level of risk.
We present the results of applying the different panel
models in the following table 2.
The results of the LM test indicate that we can
reject the null hypothesis, at 1% significance, that
non-observable individual effects are not relevant.
This being so, we can conclude that regression by the
ordinary least square method is not the most
appropriate way of carrying out an assessment of the
financial performance equation.
From application of the Hausman test we can
conclude that we reject the null hypothesis of absence
of correlation between non-observable individual
effects and the explanatory variables, and so the most
appropriate method to evaluate the financial
performance equation is the panel model assuming the
existence of fixed non-observable individual effects.
From application of the first order
autocorrelation test, we find we reject the null
hypothesis, at 1% significance, of absence of first
order autocorrelation, and so we see to be appropriate
assessment of the panel model of fixed nonobservable individual effects consistent with the
existence of autocorrelation. We cannot reject the null
hypothesis of absence of second order autocorrelation.
Results of the Wald and F tests indicate we can
reject the null hypothesis, at 1% significance, that
explanatory variables are not relevant in explaining
financial performance.
Based on the results of the panel model of fixed
non-observable individual effects, we can establish
the following relationships:
1.
there is a positive, and statistically
significant, relationship between company size and
financial performance;
2.
there is a negative, and statistically
significant, relationship between company debt and
financial performance;
3.
there is a negative, and statistically not
significant, relationship between company liquidity
and financial performance;
4.
there is a positive, and statistically
significant, relationship between companies‘ level of
risk and financial performance.
Agency costs resulting from the separation of
management and ownership, as a consequence of
greater company size, are not relevant in the
Portuguese case, since company size influences
financial performance positively, and so we reject
hypothesis H1 of this study. We can conclude that the
greater size of Portuguese firms does not necessarily
mean increased agency costs resulting from the
separation of management and ownership, and a
consequent reduction of financial performance. The
larger size of Portuguese companies does not
contribute to managers, taking advantage of greater
information asymmetry, investing in projects which
increase their own utility and could contribute to
reduced financial performance.
The negative relationship between debt and
financial performance does not allow us to accept as
valid hypothesis H2. Increased debt does not
contribute to improvement of companies‘ financial
performance, a consequence of reduced agency costs
resulting from the separation of management and
ownership. We cannot conclude that debt is used as
an instrument to discipline managers, preventing them
from investing in projects which do not contribute to
improving companies‘ financial performance.
The statistically not significant relationship
between the liquidity of Portuguese companies and
their financial performance does not allow us to
accept hypothesis H3 of this study as valid. Higher
levels of liquidity do not necessarily mean increased
management and ownership. Greater level of
company liquidity, allowing managers to meet shortterm commitments more easily, does not contribute to
reduced financial performance, as a consequence of
the possibility of managers investing in projects that
increase their own utility but which could have a
current negative liquid value, contributing to reduced
financial performance. The positive relationship
between companies‘ level of risk and financial
performance does not allow us to accept hypothesis
H4 as valid. This result allows us to conclude that
higher levels of risk do not necessarily mean
of management and ownership. Greater level of risk
does not contribute to managers investing in projects
that contribute to increasing their own utility,
affecting financial performance.
5. Conclusion
Using panel models, we show that the financial
performance of Portuguese companies is influenced
by size, by debt and by level of risk. We cannot
conclude that the financial performance of Portuguese
companies is influenced by liquidity.
We do not find empirical evidence to prove the
relevance of agency costs resulting from the
separation of management and ownership in
explaining the financial performance of Portuguese
companies, since greater size, liquidity and risk do not
influence financial performance negatively, and
greater level of debt does not influence it positively.
The results indicate the fact that managers have
more information than owners about opportunities
and specific characteristics of companies, does not
necessarily mean managerial behaviour that
contributes to diminished financial performance.
References
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Jensen, M. and Meckling, W. (1976), ´Theory of the
Firm: Managerial Behaviour, Agency Costs and
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Appendices
Table 1. Measurement of variables
Variables
Dependent variables
Financial Performance (F. PERF)
Independent variables
Size (SIZE)
Debt (LEV)
Liquidity (LIQ)
Risk (EVOL)
Measurement
Ratio between Operating Income and Total Assets
Logarithm of Sales
Ratio between Total Liabilities and Total Assets
Ratio between Current Assets and Short-Term Liabilities
Absolute Value of Percentage Change of Operating Income
Table 2. Descriptive Statistics
Variable
F. PERF
SIZE
LEV
LIQ
EVOL
Observations
705
705
705
705
705
Mean
0.059
4.876
0.552
1.798
2.910
S.D.
0.080
0.556
0.221
1.298
11.29
Minimum
-0.236
3.876
0.084
0.061
0.001
Maximum
0.528
6.768
1.074
11.64
213.2
Table 3. Panel Models
Dependent variable: F. PERF
Independent
Pooled OLS
variables
SIZE
0.04109***
(0.0054)
LEV
-0.10565***
(0.01589)
LIQ
0.00881***
(0.00242)
EVOL
0.00007
(0.00028)
Observations
705
LM (2)
Hausman (2)
R2
0.1208
Wald (2)
F statistic
26.17***
Sargan (2)
m1
m2
20
Random Effects
Fixed Effects
Fixed Effects AR(1)
0.06192***
(0.00691)
-0.11569***
(0.01712)
0.00471
(0.00498)
0.00042***
(0.00014)
705
684.63***
29.13***
0.1589
120.36***
0.07054***
(0.00765)
-0.12987***
(0.02198)
0.00192
(0.00241)
0.00041***
(0.00010)
705
0.08001***
(0.00965)
-0.15897***
(0.02382)
-0.00401
(0.00345)
0.00052***
(0.00012)
705
0.1675
0.1698
28.02***
20.41***
-5.78***
-0.39
1.
2.
3.
Heteroskedasticity consistent and asymptotic robust standard deviations are reported in brackets.
*** indicates significance at the 1% level, ** indicates significance at the 5% level, and * indicates
significance at the 10% level.
The LM test the statistical significance of the individual effects, are asymptotically distributed as
 2 , under the null hypothesis of no significance.
4.
The Hausman test the correlation between individual effects and independent variables, are
5.
asymptotically distributed as  , under the null hypothesis of no correlation.
Wald is a test of the joint significance of the estimated firm specific coefficients, are asymptotically
2
distributed as  under the null hypothesis of no relationship.
F is a test of the joint significance of the estimated firm specific coefficients, are asymptotically
distributed as N(0,1), under the null hypothesis of no relationship.
The m1 test is a test for first order autocorrelation of residuals and is distributed as N(0,1), under null
hypothesis of no first order autocorrelation.
The m2 test is a test for second order autocorrelation of residuals and is distributed as N(0,1), under null
hypothesis of no second order autocorrelation.
Estimations include constant and time dummy variables.
2
6.
7.
8.
9.
21
THE DETERMINANTS OF CAPITAL STRUCTURE: THE CASE OF LONGTERM DEBT CONSTRAINT FOR JORDANIAN FIRMS
Rami Zeitun*, Gary Tian**
Abstract
This paper contributes to the capital structure literature by investigating the determinants of capital
structure of Jordanian companies with the constraint of inadequate long-term debt as their source of
financing and regional risk. We firstly document that Jordanian companies mostly depend on shortterm debt, as a result of the banking credit policy that promotes short-term debt. Our results suggest
that the level of gearing in Jordanian firms is positively related to size, tangibility, and earning
volatility, and negatively correlated to profitability, the level of growth opportunities, liquidity and
stock market activities. The level of gearing measured by short-term debt is, however, negatively
correlated to tangibility. The Gulf Crisis between 1990 and 1991 is also found to have a significant but
positive impact on Jordanian corporate leverage. We conclude that the capital structure decision with
inadequate long-term debt access is influenced more strongly by factors such as Stock‟s Market activity
(SMA).
Keywords: capital structure, determinants, Jordan
*Assistant professor of finance in the Finance Discipline, Department of Finance and Economic, College of Business and
economic, Qatar University. Emails: R_zaiton2005@yahoo.com and rami.zeitun@qu.edu.qa.
**Corresponding author Associate Professor Gary Tian is an associate professor of finance in the Finance Discipline, School of
Accounting and Finance, University of Wollongong, Northfields Ave, 2522 Australia. Tel: +61 2 4221 4301. Email:
gtian@uow.edu.au. We would also like to thank Steve Keen for his comments on the earlier draft of this paper. The authors
remain responsible for all errors.
1. Introduction
An ongoing debate in corporate finance concerns the
question of a firm‘s optimal capital structure. Three
major theories of capital structure have been proposed
to explain the determinants of capital structure. These
are: the trade-off theory (Modigliani and Miller, 1963,
Baxter, 1967 and Ross, 1977), the pecking order
theory (Myers and Majluf (1984)), and the agency
theory (Jensen and Meckling (1976)). However, the
results from the empirical evidence on capital
structure were not conclusive and also most results
were based on matured markets (Titman and Wessels
(1988), Rajan and Zingales (1995), Bevan and
Danbolt (2002) and Antoniou et al. (2002)). There are
a small number of studies that provide evidence from
developing countries including Booth et al. (2001),
Pandey (2001), and Chen (2004).
This paper examines the determinants of the
capital structure in a representative sample of 167
Jordanian companies during 1989-2003. The
Jordanian firms provide a unique case for studying
this issue since most Jordanian firms are not able to
borrow long-term debt as their source of financing.
Only a few firms have long-term debt in their capital
structure. Therefore, a large percentage of credit
facilities are short term. According to Creane et al.
22
(2003) financial intermediation through the banking
system in Jordan is mostly short-term. The reason
why bank credit is short-term is that the banks seek to
match maturities of deposits. Also, banks‘ credit
policies may be more conservative since the Jordanian
market is very small, and as Jordanian exports depend
on Arabic countries which have a high level of
political risk (For more details see Zeitun, 2006). For
example, in 2002 Jordanian exports to the Arabic
countries amounted to JD 740.8 million out of total
exports of JD 1556.7 million to other countries, which
is about 47.6 percent of total exports. A potent
example of the political risk that affects these markets
is the first Gulf War in 1991, when Jordanian exports
to the Arab countries decreased by 33.12 percent
(Zeitun, 2006).
This study extends the existing empirical work
on this special market in three ways. Firstly, it
examines a much broader set of explanatory variables
such as stock market‘s activity, in order to investigate
the firm‘s financing behaviour under the constraint of
inadequate long-term debt. Secondly, the firm sample
used in this study is much larger than those previously
analysed. Compared with the six year data used in the
very limited previous studies, this study used a much
longer period of data. Thirdly, this study provides
more robust results since, in this study, we used
dummy variables to control for the effect of industrial
sectors and years on firms' capital structure. The
Jordanian economy is vulnerable to external shocks
especially those occurring within the Middle East
region such as the Gulf Crisis 1990-1991. There is
very little known about the possible effect of the
regional risk such as Gulf Crisis 1990-1991 and the
outbreak of Intifadah in September 2000 on corporate
decision making and bankruptcy costs. This study
examines the impact of the Gulf Crisis and the
outbreak of Intifadah on the performance of
corporations. Therefore there are two important and
interest questions we will explore in this article. First
what are the determinants of capital structure in the
case of long-term debt constraint for Jordanian firms?
Secondly, are political risks the major factors
influence the capital structure for Jordanian firms?
The remainder of the paper is organized as
follows. Section 2 examines the debt structure of
Jordanian companies during the period 1989-2003.
Section 3 discusses the determinants of capital
structure. Section 4 discusses the methodology and
the empirical model used in this study. Section 5
presents the analysis and discussion of results. Section
6 concludes the paper.
2. Capital Structure in Jordan
Heavy reliance on debt finance, mainly from the
domestic banking system, is a major feature of
developing countries and is reflected in the high
leverage of Jordanian firms. Table 1 depicts the
annual average leverage ratios for non-financial listed
companies on the Amman Stock Exchange (ASE)
over the period 1989-2003. This set of figures reveals
that Jordanian firms were more heavily leveraged in
terms of short-term debt compared with long-term
debt. For example, in 2000 the reported mean ratio for
the short-term debt to total assets (STDTA) is 0.33,
which is very high compared with the third measure
of leverage, long-term debt to total assets (LTDTA),
which is 6 percent. The mean ratio for LTDTA is
extremely low compared with developed nations such
as Germany (55%) and the US (67%). This long-term
debt is also much lower than the emerging markets in
East Asia with an average of approximately 30% in
Malaysia, Taiwan, and Thailand (Claessens et al.,
1998, p11).
The average ratio of the total debt over total
capital (TDTC)10 is about 127.44%, with the highest
ratio being 170% observed during the Gulf Crisis of
1990-1991. The ratios of short-term debt (STD) and
long-term debt (LTD) to total equity (TE)11 show
similar results compared with long-term debt (LTD)
and short-term debt (STD) to total assets (TA). For
example, in 2000 the STDTE was about 121%, which
is very high compared with 16% for the LTDTE.
Insert Table 1 Here
It was argued that a firm‘s capital structure could
affect the firm‘s health and affect the default risk, so
the capital structure of defaulted firms and nondefaulted firms should be different. Figure 1 shows
the average of the leverage ratio in both default and
non-defaulted firms over the period 1989-2002.
Moreover, Figure 1 shows that defaulted firms have a
high leverage ratio of total debt to total assets (TDTA)
over the period 1989-2002. The leverage ratio TDTA
increased sharply over the periods 1989-1993 and
1998-2001. Both defaulted and non-defaulted firms
have their lowest leverage ratio over the period 19941997. Furthermore, Figure 1 shows that the Gulf
Crisis of 1990-1991 had a strong impact on the
defaulted firms as a result of an increase in the
demand for debt finance. The highest leverage ratio
for distressed firms over the period 1998-2001 could
be explained by the growth in banks' credit facilities
over the period 1997-1999, which encouraged
distressed firms to borrow more and more. Due to the
high economic growth rate during the period 19921995 (boom period), the leverage ratio for defaulted
firms continued to decrease, while it started to
increase in 1996 due to the poor economic
performance.
Insert Figure 1
Table 2 shows the leverage ratios in both defaulted
and non-defaulted firms. Both defaulted and nondefaulted firms have a low long-term debt to total
assets (LTDTA) ratio, while short-term debt to total
assets (STDTA) is more prevalent in defaulted firms.
For example, in 2002 the LTDTA and STDTA ratios
for the defaulted firms were 16% and 63%,
respectively, compared with 7% and 44%,
respectively, for the non-defaulted firms. However,
the long-term debt to total assets (LTDTA) ratio is
lower for the defaulted firms over the period 19901992 which means the defaulted firms were unable to
borrow long-term debt, while they borrowed more in
the short-term to pay their short-term obligations.
Insert Table 2 Here
The total debt to total capital (TDTC) ratio is higher
in the non-defaulted firms compared with the
defaulted firms. The reason could be that non-
10
The total capital (TC) is defined as the paid capital. The
choice of total debt to total capital ratio instead of debt to
equity ratio is because our sample includes some firms that
had negative equity during 1989-2003, when equity values
fell as a result of the Gulf Crisis, the outbreak of Intifadah
2000, or distress and default.
11
The purpose of including different measures of capital
structure is to provide a comprehensive explanation of the
Jordanian firms‘ capital structure, as some firms have a high
debt to equity ratio and lower debt to assets ratio.
23
defaulted firms are able to borrow as a result of a high
profitability ratio which gives them the ability to
access external sources of funds, while the defaulted
firms are unable to do so as a result of decreasing
assets. Total debt to total equity (TDTE) is higher in
the defaulted firms as a result of financial distress, but
it is still high in the non-defaulted firms. Defaulted
firms have a negative value for the TDTE as a result
of distress and of facing a level of leverage that
exceeds their shareholders' equity.
3. Determinants of Capital Structure and
Hypotheses Development
To assess the determinants of capital structure in
Jordan, the individual firm‘s leverage ratios are
modelled as a function of several firm-specific factors
in a cross-sectional framework. The theoretical
literature on capital structure suggests a number of
factors that may influence the capital structure of
companies based on the agency cost of debt and
equity and other costs associated with asymmetric
information (Jensen and Meckling, 1976; Myers and
Majluf, 1984: Harris and Raviv, 1991)12. The vector
of firm-specific variables incorporates the following
factors:
1. Tangibility
Agency theory suggests that firms with a high
leverage ratio tend to under-invest as the cost of debt
increases and, thus, transfer wealth away from debt
holders to equity holders. So, the more tangible assets
a firm has, the greater the ability of that firm to secure
its debt. Firms unable to provide collateral value
(fixed assets to total assets) have to pay a higher
interest rate as a result of increased agency costs, or
will encourage investors to issue equity instead of
debt (Scott, 1977). Furthermore, the tangibility of
assets decreases the bankruptcy costs and increases
the liquidation value of the firm. Thus, a positive
relationship between tangibility of assets and leverage
is expected and a negative relationship between
tangibility and short-term debt. In Jordan, the banks‘
credit policies are more conservative as the Jordanian
market is very small. Therefore, the tangible assets
increase a firm‘s ability to access to more debt. Based
on the theoretical and empirical evidence, the
Hypothesis to be tested is as follows:
H1a :
There is a positive relationship between
leverage ratio total debt to total assets (TDTA) and
tangibility.
H1b :
leverage ratio short-term debt to total assets (STDTA)
and tangibility.
2. Profitability
It is argued that firms with a high profitability ratio
tend to have a high level of debt, as a result of the tax
deductibility of interest payments (Modigliani and
Miller, 1963). The high profitability also implies
potential lower probability of bankruptcy (default).
Zeitun (2006) showed that the average profitability of
Jordanian companies has increased considerably over
the period 1988-2004. He also suggested that the
majority of Jordanian firms do not realise a profit
which could be used as internal sources of fund.
Therefore, profitable Jordanian firms will depend less
on leverage. Based on the theoretical and empirical
evidence, the Hypothesis to be tested is as follows:
H2 :
leverage ratios and profitability.
3. Firm Size
Trade-off theory suggested a positive relationship
between firm size and leverage, since large firms tend
to be more diversified and have been shown to have
lower bankruptcy risk and lower bankruptcy cost
(Rajan and Zingales, 1995). Furthermore, large firms
are expected to incur lower agency costs for issuing
debt or equity, less cash flow volatility, and have
easier access to the credit market. Therefore, large
companies are expected to hold more debt in their
capital structures than small firms to get the benefit of
the tax shield. Also, it is argued that smaller firms
tend to have large short-term debt and less long-term
debt due to the conflict between shareholders and
debtholders (Titman and Wessels, 1988; Michaelas et
al., 1999). The Jordanian banks have restricted credit
policies which make it is difficult for small firms to
borrow money compared with large firms. Therefore,
firm size affects leverage ratio for the Jordanian
companies. Based on the theoretical and empirical
evidence, the Hypothesis to be tested is as follows:
H3
For an extensive review of the theoretical literature on the
determinants of capital structure see Harris and Raviv
(1991).
24
: There is a positive relationship between
leverage ratios and firm size
4. Growth Opportunities
Growth opportunity can be defined as a firm‘s
opportunity to invest in profitable projects. The
growth opportunity can be measured by the annual
growth of the firm‘s total assets. Myers (1977) argued
that, due to information asymmetries between insiders
and outsiders, companies with high leverage ratios
might have the propensity to undertake activities
contrary to the interests of debtholders or to invest in
risky projects that expropriate wealth from
debtholders13. Based on the above theoretical
argument, the Hypothesis to be tested is as follows:
13
12
Myers (1984) refers to this as a pecking order theory,
which states that firms prefer the internal sources of funds
to finance projects rather than debt. Therefore, it can be
argued that firms with higher growth opportunities tend to
H4 :
leverage ratios and growth opportunities.
5. Corporate Tax (Non-debt Tax Shield)
Modigliani and Miller (1963) argued that, as interest
payments on debt are tax-deductible, firms with
enough taxable income have an incentive to issue
more debt to get the benefit from the tax deduction.
However, a non-debt tax shield, such as depreciation,
can be used to reduce the corporate tax. Thus, higher
taxes might increase the demand for debt and reduce
the benefit of the non-debt tax shield (Kremp et al.,
1999). Jordanian companies are subject to tax on
income generated in Jordan. The tax rates vary
depending on the nature of the business activities. For
example, the tax rate on Mining, Industry, Hotels, and
Transportation is 15 %, while on other firms it is
about 35%.
6. Liquidity
According to Pecking Order Theory, firms with high
liquidity will borrow less as they prefer to use their
internal sources of funds. Thus, a negative
relationship between liquidity and leverage is
expected and, therefore, a lower risk of default. This
argument is supported by the empirical findings of
Ozkan (2001), Antoniou et al. (2002), Deesomsak et
al. (2004), and others. Based on the above theoretical
and empirical evidence, the Hypothesis to be tested is
as follows:
H5 :
liquidity and leverage ratios.
7. Earnings Volatility
According to Pecking Order Theory, the volatility of
earnings decreases the firm‘s debt capacity. So, a
higher volatility of earning increases the firm‘s failure
(default), as a firm may not be able to fulfil its
obligations according to the distress theory
(Deesomsak et al., 2004). The volatility of earnings is
defined as the absolute difference between the annual
changes in the earnings before interest and tax (EBIT)
and the average of the change in earnings before
interest and tax over the sample study. Thus, a
negative relationship is expected between earnings
volatility and the leverage ratio, and a positive
relationship with the firm‘s default (failure). Thus, the
Hypothesis to be tested is as follow:
H6 :
There is a negative relationship between the
rather than debt when their share prices increase. So,
the history of share prices has an impact on the firms‘
capital structure, firms‘ health, and their default or
failure. Thus, the Hypothesis to be tested is as
follows:
H7 :
leverage ratios and share price performance.
9. Stock Market Developments
Another important variable to be considered in this
study is the Stock‘s Market activity. According to
Demirguc-Kunt and Maksimovic (1996), financial
market development plays a significant role in a firm's
financing decision. Firms‘ preference for debt over
equity decreases as the stock market‘s activity
increases. Amman Stock Exchange (ASE) was
considered to be the most efficient stock exchange in
the Arab world, as well as the largest and fastest
growing market in the region open to investors (JIB,
2005). The efficiency of the ASE could affect the
firm‘s leverage ratio as it provides liquidity to the
firm's. Thus, the Hypothesis to be tested is as follows:
H8 :
There is a negative relationship between the
leverage ratios and Stock Market capitalisation.
10. Regional Crises (Gulf Crisis)
During our sampling period of 1989-2003, Jordanian
macroeconomic factors such as interest rates, political
instability around Jordan, or regional crises such as
the Gulf Crisis in 1990-1991 and Intifadah in 2000
affect the Jordanian economy. The Gulf Crisis in
1990-1991 and Intifadah in 2000 severely affected the
capital market in Jordan as the Jordan market depends
on Iraq, the Gulf States, and Palestine to export its
production. For example, market capitalisation fell by
about 14% in 1990 and 20.5% in 2000. Following
1990, the Jordanian capital market experienced a
significant growth of investment as a refuge from the
Gulf States and Iraq. Also, the outbreak of the
Intifadah in September 2000 affected the Jordanian
capital market negatively, which also had an impact
on the increasing number of defaulted and distressed
firms in Jordan. Raising capital during the Gulf Crisis
1990-1991 and the Intifadah became costly, and yet
necessary, for most Jordanian companies that
depended on the Iraqi, Gulf States, and Palestinian
markets. Therefore, these regional crises may cause
time-series effects on corporate leverage. Based on
the above argument, the Hypothesis to be tested is as
follows:
volatility of earnings and leverage ratios.
H9 :
8. Share Price Performance or Market Performance
According to market timing theory, the share price
performance negatively affects the leverage ratios
(Baker and Wurgler, 2002), as firms prefer equity
crises) affects leverage ratios
have low leverage ratios, as they tend to use the internal
sources of funds rather than debt.
Political Instability around Jordan (regional
11. Uniqueness (Industry Effect)
Each industry may have specific features that affect
the debt structure of firms in that industry (see
Hovakimian et al. (2001). These may arise from the
25
different business environments of industries, the
degree of competition in product markets, the capital
required in these industries, and the skill composition
of the industries (See Wei, Xie and Zhang, 2005).
Thus, the Hypothesis to be tested is as follows:
H10 :
Firm‟s Industrial Sectors Affect Corporate
Leverage.
The objectives of this paper are to examine the
determinants of capital structure for Jordanian firms,
to examine the effect of industrial sector, Gulf Crisis
1990-1991, and the outbreak of Intifadah in
September 2000 on the firm's capital structure. The
next section introduces the research method.
4. Data and Methodology
profitability (PROF), we use earnings before interest,
tax, and depreciation (EBITD), divided by total
assets. Tangibility (TANGB) is measured by the ratio
of net fixed assets to total assets. The growth is
proxied by the annual growth of the firm‘s total assets
(Growth)18.
The liquidity (LIQ) is measured by the ratio of
current assets to current liabilities. The volatility of
earnings (VOE) is measured by the absolute
difference between the annual percentage change in
earnings before interest and tax (EBIT) and the
average of this change over the sample period. The
share price performance (SPPR) is measured by the
difference of the logs of annual share prices. The
stock market activity (SMA) is measured by the ratio
of the market value of a firm's traded shares to market
capitalisation (See Table 3 for variables definitions).
4.1. Data
Annual data were obtained from the Amman Stock
Exchange (ASE) to cover the period 1989-2003. This
resulted in a panel database of 1595 cases for 167
companies14. Appendix 1 depicts the Number of
Listed Firms used in the Study by Sector over the
period 1989-2003. The data used in the analysis is
constructed from balance sheet and income statement
information from the Amman Stock Exchange
(ASE)15, and from the tax department. Furthermore,
firms' annual share prices and capitalisation are
constructed from the Amman Stock Exchange (ASE).
The sample includes all non-financial firms listed on
the Amman Stock Exchange (ASE). A sub-sample
was extracted from the main sample that included
healthy firms to check the effect of bankruptcy on the
leverage ratio. Our main sample includes both
financially sound companies and defaulted companies
to avoid bias, as the probability of bankruptcy may
have a significant effect on a firm‘s financing
decisions.
4.2. Explanatory Variables
The selection of the dependent and independent
variables is guided by the previous empirical studies
and the theoretical issues. In this study five variables
are used to measure leverage. These are the ratio of
total debt to total assets (TDTA), short-term debt to
total assets (STDTA), long-term debt to total assets
(LTDTA)16. The logarithm of total assets is used to
measure a firm's size (SIZE)17. To measure a firm‘s
14
To have a list of the companies used in this study please
contact the author.
15
It is worth noting that the data related to tax, depreciation,
interest payments, and cash flow was collected manually
with enormous effort.
16
It is worth noting that the total debt to total equity
(TDTE) and total debt to total capital (TDTC) were tried in
this study.
17
The logarithm of total sales and the logarithm of market
capitalisation are tried in this study.
26
Insert Table 3 Here
4.3. Econometrics models
To assess the determinants of capital structure and to
investigate the effect of the default risk on the capital
structure, an individual firm‘s leverage ratios are
modelled as a function of several factors that affect
the capital structure. We estimate the following model
for the two samples of companies in a panel data
approach:
Leverage it  0  1TANGB it   2 PROFit  3SIZE it   4Growthit  5 LIQ it
6VOE it  7SPPR it  8SMC it  9TAX it  i  u it
where
Leverage it
(1)
denotes leverage and is computed
as the ratio of total debt to total assets (TDTA), shortterm debt to total assets (STDTA),and long-term debt
to total assets (LTDTA), in alternative estimations;
TANGB refers to the firm‘s tangibility, PROF refers
to the profitability measured by earnings before
interest, tax and depreciation, divided by total assets,
LIQ refers to the liquidity, VOE the volatility of
earnings, SPPR refers to the share price performance,
SIZE refers to the logarithm of total assets, Growth
refers to the annual growth of the firm‘s total assets,
and SMA refers to the stock market activity. i is
used to capture the unobserved individual effects
(either Fixed Effects model or Random Effects
model), and uit is the error term, which represents the
measurement errors in the independent variables and
any explanatory variables that have been omitted. The
non-debt tax shield was not included as there is a
strong correlation with the profitability variable
PROF. Pooled ordinary least squares (OLS) will be
estimated to compare their results with the panel data
18
The annual growth of the firm‘s total sales and the book
value of total assets less the book value of equity plus the
market value of equity divided by the book value of total
assets are used in this study.
in order to decide whether the panel model is
appropriated.
5. Empirical Results
possible to include both of them. In this case, the
PROF variable is used in the study as it is expected to
have a more significant impact on a firm‘s capital
structure.
5.1. Descriptive Statistics
Insert Table 5 Here
Table 4 reports the summary statistics of mean,
standard deviation, maximum, minimum, coefficient
of variation (CV)19, skewness, and kurtosis for all
variables used in the analysis. Based on the first
measure of leverage TDTA, the reported mean ratio is
about 0.36 and it is relatively small and close to the
ratio 0.377 reported by Omet and Mashharawe (2004)
for Jordanian companies. Table 4, also shows that the
leverage of ratio LTDTA has the lowest standard
deviation. Note that there is a large difference in the
variance of the dependent variables used in the
analysis as measured by the standard deviation. For
example, the variable TDTA has a standard deviation
of 3.56, which is significantly higher than the 0.85
standard deviation of TDTE.
Insert Table 4 Here
5.2. Diagnostic Tests
In order to control for multicollinearity, a diagnostic
test using the correlation matrix and the variance
inflation factors was employed. Table 5 presents the
correlation matrix of the explanatory variables. The
low intercorrelations between the explanatory
variables used in the regressions indicate that there is
no reason to suspect serious multicollinearity20.
However, there is a high intercorrelation between
PROF and the non-debt tax shield (NTS), so it is not
19
The coefficient of variation CV is defined as the standard
deviation over the mean.
20
The Breusch-Pagan Lagrange Multiplier test (1980) for a
diagonal matrix (that is, no cross-section correlation) is
N
i 1
carried out. The statistic test is:
 LM  T   rij2
i 2
where
r
square (  ) distribution under the null hypothesis
that all the exogenous variables are equal to zero.
2
5.3. Empirical Results
The coefficient of variation indicates that there is a
significant variation among the explanatory variables
used in the study. The mean for the profitability
(PROF) of the Jordanian companies is 9 percent,
which is very low, the main reason being that the
sample includes defaulted firms. The ratio of fixed
assets to total assets (TANGB) is about 47 percent
which is higher than other countries such as Thailand
(0.44), Malaysia (0.38), and Australia (0.33)
(Deesomsak, Paudyal and Pescetto, 2004). The
growth opportunities measure for Jordanian
companies is quite small at 0.66 compared to Oman
for example, with 1.58, as reported by Omet and
Mashharawe (2004).
2
ij is
To ensure the robustness of the estimates, several
diagnostic tests on the chosen estimations are
performed. The Breusch-Pagan Lagrange Multiplier
test (1980) for random effect is reported at the bottom
of each table of the results for the determinants of
capital structure. The Breusch-Pagan Lagrange
Multiplier test is used to examine the suitability of the
Random Effects model over the pooled Ordinary
Least Square (OLS) estimation. STATA software
allows the estimation of White‘s corrected covariance
matrix for group-wise heteroskedasticity (Greene,
2003, p.315). The overall significance of the models
was tested using the Wald test, which has a Chi-
the ijth residual correlation coefficient.
j 1
The analysis of the results is presented here in
different sub-sections. It begins with an analysis of
the determinants of capital structure for two samples
using the leverage ratio TDTA, and then the results of
different measures of leverage are presented. The
analysis then moves on to examine the effect of the
Gulf Crisis (1990-1991) on Jordanian firms‘ capital
structure. This includes an analysis of the statistical
significance of each variable. The pooled OLS
regression and Random-Effects model are used in this
analysis. Also, the results of the Fixed-Effects model
are reported. The Random-Effects model and OLS are
then used to examine the effect of the Industrial
sectors on capital structure decisions. Specifically, the
results of the five measures of leverage using the
same explanatory variables are presented in this
section.
In order to explore the appropriateness of a
Random-Effects model, a Breusch-Pagan Lagrange
Multiplier test is conducted for the overall
significance of these effects. According to the
Breusch-Pagan test, the null hypothesis is that the
random components are equal to zero. This test also
provides support for the rejection of a pooled
Ordinary Least Squares (OLS) over a Generalized
Least Squares (GLS). The Breusch-Pagan test for the
TDTA, STDTA, and LTDTA provides support for
using the Random Effects model over a pooled OLS.
Additional support for the Random-Effects model was
further obtained from the Hausman test of model
specification, given that the results failed to reject the
null hypothesis of ―no difference‖ between the
coefficients of the Random and Fixed-Effects models.
Also, the Random-Effects model has an important
advantage over the Fixed-Effects model, as it has the
27
ability to account for time–invariant predictors. As the
industrial dummy variables are important in this
analysis, the Random-Effects model may be more
efficient and robust than the Fixed-Effects model.
The overall significance of the models was
tested using the Wald test, which has a Chi-square
(  ) distribution under the null hypothesis that all
the exogenous variables are equal to zero. The overall
significance of the models is very high, significant at
least at the 1% level in all estimations using the
Random-Effects model. The overall goodness of fit
2
2
( R ) for the Random-Effects model is greater than
the goodness of fit of the Fixed-Effect model in all
estimations. For example, the goodness of fit for
TDTA for the full sample using the Random-Effects
model is about 33% while it is 28% using the FixedEffects model.
The estimation results of Equation (1) using two
samples are presented in Table 6 using the OLS,
Random-Effects model, and Fixed-Effects model.
Table 6 reports the determinants of TDTA for two
samples with defaulted firms and without defaulted
firms. Table 7 reports the determinants of short-term
debt to total assets (STDTA) and long-term debt to
total assets (LTDTA). The results of the
heteroskedasticity test show that our models do not
suffer from a heteroskedasticity problem21. The
observed Chi-squared value is not significant at the 5
percent level in our estimations.
Insert Table 6 Here
Insert Table 7 Here
From hypothesis 1, the variable representing the
tangible assets is expected to have a positive and
significant impact on a firm‘s leverage TDTA and
LTDTA, while a negative and significant relationship
between STDTA and tangibility is expected. Based on
the reported results in Table 6, the relationship
between leverage (TDTA) and tangibility (TANGB) 22
is positive and significant at the 1 percent level. The
result of the tangibility is consistent with the agency
theory proposition that there are agency costs
associated with the use of debt. It is also consistent
with the hypothesis that there is a positive relationship
between debt and the cost of bankruptcy which causes
financial distress and increases the firm‘s likelihood
of default. In other words, tangible assets increase the
firm‘s ability to raise debt and reduce the likelihood
of default. As predicted, Table 7 shows that there is a
negative and significant relationship between
tangibility and short-term debt. Table 7 also shows
that there is a positive and significant relationship
between long-term debt and tangibility.
The finding of a positive relationship between
tangible assets and leverage is consistent with the
prior research based on developed country capital
markets, including Titman and Wessels (1988), Rajan
and Zingales (1995), among others. The results also
similar to those of Wiwattanakantang (1999) and
Omet and Mashharrawe (2004), who examined firms,
traded on emerging markets. However, for Thailand
firms, Booth et al. (2001) reported different results.
They found a negative and significant relationship
between tangibility and leverage. The findings of a
negative relationship between tangible assets and
short-term debt and a positive and significant
relationship between long-term debt and tangibility
are consistent with those of Bevan and Danbolt
(2002).
Hypothesis 2 predicts that firms with a high
profitability ratio tend to decrease their leverage ratio,
thus the coefficient of PROF is expected to be
negatively related to leverage. From the regression
results in Table 6 and Table 7, as predicted,
profitability (PROF) is found to have a negative and
significant effect on the firm‘s leverage ratios TDTA,
STDTA, and LTDTA, with a high level of
significance23. This result is consistent with, and
supports, the pecking order theory, which argues that
external finance is costly and firms prefer internal
sources of finance. It is also consistent with the
Trade-off theory hypothesis that high profitability
increases the firm‘s debt financing capacity and the
strength of the accompanying tax shield and, hence,
decreases the firm‘s likelihood of default.
These results, reported in Table 6 and Table 7,
are consistent with most of the prior research based on
developed capital markets including Titman and
Wessels (1988), Rajan and Zingales (1995), Bevan
and Danbolt (2002), Zoppa and McMahon (2002),
and Cassar and Holmes (2003), among others. The
results are also similar to those of Wiwattanakantang
(1999), Booth et al. (2001), Chen (2004) from
emerging markets, which is notable since our study
includes additional firm specific variables. It is worth
noting that NTS is used instead of PROF and found to
be negative, but not significant, at any level of
significance, which is not consistent with the previous
findings such as Wiwattanakantang (1999) and
Deesomsak et al. (2004), among others.
From hypothesis 3, the firm‘s size is expected to
have a positive impact on the firm‘s leverage. From
the regression results in Table 6 and Table 7, as
predicted, firm size (SIZE) is found to have a positive
and statistically significant impact on a firm's leverage
ratios TDTA, STDTA, and LTDTA at the 1 percent
level24. The positive and significant relationship
21
The heteroskedasticity test for across panels can be run
using the xtgls command in Stata 8.
22
It is worth noting that TANGB is found to have a positive
and significant impact on total debt to total equity (TDTE)
but insignificant impact on total debt to total capital
(TDTC).
28
23
It is worth noting that PROF is found to have a negative
but insignificant impact on TDTE and TDTC.
24
It is worth noting that a firm‘s size is found to have a
significant impact on TDTE and TDTC.
between leverage and size indicates that large firms
have a lower risk of default as they have access to
external sources of funds. This finding is consistent
with the trade-off theory, that larger firms might be
more diversified and tends to have better borrowing
capacity compared with smaller firms. Also, large
firms tend to have a lower bankruptcy cost and are
less likely to default (Bevan and Danbolt, 2002). So
small firms are expected to borrow less than large
firms and tend to have a high likelihood of default.
The finding of a positive relationship between
size and leverage is consistent with the prior research
based
on
developing
countries
including
Wiwattanakantang (1999) and Booth et al. (2001).
The result is also consistent with research based on
developed countries including Titman and Wessels
(1988) and Rajan and Zingales (1995). On the other
hand, the result for long-term debt is inconsistent with
Bevan and Danbolt (2002) who report that size is
found to be positively related to the long-term debt
and negatively related to the short-term debt.
From Hypothesis 4, growth opportunity is
expected to have a negative impact on leverage. The
regression result in Table 6 and Table 7 shows that
the impact of growth opportunity (Growth) 25 on
leverage is positive, but is not significant using the
Random-Effects model. This result does not give
statistically significant support to the prediction of the
pecking order theory that growing firms are likely to
choose debt rather than equity. Our result is consistent
with that of Omit and Mashharawe (2004) which
finds that growth opportunity does not affect the
leverage ratio for Jordanian firms. It is also
inconsistent with other previous studies (e.g. Pandey
(2001), and Buferna, Bangassa and Hodgkinson
(2005)). This result is also not consistent with the
prediction of agency theory that high growth firms
use less debt since they do not wish to expose
themselves to possible restrictions imposed by
lenders. Another variable found to be a determinant of
corporate leverage in Jordan is the liquidity ( H 5 ). The
results reported in Table 6 and Table 7 show that
liquidity (LIQ) has a negative and significant impact
on the leverage ratios TDTA and STDTA, while it has
a negative but not significant effect on the leverage
ratio LTDTA. The negative and insignificant effect
between the LDTTA and liquidity could be because
most Jordanian firms depend on short-term debt rather
than long-term debt as a result of the banks credit
policy. This finding is consistent with agency theory
and pecking order theory propositions that firms
prefer to use their internal sources of funds to finance
their investment26. It is also consistent with the free
cash flow theory as firms prefer the internal source of
funds since it decreases the risk of default. The higher
liquidity ratio increases the firm‘s ability to meet its
short-term obligations and, hence, decreases the risk
of default (failure). This finding is consistent with
prior empirical research such Ozkan (2001), Antoniou
et al. (2002), and Deesomsak et al. (2004), among
others. Hypothesis 6 predicts that volatility of
earnings is negatively related to leverage. From the
regression results in Table 6 and Table 7, VOE is
found to have a positive but not significant effect on
all measures of leverage, and this result is consistent
with other studies such as Wiwattanakantang (1999)
and Deesomsak et al. (2004). The finding is not
consistent with the trade-off theory that firms with a
high volatility of earning have a high risk of default
and a lower debt capacity. Hypothesis 7 tests whether
share price performance can be a significant
determinant of corporate leverage in Jordan. From the
regression results in Table 6 and Table 7, the
coefficient of share price performance (SPPR) is
negative, as expected, but does not have a significant
effect on TDTA and LTDTA27. The finding does not
support the market timing theory that firms prefer
equity to debt when share prices increase. This result
could reflect the view that most of Jordanian firms
depend on banks as a source of funds rather than
using the equity market, or it could be that firms
ignore the volatility of earnings if the cost of entering
into liquidation is low (Deesomsak et al., 2004).
Hypothesis 8 predicted a negative relationship
between SMC and leverage. From the regression
results in Table 6 and Table 7, the relationship
between stock market activity (SMC) and the leverage
ratios TDTA and LTDTA is found to be significant
and negative28. This result is consistent with the
Demirguc-Kunt and Maksimovic (1996) argument,
that financial market development plays an important
role in firms‘ financing choice. However, the SMC is
found not to have a significant impact on STDTA. It
also shows that the activity of the Amman Stock
Exchange (ASE) decreases the demand for debt.
Therefore, as the ASE activity increased as
companies' preference for equity over debt increased.
5.4. Regional Crises (Gulf Crisis)
From Hypothesis 9, regional crises; Gulf Crisis 90-91
and outbreak of the Intifadah in September 2000, are
26
25
The other two measures of growth were used in the study
and found to have a positive effect on firm‘s leverage.
Growth in sales is found to be not significant, while the
growth ratio (Growth3) measured by book value of total
assets minus book value of equity divided by the book value
of total assets has a positive and significant impact on the
leverage ratio, at the 1% level of significance. Due to the
high correlation between Growth3 and PROF we used
Growth is assets in our analysis.
It is worth noting that LIQ is found to have a negative and
significant impact on TDTC, while it has a negative but
insignificant impact on TDTE.
27 27
It is worth noting that SPPR is found to have a positive
and significant impact on TDTC, while it does not have any
significant impact on TDTE.
28 28
It is worth noting that SMC is also found to have a
negative and significant impact on TDTC and TDTE
reflecting the importance of stock market activity on
corporate finance decisions.
29
expected to have a significant impact on corporate
leverage. The results for the estimated effect of the
Gulf Crisis of 1990-1991 and Intifadah and the
macroeconomic factors are presented in Table 6 and
Table 7.
The estimated coefficients on time dummies
suggest significant effects of macroeconomic
variables on firms' leverage, implying that major
changes to the overall economic environment may
significantly affect a firm's choice of capital structure.
From 1990 to 1993, time dummies almost had a
significant effect on the firm‘s leverage ratios TDTA
and LTDTA. The significance of the time dummies
DUM1990, DUM1991, DUM1992 and DUM1993
show that the Gulf Crisis 1990-1991 had a positive
impact on the leverage ratio as firms' demand for debt
to finance short-term obligations increased. Another
reason that could have lead to an increase in the
leverage ratios during the Gulf Crisis is that banks‘
credit policies may have encouraged firms to borrow
and invest.
The time dummy variable DUM1995 had a
significant effect on the capital structure. The time
dummies DUM1994, DUM1996, DUM1997,
DUM1998, DUM1999, DUM2000, DUM2001, and
DUM2002 had no significant effect on the firm
leverage ratios TDTA and LTDTA. The outbreak of
the Intifadah in September 2000 is found to have had
no significant impact on the firm leverage ratios
TDTA and LTDTA29.
From Hypothesis 10, industrial sectors are
expected to have a significant impact on corporate
leverage. The results of including dummy variables
for industries are reported in Table 8. This Table
shows that the results have changed very little. For
example, the growth (Growth)30 becomes highly
significant as we control for industrial sectors in the
Random Effects model.
In this study, 16 dummy variables are included
in the regression. It is worth noting that the Hotels and
Tourism, Transportation, and Educational services are
dropped from the regression; therefore, they are
excluded from the analysis. The dummy variables for
the Foods sector, Paper, Glass, and Packaging sector,
Steel, Mining and Heavy Engineering sector,
Chemical and Petroleum sector, Textiles and Clothing
sector, Utilities and Energy sector, Construction and
Engineering sector, Real Estate sector, and Trade,
29
It is worth noting that, the outbreak of the Intifadah in
September 2000 had a significant impact on other measures
of leverage, such as TDTE and TDTC, at a high level of
significance. The significance impact of DUM2000 on
TDTE and TDTC shows that most Jordanian firms
increased their debt to equity and capital during 2000 as a
result of the impact of Intifadah.
30
The growth ratio measured by book value of total assets
minus book value of equity divided by the book value of
total assets is also found to be significant and positive in
both the Random Effects model and the OLS, while the
growth in sales is found to have a positive but not
significant effect in the three models.
30
Commercial services, Rental, and Communication
sectors, have a positive and significant impact on the
financial leverage. This indicates that these sectors
have a high demand for debt and have high leverage
ratios in capital structure compared with other sectors.
It also shows that firms in these sectors have the
ability to borrow more, which increases their ability to
manage debt in their capital structure.
The dummy variable for the Medical services
sector has a negative and significant impact on the
leverage ratio. The negative coefficient of Medical
services indicates that these firms have a lower ability
to increase their leverage. It may also indicate that
these firms have a lower demand for debt. The other
industrial dummy variables for Medical and
Pharmaceutical services, Tobacco, and Media sectors
do not have a significant impact on firms' leverage
TDTA. The finding is consistent with prior empirical
research such as Titman (1984) and Bradley, Jarrell
and Kim (1984), that that firm industry sectors affect
corporate leverage.
It is worth noting that the other two measures of
size, the logarithm of total sales (SAL) and the
logarithm of market capitalization (CAP) are
significant. Regarding the other two measures of
growth, the book value of total assets less the book
value of equity plus the market value of equity
divided by the book value of total assets had a
positive and significant impact on leverage in the
three models, while the annual growth of the firm‘s
total sales had a positive but not significant effect in
the three models.
6. Conclusion
This paper analyses the capital structure of the listed
firms on the Amman Stock Exchange (ASE) from
1989 to 2003. The issue of how firms in developing
countries finance their activities attracts considerable
interest since most of the theoretical and empirical
work on capital structure considers only developed
countries. Hypotheses were developed to test which
capital structure theories best explained the Jordanian
companies‘ capital structure, by comparing the
relationships between long-term debt, short-term debt,
total debt to total assets, total debt to total capital, and
total debt to shareholders equity and eight explanatory
variables that represent profitability, growth,
tangibility, liquidity, size, volatility, market
performance, and financial market development.
Based on the time period 1989-2003, our results
indicate that Jordanian companies mostly depend on
short-term debt, as a result of the banking credit
policy that promotes on short-term debt. Our results
suggest that the level of gearing in Jordanian firms is
positively related to size, tangibility, volatility of
earnings, and negatively correlated with profitability,
the level of growth opportunities, liquidity and stock
market activities. The level of gearing measured by
short-term debt is, however, negatively correlated
with tangibility. The Gulf Crisis between 1990 and
1991 is also found to have a significant and positive
impact on Jordanian corporate leverage. The rationale
behind this finding is that most Jordanian companies
export their products to Gulf markets, and the demand
for the exporting product increased, leading to many
not having enough liquidity to finance their
expansion. The outbreak of Intifadah in September
2000, however, does not have a significant impact on
the firms' leverage ratios, measured by TDTA,
LTDTA, and STDTA.
The finding of a strong positive relationship
between size and leverage, as well as between the size
and the leverage measured by short-term debt,
suggests that the capital structure decision with
inadequate long-term debt access is influenced more
strongly and positively by factors such as the
bankruptcy cost which is represented by SIZE.
Furthermore, the finding of a very strong negative
relationship between market activity and gearing
further supports our previous finding that Jordanian
firms have inadequate long-term debt access as their
source of financing. Once the ASE activity increased,
companies' preference for equity over debt increased
substantially due to their inadequate long-term debt
access and the high cost of short-term debt. We
conclude that the capital structure decision with
inadequate long-term debt access is influenced more
strongly by factors such as bankruptcy costs and
Stock Market Activity (SMA).
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Appendices
Table 1. The Average of Leverage Ratios for Jordanian Listed Firms 1989-2003
Year
STDTA
LTDTA
TDTA
STDTE
LTDTE
TDTE
TDTC
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
0.389
0.433
0.429
0.344
0.329
0.261
0.250
0.248
0.249
0.255
0.249
0.327
0.238
0.101
0.075
0.065
0.058
0.054
0.043
0.042
0.046
0.057
0.073
0.071
0.062
0.068
0.508
0.523
0.518
0.423
0.401
0.314
0.305
0.313
0.328
0.353
0.357
0.365
0.345
0.966
1.708
1.674
0.957
0.262
0.437
0.468
0.504
0.691
0.506
1.213
1.209
0.542
0.3242
0.471
0.182
0.143
0.129
0.096
0.098
0.109
0.082
0.117
0.367
0.163
0.216
1.359
2.279
1.983
1.200
0.471
0.595
0.636
0.690
0.857
0.725
1.670
1.572
0.876
1.634
1.691
1.630
1.409
1.345
1.194
1.227
1.287
1.224
1.055
1.039
1.144
1.087
2002
2003
0.226
0.214
0.069
0.057
0.338
0.309
0.331
0.324
0.165
0.123
0.643
0.625
1.096
1.056
Average
0.296
0.063
0.380
0.786
0.186
1.079
1.274
Source: Amman Stock Exchange and author's calculation based on data from annual reports.
32
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Default
Non-default
Figure 1. Average Leverage Ratio TDTA in Defaulted and Non-Defaulted Firms: 1989-2002
Table 2. Average Leverage Ratios in both Defaulted and Non-Defaulted Firms over 1989-2002
LTDTA
Year
STDTA
TDTE
TDTC
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Default
0.11
0.05
0.04
0.04
0.05
0.05
0.04
0.07
0.12
0.16
0.09
0.06
0.24
0.16
Non-default
0.10
0.09
0.07
0.07
0.05
0.04
0.04
0.04
0.04
0.05
0.07
0.06
0.06
0.07
Default
0.47
0.64
0.66
0.48
0.42
0.29
0.26
0.27
0.25
0.29
0.32
0.40
0.48
0.63
Non-default
0.35
0.34
0.33
0.29
0.29
0.25
0.25
0.24
0.25
0.25
0.23
0.31
0.36
0.44
Default
1.40
2.66
3.16
2.22
-0.27
0.59
0.66
0.88
0.46
0.74
6.49
4.97
2.62
4.89
Non-default
1.34
2.11
1.45
0.82
0.74
0.60
0.63
0.63
0.94
0.72
0.66
0.98
0.77
0.57
Default
1.51
1.62
1.70
1.24
1.07
1.32
1.05
1.11
0.57
0.67
1.01
1.44
1.46
0.93
Non-default
1.69
1.72
1.60
1.47
1.44
1.15
1.28
1.34
1.37
1.14
1.05
1.09
1.06
1.10
Average
0.09
0.06
0.42
0.30
2.25
0.93
1.19
1.32
Table 3. Variables Definitions
Variable
TDTA
TDTE
TDTC
STDTE
LTDTA
TANGB
PROF
LIQ
SIZE
Growth
NTS
SPPR
VOE
SMC
Variable Definition
Total debt/Total assets
Total debt/Total equity
Total debt/Total capital
Short-term debt/Total equity
Long term debt/ Total assets
Total Fixed assets/Total assets
(Earnings before interest and tax plus Depreciation)/Total assets
Current liabilities/Total assets
Logarithm of Assets
Changes in Total Assets
Depreciation/Total assets
Share Price Performance (log P1 - log P0 )
Volatility of Earnings (EBIT  EBIT  Average)
1
0
Stock Market Activity (Market value of traded shares/market value of stock market
capitalisation
33
Table 4. Description Statistics for the Dependent (s) and Independent Variables
Variable
TDTA
Mean
0.366
Std. Dev.
3.56
Minimum
0
STDTA
0.311
0.85
0
LTDTA
0.062
0.115
TDTE
1.899
SIZE
CV
9.73
Skewness
2.95
Kurtosis
18.31
26.71
2.73
23.97
673.52
0
2.023
1.85
5.005
62.428
35.28
-15.67
1407.99
18.58
39.21
1562.01
6.9
0.6
5.07
9.04
0.09
0.73
4.24
PROF
0.09
0.25
-6.25
0.7
2.78
-15.46
349.14
TANGB
0.47
0.26
0
0.98
0.55
0.03
2
Growth
0.33
8.68
-0.87
328.61
26.30
37.71
1427.29
NTS
0.12
2.05
0
76.86
17.08
34.28
1236.87
LIQ
17.72
127.06
0.02
3331.44
7.17
16.83
362.16
VOE
0.68
11.96
-278.85
53.58
17.59
-16.77
371.72
SPPR
-0.01
0.18
-1.58
0.88
-18.00
-0.14
10.86
0
0.23
2.00
8.23
89.63
SMC
0.01
0.02
Note: See Table 3 for variable definitions.
Maximum
3.555
Table 5. Correlation Matrix for the Explanatory Variables
SIZE
PROF
TANG
Growth1
NTS
LIQ
VOE
SPP
SIZE
1
PROF
0.057
1.000
TANGB
0.078
0.041
1.000
Growth
-0.022
0.018
-0.067
1.000
NTS
-0.029
-0.911
-0.081
-0.002
1.000
LIQ
-0.176
-0.070
-0.096
0.022
0.031
1.000
VOE
-0.025
0.001
0.007
0.001
-0.001
0.040
1.000
SPPR
0.022
0.086
-0.024
0.044
-0.002
-0.034
-0.025
1.000
SMC
0.571
0.078
0.066
-0.012
-0.014
-0.056
-0.021
0.034
SMC
1.000
Note: Annual growth of total assets SMC (Stock market capitalisation) is the ratio of traded value to the market capitalisation.
See Table 3 for variable definitions.
Table 6. Regression Results for Total Debt to Total Assets (TDTA)
Independent
Variables
Constant
TANGB
PROF
SIZE
LIQ
VOE
SPPR
Growth
SMC
34
Full Sample (defaulted and non-defaulted Firms)
Sample without defaulted Firms
OLS
Random Effect
Fixed effect
OLS
Random Effect
Fixed Effect
-1.0873
(-11.21)***
0.156
(5.63)***
-0.0459
(-1.97)**
0.1938
(14.52)***
-0.0051
(-7.03)***
0.0003
(0.6)
-0.0669
(-1.58)
-0.0002
(-0.45)
-3.0248
(-7.06)***
-0.7158
(-4.34)***
0.2010
(5.53)***
-0.0623
(-2.38)**
0.1386
(6.06)***
-0.0060
-6.95)***
0.0003
(0.71)
-0.0304
(-1.04)
0.0007
(1.39)
-1.4483
(-3.01)***
-0.7950
(-2.79)***
0.2238
(4.88)***
-0.1740
(-4.23)***
0.1519
(3.84)***
-0.0075
(-6.29)***
0.0003
(0.80)
-0.0163
(-0.55)
0.0027
(3.6)***
-1.0426
(-2.02)**
-1.1255
(-11.27)***
0.1448
(5.07)***
-0.0254
(-1.09)
0.2015
(14.66)***
-0.0048
(-6.48)***
0.0004
(0.62)
-0.0472
(-1.09)
-0.0003
(-0.61)
-3.0266
(-7.09)***
-0.6461
(-3.78)***
0.1931
(5.00)***
-0.0253
-(0.97)
0.1308
(5.55)***
-0.0062
(-7.09)***
0.0003
(0.71)
-0.0318
(-1.09)
0.0002
(0.46)
-1.3493
(-2.88)***
-0.5765
(-1.98)**
0.2081
(4.12)***
-0.0822
(-1.98)**
0.1237
(3.09)***
-0.0078
(-6.52)***
0.0003
(0.73)
-0.0275
(-0.93)
0.0013
(1.670)*
-1.0476
(-2.090)**
Table 6 continued
DUM1990
DUM1991
DUM1992
DUM1993
DUM1994
DUM1995
DUM1996
DUM1997
DUM1998
DUM1999
DUM2000
DUM2001
DUM2002
Observation
Adjusted R-square
Wald-test
0.1744
(5.02)***
0.1646
(5.05)***
0.1606
(4.94)***
0.1335
(4.08)***
0.0619
(1.87)*
0.0630
(1.93)**
0.0427
(1.31)
0.0552
(1.71)*
0.0443
(1.35)
0.0355
(1.11)
0.0504
(1.55)
-0.0027
(-0.1)
0.0010
(0.04)
0.1407
(5.69)***
0.1253
(5.43)***
0.1172
(5.11)***
0.1007
(4.39)***
0.0370
(1.61)
0.0395
(1.75)***
0.0158
(0.7)
0.0315
(1.41)
0.0265
1.17
0.0115
(0.52)
0.0226
(1.00)
-0.0001
(0)
0.0022
(0.13)
0.1453
(5.62)***
0.1254
(5.27)***
0.1160
(4.94)***
0.1000
(4.29)***
0.0363
(1.56)
0.0361
(1.58)
0.0089
(0.39)
0.0259
(1.15)
0.0218
(0.96)
0.0045
(0.20)
0.0164
(0.72)
0.0022
(0.12)
-0.0008
(-0.05)
0.1548
(4.33)***
0.1376
(4.1)***
0.1280
(3.8)***
0.1059
(3.14)***
0.0479
(1.39)
0.0429
(1.27)
0.0177
(0.52)
0.0312
(0.93)
0.0200
(0.59)
0.0028
(0.08)
0.0070
(0.21)
-0.0166
(-0.62)
-0.0129
(-0.5)
0.1115
(4.51)***
0.0951
(4.13)***
0.0817
(3.55)***
0.0672
(2.93)***
0.0151
(0.65)
0.0125
(0.55)
-0.0108
(-0.48)
0.0061
(0.27)
0.0023
(0.1)
-0.0188
(-0.85)
-0.0194
(-0.86)
-0.0186
(-1.09)
-0.0147
(-0.88)
0.1055
(4.08)***
0.0882
(3.71)***
0.0751
(3.18)***
0.0605
(2.59)***
0.0090
(0.38)
0.0053
(0.23)
-0.0190
(-0.83)
-0.0016
(-0.07)
-0.0037
(-0.16)
-0.0253
(-1.14)
-0.0252
(-1.1)
-0.0186
(-1.09)
-0.0176
(-1.06)
834
834
834
763
763
763
0.3344
0.3283
0.2835
0.3413
0.3294
0.2955
F= 8.31
(0.00)***
F= 19.34
(0.00)***
F= 20.92
(0.00)***
 2 = 212.12
(0.00)***
 2 = 191.79
(0.00)***
 2 = 23.56
Huasman Test
F= 7.16
(0.00)***
 2 = 23.51
(0.3149)
(0.318)
 2 = 1190.59
 2 = 1188.96
Breusch and Pagan
Lagrangian
(0.00)***
(0.00)***
Notes: *** Significant at 1% level, ** Significant at 5% level, and **Significant at 10% level. TANGB (tangibility) is the ratio of total fixed
assets to total assets. PROF (profitability) is the ratio of earnings before interest, tax and depreciation to total assets. NTS (non-debt tax
shield) is the ratio of depreciation to total assets. LIQ (liquidity) is the ratio of current assets to current liabilities. VOE (volatility of earnings)
is the absolute difference between annual change in earnings before interest and tax and the average of this change. SPPR (share price
performance) is measured as the first difference of logs of annual share prices. SIZE is the natural logarithm of total assets. Growth (growth
opportunity) is the annual growth of total assets. SMC (Stock market capitalization) is the ratio of traded value to the market. See Table 3 for
variable definitions.
Table 7. Regression Results for Short-term Debt to Total Assets (STDTA) and Long-term Debt to Total Assets
(LTDTA) ratio, 1989-2003
Constant
TANGB
PROF
SIZE
LIQ
VOE
SPPR
Growth
SMC
DUM1990
OLS
0.0768
(0.36)
STDTA
Random-effect
Model
0.0293
(0.12)
Fixed-effect
Model
-0.0043
(-0.01)
-0.2623
(-4.26)***
-3.7320
(-72.4)***
0.0828
(2.8)***
-0.0076
(-4.74)***
0.0012
(0.96)
0.4522
(4.83)***
0.0009
(0.74)
0.3040
(0.32)
0.5744
(7.46)***
-0.2346
(-3.54)***
-3.7716
(-75.39)***
0.0875
(2.63)***
-0.0069
(-4.34)***
0.0012
(1.04)
0.4380
(5.05)***
0.0001
(0.11)
0.6271
(0.61)
0.5771
(8.09)***
0.1004
(1.13)
-2.0239
(-25.5)***
0.0600
(0.79)
-0.0069
(-3.02)***
0.0008
1.14
0.2018
(3.56)***
-0.0334
(-22.8)***
1.2602
(1.27)
0.3375
(6.77)***
OLS
-0.4327
(-11.76)***
LTDTA
Random-effects
model
-0.3802
(-5.55)***
Fixed-Effects
Model
-0.389
(-3.18)***
0.1062
(10.08)***
-0.0167
(-1.89)*
0.0625
(12.34)***
-0.0003
(-1.06)
0.0002
(0.84)
-0.0153
(-0.96)
0.0001
(0.43)
-0.1499
(-0.92)
0.0387
(2.94)***
0.0976
(6.42)***
-0.0204
(-1.87)*
0.0560
(5.89)***
-0.0003
(-0.87)
0.0001
(0.52)
-0.0122
(-0.99)
0.0003
(1.19)
-0.3375
(-1.66)*
0.0393
(3.77)***
0.096
(4.89)***
-0.042
(-2.38)**
0.057
(3.36)***
0.000
(-0.21)
0.000
(0.46)
-0.011
(-0.85)
0.001
(2.01)**
-0.354
(-1.6)
0.043
3.86
35
Table 7 continued
DUM1991
DUM1992
DUM1993
DUM1994
DUM1995
DUM1996
DUM1997
DUM1998
DUM1999
DUM2000
DUM2001
DUM2002
No. of Observations
Adj R-squared
Wald-test
0.3883
(5.37)***
0.3856
(5.35)***
0.4200
(5.79)***
0.3499
(4.76)***
0.3047
(4.21)***
0.1642
(2.27)**
0.1783
(2.5)**
0.1308
(1.8)*
0.0529
(0.75)
0.0564
(0.78)
0.0618
(1.04)
0.0137
(0.24)
834
0.8644
F=253.92
(0.00)***
0.3909
(5.84)***
0.3886
(5.82)***
0.4201
(6.26)***
0.3559
(5.24)***
0.3108
(4.65)***
0.1683
(2.52)**
0.1834
(2.78)***
0.1345
(2.01)**
0.0564
(0.87)
0.0611
(0.92)
0.0544
(1.00)
0.0060
(0.11)
834
0.8676
 2 =5838.5
0.00)***
0.2373
(5.17)***
0.2345
(5.17)***
0.2532
(5.63)***
0.2012
(4.47)***
0.1778
(4.03)***
0.0892
(2.03)**
0.1093
(2.52)**
0.0807
(1.84)*
0.0261
(0.61)
0.0343
(0.78)
-0.0184
(-0.54)
0.0054
(0.16)
834
0.5635
0.0376
(3.04)***
0.0277
(2.24)**
0.0101
(0.81)
-0.0001
(0.00)
-0.0046
(-0.37)
-0.0063
(-0.51)
-0.0046
(-0.38)
0.0009
(0.07)
0.0024
(0.2)
0.0011
(0.09)
-0.0034
(-0.34)
0.0057
(0.57)
834
0.2998
F= 321.14
(0.00)***
F=17.99
(0.00)***
 2 = 732.32
Huasman Test
0.0386
(3.96)***
0.0275
(2.83)***
0.0114
(1.18)
0.0018
(0.18)
-0.0032
(-0.34)
-0.0053
(-0.56)
-0.0032
(-0.34)
0.0020
(0.21)
0.0029
(0.31)
0.0005
(0.05)
-0.0037
(-0.5)
0.0047
(0.64)
834
0.3144
 2 =105.930
(0.00)***
0.041
(4.04)***
0.030
(2.99)***
0.014
(1.41)
0.004
(0.42)
-0.001
(-0.1)
-0.004
(-0.39)
-0.002
(-0.17)
0.003
(0.31)
0.004
(0.37)
0.001
(0.09)
-0.004
(-0.49)
0.004
(0.49)
834
0.296
F= 3.250
(0.00)***
 2 = 6.60
(0.00)***
(0.9988)
 =
2
 = 537.68
Breusch and Pagan
469.49
Lagrangian
(0.00)***
(0.00)***
Notes: *** Significant at 1% level, ** Significant at 5% level, and *Significant at 10% level. See Table 3 for variable definitions.
2
Table 8. Regression Results for Total Debt to Total Assets (TDTA) with Industry Dummies
Independent Variables
Constant
TANGB
PROF
SIZE
LIQ
VOE
SPPR
Growth
SMC
Dummy for Food Sector
Dummy for Paper, Glass, and Packaging
Dummy for Steel, Mining and Heavy Engineering
Dummy for Medical Pharmacy
Dummy for Chemical and Petroleum
Dummy for Textiles and Clothing
Dummy for Utilities and Energy
Dummy for Tobacco
36
Pooled OLS regression
-1.0724
(-10.42)***
0.1969
(7.35)***
-0.0717
(-2.89)***
0.1742
(12.44)***
-0.0038
(-5.65)***
0.0004
(0.82)
-0.0383
(-1.04)
0.0005
(0.97)
-2.0820
(-5.16)***
0.0935
(4.24)***
0.1128
(4.79)***
0.0667
(3.14)***
0.0015
(0.05)
0.2308
(10.75)***
0.1467
(4.94)***
0.2938
(10.78)***
0.0582
(0.88)
Random-effect Model
-0.8978
(-5.07)***
0.2264
(6.22)***
-0.0999
(-3.38)***
0.1467
(6.19)***
-0.0058
(-6.6)***
0.0003
(0.73)
-0.0272
(-0.94)
0.0014
(2.43)**
-1.3090
(-2.75)***
0.1368
(2.72)***
0.1181
(2.13)**
0.0870
(1.79)*
0.0345
(0.53)
0.2299
(4.19)***
0.1750
(2.27)**
0.2907
(4.42)***
0.0808
(0.75)
Table 8 continued
Dummy for Construction and Engineering
Dummy for Real Estate
Dummy for Media Sector
Dummy for Medical Services
Dummy for Trade, Commercial Services, and Rental
DUM1990
DUM1991
DUM1992
DUM1993
DUM1994
DUM1995
DUM1996
DUM1997
DUM1998
DUM1999
DUM2000
DUM2001
DUM2002
Adjusted R-square
Wald-test
0.2151
(7.37)***
0.0228
(0.65)
0.0171
(0.51)
-0.1482
(-1.71)*
0.1343
(4.52)***
0.1519
(5.00)***
0.1349
(4.73)***
0.1285
(4.52)***
0.1071
(3.75)***
0.0384
(1.33)
0.0426
(1.5)
0.0225
(0.79)
0.0362
(1.29)
0.0271
(0.95)
0.0130
(0.47)
0.0249
(0.88)
-0.0020
(-0.08)
0.0033
(0.15)
0.53
F= 27.72
(0.00)***
Huasman Test
Breusch and Pagan Lagrangian
0.2287
(3.02)***
0.1735
(2.43)**
0.0343
(0.35)
-0.2257
(-1.75)*
0.1385
(2.22)**
0.1412
(5.73)***
0.1245
(5.42)***
0.1157
(5.06)***
0.0990
(4.34)***
0.0345
(1.51)
0.0366
(1.63)
0.0117
(0.52)
0.0277
(1.25)
0.0222
(0.99)
0.0062
(0.28)
0.0171
(0.76)
0.0001
(0.01)
0.0016
(0.09)
0.53
 2 = 284.53
(0.00)***
11.53
(0.9515)
436.26
(0.00)***
Notes: *** Significant at 1% level, ** Significant at 5% level, and *Significant at 10% level. t-statistics are in parentheses. See Table 3 for
variable definitions. 16 industrial dummy variables are included in the regression. The Hotels and Tourism, Transportation, and Educational
Services are dropped from the regression, therefore not reported
Appendix 1. Number of Listed Firms used in the Study by Sector over the Period 1989-2003
Sector
No. of Firms
Foods
19
Paper, Glass, and Packaging
12
Steel, Mining and Heavy Engineering
20
Medical Pharmacy
11
Chemical and Petroleum
11
Textiles and Clothing
8
Utilities and Energy
11
Tobacco
3
Construction and Engineering
10
Hotels and Tourism
11
Real Estate
10
Media
6
Medical Services
5
Trade and Commercial Services and Rental, Communication
17
Educational Services
3
Total
167
37
DIVIDENDS AND INSTITUTIONAL INVESTORS ACTIVISM: PRESSURE
RESISTANT OR PRESSURE SENSITIVE?
José María Diez Esteban*, Óscar López-de-Foronda**
Abstract
This paper provides new international evidence on the relationship between dividend policy and
institutional ownership by analysing a sample of US and UK and Irish firms characterised by an AngloSaxon tradition and a matching sample of other EU companies from Civil Law legal systems. We
hypothesize that, due to the different characteristics of both the legal system and the nature of agency
conflicts in firms from those countries, the type of institutional investors and their role in corporate
governance is different and so the use of dividend policy to solve the conflict of corporate governance
problem differs in each legal system. We find that while in firms from Anglo-Saxon tradition the
relation between dividends and institutional investors, pension and investment funds, is possitive, in
Civil Law countries the relation is negative where investors are banks or insurance companies with
other private interest inside the firm. These results are consistent with our hypotheses and breed new
insights into the role of dividend policy as a disciplining mechanism in firms from different legal
system with an important presence of institutional investors.
Keywords: dividend policy, corporate governance, institutional investor activism, pressure and
pressure insensitive, international financial markets
* Departamento de Economía y Administración de Empresas, Área de Economía Financiera y Contabilidad, Universidad de
Burgos, Plaza Infanta Elena, 09001 Burgos s/n, España.
** Corresponding author. Departamento de Economía y Administración de Empresas, Área de Economía Financiera y
Contabilidad, Universidad de Burgos, Plaza Infanta Elena, 09001 Burgos s/n, España. Tel (34)-947259040, Fax (34)947258960. E-mail: oscarl@ubu.es
1. Introduction
Financial institutions' aggregate investments have
grown substantially across world equity markets, and
they have incentives to monitor managers when
institutions are large shareholders. So, institutions
may demand more dividends to avoid managerial
discretion in the use of free cash flow ( Jensen; 1986)
and to force firms to obtain external funds and be
subject to monitoring by external capital markets
(Short et al., 2002).
In anglosaxon countries,
institutional investors as pension and investments
funds pension are frequent owners of important
shareholdings and they can use the payout policies to
play an active role in the corporate governance
problems.
But activities of institutional investors differs
both across types of investors and across countries.
Recent studies have focused on the different
objectives of different institutional investors in
corporate governance such as pension funds, banks, or
insurance companies. Pound (1988) and Bhattacharya
and Graham ( 2007) distinguish two types of
institutional holdings: pressure sensitive investors
when they are more sensitive to pressure from
corporate management and pressure insensitive when
they are not sensitive to pressure from corporate
38
management. Pressure sensitive investors are banks
and insurance companies because they have
frequently other business relations with companies.
This type of investors is more frequent in countries
where investors protection are weaker, the ownership
concentration is higher and firms use more debt to
finance their investments. It is the case of civil law
countries where investors as banks and insurance
companies with other private interest in firms try to
reduce dividends to get their private interests inside
firms contrary to the attitude of pressure resistant
investors, pension and investment funds, which are
more frequent in anglosaxon firms.
The objective of our paper is to demonstrate that,
due to the distinct characteristics of anglosaxon and
civil law firms, the type of institutional investors and
their role in corporate governance is different and so,
the use of dividend policy to solve the agency
problems differs in each legal system.
Our results suggest that while in firms from
Anglo-Saxon tradition the relation between dividends
and institutional investors, pension and investment
funds, is possitive, in Civil Law countries the relation
is negative where investors are banks or insurance
companies with other private interest inside the firm.
So, different institutional investors can have a distinct
impact on dividend policies according to the
particularities of corporate governance environments
of each legal system.
The paper proceeds as follows. Section 2
provides the arguments to link dividends and
institutional shareholders in different legal system
with the hypotheses to be tested, while the following
section describes the data and methodology. Section 4
presents and discusses the major results. The final
section summarizes and discusses the paper‘s
contribution to the literature.
impact of these investors on dividends policy could be
negative or positive. Therefore, we set two different
hypotheses for firms from anglo and civil law system
respectively.
Hypothesis 1: In anglosaxon firms, dividends
increase when the ownership of institutional investor
is higher.
Hypothesis 2: In civil law firms, dividends
decrease when the ownership of institutional investor
is higher.
2.The Link Between Institutional
Investors Activism and Dividend Policy in
Each Legal System
3. Methodology
The relation between dividends and institutional
investor can be influenced by the nature of each
institutional investor and by the particular corporate
governance problem existing in firms from different
legal system.
The so-called law and finance approach is based
on the legal tradition of each country. According to
which, the legal and institutional features are not
unrelated to the agency problems within firms. There
are two conflicts of interest to which most attention
has been paid: the relationship between managers and
firm owners and the relation between shareholders
and creditors. Nevertheless, in recent years there is
more concern with the conflict of interest between
large and small minority shareholders. As stated by
Becht and Röell (1999) and Bianco and Casavola
(1999), in the Anglo-Saxon common law countries,
the main agency problem arises from the dispersion of
corporate ownership and from a certain lack of
shareholder activism. On the contrary, the main
problem in civil law countries is the too high
concentration of ownership and, consequently, large
shareholders may use their voting power to extract
private benefits from small shareholders. These
aspects have an influence on the participation and the
nature of institutional investors in corporate
governance.
Bhattacharya and Graham (2007) suggest that an
institutional investor with other profitable business
relationships with the firm such as banks as lenders or
insurance companies that act as primary insurers, can
create conflicts of interest while other institutional
investors can exert an effective monitoring on
managers. Li and others (2007) find evidence that
banks and insurance companies are frequent investors
in civil law firms while pension funds are frequent
owners of important shareholdings in anglosaxon
countries. It is due to differences in the legal
framework of civil law with a bank orientation of
firms and anglosaxon firms with a market orientation
to obtain funds respectively (Rajan and Zingales,
1995 and La Porta et al., 1998, 2000ab and 2002). As
we mentioned, the authors distinguish pressure
resistant versus pressure sensitive institutional
investors according to whether these can reduce or
increase corporate governance problems so that the
The information required to test the two hypotheses
that were advanced in the previous section has been
gathered from different sources. The Compustat
Database was used to obtain firm financial data.
Information on US company ownership over the
period 1996-2000, during which the research was
conducted, was collected from Deloitte and Touch's
Peerscope and Investor Insight's Market Guide
databases. Amadeus, provided by the Bureau van
Dijk, was used for ownership data on European
companies. La Porta et al.'s (1997) international data
on Shareholders and Creditors rights was also used.
The final sample is shown in table 1. As can be
seen from the table, the sample is composed of 931
companies over the period 1996-2000 and involves a
total of 4,092 firm-year observations. Of the total
number of companies, 462 are from the US and 469
are European.
3.1. Sample and Variables
INSERT TABLE 1
3.2. Empirical Model
The extended model that we use in our empirical
analysis is as follows:
DIVit=0 +1DIVi(t-1)+(2+ 2ANGLOi) INSTIit
+(3+3ANGLOi) INSIit +(6+6ANGLOi) DRit
+(7+7ANGLO) MBit+ 1 SRi+ 2 CRi+
(7+7ANGLOi) LOGACTit + i+ it
(1)
DIVit is defined as dividend yield (dividends
divided by market capitalization of equity), or as
dividend payout (dividends divided by earnings) or
the ratio between dividends and total assets. This
variable was previously censored using a TOBIT
model given that one cannot directly include such in a
Generalized Method of Moments (GMM) panel
without it being censored, as referred by Arellano and
Bover (1997); INSTIit is the degree of institutional
ownership; INSIit is the ownership by insider
shareholders as a percentage of total shares; DR it
represents the level of debt defined as the ratio
between the book value of debt and total assets; MB it
is the market-to book ratio; SR and CR are indexes
for shareholders and creditors rights ,respectively, as
taken from La Porta et al. (1997); LOGACT measures
size, defined as the log of the book value of the assets.
39
ANGLO is a dummy variable where a value of 1 is
assigned for firms from the US, United Kingdom or
Ireland (Common Law countries), and a 0 for all other
firms (Civil Law firms).
We test this model with panel data to allow the
values taken over time by a series of variables to be
known on an individual basis (The panel data used is
characterized as being incomplete or unbalanced. In
particular, the variant chosen for this work is referred to a
micropanel data, which is to say, a data group in which the
dominant dimension corresponds to the number of
individuals while the number of periods is significantly
lower). The use of this methodology has a number of
advantages when compared with a cross sectional
data. The first is the so-called control of constant
unobserved heterogeneity. In our case, the particular
singularities of the firms can affect their dividend
payment policies, as already stated, and such features
can persist for long periods of time. The second is the
dynamic dimension of our data panel that allows
dividend policies to vary according to the proposed
explanatory variables over a period of time and
furthermore considers the impact on dividends in the
light of changes in the model's other variables.
The existence of individual as well as
endogenous effects leads us to consider the variables
in first differences and to estimate the parameters of
the model using the generalized method of moments
(The endogenous character of the ownership structure has
been considered in recent studies as Villalonga and Amit
(2006) for US firms, Short and Keasey (2002) for UK firms,
De Miguel et al. (2002) and Alonso-Bonis and De AndrésAlonso (2007) for Spanish firms and López Iturriaga, and
Saona Hoffman (2005) for Chilean firms among others).
4.
Results
Descriptive Results
The results are shown in tables 2 and 3. In table 2,
descriptive statistics on the most significant variables
used in firms within each legal and institutional
framework reveal the existence of important and
significant differences between the two sets of firms.
INSERT TABLE 2
Table 2 reveals that Anglo-Saxon firms on
average pay out more dividends, carry less of a debt
burden - with levels of debt that do not reach 30% of
total liabilities, against 50% in firms from Civil Law
countries -, display an ownership structure that is
characterized by a much higher participation of
institutional investors – reaching 40% of total
ownership against a mere 7% for firms within the
Civil Law tradition - and have greater opportunities
for growth than firms in continental Europe (as
measured by the market-to-book ratio). If a greater
degree of shareholder protection is added to this
already dissimilar model of financial architecture, a
picture emerges of the different scope of agency
problems in companies within the two legal and
40
institutional frameworks and, consequently, of the
different dividend policies that are adopted.
Regression Results
Table 3 shows the estimated coefficients for the
variables in our model, first for Anglo Saxon firms
and then for Civil Law firms, followed by the
coefficients for the institutional variables and the
results of the statistic tests31.
INSERT TABLE 2
We observe an important difference between our
Anglo-Saxon and Continental European samples,
which is the sign and magnitude of the coefficient
estimate for INSTI. This coefficient is positive and
significant for the Anglo-Saxon. So, we obtain
evidence to confirm the hypothesis 1 of our study. In
these firms, institutional investors as pension and
investment funds are pressure sensitive to corporate
governance problem and they are interested in
increasing dividends to effective monitoring on
managers. While the coefficient is negative and
significant in the Civil Law sample (although not
when we use the dividend payout ratio as the
dependent variable). We also evidence to confirm the
hypothesis 2 of our study. In this case, banks as
lenders or insurance companies that act as primary
insurers, can create conflicts of interest and they
prefer reduce dividends to get their private interest in
firms.
From Table 3 one can also observe a statistically
significant negative impact of the DIV variable from
the previous period. Although, as referred earlier, one
would expect, instead, a positive impact (Lintner,
1956), it should be kept in mind that the 1996-2000
sample period a dramatic fall in dividend payments
was observed in many countries, as observed by Fama
and French (2001), although in later years,
particularly after 2003, this phenomena has somewhat
reversed. Thus, it may be the case that the negative
sign observed in Table 3 for the DIV variable may
well reflect this particular feature of recent aggregate
dividend behaviour.
The values obtained by the Wald test, the Sargan
test and the second order serial correlation allow us to
confirm the validity of the instruments used and the
absence of second order correlation.
5.
Summary and Conclusions
In summary, the results obtained from our empirical
model show a relation between institutional
ownership and dividend policy which is remarkably
31
Year dummies were included as explanatory variables but
are not reported in Table 5 for simplicity. Only the
coefficient for the 2000 year dummy showed some
statistical significance at the 10% level.
different between the two legal and institutional
environments (Civil or Common Law).
We evidence that the type of institutional
investors and their role in corporate governance is
different due to the different characteristics of both
the legal system and the nature of agency conflicts in
firms from those countries. And so, the use of
dividend policy to solve the c1onflict of corporate
governance problem differs in each legal system. We
find that, in firms from Anglo-Saxon tradition, the
relation between dividends and institutional investors
as pension and investment funds is positive. In this
case institutional investors try to force to increase
dividend policy in order to reduce the agency
problems between managers and shareholders. While,
in Civil Law countries, the relation between dividends
and institutional investors is negative due to the
influence of banks or insurance companies with other
private interest inside the firm.
Therefore, we breed new insights into the role of
dividend policy as a disciplining mechanism in
presence of institutional investors in ownership
structure of firms from different legal systems and
distinct agency problems. But there is a significant
scope for further investigating the relationship
between this type of investors and different methods
of payout, dividends and/or share repurchases, in an
international context.
6. References
1.
2.
3.
4.
5.
6.
7.
Aivazain, V., Booth, L. and Cleary, S. (2003):
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Becht, M., and Röell, A. (1999): ―Blockholdings in
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Bianco, M. and Casavola, P. (1999): ―Italian corporate
governance: Effects on financial structure and firm
performance‖. European Economic Review. 43, pp.
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Accounting, Economics and Finance, Faculty of
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Chen, C.R. and Steiner, T.L. (1999): ―Managerial
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Policy‖. Financial Review, vol. 34,No.1, pp. 119-136.
Fama, E., and French, K. (2001): ―Disappearing
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Jensen, M.C. (1986): ―Agency Costs Of Free Cash
Flow, Corporate Finance, And Takeovers‖. American
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La Porta, R., López De Silanes, F., Shleifer, A. and
Vishny, R. (1998): ―Law and Finance‖. Journal of
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Vishny, R. (1999): ―Corporate Ownership Around
The World‖. Journal of Finance, vol. 54, No.2, pp.
471-517.
Vishny, R. (2000a): ―Investor Protection And
Corporate Governance‖. Journal of Financial
Economics, vol. 58, Nos.1&2, pp. 3-27.
Vishny, R. (2000b): ―Agency Problems And
Dividends Policy Around The World‖. Journal of
Finance, vol. 55, No.1, pp. 1-33.
Vishny, R. (2002): ―Investor Protection And
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vol. 106, pp. 1113-1115.
Li, D.; Moshirian, F.; Kien Pham, P. y Zein, J. (2006):
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41
Appendices
Table 1. International distribution of the sample of firms by different origin legal and country
Civil Law tradition
Firms
71
44
29
12
6
2
2
1
167
Firms
71
8
79
Firms
33
23
56
11,94%
Observations
350
212
151
63
33
10
10
5
834
Observations
341
38
379
Observations
158
70
228
USA
United Kingdom
Ireland
Firms
462
165
2
Observations
1.830
811
10
Total
Percentage
167
35,61%
821
French origin
France
Spain
Netherlands
Belgium
Greece
Italy
Luxemburg
Portugal
Total
German origin
Germany
Austria
Total
Scandinavian origin
Denmark
Sweden
Total
Percentage
Common Law tradition
Table 2. Summary statistics for Anglo Saxon firms and Civil Law firms
Mean
Median
Variable
Anglo Civil
p value
DIV
0.019
0.000
INSI
INSTI
DR
MB
LOGACT
ROE
ROA
0.309
0.469
0.277
1.866
3.835
0.146
0.073
0.019
0.524
0.079
0.492
1.022
2.715
0.142
0.069
0.000
0.000
0.000
0.000
0.000
0.427
0.019
Máximum
St. Desv.
Anglo
Civil
*** 0.014
0.007
*** 0.284
0.562
*** 0.493
0.024
*** 0.277
0.499
*** 1.113
0.569
*** 3.358
2.606
0.137
0.129
*** 0.066
0.060
Mínimum
Anglo
Civil
Anglo
Civil
0.029
0.052
0.885
0.782
0.207
0.232
0.189
2.236
1.684
0.120
0.068
0.235
0.120
0.189
1.873
0.913
0.793
0.870
0.884
13.360
7.527
0.2231 0.925
0.841
0.366
0.875
0.849
0.962
6.220
6.689
2.631
0.755
Anglo
0.000
0.000
0.000
0.000
0.016
0.912
-0.478
-0.262
Civil
0.000
0.000
0.000
0.000
0.551
1.106
-0.776
-0.2462
DIV is the dividend yield, measured as dividends divided by market capitalization of equity; INSI is the variable that
measures ownership by insider shareholders, calculated as the total percentage of all shares owned by the members of the
managerial team, both executive and non-executive board members, in addition to those owned by shareholders whose stake
is over 5% of the total shares of the company; INST measures the degree of institutional ownership; Lit represents the level of
debt, measured as the ratio between the book value of debt and of total assets; MB is the market to book ratio (market
capitalization of equity plus book value of total assets less book value of equity, divided by the book value of total assets);
LOGACT measures firm size as the log of total assets; ROE is the ratio between Net Income and Shareholders Equity; ROA
is the ratio between Net Operating Profits and Total assets.
42
Table 3. Results of a Tobit Regression estimated as a dynamic panel data analysis using GMM estimation
Variable
Anglo firms
Civil law firms
Constant
-0.044
(0.070)
-0.044
(0.070)
DIVi(t-1)
-1.828
(0.208)
***
-1.828
(0.208)
***
INSTIit
0.082
(0.027)
***
-0.197
(0.069)
**
INSIit
-0.235
(0.276)
0.484
(0.319)
*
DRit
-0.4993
(0.459)
**
1.088
(0.589)
MBit
-0.033
(0.010)
***
-0.002
(0.028)
LOGACTit
0.028
(0.014)
SRi
0.038
(0.011)
CRi
0.015
(0.013)
Wald test
m1
4180.75 (20)
3.67
m2
0
Hansen/Sargan test
13.67 (12)
-0.314
(0.814)
**
0.038
(0.011)
**
0.015
(0.013)
***
DIV is the dividend yield (dividends to market capitalization ratio); INSTI measures the degree of institutional ownership;
INSI is the variable that measures ownership by insider shareholders, calculated as the total percentage of all shares owned by
the members of the managerial team, both executive and non-executive board members, in addition to those owned by
shareholders whose stake is over 5% of the total shares of the company; DR represents the level of debt, measured as the ratio
between the book value of debt and of total assets; MB is the market to book ratio (market capitalization of equity plus book
value of total assets less book value of equity, divided by the book value of total assets); LOGACT measures firm size as the
log of total assets; SR and CR are indexes for shareholders and creditors rights, respectively, as taken from La Porta et al.
(1998) ANGLO is a dummy variable where a value of 1 is assigned for firms from the US, the United Kingdom or Ireland
(from Common Law countries) , and a 0 for all remaining firms (from Civil Law countries). The results are presented in two
columns: In first column we present the coefficients obtained for anglosaxon firms and, in second column, we present the
results for civil law firms of our sample. The constant, the coefficients for dummy variables SR and CR and the coefficient for
previous dividends are the same for both samples of firms. *** for 99% confidence level, ** for 95% and * for 90%.
43
INFORMATION SIGNALING AND OWNERSHIP TRANSITION –
VALUE EFFECTS OF SHARE ISSUE PRIVATIZATIONS
Martin Ahnefeld*, Mark Mietzner**, Tobias Roediger***, Dirk Schiereck****
Abstract
Privatizations are commonly associated with an increase in efficiency due to a stronger focus on profit
maximization and less agency conflicts because the management does not have to serve political
objectives anymore. This paper discusses whether SIPs generate positive announcement returns
because of increased efficiency after the ownership transition. We apply a market model event-study
methodology based on a sample of 134 SIPs in the 1979-2003 period. We identify significantly negative
CAARs between -0.125% and -1.766% and find that firm and offering size, the proportion of secondary
shares issued within the SIP as well as the market environment have a negative impact on
announcement returns. In contrast, the negative CAARs are less distinctive for enterprises that had
prior SIPs.
Keywords: Share issue privatization, seasoned equity offerings, ownership structure, event study
*Department of Finance, Accounting and Real Estate, European Business School (EBS)
**Department of Finance, Accounting and Real Estate, European Business School (EBS)
***Department of Finance, Accounting and Real Estate, European Business School (EBS)
****Department of Finance, Accounting and Real Estate, European Business School (EBS), International University Schloss
Reichartshausen, Rheingaustr. 1, D-65475 Oestrich-Winkel, Germany, Phone: +49 (0) 6723-991-212, Fax: +49 (0) 6723-991216, e-mail: Mark.Mietzner@ebs.edu and Dirk.Schiereck@ebs.edu.
I.
Introduction
A number of studies analyze the returns of initial
public offerings of divested state-owned enterprises
as well as returns to subsequent share issuances, 32
e.g., Dewenter and Malatesta (1997) or Jones,
Megginson, Nash and Netter (1999). Prior research
has found significant positive returns which are often
attributed to substantial underpricing. These
observations are reflected by Altinilic and Hansen
(2003) or Laurin, Borardman and Vining (2004), who
argue that governments deliberately underprice initial
and subsequent share issue privatizations (SIP) in
32
Prior research distinguishes between two methods of
privatization through a sale of ownership claims in state
property for cash payments: On the one hand, the
government may sell the state-owned enterprise to
individual, strategic or groups of investors. On the other
hand, some or all of a government‘s stake in a state-owned
enterprise is sold to investors through a public share
offering. We define this process as share issue privatizations
(SIPs), whereas some or all of a government‘s stakes are
sold via a public offering. Although this process is similar to
IPOs of privately held enterprises, the government‘s
motives are different. Megginson and Netter (2001) claim
that the motivation for SIPs is to raise money and to respond
to political objectives. By contrast, private offerings are
structured primarily to raise proceeds. We refer to the
offering of a government‘s stakes in a state-owned
enterprise for the first time as initial share issue
privatization, while subsequent equity offerings are defined
as seasoned or subsequent share issue privatization.
44
order to signal that they do not intend to redistribute
the value of shareholders‘ investments and to align
shareholders‘ interests with those of the privatizing
government.
However, if underpricing is a reliable signal for
stating that governments will not interfere in a firm‘s
operating activities in the future, then, as suggested
by Dewenter and Malatesta (1997), a SIPs should be
underpriced more strongly compared to IPOs and
seasoned equity offerings (SEO) of firms in the
private sector. In turn, this expectation should be
incorporated into stock prices at the day the
information on a subsequent equity offering of a SEO
becomes public.
Several
studies
document
that
the
announcement of an issuance of seasoned equity for
non-state-owned enterprises is associated with
average negative abnormal returns between -2.00%
and -3.00%.33 Even though theses findings may not
be strictly comparable with the announcements of a
SIPs, because private-sector SEOs might be
underpriced for different reasons, one may expect the
announcement of a subsequent share issuance (of
secondary or primary shares) during a privatization
33
See, for example, Asquith and Mullins (1986), Mikkelson
and Partch (1986), Akhigbe and Harikumar (1996), Bayless
and Chaplinsky (1996), Guo and Mech (2000), Clarke,
Dunbar and Kahle (2001), Gajewski and Ginglinger (2002),
Best, Payne and Howell (2003), D'Mello, Tawatnuntachai
and Yaman (2003) and Byoun (2004).
process to result in negative market reactions.
Asymmetric information is regarded as one reason
for the negative market reaction as outside investors
usually do not exhibit the same information about the
firm‘s true value than inside investors. Furthermore,
the government‘s motives to privatize are ambiguous.
A rich body of literature on post-privatization
performance has emerged over time providing
evidence that profitability, operating efficiency,
output as well as the financial performance increase
after a reduction of state ownership.34 Barberis,
Boycko, Shleifer, and Tsukanova (1996), Frydman,
Gray, Hessel, and Rapaczynski (1999) and more
recent Jelic, Briston, and Aussenegg (2003)
demonstrate that the rationale behind these empirical
findings is primarily to be found in changes in the
ownership structure and the board of directors.
Profit-oriented shareholders participating in SIPs
processes encourage managers to the primary goal of
shareholder value, whereas, in line with Moore
(1992), purely state-owned enterprises (SOE) may
pursue multiple aims related to diverse political
objectives, for instance, job security. Hence, one can
assume that the announcement of a SIP, and, more
specifically, the direct (SIPs with secondary shares
only) or indirect (SIPs with secondary and/or primary
shares) reduction of state ownership, generate
positive announcement returns.
Overall, the valuation effects associated with an
announcement of a SIP are ambiguous. To the extent
that an intensified monitoring by capital markets
result in performance improvements, announcements
of SIPs should cause positive valuation effects. By
contrast, a negative market reaction reflects the
market's perception of the degree to which the
government intends to redistribute firm value after
privatization, i.e., affect the value of the firm through
policy changes in regulation, taxation and so forth.
Since the valuation effect of SIP announcements is
ambiguous, we enlarge the body of research by
analyzing the market reaction to announcements of
SIPs. Consequently, two questions arise: First, do
share prices react to SIP announcements? Second, if
valuation effects are observable, are they caused by
an expected increase of performance or by the
market's perception of a government‘s motives for
privatization?
Our study design applies a market model eventstudy methodology based on a sample of 134 SIPs,
which are conducted by 82 enterprises from 15
Western European countries between 1979 and 2003.
We identify negative cumulated average abnormal
34
Studies documenting an improvement of profitability
include Boubakri and Cosset (1998), Boycko, Shleifer and
Vishny (1996), D'Souza and Megginson (1999), Megginson
and Netter (2001) and D'Souza, Megginson and Nash
(2005). However, Martin and Parker (1995) analyze eleven
British enterprises privatized during the 1981-1988 period
and observe decreasing values of both performance
measures they applied.
announcement returns between -0.125% and -1.766%
which can largely be explained by firm and offering
size as well as the market environment. In contrast,
the negative CAARs are less distinctive for
enterprises that had prior SIPs
The remainder of this paper is organized as
follows: First, we explore the manifold theoretical
and empirical background against which our
investigation is organized. Section III deals with the
data and the methodology used in our event-study
analysis. Subsequently, section IV describes the
results of the univariate analysis. Section V discusses
the results of our event-study, while section VI
presents the results of the cross-sectional regression.
Finally, section VII concludes with a summary and
discussion of the results.
II. Theoretical Framework and
Hypotheses
It is usually assumed that state-owned enterprises
(SOEs) are less efficient compared to private ones
due to the fact that they have to cater to the
objectives of politicians and are not able to pursue
the aim of maximizing efficiency. In line with
Villalonga (2000), three distinct theoretical
approaches (Agency and Property Rights Theory,
Public Choice Theory and the Organizational
Theory) can be made to explain why efficiency of
SOEs is lower. Most important, as proposed in this
analysis, managers of SOEs attempt to maximize
their private benefits rather than the utility function
of the government [De Alessi (1969)]. Furthermore,
reducing ownership in SOEs is impossible for
individuals prior to an equity offering. Therefore, in
order to explain different levels of efficiency one has
to consider the agency conflict between owners and
managers as well as the absence of a market for
corporate control. This leads to the objectives of the
Agency and Property Rights Theory. However, the
Public Choice Theory assumes that politicians are
self-interested agents who aim at maximizing their
own utility. Third, Villalonga (2000) suggests that
the Organizational Theory explains differences
between public and private firms with regard to
efficiency by analyzing the SOE inherent
organizational characteristics. The overviews of
theoretical and empirical studies provided by
Villalonga (2000) and Megginson and Netter (2001)
show that considerable research energy has been
invested into determining what factors may explain
differences in efficiency between privately and stateowned firms. Overall evidence consistently shows
that privately owned enterprises provide superior
degrees of efficiency.
Boycko, Shleifer and Vishny (1996) highlight
the problem of inefficient state-owned enterprises
and argue that efficiency could be enhanced after
privatization. A privatization transfers several control
rights over a firm‘s resources to managers who are
willing to meet the interest of the shareholders.
45
Therefore, vote maximizing politicians who have a
fundamental interest in employment in order to gain
support of trade-unions in elections have to
compensate managers for excess employment via
subsidies. Budget restrictions for politicians are the
principle reasons why a reduction of excess
employment and a restructuring of the firms will be
achieved after a privatization [Boycko, Shleifer and
Vishny (1996)]. A privatization will subject
managers to profit maximization, since shareholders
are profit-oriented, whereas, in line with Moore
(1992), a state-owned enterprises pursues multiple
objectives, such as keeping employment rates high.
Moreover, a rich body of empirical studies on postprivatization performance has emerged over time,
applying a broad set of sophisticated methods and
indicators to measure possible performance
variations of newly privatized firms. Empirical
investigations of D'Souza, Megginson and Nash
(2005) and the research pooled in Megginson and
Netter (2001), document that firms experience
significant increases in efficiency and profitability
due to privatization because managers are monitored
by the capital market [Boubakri and Cosset (1998)].
The basic idea of the performance improvement test
is to compare the pre-privatization performance for
enterprises with their post-privatization performance.
Megginson, Nash and van Randenborgh (1994) were
one of the first concerning performance changes after
a divesture. Backed on a sample of 61 privatized
firms of 18 countries during 1961-1989 they show
that profitability, operating efficiency, output as well
as the financial performance increases due to a SIP.
Additionally, D'Souza and Megginson (1999) and
Boubakri and Cosset (1998) offer similar results as
Megginson, Nash and van Randenborgh (1994).
In contrast, Martin and Parker (1995) analyze eleven
British enterprises during the 1981-1988 time period
and find decreasing values for their performance
measures applied. They assume that privatization
does not result in an enhancement of performance, as
they concede that the management could have
reorganized the firm prior to the privatization process
with respect to capital market requirements.
Frydman, Gray, Hessel and Rapaczynski (1999)
report an improvement in performance after the
government sold parts of their shares to outside or
foreign owners. However, they show that there is no
evidence for a beneficial effect on performance if
ownership rights were transferred to insiders like
managers or employees. Barberis, Boycko, Shleifer
and Tsukanova (1996) analyze a sample of Russian
shops which have been privatized during the 1990s
and conclude that for an effective privatization the
chief executive officer has to be changed. In a more
recent study, Jelic, Briston and Aussenegg (2003)
find for Polish privatized firms a significant effect of
foreign ownership on the development of share
prices. In sum, Megginson and Netter (2001)
conclude that their review of 22 studies provides
‖[...] at least limited support for the proposition that
46
privatization is associated with improvements in the
operating and financial performance of divested
firms‖ [Megginson and Netter (2001)] and that
almost ‖[...] all studies that examine postprivatization changes in output, efficiency,
profitability, capital investment spending and
leverage document significant increases in the first
four and significant declines in leverage‖
[Megginson and Netter (2001)].
All studies mentioned poses insights into the
impact of ownership transition, and provide guidance
for an effective privatization. In this context, a
reduction of state ownership seems to be value
enhancing and should result in a positive market
reaction. One commonly applied methodology to
privatize state-owned enterprises is a share issue
privatization. Many studies, e.g., Dewenter and
Malatesta (1997) or Jones, Megginson, Nash and
Netter (1999), analyze the returns of initial share
issue privatizations and find significant positive
returns which are often caused by substantial
underpricing. Perotti (1995) and Biais and Perotti
(2002) provide a theoretical foundation for
underpricing, based on a government‘s ability to
signal that they do not intend to redistribute the value
of the shareholders‘ investment, i.e., affect the value
of the firm through policy changes in regulation,
taxation and so forth.
Perotti (1995) categorizes governments as either
populist or committed governments and only the
latter can resist the politically valuable option of
reallocating firm value to a specific constituency
after a privatization. Since a populist government
would also pretend to pursue the privatization
process, a committed government requires a credible
signal, whereas ‖[...] a partial sale and (possibly) its
underpricing are signals of commitment‖ [Perotti
(1995), p. 848)]. This approach implies that the
consequences of subsequent interference also affect
the government that is still the biggest shareholder
after a gradual sale [Perotti (1995) and Jones,
Megginson, Nash and Netter (1999)]. Furthermore,
successive selling of small proportions of the
governmental stake bears the risk that the motives of
a populist governments become public, which
reduces the proceeds achievable in subsequent share
issuances.
In contrast, divesting SOE via SIP leads to the
problem that the government has to assure that it
intends to transfer the right of disposal. However,
underpricing is a reliable signal when it is used by a
committed government in order to capture the
economic benefits of a privatization. Hence, the level
of underpricing necessary is related to the investors‘
expectations about future policy and ‖[...] the
secondary market will place a higher value on a firm
if the government credibly signals commitment‖
[Jones, Megginson, Nash and Netter (1999)]. In
addition, to signal a government‘s identity with the
privatization process and to overcome uncertainty
about future policy, underpricing of an IPO or
subsequent SIPs may provide the opportunity to
maximize the present value of the total net proceeds
from all equity offerings [Laurin, Borardman and
Vining (2004)].
Altinilic and Hansen (2003), argue that
underpricing is important to compensate investors for
the uncertainty about the firm‘s prospects and thus,
the value of the firm. With respect to the uncertainty
about the firm‘s value and the government‘s motives
to privatize a SOE, Jones, Megginson, Nash and
Netter (1999) analyze if political objectives and
economic factors have an impact on initial returns.
Using sample of 630 SIPs during 1977-1997, they
find returns of 34.1% for initial and 9.4% for
seasoned share issue privatizations and document
that their results ‖[...] indicate that much of the
underpricing of initial SIPs is a concession by
governments designed to overcome the political
obstacles that stand in the way of successful
privatization and the economic benefits that might
flow from it‖ [Jones, Megginson, Nash and Netter
(1999), p. 234)].
The empirical studies reviewed provide
evidence that returns of subsequent SIPs are positive
and that the decision to privatize, i.e., the time pattern
for later SIPs is made by politicians or managers who
exhibit superior information of the firm. Assuming
managers to act in the interest of their shareholders, a
strong incentive exists to issue new equity, when the
capital market evaluates shares above the value
which would be justified by the firm‘s prospects.
Consequently, the announcement of issuing stocks
should result in a re-evaluation of the share price by
the investors [Asquith and Mullins (1986)].
Therefore, stock prices of partially privatized firms
should decline when the government is willing to sell
its shares.
Concluding from the arguments mentioned
above, the transition of ownership should result in an
improvement of operating and financial performance.
Thus, the announcement of a further equity offering
should cause a positive market reaction. In contrast,
underpricing of initial or subsequent share issuances,
information asymmetries as well as agency problems
should have a negative impact on share prices.
Hence, the question can be raised which effect will
predominate:
Question
Do share prices react to seasoned
1:
share
issue
privatization
announcements?
Question
Second, if valuation effects are
2:
observable, are they caused by an
expected increase in performance
(positive valuation effects) or by the
market's perception of a populist
government‟s motives for privatization
(negative valuation effects)?
The empirical research supports the existence of
widespread negative returns related to SEO
announcements of non state-owned enterprises. Prior
research on non-state-owned enterprises provides
evidence that an announcement of an equity issuance
results in a decline of share prices between -0.82%
and -3.56% within two days the information becomes
public (see table 1).35
But to what extent are these findings
transferable to SIPs and more generally, what affects
announcement returns in a SIP process? Following
the efficient market hypothesis (EMH), the
announcement of an issuance will cause no price
effect because arbitrage will equalize stock prices
and the prices of stocks‘ close substitutes. Thus, sales
of large blocks of shares will only cause a price
reaction because the stock is priced relative to its
substitutes. If close substitutes are not available, then,
according to the price pressure hypothesis, an excess
supply leads to a negative price movement [Akhigbe
and Harikumar (1996)]. Hess and Frost (1982)
provide empirical support for this theory.
Allocating income rights to the capital market
can result in an improvement of a firm‘s profitability
because of a reduced likelihood of political
interference. Faccio, Masulis and McConnell (2006)
find empirical support that firms with small
governmental influence outperform enterprises
facing interference by politicians. In this context we
assume governments to be at least one of the
companies‘ biggest blockholders, who usually
possess superior information about the companies‘
prospects. Therefore, a sale of shares conjectures the
information that the government trades on an
informational advantage. By selling a large
proportion of shares, the government may
communicate a negative signal about the firm‘s
future cash flows. This argument corresponds to the
one adduced by Fidrmuc, Goeren and Renneboog
(2006) to explain negative market reactions to the
announcement of insider stock sales. Furthermore,
the government may be a populist government as
defined by Jones, Megginson, Nash and Netter
(1999) that faces the problem of liquidity needs for
their redistributive policy. Thus, the negative signal
of a government that sells its shares should be
evaluated by the capital market with respect to the
firm‘s cash flow [Jones, Megginson, Nash and Netter
(1999)].36
Additionally, the findings of Loughran and
Ritter (1995) and Loughran and Ritter (1997) provide
empirical support that firms take advantage of a
current overvaluation of their shares to issue equity;
then, perceived overvaluation leads to a subsequent
negative market reaction if a seasoned equity offering
is announced. The reason for the ‖window of
opportunity problem‖ can be found in an asymmetric
35
Most of the results correspond to an event-window
starting one day prior the announcement day and ending one
day thereafter.
36
Conversely, director‘s put their own wealth at stake and
their signal of selling shares is therefore less informative, if
they act also due to liquidity needs [Fidrmuc, Goeren and
Renneboog (2006)].
47
information problem which transfers into information
costs. Thus, firms will issue new equity only if
information costs are low [Myers and Majluf (1984)].
This leads to the following hypothesis:
Question
The valuation effect is more
3:
detrimental for larger SIPs.
Considering IPOs of private non-state-owned
enterprises, Ritter (1991) suggest that firms go public
at market peaks, when comparable companies are
valued above their true value, and therefore the issuer
can take advantage of a ―window of opportunity‖.
Therefore, the question arises, whether abnormal
returns are less negative in strong equity markets,
i.e., in a market environment with substantial
increases in the index return over 200 days prior to
the issue as well as a low standard deviation in that
period. A positive market assessment may force a
clustering of equity (initially and seasoned) issuances
and ‖[...] may induce information spillovers and
hence
lower
adverse
selection
problems‖
[Huyghebaert and Van Hulle (2006), p. 302)]. An
explanation for IPO clustering was provided by
Bayless and Chaplinsky (1996) who asserted reduced
discount rates and behavioral finance effects, e.g.,
herding, as possible reasons. Therefore, we would
expect governments to increase the relative as well as
the absolute number of shares during periods of high
pre-issuance market conditions because of reduced
information costs:
Question
Do abnormal returns associated with
4:
sales of ownership claims depend on
market conditions?
Given the decision to sell parts of an enterprise,
the level of information asymmetry as to politicians‘
intention to privatize should decrease in case of a
seasoned SIP because the potential risk of
redistribution of firm value by politicians will be
reduced
as
described
above.
D'Mello,
Tawatnuntachai and Yaman (2003) observe a
relationship between the sequence of SEOs and the
uncertainty about a firm‘s value. They provide
evidence for less unfavorable announcement
reactions because of declining level of asymmetric
information. Here, the rationale is that prevalently
issuers experience lower information costs due to the
issuers heightened reputation of not taking advantage
of new shareholders, i.e., not to pursue multiple aims
related to diverse political objectives:
Question
The level of asymmetric information
5:
associated with SIP depends on
offering frequency. The market is less
concerned about successive SIP
announcements of firms. Conversely,
the market is more concerned about the
announcement of the first equity
issuance after the IPO.
Issuing equity provides the possibility of issuing
not only secondary shares but also new equity which
ceteris paribus improves the financial situation of the
enterprise. In addition, this effect should be
supported by an increase in profitability, which is to
48
be expected after privatization [Megginson, Nash and
van Randenborgh (1994) and Alexandre and
Charreaux (2004)].
However, the impact of the amount of
secondary shares issued in a SIP process on
announcement reactions may be of a dual nature: On
the one hand, selling secondary shares only conveys
the market‘s conviction of a reduction of political
connection. This should be associated with a positive
market reaction. Moreover, Alexandre and Charreaux
(2004) argue that a retraction of the government and
the issuance of new equity should also foster
profitability due to the reduced likelihood of
bankruptcy. However, a relative decrease in financial
leverage due to a raise of new capital may cause
declining monitoring activities of creditors [Jensen
(1986)], which should result in negative
announcement effects. On the other hand, the capital
market may perceive a high amount of secondary
shares as an indicator that the current stock price is
high relative to managers‘ assessment of the firm's
prospects, i.e., selling overpriced shares [Asquith and
Mullins (1986)]. Consequently, this should results in
a negative market reaction.
Question
The abnormal market reaction
6:
associated with SIP announcements
depends on the proportion of
secondary shares issued. A high (low)
proportion of secondary shares should
be associated with a negative (positive)
market reaction.
Examining market reactions to subsequent
equity offerings, Jensen (1986) draw the conclusion
that managers act in their own interest by enhancing
the assets under their management. The rationale is
that managers even risk the consequence of a
declining equity value, i.e., investment in projects
with negative net present values, in order to increase
the total assets controlled by them. In general, large
free cash flows as well as lower financial constraints
are mentioned as the origin of the over-investment
problem in diversified firms [e.g., Berger and Ofek
(1995)]. However, the negative market reaction
caused by this agency conflict may be attenuated if
the firm exhibits substantially growth opportunities.
In line with previous research, the existence of
growth opportunities induces less negative market
reactions [e.g., Denis (1994)]. Interestingly, the study
conducted by Denis (1994) does not detect any
relationship between announcement effects and the
profitability of new investment projects. Yet, firms
with an optimistic assessment of their future
prospects, as reflected in high market-to-book-ratios,
should experience a less negative announcement
effect:
Question
The market reaction to announcements
7:
of share issue privatizations depends
on the market‟s perception about a
firm‟s investment opportunities. The
market reaction to the announcement
of firms with more (less) investment
opportunities is positive (negative).
Changes in the number of employees prior to a
SIP may be an important signal for the capital market
perception of a firm's profitability. On the one hand,
a remarkable reduction in the number of employees
conveys that a firm has downsized its staff in order to
become more profitable, e.g., indicates a reduction of
overemployment. On the other hand, politicians may
noticeably increase the number of employees as a
means to gain support of trade-unions for increasing
employment.
Question
A relative decrease (increase) in the
8:
number of employees one year prior to
a SIP announcement causes a positive
(negative) market reaction.
III. Data and Methodology
A. Data and Methodology
Our initial sample consists of 248 SIPs from 15
Western European countries and covers the period of
1979 through 2003. Announcement dates are
obtained from the Securities Data Corporation (SDC)
database and encompass information on the type of
equity issue, e.g., primary, secondary or both types,
the number of shares issued, the issue price, and the
issue dates. Stock price data are obtained from
Thomson
Financial
DataStream
and
the
announcement dates come from Dow Jones, Reuters
and the Lexis Nexis databases. For an inclusion in
the final sample, we require a firm‘s announcement
of a privatization via SIP to satisfy at least one of the
following criteria: (1) the government announced an
equity offering, (2) the enterprise announced a share
issuance, (3) a state-owned holding company
announced or accomplished a stock disposition, (4)
the government authorized a further reduction in their
stake, (5) the government actually sold a further stake
or approved an offering of a further stake in the near
future, (6) the shareholders agreed to a further SIPs
or (7) an investment bank acknowledged that shares
had been sold.
For sample refinement purposes, initial public
offerings and events of uncertain announcement days
are excluded from the sample. As our research
interest centers on examining the effects of seasoned
share issue privatization announcements, we require
all sample firms to have stock returns throughout all
event and estimation periods. Since Thomson
Financial DataStream does not provide share prices
for every enterprise in the initial sample, our data set
is reduced by 47 transactions. Moreover, in order to
avoid confounding events within the event windows
as well as defining different lengths of estimation
periods, the final sample was pared down to 82
enterprises that conducted 134 SIPs.
B. Control Variables
We use the Thomson Financial DataStream INDC3
code to classify the firms of the final sample into ten
industries: basic industry (BASIC), cyclical
consumption industry (CYCGD), cyclical services
(CYSER), general industry (GENIN), information
technology (ITECH), non-cyclical consumption
industry (NCYCG), non-cyclical services (NCYSR),
resources (RESOR), financial services (TOTLF), and
utilities (UTILS). As more than half of the SIPs
originate from the non-cyclical consumption, the
resource or the financial services industry, we
construct the binary variables Financial Services and
Utility to capture a firm‘s affiliation to the financial
or utility industry.
Firms that experience political interference, i.e
due to changes in the regulatory environment, may
also suffer from an increase in their systematic risks
[Schwert (1981)]. In order to control for a company‘s
risk, we include the systematic risk factor obtained
from the market model regression in the estimation
period.
The probability to receive political attention
seems to be greater for large firms. To control for
firms‘ size, we include the company‘s market value
at the announcement day, which is obtained from
Thomson Financial DataStream. The absolute and the
relative value of shares issued as well as the
proportion of secondary shares offered comes also
from Thomson Financial DataStream and is based on
the information of the type of equity issuance.
Furthermore, we include the proxy SIP-frequency to
indicate whether the enterprise had prior SIPs (coded
as zero) or if the firm conducts its first subsequent
equity offering (coded as one).37 We use the relative
change in the number of employees one year prior to
the announcement to capture reorganization
activities. Additionally, we include the market-tobook value at the announcement day to measure the
market‘s perception of the firm‘s future prospects.
Finally, we apply two measures to control for the
overall market environment: the mean return and the
standard deviation of the benchmark index during the
estimation period.
C. Event-Study Methodology
The stock market reactions to seasoned equity
offering announcements are measured using daily
stock returns. One testing strategy is to consider SIP
activities and to clarify whether prices adjust to this
news immediately or over a long time period
[Shleifer (2000)]. For that purpose, an event-study
analysis is designed to identify abnormal returns
within a well-specified event period.38 Abnormal
returns are calculated as the ex post observable
returns' deviations from those returns which had
occurred in the absence of SIP announcements.
Following the methodology of Armitage (1995),
a market-adjusted model is used to isolate potential
extraordinary
effects
associated
with
SIP
announcements. We estimate abnormal returns for
each security within our final sample by comparing
37
As mentioned above, we exclude IPOs of SOE.
The term "event period" is a synonym for "event window"
within this paper.
38
49
the security's returns which occurred around the
announcement dates to the returns of a market index.
Thereby, it is possible to estimate expected returns
for given returns of the market index as follows:
Ri ,t = i  i Rm,t   i ,t ,
where
i
and
i
,
are estimates from an Ordinary
Least Square regression,
term,
 i,t
denotes the disturbance
Ri ,t is the logarithmic return of security i and
Rm ,t is the logarithmic return of a market index for
day t. Abnormal returns are calculated as prediction
errors:
ARi ,t = Ri ,t  i  i Rm,t ,
where
ARi ,t is the excess return on security i for
day t and
t0 denotes the announcement day.39 We
defined an estimation period of 200 days which
ranges from [t220, t20 ] days prior to the event day
in order to estimate the market model parameters. For
each individual security, the calculated abnormal
returns have to be aggregated in order to control for
price adjustments over the time period. Therefore,
cumulated abnormal returns (CAR) around the
announcement day t0 are calculated as the sum of
the prediction errors for each security within the
event window of [t0   , t0   ] days:
t  t0 
CARi ,[ t0  ,t0  ] =
 AR
t  t0 
(3)
i ,t
Since our research scope is directed towards
examining whether joint cumulated effects are
different from zero, we construct a portfolio
comprising all securities as well as subsample
portfolios according to different categories of SIPs,
e.g., the issuances of secondary shares only. For each
portfolio we test the null hypotheses whether the
cross-sectional cumulated average abnormal returns
(CAAR) in the event period are different form zero.
For a sample of N securities CAARs are calculated as
defined by equation (4) :
CAAR[ t0  ,t0  ] =
1
N
N
CAR
i
i =1
We draw statistical inferences for the different
event-window cumulative average abnormal returns
using a standard t-test statistic. However, Brown and
Warner (1985) mention that an event might increase
the variance, and as a consequence the null
hypothesis is rejected too often. In order verify our
test results, we implement the test statistic described
by Böhmer, Masumeci and Poulsen (1991) and use
the variance of the market model residuals to
39
In this paper, the terms "prediction error" and "abnormal
return" are used as synonyms.
50
standardize cumulated abnormal returns. Finaly, we
also apply a non-parametric rank test according to
Corrado (1989), which is more powerful than the
usual t-test.
IV.
Descriptive Statistics
(1)
The sequence of share issuances for the full sample,
except 14 announcements for which further
information was not available, is shown in table 2.
The table provides evidence that most of the
enterprises conduct up to three subsequent equity
offerings. 79 firms offer shares at least once after
their initial privatization step, whereas 16 out of 79
enterprises issue new shares within the first
subsequent SIP only. Approximately 24% of (2)
the
firms (32 firms) issue conduct two equity offerings
and about 17% (23 firms) are divested in three or
more stages.
Remarkably, in the majority of the SIPs (91
announcements or 67,91%) the government sells
secondary shares only. We interpret this observation
as an indication for limited growth opportunities
because the companies obviously do not need
additional equity. Around one of six SIPs is a
primary share issuance.
Table 3 shows the annual distribution of all
equity offering announcements and the respective
characteristics of the SIP: Most of the firms issue
shares in the second half of our sample period,
whereas many SIPs are conducted within a four-year
time period (1996-1999). Regarding the combined
equity offerings, Table 3 shows that almost all
announcements have been conducted between 1997
and 2000.
V.
Market Reaction to Seasoned SIP
Announcements
An aggregated view on the results of the event-study
reveals remarkable patterns with respect to the speed
of stock price adjustments to announcements of SIPs
(see Figure 1). The stock prices begin to decline prior
to the announcement day and drop substantially at
the day the information becomes public. In line with
market efficiency hypothesis the CAARs remain
stable thereafter.
(4)
Statistical inferences about these observations
are provided by table 4.
The CAARs for the full sample range between 1.766% to -0.125%. The results show that investors
perceive the announcement of a SIP of seconday,
primary and combined shares as unfavourable
information.40 Nevertheless, compared to existing
evidence provided for private companies‘ SEOs of up
40
See Akhigbe and Harikumar (1996) for a detailed
discussion of stock price adjustments to SEO of all equity
firms and D'Mello, Tawatnuntachai and Yaman (2003) for
results for returns of firms that announced multiple primary
SEOs.
to -3.30% the capital markets seem to be less
concerned about the announcement of a subsequent
equity offering within a privatization process. The
implication of this result may be of a dual nature: On
the one hand, an average decline of -0.691% (CAAR)
implies a predominance of the negative effects
associated with an announcement of a successive
equity offering. On the other hand, these results
could support the theory that positive privatization
effects attenuate the negative market reaction.
A closer look at Table 5 reveals that omitting
the announcements of primary and combined SIPs'
the cumulated average market reaction for pure
secondary SIPs is more negative. A pure sell-off of
public ownership without proceeds for the listed
comnpany to finance future growth signals at least to
some extent an attractive share price level from the
perspective of the seller. Yet, seasoned equity
offerings, in general, are underpriced in order to
compensate new shareholders for the uncertainty
about the firm's value. Our results also indicate that
the underpricing has already partially been
incorporated into share prices the day the subsequent
offering becomes public.
Comparable studies report initial returns
associated with an SEO ranging between 2.2% for
private SEOs and 9.4% for seasoned SIP [Jones,
Megginson, Nash and Netter (1999) and Corwin
(2003)]. Moreover, Dewenter and Malatesta (1997)
provide evidence for the United Kingdom that IPOs
of private enterprises are less underpriced compared
with the degrees of underpricing within a SIP. Jones,
Megginson, Nash and Netter (1999) find mixed
evidence for a greater underpricing of initial SIPs
compared with IPOs. However, when we compare
the difference between the negative market reaction
associated with a SIP announcement and the degree
of underpricing of IPOs with the differences
observed for SIPs, we find some indication that SIPs
are more detrimentally affected than equity offerings
of private firms.
VI.
Regression Results
Table 6 provides the results of our regression
analysis. The four models are estimated using
ordinary least squares, whereas White (1980)
Heteroskedasticity-Consistent Standard Errors and
Covariances are applied to calculate t-statistics.
The third question addresses that the market
reaction to an announcement of a further SIP to be
more negative for large SIPs. Previous research uses
the relative offering size as a proxy for the price
pressure hypothesis and finds a negative relationship
between the relative offering size and the
announcement reaction [Asquith and Mullins (1986)
and Akhigbe and Harikumar (1996)]. Accordingly,
our two proxies for offer size (absolute and relative
value of shares issued) have a negative sign and are
significant on a 1% level. Beyond the potential price
pressure we interpret this result as being consistent
with the hypothesis that the issuer trades on superior
information and sells shares at attractive price levels.
However, the capital market may also perceive
an announcement of an issuance of a large proportion
of the enterprises‘ equity as a signal of a populist
oriented government. A populist government may
prefer to achieve privatization proceeds in the short
term, because their underlying motives may become
public. In contrast, the regression results indicate a
weak relation between the proportion of secondary
shares issued and the announcements effects. In one
of four models, the variable is significantly related to
CARs only. While our above mentioned results show
that the capital market is more concerned about a
solely secondary share offering, the regression
analysis provide at most weak evidence.
In line with the results of previous research, but
conversely to Masulis and Korwar (1986) and Denis
(1994) strong equity markets, i.e., stock market runups prior to the announcement date, are negatively
related to announcement period CARs. In all four
models, the proxy for market environment (Mean
Return Ri,(t-220;t-20)) is significant, which confirms our
hypothesis that the market reaction depends on
market conditions. Furthermore, our second measure
for hot equity markets, the standard deviation of the
benchmark index during the estimation period,
provides further support for this view. In contrast to
our previous assumption, the sign of our two
measures (Mean Return Ri,(t-220;t-20) and the standard
deviation of the benchmark index) do not indicate,
that the market environment may reduce information
costs. This observation, combined with the negative
impact of selling a high proportion of secondary
shares, supports the hypothesis that market
participants are aware that the government may take
advantage of a window of opportunity.
Focusing on the possible allocation of the
issuance proceeds, we suggest that issuing firms with
less growth opportunities are more likely to
undertake investment projects with negative net
present values. Therefore, we previously concluded
that the existence of growth opportunities should
attenuate the negative market reaction. As our proxy
for growth opportunities, the market-to-book-ratio at
the announcement date, is not significant, we are not
able to support this hypothesis. Thus, the short-term
market reaction seems to be independent from the
existence of future growth opportunities.
If we take the SIP frequency into account, we
find that the negative market reaction is less
distinctive for enterprises that had prior equity
offerings. This supports the view of D'Mello,
Tawatnuntachai and Yaman (2003) that prevalently
issuers experience lower information costs.
Therefore, the advantageousness of conducting more
SIPs, expressed in less pronounced negative
abnormal returns, confirms the hypothesis that a
higher information flow to the capital market via
subsequent equity offerings reduces the uncertainty
regarding a government‘s future policy as to
51
interference.
Because politicians may perceive seasoned
equity offerings as a means to obtain votes for
subsequent elections, e.g., due to preferential
allocations of stock at discounted prices, we suggest
that companies which have experienced an increase
in employees one year prior to the announcement of a
SIP, may be subjected to governmental interests. The
results of table 6 show that the coefficient of a
percentage change in the number of employees is
negative and significant at the 10% level in Model I
and II. We interpret this observations as an only
minor support for the hypothesis that politicians take
advantage of a subsequent SIPs by increasing staff.
Following research by Best, Payne and Howell
(2003) we controlled for a firm‘s affiliation to
selected industries, systematic risk and size. We find
the coefficient for utilities to be significantly
positive, whereas for firms of the financial services
sector no relationship is observable. In accordance
with D'Mello, Tawatnuntachai and Yaman (2003),
regulated industries are characterized by less
information asymmetry and utility firms can reduce
adverse selection costs due to an information
improvement at subsequent offerings. Given a
revealing base of information, our result suggests that
firms in the utility sector exhibit lower negative
abnormal market reactions, which is in line with
reduced information asymmetries.
Following previous research, we include the
market value at the announcement day as a proxy for
uncertainty and asymmetric information [Corwin
(2003) and Laurin, Borardman and Vining (2004)].
We assume that small firms experience more
information asymmetries and greater uncertainty.
However, given the coefficient‘s sign these firmspecific characteristics appear to have a negative
influence on market reactions indicating that large
firms are associated with larger information
asymmetries. One possible explanation for this result
might be that governmental interference is more
likely in larger firms since a populist politician‘s
intention is to raise privatization proceeds and to
obtain the opportunity to redistribute firm value after
privatization. Since the risk coefficients are
statistically insignificant in both models, our analysis
provides only weak evidence that announcement
returns are dependent on a firm‘s systematic risk.
European countries during the 1979-2003 period we
identify negative cumulated average abnormal
announcement returns between -0.125% and 1.766%. Using different event-windows and
comparing offerings of secondary shares with our full
sample we find abnormal returns to be pronounced
more negative. Relating our results to prior evidence
form non-state-owned enterprises, our results show
that the capital market seems to be less concerned of
the announcement of a subsequent equity offering
within a privatization process. However, these
univariate comparisons do not account for firm, issue
and market environment specific effects.
The regression results reveal that offering size
has a significant negative impact on the cumulated
abnormal returns indicating that the capital market
perceives a high proportion of the company to be
sold in a SIP as consistent with a signal for a populist
government. Regarding subsequent equity offerings
we find that the negative abnormal returns are less
distinctive indicating that each equity issue is not an
independent SIP. Moreover, the results for the market
environment proxies are difficult to reconcile with
existing theoretical explanations. Contrary to
theoretical predictions, the market environment does
not seem to reduce information costs. However, we
assume this finding to be in line with the idea of a
window of opportunity.Finally, we control for a
firm‘s affiliation to selected industries, systematic
risk and size. In addition to previous research, we can
conclude that firms in the utility sector exhibit lower
negative abnormal market reactions. This might be
attributed to lower information asymmetries. Our
findings have implications for the privatization
process as a gradual sale of state-owned enterprises
via several steps that mitigate negative valuation
effects and therefore preserve shareholder value.
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51. Shleifer, Andrei, 2000. Inefficient Markets: An
Introduction to Behavioral Finance (Oxford
University Press, Oxford).
52. Villalonga, Belen, 2000, Privatization and efficiency:
differentiating ownership effects from political,
organizational, and dynamic effects, Journal of
Economic Behavior & Organization 42, 43-74.
53. White, Halbert, 1980, A HeteroskedasticityConsistent Covariance Matrix and a Direct Test for
Heteroskedasticity, Econometrica 48, 817-838.
Appendices
Cumulative Average Abnormal Returns
1.00%
t-20
t-15
t-10
t-5
t-0
t+5
t+10
t+15
t+20
t+25
t+30
t+35
t+40
t+45
t+50
-1.00%
-3.00%
Days relative to announcement day
Figure 1. Cumulative average abnormal returns around a SIP announcement
Cumulative average abnormal returns for the entire sample
Table 1. Overview of selected studies on market reactions to SEO announcements
Research provided by…
Byoun (2004)
Clarke, Dunbar and Kahle (2004)
Bayless (1994)
Bayless and Chaplinsky (1996)
Akhigbe and Harikumar (1996)
Best, Payne and Howell (2003)
Gajewski and Ginglinger (2002)
Karim, Rudledge, Gara and Ahmed
(2001)
Denis (1994)
Guo and Mech (2000)
Asquith and Mullins (1986)
Mikkelson and Partch (1986)
54
Market Reaction
-2.68%
-2.25%
-2.92%
-2% to -3.3%
-0.82%
-1.75%
-1.00%
-1.57%
Market
USA
USA
USA
USA
USA
USA
France
USA
Period
1980-1997
1980-1996
1974-1983
1974-1990
1977-1988
1976-1993
1986-1996
1991-1994
Sample Size
5,776
424
223
1,881
60
1,861
237
283
-2.49%
-2.79%
-2.70%
-3.56%
USA
USA
USA
USA
1977-1990
1980-1994
1963-1981
1972-1982
435
1,509
531
80
Table 2. Frequency Distribution
Frequency distribution of a sample of 82 firms from 15 Western European countries that announced multiple subsequent
primary, secondary as well as both equity offerings within a share issue privatization process between 1979 and 2003.
Sequence of issue
Total (%)
Primary shares issued
Secondary shares issued
Primary and secondary
shares issued
1
79
58.96%
32
23.88%
15
11.19%
7
5.22%
1
16
69.57%
5
21.74%
2
8.70%
0
0.00%
0
55
60.44%
21
23.08%
9
9.89%
6
6.59%
0
3
50.00%
1
16.67%
2
33.33%
0
0.00%
0
0.75%
0.00%
0.00%
0.00%
134
23
91
6
2
3
4
5
Total
Table 3. Annual Distribution of SIP Transactions
Annual distribution of a sample of 82 firms from 15 Western European countries that announced multiple subsequent primary,
secondary as well as both equity offerings within a share issue privatization process between 1979 and 2003.
Year
No. of
SEOs
1979
1983
1985
1986
1987
1988
1989
1991
1992
1
2
3
1
2
3
2
1
5
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
6
9
7
18
13
15
11
9
5
10
2003
11
6.72%
5.22%
13.43%
9.70%
11.19%
8.21%
6.72%
3.73%
7.46%
8.21%
Sum
134
100.00%
Percent
0.75%
1.49%
2.24%
0.75%
1.49%
2.24%
1.49%
0.75%
3.73%
4.48%
cum. Percent
0.75%
2.24%
4.48%
5.22%
6.72%
8.96%
10.45%
11.19%
14.93%
19.40%
26.12%
31.34%
44.78%
54.48%
65.67%
73.88%
80.60%
84.33%
91.79%
Primary
shares
issued
1
Secondary shares
issued
1
Primary and
secondary shares
issued
n.a.
2
2
1
1
1
3
1
1
1
1
4
2
3
2
2
1
3
3
1
1
1
2
5
5
13
10
10
5
6
3
9
100.00%
1
1
2
1
1
10
23
91
1
1
3
1
2
1
1
1
6
14
55
Table 4. CAARs of SIP announcements – all transactions
Panel I: all transactions
Event window
Nobs.
Median CAR
CAAR
t-Test
t-value
Boehmer Test
Corrado Rank Test
z-score
z-score
[-10;+10]
[-10;+5]
[-10;+1]
[-10;0]
[-5;+10]
[-5;+5]
[-5;+1]
[-5;0]
[-1;+10]
[-1;+5]
[-1;+1]
[-1;0]
134
134
134
134
134
134
134
134
134
134
134
134
-1.166%
-1.436%
-1.560%
-0.823%
-1.704%
-1.442%
-1.417%
-0.966%
-0.148%
-0.056%
-0.666%
-0.270%
-1.766%
-1.282%
-1.442%
-0.876%
-1.517%
-1.033%
-1.193%
-0.626%
-1.015%
-0.531%
-0.691%
-0.125%
-2.021**
-1.613
-2.268**
-1.495
-2.120**
-1.606
-2.427**
-1.479
-1.655
-0.975
-1.913*
-0.426
-1.165
-1.111
-1.907*
-1.276
-1.253
-1.211
-2.201**
-1.506
-0.812
-0.712
-1.900*
-0.858
-5.504***
-5.110***
-6.886***
-4.635***
-5.263***
-4.853***
-6.668***
-4.361***
-2.744***
-2.265**
-4.064***
-1.699*
[0;0]
134
-0.397%
-0.373%
-1.547
-1.675*
-2.775***
***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectivel
Table 5. CAARs of SIP announcements – offering of secondary shares only
Panel II: secondary SIPs
Event window
Nobs.
Median CAR
CAAR
t-Test
Boehmer Test
Corrado Rank Test
t-value
z-score
z-score
[-10;+10]
[-10;+5]
[-10;+1]
[-10;0]
[-5;+10]
[-5;+5]
[-5;+1]
[-5;0]
[-1;+10]
[-1;+5]
[-1;+1]
[-1;0]
91
91
91
91
91
91
91
91
91
91
91
91
-1.803%
-2.093%
-0.943%
-0.113%
-2.404%
-2.217%
-1.917%
-1.171%
-1.568%
-1.186%
-0.905%
-0.448%
-2.825%
-1.922%
-1.560%
-1.013%
-2.657%
-1.754%
-1.392%
-0.845%
-2.154%
-1.251%
-0.889%
-0.342%
-2.538**
-1.936*
-1.773*
-1.273
-2.682***
-2.068**
-1.930*
-1.363
-2.849***
-2.172**
-1.818*
-0.898
-1.911*
-1.455
-1.295
-0.955
-2.151**
-1.744*
-1.646
-1.296
-2.045**
-1.563
-1.381
-0.831
-8.510***
-6.155***
-4.753***
-3.723***
-8.820***
-6.416***
-4.986***
-3.931***
-6.805***
-4.307***
-2.807***
-1.720*
[0;0]
91
-0.598%
-0.459%
-1.363
-1.461
-2.883***
***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively.
56
Table 6. Regression Results
Abnormal returns are the dependent variable in all regressions and are calculated as the twelve and 16-day abnormal returns
surrounding the SIP announcement date. The abnormal returns are based on a market model, which was estimated over the
[t−220,t−20] time period. Financial Services and Utility are binary variables to capture a firms affiliation to the financial or utility
industry. Market Value t0 is the market value of equity calculated at the the announcement day. Risk is a slope coefficient of
the market model regression in order to control for a company‘s systematic risk. Absolute Value of Shares and Relative Value
of Shares Issued are the absolute amount of equity issued as well as the proportion of shares issued to the total number of
shares outstanding. SIP Frequency indicates whether a firm had prior subsequent SIPs (coded as zero) or not (coded as one).
Relative Changes in Number of Employees One Year Prior to Announcement refers to the percentage change in staff one year
before the subsequent announcement. Market-to-Book Value t0 is the ratio of the market value of equity and the book value of
equity at the announcement date. Mean Return (Ri(t−220,−20)) is the mean stock during the [t−220,t−20] time period, whereas
Standard Deviation of Benchmark Index captures the volatility of the respective benchmark index. We estimated two models
for each event-window in order to avoid the problem of multicollinearity. All test statistics are computed using the
heteroskedasticity-consistent covariance matrix from White (1980).
CAR [-10;1]
Model I
Model II
CAR [-5;10]
Model III
Model IV
Constant
Financial Services
Utilities
Market Value t0
Abs. Value of Shares Issued
Relative Value of Shares Issued
0.040
-0.006
0.048**
---0.000**
---
0.0715**
-0.008
0.0437**
-0.000***
---0.010***
0.074***
-0.038
0.041***
---0.000**
---
0.115***
-0.035
0.040**
-0.000**
---0.009***
Proportion of Secondary
Shares of all Shares Issued
SEO Frequency
-0.005
-0.014
-0.018
-0.018
-0.016
-0.022*
-0.029*
-0.027**
rel. Changes in No. of
Employees One Year Prior to
Announcement
Market to Book Value t0
Mean Return RI(200)
Risk
-0.062*
0.001
-9.878*
---
-0.068*
---9.978**
-0.019
Standard deviation of
Benchmark Index
-3.052**
-2.553
-4.281***
-4.121***
Number of Observations
adj. R2
103
12.78%
108
24.30%
103
16.65%
108
24.35%
-0.020
0.001
-13.233**
---
-0.027
---12.884***
-0.028*
***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively.
57
CEO DUALITY AND FIRM PERFORMANCE—AN ENDOGENOUS ISSUE
Chia-Wei Chen*, J. Barry Lin**, Bingsheng Yi***
Abstract
Whether dual CEO leadership structure is better for corporations is one of the most hotly debated
issues in corporate finance. This paper uses a recent data to re-examine the relationship between CEO
duality and firm performance, controlling for other important variables such as firm characteristics,
ownership structure, CEO compensation, and agency costs. We find a recent trend of increased number
of firms converting from dual to non-dual CEO structure. However, our empirical results do not show
a significant relationship between CEO duality and firm performance nor improvement in firm
performance after change in leadership structure. We find evidence of endogeneity, and we attribute
the insignificance of the relationship between CEO duality and firm performance to the possibility that
CEO duality is endogenously and optimally determined given firm characteristic and ownership
structure.
Keywords: Corporate governance, CEO duality, Leadership structure, endogeneity
*Tunghai Univeristy, Taichung, Taiwan
Email: cchen@coba.usf.edu
**School of Management, Simmons College, 409 Commonwealth Avenue, Boston, MA 02215, Tel: 617-521-3845, Email:
j.lin@simmons.edu
*** corresponding author, College of Business and Public Policy, California State University-Dominguez Hills, 1000 E. Victoria
ST, SBS C 327, Carson, CA 90747
Tel: (310) 243-2621, Fax: (310) 217-6964, Email: byi@csudh.edu
1. Introduction
In the period from 1999 to 2003 hundreds of firms
converted from dual CEO leadership structure to nondual structure, while a much smaller number of firms
converted in the opposite direction. This recent trend
is partly due to several high-profile cases where
powerful dual CEOs were found to abuse their
tremendous power at the expenses of the company
and shareholders. However, empirical evidence is
scant and inconclusive on whether non-dual, as versus
dual, CEO leadership structure is associated with
better firm performance.
The objective of this paper is to re-examine this
important issue in corporate finance by using a more
recent data set as well as methodologies to control for
potential selection bias and endogeneity, thus
providing clear and timely evidence on this important
issue. In addition to providing evidence on the
relationship between CEO duality and firm
performance, we attempt to answer the research
question as to, given firm characteristics, whether
leadership structure in term of CEO duality is in fact
endogenously determined.
Theoretical studies provide no consensus as to
whether firms with split titles (CEO and chairman of
the board) outperform firms with combined titles.
Fama and Jensen (1983) and Jensen (1993) suggest
that CEO duality may hinder board‘s ability to
58
monitor management and thereby increase the agency
cost. As a result, splitting the titles of CEO and
Chairman of the Board will improve firm
performance. In contrast, Stoeberl and Sherony
(1985) and Anderson and Anthony (1986) argue that
CEO duality provides clear-cut leadership in strategy
formulation and implementation and will therefore
lead to better firm performance. Splitting titles may
create information sharing costs, conflicts between
CEO and non-CEO chairman and inefficiency: It will
be costly to communicate firm-specific information to
others in a timely manner; decision making process
and execution may both be less efficient when there
are two versus one key leader; it may be more
difficult to assign blame for bad company
performance.
Whether combining or separating the leadership
is beneficial to the firm is then an empirical question.
However, the empirical evidence is mixed and
inconclusive. Pi and Timme (1993) find that there is
negative relationship between CEO duality and
accounting performance measures in banking
industry. Baliga, Moyer, and R. Rao (1996) found no
evidence of performance changes surrounding
changes in the duality status. Daily and Dalton (1997)
find that there is no significant difference in
performance between dual CEO and non-dual CEO
firms. Dahya and Travlos (2000) document a positive
association between CEO duality and firm
performance. Dahya (2005) show that splitting the
titles of CEO and Chair of the Board among U.K
companies is not associated with performance
improvement. Faleye (2007) find that CEO duality is
positively related to organizational complexity, CEO
reputation and managerial ownership. His results
suggest that firms do consider the costs and benefits
of alternative leadership structure. As a result, the
observed sample of firms that have chosen one type of
leadership structure over the other are not random,
consequently the OLS estimates are biased and
inconsistent. Prior studies on leadership structure and
performance fail to control for such potential selection
bias. In this paper we use Heckman two-step
procedure and control for the selection bias. We also
use the fixed-effect model to control for unobservable
factors, which may affect the relationship between
CEO duality and firm performance.
Furthermore, we examine the difference between
sub-samples of firms announcing new dual CEOs
versus non-dual CEOs without CEO replacements.
By looking at only title change, without CEO
replacements, we provide a clear view as to whether
combined titles really affect firm performance. We
then use multivariate analyses to examine CEO
duality and firm performance controlling for potential
endogeneity. We also examine changes in firm
performance within the 3-year period surrounding
leadership structure changes. We find consistent
evidence that there is no significant relationship
between CEO duality and firm performance. We find
that firms may change their leadership structure (from
duality to non-duality or vice versa) in response to
deteriorating performance. However, after change in
the leadership structure, there is no improvement in
firm performance. Our results suggest that the
leadership structure in firms is endogenously and
optimally determined given firm characteristic and
ownership structure.
This paper proceeds as follows. Section 2
describes methods and data. Section 3 presents recent
trend in firms‘ leadership structure. Section 4 reports
our empirical tests, and section 5 concludes.
2. Methods and Data
A firm‘s leadership structure should maximize its
value. Each type of leadership structure has its own
benefits and costs. A non-duality leadership structure
provides better oversight on CEOs and thereby
reduces managerial agency costs. But in the mean
time, it may generate information sharing costs, create
rivalry between CEO and non-CEO chairman, lead to
inefficient strategy formulation and implementation.
In cases when the costs of maintaining a non-duality
leadership structure exceed its monitoring benefits, a
duality leadership structure should be preferred. The
leadership structure of a firm should be considered an
endogenous outcome that maximizes firm valuation
given firm‘s characteristics. Evaluating the impact of
leadership structure should also account for the
endogeniety of choice of leadership structure.
Following Campa and Kedia (2002), we use an
endogenous self-selection model and Heckman‘s
(1979) two-step procedure to control for the selection
bias.
Dit* = αZit + μit
(1)
Where Dit* is an unobservable latent variable
about the type of leadership structure, Zit is a set of
firm characteristics that may affect leadership
structure. Suppose a duality leadership structure is
chosen if Dit* >0, and a non-duality leadership
structure is chosen if Dit*  0. We can only observe
whether a firm has a dual CEO or none-dual CEO.
We model a firm‘s performance (measure by
Tobin‘s Q, the ratio of market value to book value of
assets. Market value of assets is computed as market
value of equity plus book value of assets minus book
value of equity.) as a function of leadership structure
and a set of firm characteristics as Equation (2):
Qit = β0 + β1 Dit + β2X it + vit
(2)
Where Dit is a CEO duality dummy variable,
which equals one if CEO is also the chairman of the
board, and is 0 otherwise. The OLS estimation on β1
will be biased if there is correlation between the error
term in equation (1)—μit, and the error term in
equation (2)—vit. We employ a treatment-effects
model based on Heckman‘s (1979) two-step
procedure that corrects for self-selection bias. The
model accounts for the possibility that some firm
specific characteristics that affect leadership structure
may also affect firm performance. We first estimate
equation (1) using a probit model to get consistent
estimates of α, which are then used to get estimates of
selectivity correction λit (lambda, or inverse of Mill‘s
ratio). Then we model firm performance as a function
of leadership structure, firm characteristics and
selectivity correction as shown in equation (3):
Qit = β0 + β1 Dit + β2X it + β3λit + vit
(3)
If β3, the coefficient of λit is significant, it
indicates the existence of self-selection bias. We also
use the fixed-effect model to control for unobservable
firm characteristics that may affect firm performance.
Besides comparing firm characteristics and
performance among firms with different leadership
structure, we specifically examine firms changing
their leadership structure without replacing their
CEOs, which hasn‘t been done in prior researches.
Without controlling for whether CEOs are replaced or
not when leadership structure changes, it will be
difficult to decide whether the change in firm
performance is due to change in CEO or the
leadership structure or both, since the new CEOs
might have different characteristics or skills, which
may affect firm performance as well. Our method
therefore provides a better test on the impact of
leadership. We collect CEO duality, CEO career
information, and compensation data from Standard
and Poor‘s ExecuComp database from 1999 to 2003.
ExecuComp includes executive compensation data for
firms in the S&P 1500 index, which comprises the
S&P 500, the S&P 400 mid cap, and the S&P 600
59
small cap indices.41 We obtain accounting data and
stock return from COMPUSTAT and Center for
Research in Security Prices (CRSP) respectively.
Board structure and ownership data are obtained from
Compact Disclosure database and proxy statements.
To investigate the effect of CEO duality, we
include variables related to corporate governance
mechanisms, firm characteristics, agency costs, and
compensation structure. For corporate governance
mechanisms, we measure the CEO ownership,
institutional ownership, board size, percentage of
independent directors, financial leverage, G-index,42
CEO age, and chairman age. These variables reflect
the degree of agency problems and internal or external
monitoring mechanisms.
Firm characteristics include firm size, firm age,
number of business segments, R&D expenses scaled
by annual sales, and sales growth in percentage. Firm
size is the market value of each firm calculated by
stock price at the end of the year times the common
shares outstanding. Sales growth is the percentage of
sales growth in the last 3 years. These variables
provide measures to check if combined or split titles
are related to certain type of firms. We follow Ang et
al. (2000) in using operating expense ratio and asset
utilization to capture agency costs. Operating expense
ratio is operating expense scaled by annual sales.
Asset utilization ratio is annual sales divided by total
assets. Agency costs are inversely related to asset
utilization ratio but positively related to expense ratio.
Compensation structure measures how the CEO
is compensated. Salary, bonus, value of restricted
stock granted, and value of stock options granted are
all measured in thousands of dollars. Value of stock
options granted is calculated by S&P using the Black
and Scholes methodology. Percentage of options
granted is calculated by value of stock options granted
divided by total compensation. Total compensation is
the variable TDC1 extracted from ExecuComp
database. It includes salary, bonus, other annual
compensation, value of restricted stock granted, value
of stock options granted, long-term incentive payouts,
and all other total. These variables provide
information on whether dual and non-dual CEOs are
compensated differently in both dollar amount and in
the structure of their compensation, which might
result in different incentive for CEO to work hard.
3. Recent trend in CEO duality
Most previous work related to CEO duality focuses
on the period of 1980s and early 1990s and find U.S
41
ExecuComp also contains information on firms that are
not currently in the S&P500, the S&P400, and the S&P600
indices, but were previously included in one the
aforementioned indices. Thus, the number of observations
in each year could be different.
42
G-index, or governance index as developed by Gompers,
Ishii and Metrick (2003), is obtained from
http://finance.wharton.upenn.edu/~metrick/governance.xls.
60
firms are more likely to have combined titles
compared with European firms, the percentage of dual
CEOs firms is around 80% and there is no evidence of
a decline in the popularity of the duality leadership
structure in the U.S. (Baliga, Moyer, and Rao, 1996;
Brickley, Coles and Jarrel, 1997, among others). 43
Different from previous studies, we investigate CEO
duality with a relatively large sample from recent
years. Before directly testing the relation among CEO
duality, firm characteristics, and firm performance, it
is of interest to examine the recent trend in CEO
duality. Despite the mixed evidence of superiority of
non-duality over duality leadership structure in firm
performance, corporations have been facing
increasingly stronger pressure from regulators,
exchanges, and or shareholders to separate CEO and
chairman duties after corporate scandals since 2001.
For example, in the U.S., the number of shareholders
proposal calling for non-duality leadership structure
increase from 3 in 2001 to 20 in 2003, and 32 in 2004
(Faleye, 2007). Table 1 shows a tendency that duality
leadership structure is becoming less and less popular
in the U.S. Part I of Table 1 shows that the proportion
of firms with combined titles drop from about 65.5
percent in 1999 to just over 60 percent in 2003,
compared the stable level of 80 percent in the 1980s
and early 1990s. More and more firms switch their
leadership structure from duality into non-duality as
shown in Part II. Among firms that changed their
leadership structure, the proportion of firms switching
from duality to non-duality increased from 55 percent
in 1999 to nearly 70 percent in 2003.
4. Empirical Results
4.1 CEO duality and firm characteristics
Table 2 compares firm characteristics and
performance measures for dual versus non-dual CEO
firms. We find significant differences in most of the
variables.
For corporate governance mechanisms, dualCEO firms have higher G-index and larger board size,
suggesting that dual CEO firms have poorer
governance and more inefficient board. Interestingly,
dual CEO firms also have higher CEO ownership,
which might be required to more strongly align the
interests of CEO and shareholders. Dual-CEO firms
also have higher institutional ownership and financial
leverage, indicating more external monitoring, which
also might be required to reduce agency problem
resulting from the increased power of dual-CEOs.
Similarly, we found a relatively high percentage of
independent directors in dual CEO firms. The results
suggest that dual CEO firms might suffer poor
corporate governance from the board, however,
alternative mechanisms (CEO ownership, oversight
from institutional investors, more independent board
43
Dahya, and Travlos (2000) provides clear summary of
previous studies related to CEO duality.
members, creditors, etc.) might come to play and
reduce the agency costs for CEO duality. There is no
significant difference in operating expense ratio
between non-dual CEO and dual-CEO firms, while
dual-CEO firms have significantly higher asset
utilization ratio than non-dual CEO firms. The results
indicate that the agency costs of dual-CEO firms are
not higher than those of non-dual CEO firms.
Table 1. Distribution of firms with different leadership structure from 1999 to 2003
Table 1 provides the number of Dual and Non-dual CEOs in each year from 1999 to 2003 on part I. Part II provides the
distribution of firms that changed their leadership structure in each year.
Year
1999
2000
2001
2002
2003
Average %
I: Distribution of duality and non-duality
firms
Number of firms with dual CEOs
1186
1137
1031
1029
904
62.56
(65.49)
(63.45)
(61.74)
(61.88)
(60.23)
Number of firms with non-dual CEOs
625
655
639
634
597
37.44
(34.51)
(36.55)
(38.26)
(38.12)
(39.77)
II: Distribution of firms that changed
their leadership structure
Number of firms switching from non184
150
90
68
67
37.19
duality to duality
(44.99)
(41.90)
(35.29)
(33.17)
(30.59)
Number of firms switching from duality
225
208
165
137
152
62.81
to non-duality
(55.01)
(58.10)
(64.71)
(66.83)
(69.41)
Table 2. Comparisons of Dual and Non-dual CEO Firms
Table 2 provides summary statistics for the whole sample firms and compares firm characteristics between duality and nonduality firms. CEO ownership, insider ownership, institutions ownership, blockholder ownership are the proportions of
common stocks held by CEOs, corporate insiders, institutional investors and blockholders respectively. G-index is the
governance index constructed by Gompers, Ishii and Metric (2003) to proxy for the level of shareholder rights. Board size is
measured by the number of directors. Independent directors are directors whose only connection to the corporation is their
directorship. The ratio of independent directors is the number of independent directors divided by the number of directors.
Leverage is long-term debt divided by book value of total assets. Tobin‘s q is the ratio of market value to book value of assets.
Market value of assets is computed as market value of equity plus book value of assets minus book value of equity. Return on
asset is net income divided by book value of asset. Return on equity is net income divided by book value of common equity.
Firm size is natural logarithm of the book value of total assets. Operating income before depreciation, R&D expenses,
advertising expenses, capital expenditure, tangible assets are all scaled by book value of total assets. Operating expense scaled
by annual sales and asset utilization ratio are measures of agency costs. Salary, bonus, and value of restricted stock granted,
Black-Scholas value of options granted, and total compensations are in thousands of dollars. Levels of significance for the tand Wilcoxon tests are indicated by a, b, and c for 1%, 5%, and 10% respectively. The value in parenthesis is the number of
observations.
All sample firms
Non-dual CEO
Dual CEO firms
Differences
(5154)
firms
(3354)
(1800)
Mean
Median
Mean
Median
Mean
Median
t-test
Wilcoxon
Corporate governance
mechanisms
CEO ownership
0.026
0.003
0.020
0.002
0.029
0.004
-5.21a
-8.44a
a
Insider ownership
0.068
0.018
0.077
0.025
0.063
0.014
3.80
9.87a
Institutional ownership
0.651
0.687
0.642
0.671
0.655
0.695
-2.13b
-2.67a
Blockholder
ownership
0.344
0.323
0.380
0.359
0.325
0.301
8.46a
8.81a
Board size
9.270
9
8.905
9
9.467
9
-7.61a
-13.7a
Ratio of independent
directors
0.650
0.667
0.607
0.625
0.673
0.7
-12.9a
-13.3a
a
Leverage
0.200
0.194
0.188
0.169
0.206
0.205
-3.70
-5.35a
CEO age
55.26
55
53.67
53
56.12
56
-10.4a
-11.6a
a
G-index
9.319
9
8.754
9
9.613
10
-6.94
-7.05a
(1968)
(1968)
(674)
(674)
(1294)
(1294)
Agency costs
Operating expense
scaled by annual
0.263
0.219
0.263
0.224
0.263
0.215
0.034
1.43
sales
(4261)
(4261)
(1572)
(1572)
(2689)
(2689)
Asset utilization
ratio
1.052
0.895
1.089
0.903
1.032
0.891
2.41a
1.39
61
Table 2 continued
Firm performance
and characteristics
Tobin‘s q
Return on asset
Return on equity
Firm size
Number of business
segments
Firm age
R&D expenses
Advertising
expenses
Operating income
before depreciation
Capital expenditure
Sales growth
Tangible assets
Compensation
structure
Salary
Bonus
Value of restricted
stock granted
Value of stock
options granted
Total compensation
2.519
0.025
-0.065
(5153)
7.541
2.974
(4618)
20.55
0.030
1.937
0.042
0.109
(5153)
7.358
3
(4618)
17
0
2.638
0.018
2.049
0.043
2.455
0.028
1.866
0.042
2.83a
-1.69c
6.01a
-0.96
0.008
7.105
2.643
(1591)
18.13
0.036
0.098
6.961
2
(1591)
15
0
-0.105
7.776
3.148
(3027)
21.84
0.026
0.116
7.609
3
(3027)
20
0
0.475
-15.5a
-8.93a
-6.24a
-14.4a
-9.31a
-10.4a
5.34a
-9.13a
3.04a
0.011
0
0.010
0
0.012
0
-1.93c
-1.98b
0.132
0.004
0.930
0.300
0.130
0.041
0.262
0.241
0.129
0.058
0.695
0.298
0.129
0.041
0.294
0.233
0.134
0.054
1.056
0.302
0.130
0.042
0.246
0.245
-1.69c
2.28b
-1.10
-0.63
-1.47
0.723
1.218
-1.67c
666.7
753.1
618.7
383.1
552.3
509.0
500.6
257.0
728.2
884.2
696
488
-19.5a
-9.59a
-19.7a
-11.2a
534.9
3439.4
(5135)
5828.1
(5135)
0
951.9
(5135)
2713.9
(5135)
385.7
3251.2
(1792)
4911.2
(1792)
0
716.8
(1792)
1964.9
(1792)
614.9
3540.0
(3343)
6319.5
(3343)
0
1084.6
(3343)
3123.8
(3343)
-3.11a
-0.63
-6.00a
-6.72a
-2.92a
-12.9a
For firm performance, non-dual CEO firms have
mean (median) Tobin‘s Q of 2.64 (2.05), while dualCEO firms have mean (median) Tobin‘s Q of 2.46
(1.87), the differences in mean and median are both
significant at the one percent level. Non-dual CEO
firms have higher mean return on assets (ROA) than
dual-CEO firms but there is no significant difference
in median. In contrast, non-dual CEO firms have
lower median return on equity (ROE) than dual-CEO
firms but there is no significant difference in mean
return on equity.44 In terms of firm characteristics,
larger and older firms tend to give combined titles to
their CEOs. Firms with combined titles have
relatively more business segments. These firms tend
to have less growth opportunity, spend less in R&D
expenditure, and carry more tangible assets. For CEO
compensation structure, dual CEOs have significantly
higher total compensation, with higher salary, higher
restricted stock, and higher bonuses, while there is no
significant difference in stock option.
In the univariate tests we find non-dual-CEO
firms have significantly higher Tobin‘s Q than dualCEO firms. However, without controlling for other
44
Harris and Helfat (1998) located 13 studies providing
statistical evidence regarding impact of CEO duality on firm
performance. Only three of those studies find negative
impact of CEO duality on firm performance. Pi and Timme
(1993) examine the banking industry only. Berg and Smith
(1978) find a negative impact of CEO duality on return on
investment but not on return on equity. Rechner and Dalton
(1991) find a negative effect of duality on return on
investment and return on equity. We will focus on Tobin‘s
Q, which is a widely used firm performance measure in
finance literature.
62
factors that may impact firm performance, we cannot
be confident whether leadership structure affects firm
performance or not. Since a firm‘s leadership
structure might be an endogenous outcome of its
characteristics, we apply Heckman‘s two-step
procedure to control for the endogeneity of leadership
structure and examine its impact on firm performance
4.2 Determinants of CEO duality
Table 3 reports a probit regression on the relation
between CEO duality and firm characteristics. Model
one includes Tobin‘s Q as a measure of performance.
Faleye (2007) finds that organization complexity,
CEO reputation, and managerial ownership increase
the probability of CEO duality. We find firm size,
CEO-age, and CEO-ownership to increase the
probability of CEO duality. In addition we find that
board independence and institutional ownership are
positive determinants, while block ownership is a
negative determinant on CEO duality.
The
performance variable Tobin‘s q is insignificant,
although positive.
Table 3. Determinants of CEO duality
This table reports probit regression results of firm performance and characteristics on CEO duality dummy. Firm performance is measured by
Tobin‘s q, return on asset and return on equity. CEO duality dummy equals one if CEOs also act as chairs of the boards of directors and
equals zero otherwise. Levels of significance are indicated by a, b, and c for 1%, 5%, and 10% respectively.
Intercept
-2.755a
-2.755a
Tobin‘s q
0.00007
Firm size
0.146a
0.146a
Sales growth
0.008
0.008
Tangible asset
-0.108
-0.108
CEO age
0.020a
0.020a
CEO ownership
3.606a
3.606a
Ratio of independent directors
1.336a
1.336a
Insider ownership
-0.323
-0.323
Insider ownership square
0.736
0.736
0.713a
0.713a
Blockholder ownership
-0.593a
-0.593a
Leverage
0.093
0.093
Yeas dummies
Yes
Yes
Industry dummies
Yes
Yes
No. of observations
LR Chi2
Pseudo R²
5154
658.8
0.099
4.3 CEO duality and firm performance
Table 4 reports the effect of CEO duality on firm
performance based on OLS regression, a regression
using Heckman self-selection model to control for
selection bias, and a fixed effect model to control for
impacts of non-observable firm characteristics.
5154
658.8
0.099
While many of the firm characteristics variables are
statistically significant, our key variable, the dualCEO dummy variable, is insignificant for all three
models. This is strong and robust evidence that,
cross-sectionally, there is no evidence that CEOduality significantly affects firm performance.
Table 4. CEO duality on firm performance
This table reports results of CEO duality on firm performance based on OLS regression which does not control endogeniety of CEO duality,
regression using Heckman self-selection model, and fixed effect model to control for the endogenity of CEO duality. Levels of significance
are indicated by a, b, and c for 1%, 5%, and 10% respectively.
OLS
Self-selection
Fixed effects
Intercept
1.993a
-1.603a
12.67a
CEO duality dummy
-0.044
0.014
0.095
Board size
-0.069a
-0.070a
-0.064b
c
c
Insider ownership
0.862
0.967
-2.728a
c
a
1.362
3.833
6.823a
-0.113
0.719a
-0.129
-0.249c
-1.265a
0.177
Firm size
0.065a
0.207a
-1.352a
Leverage
-2.099a
-3.416a
-1.436a
R&D expenses
9.641a
9.611a
-2.228
A&D expenses
2.385a
2.370a
3.698
Operating income before depreciation
7.030a
7.054a
7.121a
Capital expenditure
0.094
0.028
0.286
Lambda
3.864a
Yeas dummies
Yes
Yes
No
Industry dummies
Yes
Yes
No
No. of observations
F-Statistic
R²
4.4 CEO duality change and firm
performance
To further investigate the relationship between CEO
duality and firm performance, we identify a sample of
firms that changed their leadership structure (from
dual to non-dual or vice versa). We focus only on
firms with new announcement of dual or non-dual
CEOs without changing the CEO to avoid the
potential contaminating impact of CEO replacement
5154
78.57
0.277
5154
79.53
0.287
5154
44.75
0.054
on firm performance. Table 5 reports the effect of
CEO duality on firm performance for firms changing
their leadership structure without replacing CEOs.
Here we use only two of the three earlier regression
models, as the fixed effect model is not applicable due
to insufficient number of observations.
We again find the CEO duality dummy to be
statistically insignificant, though positive, confirming
earlier regression results. We note that the existence
of endogeneity is indicated in both Table 4 and 5,
63
where the coefficients of lambda are both significant
at one percent level. This suggests that firms
endogenously choose their leadership structure as a
part of the broader firm characteristics and ownership
structure decision. To provide some evidence of the
endogeneous relationship between firm performance
and CEO duality, we investigate the time patterns of
firm performance around a CEO-duality change.
Table 5. Effects of CEO duality on firm performance for firms changing their leadership structure without
replacing CEOs
Fixed-effect model is not applicable due to insufficient number of observations.
Intercept
CEO duality dummy (1 = dual CEO)
OLS
4.573
1.076
Board size
Insider ownership
Firm size
Leverage
R&D expenses
A&D expenses
Operating income before depreciation
-0.365b
-15.17b
35.65a
-3.750b
0.976
0.134
-2.439
6.462a
38.59a
7.882a
-0.354b
-16.98a
34.31a
-8.182a
1.966
0.035
-2.336
4.530
35.02b
8.729a
Capital expenditure
Lambda
Yeas dummies
Industry dummies
No. of observations
F-Statistic
Adjusted R²
-3.186
-1.108
-7.276a
Yes
Yes
254
4.95
0.362
Yes
Yes
254
4.70
0.340
Self-selection
10.17a
0.505
Table 6. Tobin‘s Q surrounding change in leadership structure
Table 6 reports measures of firm performance from three years before occurrence of change in leadership structure until three years after the
change in leadership structure. Firms included are firms that changed their leadership structure without replacing their CEOs. Year 0 is the
year in which firms changed their leadership structure.
Year
From dual to non-dual
From non-dual to dual
Mean Difference
(# of observations)
(# of observations)
(t-test, H0: Diff = 0)
-3
3.144 (54)
2.806 (307)
0.338 (0.862)
-2
3.418 (55)
2.937 (324)
0.482 (0.817)
-1
2.919 (54)
2.902 (323)
0.017 (0.040)
Pre-change average
3.162(163)
2.883 (954)
0.279 (1.006)
0
2.423 (52)
2.768 (323)
-0.345 (-0.927)
1
2.312 (50)
2.454 (319)
-0.142 (-0.634)
2
2.041 (45)
2.394 (302)
-0.353 (-1.758c)
3
Post-change average
2.422 (40)
2.242 (253)
2.254 (135)
0.908 (3.177a)
2.372 (874)
0.511 (3.919a)
Difference
(t-test)
Table 6 shows Tobins‘ Q from three years
before an announcement of change in leadership
structure to three years after the change in leadership
structure. As in Table 5, firms included are firms that
changed their leadership structure without replacing
their CEOs. Figure 1 plots the changes in Tobin‘s Q.
We observe in Table 6 and Figure 1 that firms
switching from duality to none duality or vice versa
were experiencing deterioration in performance prior
to leadership change announcements, and the
deterioration in performance continues even after
change in leadership structure. For example, for firms
that switched from dual CEOs into non-dual CEOs,
their three-year average pre-change Tobin‘s Q is
64
0.179 (0.524)
-0.110 (-0.770)
3.162, exceeding the three-year average post-change
Tobin‘s Q by 0.91. And the difference is significant at
the one percent level. Similar results can be found
among firms switching from non-dual to dual CEOs.
The time pattern in Tobin‘s q illustrate clearly that
CEO duality changes are motivated by firms in
response to deteriorating performance, in support of
the notion that firm leadership structure is
endogenously determined.
Our results therefore cast doubt on the
arguments for the non-duality leadership structure,
which has been more prevalent after recent corporate
scandals.
Figure 1. Tobin's Q Surrouding Change in Leadership Structure
5. Conclusion
Both theoretical and empirical studies are
inconclusive as to which might be better: vesting both
CEO and Chair of the Board positions into one
person, or splitting the titles. However, in many
countries including the U.S., regulators and investors
have become more and more strongly recommending
separation of CEO and chairman duties. In this paper,
we utilize a more recent set of data and investigate the
issue of CEO duality in relation to firm
characteristics, ownership characteristics, agency
costs, and firm performance. We apply methodology
to control for endogeineity of leadership structure.
Our empirical findings provide clear answers to
the research question that we raise in the beginning of
the paper. We find significant differences in firm
characteristics between dual and non-dual CEO firms.
However, our multivariate tests find no evidence that
CEO duality has a significant effect on firm
performance. It is important to note that we find the
existence of endogeneity in CEO duality, indicating
that the corporate leadership structure is
endogenously and optimally determined, given firm
characteristic and ownership structure. Our evidence
casts doubt on the notion that firms changing from
dual to non-dual leadership structure would improve
performance. It seems that, given firm characteristics
and ownership structure, firms endogenously and
optimally determine their choice of dual or non-dual
CEO structure. This paper contributes new evidence
to this important issue in corporate finance.
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Baliga, R., Moyer, C., and R. Rao, 1996, ―CEO
duality and firm performance: What‘s the fuss?‖
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Berg, S. and S. K. Smith, 1978, ―CEO and board
chairman: A quantitative study of dual vs. unitary
board leadership‖, Directors & Boards 3, 34-39
Boyd, B., 1995, ―CEO duality and firm performance:
A contingency model,‖ Strategic Management
Journal 16, 301-312.
Brickley, J.A., Coles, J.L., and G. Jarrell, 1997,
―Leadership structure: Separating the CEO and
chairman of the board,‖ Journal of Corporate Finance
3, 189-220.
Campa, J., Kedia, S., 2002. Explaining the
diversification discount. Journal of Finance 57, 1731-1762.
Dahya, J., A.A. Lonie, and D.M. Power, 1996, ―The
case for separating the roles of chairman and CEO:
An analysis of stock market and accounting data,‖
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71-77.
Dahya, J. and N.G. Travlos, 2000, ―Does the one man
show pay? Theory and evidence on the dual CEO
revisited,‖ European Financial Management 16.
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Commotion!" (August 2005). Available at SSRN:
http://ssrn.com/abstract=853006
Daily, C. and D. Dalton, 1997, ―Separate, but not
independent: board leadership structure in large
corporations,‖ International Corporate Governance –
An International Review 5, 126-136.
Faleye, O., 2007, ―Does one hat fit all? The case of
corporate leadership structure,‖ Journal of
Management and Governance, Vol 13. N.3, 239-259
Fama, E.F. and M. Jensen, 1983, ―Separation of
ownership and control‖, Journal of Law and
Pi, L. and S.G. Timme, 1993, ―Corporate control and
bank efficiency‖, Journal of Banking and Finance 17,
515-530.
Harris, D., and C.E. Helfat, 1998. ―CEO Duality,
Succession, Capabilities, and Agency Theory:
Commentary and Research Agenda‖, Strategic
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Rechner, P.L. and D. R. Dalton, 1989, ―The impact of
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Evidence vs. rhetoric‖, Academy of Management
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Stoeberl, P. A. & Sherony, B. C. (1985). Board
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65
VALUE BASED FINANCIAL PERFORMANCE MEASURES: AN
EVALUATION OF RELATIVE AND INCREMENTAL INFORMATION
CONTENT
Pierre Erasmus*
Abstract
Value-based (VB) financial performance measures are often advanced as improvements over
traditional measures. It is argued that the inclusion of a firm‟s cost of capital in the calculation of these
measures facilitates the evaluation of value creation. Furthermore they attempt to remove some
accounting distortions resulting from the limitations of conventional accounting information. This
paper investigates the ability of four VB measures to explain market-adjusted share returns and
compare it to that of some traditional measures. Empirical results indicate that the relative information
contents of the VB measures are not greater than that of earnings. The incremental information content
tests indicate that their components add significantly to the information content of earnings, but that
the level of significance is relatively low.
Keywords: financial performance, cost of capital, accounting information
*Department of Business Management, University of Stellenbosch, Private Bag X1, Matieland, 7602, SOUTH AFRICA
E-mail: pde@sun.ac.za, Tel : +27 21 8082215, Fax : +27 21 8082226
1. Introduction
Firms focused on the maximisation of shareholder
value need to ensure that all activities yield positive
net present values. A number of value-based financial
performance measures have been developed in an
attempt to guide management actions towards
achieving this objective. These value-based measures,
such as Economic Value Added (EVA) and Cash
Value Added (CVA), attempt to include a firm‘s cost
of capital and to adjust financial statement
information in order to remove some of the
accounting distortions contained in traditional
financial performance measures. Performance
exceeding the cost of capital yields value, while the
failure to achieve this results in the destruction of
shareholder value.
Value-based financial performance measures
(VBM) are presented by their proponents as a major
improvement over the traditional performance
measures. Most importantly, by including a firm‘s
cost of capital in their calculation they could be
applied in order to evaluate the value creating
potential of a firm (Young and O‘Byrne, 2001: 431;
Lehn and Makhija, 1996: 35). If the returns generated
on a firm‘s projects are in excess of the cost of
capital, these projects would yield positive net present
values and consequently shareholder value is
increased (Grant, 2003: 81; Stewart, 1991: 174).
These VBM also attempt to overcome some of the
problems associated with the traditional measures by
removing the accounting distortions contained in the
66
financial statements (Ehrbar, 1998: 80; Peterson and
Peterson, 1996: 10; Stewart, 1991: 66).
Perhaps one of the best known value-based
performance measures is Economic Value Added
(EVA). EVA is an estimate of the economic profit
generated by a firm (Stewart, 1994: 73) and is
calculated by comparing a firm‘s net operating profit
after tax (NOPAT) to the total cost of all its forms of
capital (debt, as well as equity) (Grant, 2003: 2).
Maximising a firm‘s EVA should result in an increase
in shareholder value created (Stewart, 1991: 174).
Proponents of the measure report high levels of
correlation with share returns (Worthington and West,
2004: 201; O‘Byrne, 1999: 95; Bacidore, Boquist,
Milbourne and Thakor, 1997: 17; O‘Byrne, 1996:
117; Grant, 1996: 44; Lehn and Makhija, 1996: 36;
Peterson and Peterson, 1996: 45; Stewart, 1994: 75,
136; Stewart, 1991: 66).
The measure Cash Value Added (CVA) is
considered as another form of residual income
(Young and O‘Byrne, 2001: 428). This measure
calculates the difference between a firm‘s operating
cash flow and a capital charge based on the gross
amount of invested capital (Young and O‘Byrne,
2001: 440). One of the major differences between
CVA and EVA is that depreciation and accruals are
added back to NOPAT when calculating the operating
cash flow values included in CVA (Martin and Petty,
2000: 128). Furthermore, accumulated depreciation is
included with the invested capital amount when the
gross invested capital is determined (Martin and
Petty, 2000: 141). According to Young and O‘Byrne
(2001: 429), the calculation of CVA is less complex
than the calculation of EVA since no accounting
adjustments are required. They also argue that since
depreciation is added back during the calculation of
CVA the measure is not influenced by a firm‘s
depreciation policy (Young and O‘Byrne, 2001: 440).
They perceive this characteristic of CVA as an
advantage over EVA where different depreciation
policies can result in large variations in the value of
the measure.
A number of limitations with regard to CVA,
however, are also highlighted. According to Young
and O‘Byrne (2001: 461), EVA is a better financial
measure than CVA. They argue that the problem of
different depreciation policies in the case of EVA can
be solved by including an accounting adjustment.
Furthermore, they indicate that by removing accruals
and depreciation from the calculation of CVA the
measure may loose important information required by
the market when evaluating an enterprise. The
process of removing the effects of accounting accruals
in the calculation of CVA could also be relatively
complex. They also warn that the incorporation of
CVA values into valuation models should be
considered carefully since CVA is based on historical
accounting figures that do not represent the expected
future cash flow generated by the enterprise (Young
and O‘Byrne, 2001: 442).
Another problem experienced with CVA occurs
when uneven cash flow values are considered (Martin
and Petty, 2000: 149). The resulting CVA values may
provide conflicting signals with regard to the value
creation of the projects under consideration. From the
existing literature it is not clear whether CVA is able
to outperform other financial performance measures.
The measure Cash Flow Return on Investment
(CFROI) has been presented as an improvement over
some of the other traditional and value-based
measures by its proponents (Dzamba, 2003: 10). It is
calculated by considering the inflation-adjusted
investment in assets, the inflation-adjusted cash flow
generated by employing these assets in the firm, and
determines the yield generated over the estimated
lifetime of the assets.
Madden (1999: 110) considers the calculation of
CFROI to be based on basic DCF principles. The
four inputs required to calculate the measure are as
follows:
o
The average life of the depreciating
assets.
o
The total amount of assets (includes
both depreciating, as well as nondepreciating assets) adjusted for
inflation.
o
The inflation-adjusted cash flows
generated by the assets over their
lifetime.
o
The final inflation-adjusted residual
value of the non-depreciating assets
at the end of the asset lifetime.
The calculations of the CFROI inputs are
discussed in greater detail in Reviewers‘ Appendix 1.
These four inputs are represented in the cash flow
diagram provided in Figure 1:
Inflation-adjusted
gross cash flows
1
2
3
4
5
Non-depreciating
assets
Estimated asset
lifetime
Non-depreciating
assets
Depreciating assets
Figure 1. Cash flow diagram representing the four CFROI components
67
Based on these inputs the firm‘s CFROI value is
calculated as the discount rate that would ensure that
the present value of all the future cash flows (the
equal annual inflation-adjusted gross cash flows, as
well as the terminal non-depreciating assets amount)
is equal to the initial investment (total nondepreciating and depreciating assets). As such, the
CFROI may be viewed as a return on investment
(ROI). However, it is not calculated for individual
projects, but rather for the firm as a whole.
This CFROI figure is compared to the firm‘s
inflation-adjusted (real) cost of capital. If a firm is
able to generate CFROI values in excess of its
inflation-adjusted cost of capital it should increase its
shareholders‘ value while CFROI values below the
real cost of capital will result in the destruction of
shareholders‘ value. One of the characteristics of this
measure is that is focuses on the return offered to all
the capital providers of the firm and not only the
shareholders (Madden, 1999: 101). Relatively little
empirical research, however, have been conducted on
the performance of CFROI relative to other financial
performance measures.
In this paper the ability of the value-based
measures residual income (RI), EVA, CVA and
CFROI to explain market-adjusted share returns is
investigated for a sample of firms listed in the
Industrial Sector of the Johannesburg Securities
Exchange (JSE) and compared to that of the
traditional financial performance measures earnings
before extraordinary items (EBEI) and operating cash
flow (CFO). In the first part of the study the relative
information contents of the value-based measures
relative to the traditional measures are evaluated. The
second part of the study investigates the incremental
information content of the components of the valuebased measures, and test whether the inclusion of
these components contributes significantly to the
information content of the other measures.
The empirical results indicate that the relative
information contents of the value-based measures are
not greater than that of earnings. The incremental
information content tests indicate that the components
of some of the value-based measures do add
significantly to the information content of earnings.
The level of significance, however, is relatively low.
The remainder of the paper consists of six
sections. The first section focuses on the breakdown
of the measures into their contributing components
that is required for the information content tests. The
second section describes the research method. The
third section contains the descriptive statistics of the
measures and components included in the relative and
incremental information content tests. The fourth
section provides the results from the relative
information content tests, while the fifth section
reports on the incremental information content tests.
The final section contains the summary and the
conclusions.
68
2
Components of the Value-Based
Measures
This paper investigates the relative and incremental
information content of the measures cash flow return
on investment (CFROI), nominal and inflationadjusted cash value added (CVAnom and CVAreal),
nominal and inflation-adjusted economic value added
(EVAnom and EVAreal), operating cash flow (CFO),
earnings before extraordinary items (EBEI) and
residual income (RI). To do so, these measures are
partitioned into their contributing components using
an approach applied by Biddle, Bowen and Wallace
(1997: 305).
The following section provides a break-down of
the components included in the calculation of the
nominal versions of the measures included in the
study. Thereafter, the inflation adjustments proposed
by International Accounting Standard 15 (IAS15) are
highlighted. Finally, the components of the inflationadjusted measures EVAreal, CVAreal and CFROI are
considered.
2.1
Nominal Measures
To explore the relationships between the various
measures, one should commence by defining EBEI,
and then discuss all the additional components
required to calculate the measures. According to
Biddle et al. (1997: 305) a firm‘s EBEI could be
defined as follows:
EBEIt = CFOt + Accrualt,
where:
EBEIt = The earnings before extraordinary items and
tax for period t.
CFOt= The net cash from operating activities.
Accrualt = The total operating accruals of the firm.
The difference between EBEI and the net
operating profit after tax (NOPAT) is that NOPAT
does not take the after-tax interest expense into
account, while EBEI does. Therefore:
NOPATt - ATIntt = EBEIt
where:
ATIntt = Interest expense after provision for tax
While EBEI makes provision for the cost of debt
by subtracting the interest expense, RI is calculated by
deducting the cost of the total (i.e. debt and equity)
capital.
RIt = NOPATt – (c* x ICt-1)
where:
c* = The firm‘s estimated weighted average cost of
capital (WACC) after tax
ICt-1= The amount of capital invested in the firm at
the beginning of the period
Firms that achieve positive RI values are able to
generate profits in excess of their total cost of capital,
and consequently shareholder value should be created.
Negative RI values are an indication that insufficient
profits are generated, and as a result, shareholder
value could be destroyed.
EVA is calculated in a similar way as RI. The
major difference between the two measures relates to
a number of adjustments to NOPAT and IC included
in the calculation of EVA. These adjustments are
included with a view to removing some of the
accounting distortions identified by Stewart (1991:
28).
EVAt=(NOPATt + AcctAdjop; t) – [c* x (ICt-1+
AcctAdjc;t)]
where:
AcctAdjop; t=Adjustments to remove the accounting
distortions from operating profit
AcctAdjc; t=Adjustments to remove the accounting
distortions from invested capital
Since EVA values are not published by Stern
Stewart for South African firms, the EVA values are
obtained from the McGregor BFA database (2005).
Although these EVA values do not include all the
adjustments recommended by Stern Stewart, the
standardisation process applied to the financial
statements contained in the database already makes
provision for a number of the adjustments.
A firm‘s CVA is calculated by considering the
operating cash flow rather than operating profit (as
was the case for EVA), and subtracting the gross
capital charge. To convert NOPAT into the operating
cash flow, depreciation and amortisation are added
back (Martin & Petty, 2000: 128). Changes in other
long-term liabilities, such as provisions and deferred
taxes, are also added to NOPAT to convert it into a
cash flow figure (Young & O‘Byrne, 2001: 441). The
capital charge is based on the gross value of the
invested capital and not on the net figure (Martin &
Petty, 2000: 141). Accumulated depreciation is,
therefore, added back to the invested capital.
CVAt=Operating cash flow –gross capital charge
=(NOPATt + CVAAdjop; t) – [c* x (ICt-1+ AccDeprt-1)]
where:
CVAAdjop; t=Depreciation, amortisation and changes
in other long-term liabilities
AccDeprt-1=Accumulated depreciation
Based on these definitions CVA can be
presented as follows:
CVA=CFO + Accrual + ATInt – CapChg + AcctAdj
+ CVAAdj where:
CapChg =c* x ICt-1
AcctAdj =AcctAdjop; t – (c* x AcctAdjc; t)
CVAAdj=CVAAdjop; t – AcctAdjop; t + [c* x
(AcctAdjc; t + AccDeprt-1)]
2.2
Inflation-Adjusted Measures
In addition to the nominal measures, this study also
investigates the information content of the inflationadjusted versions of EVA and CVA, as well as the
measure CFROI. In order to calculate the inflationadjusted versions of these measures, inflation
adjustments are calculated according to the guidelines
contained in IAS15. These guidelines recommend
adjustments to the cost of sales, the depreciation, the
level of gearing, and the property, plant and
equipment (PPE).
The calculations of these
adjustments are described in more detail in
Reviewers‘ Appendix 2.
After
calculating the
IAS15
inflation
adjustments, the inflation-adjusted version of the
measure EVA is calculated as follows:
EVAreal;t =NOPATreal;t
–
(ICreal;t-1
x
c*real; t ) =
(NOPATnom;t - COSAdjt – DeprAdjt ± GearAdjt) –
[(ICnom;t-1 + PPEAdjt) x
c*real; t ]
where:
EVAreal;t =EVA in real terms, calculated after the
inflation adjustments to NOPAT and IC, are included
NOPATreal;t=NOPAT after including the cost of sales,
depreciation and gearing adjustments
c*real; t =the inflation-adjusted cost of capital
ICreal;t-1 =the invested capital after including the PPE
inflation adjustment
The real CVA is then calculated as follows:
CVAreal; t= (NOPATnom; t + CVAAdjop; t - COSAdjt –
*
DeprAdjt ± GearAdjt) – [ c real x (ICnom; t-1 + PPEAdjt
+ AccDeprt-1)]
where:
CVAreal; t = CVA in real terms, calculated after the
inflation adjustments to NOPAT and capital, are
included
CVAAdjop; t = Depreciation, amortisation and changes
in other long-term liabilities
AccDeprt-1 = Accumulated depreciation
The measure cash flow return on investment
(CFROI) compares the inflation-adjusted cash flow
generated by a firm with the inflation-adjusted cash
investment required to achieve it (Young & O‘Byrne,
2001: 382). By including the estimated lifetime of the
firm‘s depreciable assets and the expected residual
value of its non-depreciable assets an internal rate of
return is calculated. This CFROI figure is then
compared to the firm‘s inflation-adjusted (real) cost of
capital.
In order to investigate the relative and
incremental information content of the measure and to
compare it with the other measures included in this
study the CFROI margin is defined as the difference
between a firm‘s CFROI and its real cost of capital:
CFROIMargin =CFROI -
c*real
The CFROI margin can be presented as follows:
CFROIMargin = CFO + Accrual + ATInt – CapChg +
AcctAdj + InflAdj + CVAAdjreal + CFROIAdj
where:
Accrual = The total operating accruals of the firm
ATInt = Interest expense after provision for tax
CapChg = The capital charge based on the cost of
capital and the invested capital at the beginning of the
financial year
AcctAdj = The accounting adjustments to NOPAT
and ICt-1 to calculate EVAnom
InflAdj = The IAS15 inflation adjustments included to
calculate EVAreal
69
CVAAdjreal = The adjustments made to EVAreal to
calculate CVAreal
CFROIAdj = The difference between CVAreal and the
firm‘s CFROIMargin
The relationship between the CFROIMargin
components is summarised in Figure 2 (Biddle et al.,
1997: 307):
CFROIMargin = CFO + Accrual + ATInt – CapChg + AcctAdj + InflAdj + CVAAdj real + CFROIAdj
earnings (EBEI)
operating profits (NOPAT)
residual income (RI)
economic value added (EVA)
real economic value added (EVAreal)
real cash value added (CVAreal)
cash flow return on investment margin (CFROIMargin)
Figure 2. Components of the cash flow return on investment margin (CFROIMargin)
3
Research Method
3.1
Hypotheses
The information content of a financial measure refers
to the additional information that the market deduces
from its publication and incorporates into the
expected future financial performance of the firm. In
order to evaluate the relative and incremental
information content of the traditional and the value
based measures included in this study, an approach
developed by Biddle et al. (1997: 307) is applied.
According to this approach, relative information
content comparisons should be used to compare
different measures, or when a choice between the
70
measures is required.
Incremental information
content is used to determine whether one component
of a measure provides additional information over and
above that provided by another component.
To investigate the relative information content of
the measures, the following null hypothesis is
formulated (Biddle et al., 1997: 308):
HREL: The information content of measure X1 is
equal to that of X2
where X1 and X2 are pairwise combinations of
the measures under investigation. Rejection of the
null hypothesis indicates a statistically significant
difference in the information content of the two
measures.
In order to investigate the incremental
information content of the components of measure Xi,
it is necessary to decompose it into its contributing
components:
Xi = Y1 + Y2 + Y3 + … + Yn
The following null hypothesis is then formulated
(Biddle et al., 1997: 308):
HINC: Component Y1 does not provide
information content beyond that provided by the
remaining components Y2-Yn
where Y1-Yn are the various components of the
measure Xi investigated. Pairwise comparisons of the
components are conducted to evaluate the incremental
information content. Rejection of the null hypothesis
indicates that the inclusion of the component under
investigation will contribute significant additional
information content.
3.2
Statistical Techniques
In order to evaluate the information content of the
measures, the relationships between the measures and
market adjusted share returns are investigated. For
this purpose, regression analyses with the share return
as dependent variable and the various measures as the
independent variables are conducted. The statistical
technique employed in this study focuses on the
forecast errors of the various measures (calculated as
the difference between the actual and expected
values), which are standardised to size.
When assessing the information content of a
measure, the statistical significance of the slope
coefficient b1 from the following ordinary-least
squares regression is examined (Biddle et al., 1997:
308):
Dt = b0 + b1 FEXt / MVEt-1 + et
(1)
where Dt (the dependent variable) is a measure
of return for time period t;
FEXt / MVEt-1 is the unexpected realisation (or
forecast error) of the measure X (FEXt), divided by the
market value of the firm‘s equity at the beginning of
the financial year (MVEt-1); while et is a random
disturbance term.
The unexpected realisation of the measure X for
time period t is defined as the difference between the
observed value of the measure (Xt) and the market‘s
expected value of the measure (E(Xt)):
FEXt = Xt – E(Xt)
(2)
Assuming that the market‘s expected value is
formed according to a discrete linear stochastic
process in autoregressive form, E(Xt) may be defined
as:
E(Xt) = δ +  1Xt-1 +  2Xt-2 +  3Xt-3 + …
(3)
where δ is a constant and the  ‘s are the
autoregressive parameters. Substituting Equations (2)
and (3) into Equation (1) yields:
D = b0 + b1 [Xt – (δ +  1Xt-1 +  2Xt-2 +  3Xt-3 + …)]
/ MVEt-1 + et = b  b X / MVE  b X / MVE  b X / MVE
'
0
'
1
t
t 1
'
2
t 1
 b4' X t 3 / MVEt 1  ...  et
t 1
'
3
t 2
where
 
 
 
E b0'  b0  b1 δ , E b1'  b1 , and
E b   bi i 1 for i > 1. Equation (4) provides
'
i
the relationship between abnormal returns (Dt), and
the lagged measures of accounting performance (X)
scaled by MVE. For the purpose of this study,
Equation (5) is limited to one lag:
Dt = b0'  b1' X t / MVEt 1  b2' X t 1 / MVEt 1  et (5)
3.2.1 Tests for Relative Information
Content
The relative information contents of the measures are
assessed by means of a statistical test developed by
Biddle, Seow and Siegel (1995: 9). The independent
variables are included in individual regressions
against the dependent variable based on the following
equation:
Dt = b0'  b1' X t / MVEt 1  b2' X t 1 / MVEt 1  et (6)
where Dt is the market-adjusted return on a
firm‘s shares for time period t, X is one of the
measures investigated, and MVE is the market value
of the firm‘s equity. According to the test, pairwise
comparisons of the adjusted R2 values from the
individual regressions are conducted. Statistically
significant differences between two adjusted R2 values
result in the rejection of the null hypothesis HREL.
This indicates a statistically significant difference in
the ability of the two measures under investigation to
explain the variation in the dependent variable (Biddle
et al., 1997: 310).
3.2.2 Tests for Incremental Information
Content
In order to evaluate the incremental information
content of the components of the measures
investigated in this study, the following regression is
conducted (Biddle et al., 1997: 311):
Dt = d0 + d1 Y1;t / MVEt-1 + d2 Y1;t-1 / MVEt-1 + d3 Y2;t /
MVEt-1 + d4 Y2;t-1 / MVEt-1 + et
(7)
where Y1 and Y2 are two different components of
the measure under investigation. The individual
regression coefficients are assessed by means of ttests to investigate the contribution of the specific
component. F-tests are used to assess the following
joint null hypotheses:
H 0Y1 :
d1 = d2 = 0
H 0Y2 :
d3 = d4 = 0
Rejection of the null hypotheses indicates that
the inclusion of a component provides significant
incremental information.
3.3
Measures
3.3.1
Dependent Variable
t 1
(4)
The relative and incremental information content tests
applied in this study focus on the relationship between
71
the independent variables and the unexpected return
generated on a firm‘s shares. In order to estimate the
unexpected return, the market adjusted return is
calculated (Biddle et al., 1997: 312). This value
indicates whether a firm over- or under performed
relative to the overall market.
MktAdjRet The market adjusted return is
calculated as the difference between the 12-month
compounded return on a share and the 12-month
compounded return on the ALSI index. These returns
are calculated for a period ending three months after
the end of a firm‘s financial year-end to ensure that
the information contained in the financial statements
is reflected in the share prices.
The 12-month compounded share returns, as
well as the return on the ALSI index, are obtained
from the McGregor BFA database (2005).
3.3.2
The primary objective of this study is to investigate
the relative and the incremental information content
of a number of traditional and value based financial
performance measures. The measures included in the
relative information content test are CFO, EBEI, RI,
EVA, and CVA, as well as the inflation-adjusted
measures EVAreal, CVAreal and CFROI. The measures
are calculated based on information obtained from the
standardised financial statement data contained in the
McGregor BFA database (2005).
Stern Stewart does not publish EVA values for
South African firms. The McGregor BFA database
(2005), however, contains EVA values that are
calculated based on the standardised financial
statements included in the database. Through the
standardisation process applied by the database the
majority of the EVA accounting adjustments are
addressed. The equity adjustments proposed by Stern
Stewart, however, are not included in the EVA values
reported in the database.
In the case of firms listed at the end of the
research period, values for EVA, cost of capital and
invested capital are obtained from the McGregor BFA
database (2005). Since these values are not available
for those firms that delisted during the period under
review, they are estimated using the same method as
the one employed in the database. In order to
evaluate the effect of inflation on the measures, the
inflation adjustments proposed by IAS15 are
quantified and included in the calculation of EVAreal
and CVAreal. CFROI values are not available from the
McGregor BFA database (2005). Consequently, these
values are estimated by using the approach described
by Madden (1999).
content of the components of the measures EVA,
EVAreal, CVA, CVAreal and CFROI, the components
72
indicated in Figure 2 are required. These components
are quantified by information obtained from the
McGregor BFA database (2005).
To reduce heteroscedasticity in the data, all the
independent variables are divided by the market value
of equity as measured three months after the
beginning of the firm‘s financial year (MVE t-1)
(Biddle et al., 1997: 313). This period is chosen to
correspond with the period over which the dependent
variable is calculated.
3.4
Data
The measures CFO, EBEI, RI, EVAnom, EVAreal,
CVAreal and CFROI, as well as their contributing
components, are calculated for all firms listed in the
industrial sector of the JSE during the 15-year period
from 1991 to 2005. Those firms listed at the end of
this period are considered for the initial sample.
Focusing only on these firms, however, would expose
the study to a survivorship bias. Consequently, all
delisted firms that were listed during the period under
investigation are also included in the sample. A total
of 198 listed firms and 188 delisted firms are
identified.
Following Biddle et al. (1997: 311), those
observations in excess of eight standard deviations
from the median are classified as extreme outliers,
and consequently 41 observations were removed from
the sample. The number of observations classified as
extreme outliers relative to the overall sample is
relatively small. A closer investigation of those firms
classified as extreme outliers also reveals that the
majority of these values are observed for firms at the
end of their lifecycle, where financial performance is
diminishing, and share prices have already collapsed.
Other examples include the first financial year of
firms that listed for the first time, or firms that
underwent financial reorganisation.
Both the
dependent and independent variables are also
winsorised to ± four standard deviations from the
median. The final sample investigated in the
information content tests consists of 316 firms with 2
837 complete observations.
4
Descriptive
Statistics
of
the
Measures and Components Included in
the Information Content Tests
4.1
Measures Included in the Relative
Information Content Tests
The descriptive statistics of the winsorised values of
MktAdjRet, EBEI, CFO, RI, EVAnom, EVAreal, CVAreal
and CFROIMargin included in the relative information
content tests pooled across time are provided in Table
1.
Table 1. Descriptive statistics on the dependent and independent variables in the relative information content
tests of CFROIMargin
Descriptive statistics
Dependent
Variable
MktAdjRet
EBEI
CFO
RI
EVAnom
EVAreal
CVAreal
CFROIMargin
Mean
0.141
0.202
0.297
-0.089
-0.142
-0.135
-0.039
-0.007
Median
0.018
0.125
0.151
0.003
-0.019
-0.007
0.022
-0.002
Std. Dev.
0.761
0.508
0.647
0.495
0.532
0.687
0.698
0.155
CVAreal
CFROIMargin
Correlations
Dependent
Variable
MktAdjRet
EBEI
CFO
RI
EVAnom
EVAreal
MktAdjRet
1.000
EBEI
0.297
1.000
CFO
0.165
0.491
1.000
RI
0.161
0.374
0.018
1.000
EVAnom
0.118
0.261
-0.037
0.909
1.000
EVAreal
0.095
0.229
-0.065
0.747
0.833
1.000
CVAreal
0.121
0.314
0.069
0.687
0.748
0.954
1.000
CFROIMargin
0.186
0.280
0.056
0.418
0.342
0.323
0.317
1.000
Notes:
All the variables are winsorised at ± four standard deviations from the median values. All the independent
variables are size-adjusted by divided them by the market value of the equity as measured three months after the
beginning of the financial year. All correlations are significant at the 1% level, except between CFO, and RI and
EVAnom.
The measures EBEI and CFO exhibit the highest
mean and median values, while the value based
measures display small mean and median values,
which are all close to zero. The lowest mean and
median values are observed for the measure
CFROIMargin.
If the correlations are considered, all are found
to be statistically significant at the 1% level, except
the correlations between CFO, and RI and EVAnom.
The highest correlation between the dependent
variable and an independent variable is observed
between MktAdjRet and EBEI. In the case of
CFROIMargin, the highest correlation is between the
measure and RI (correlation coefficient of 0.418). It
is also interesting to note that the correlation between
MktAdjRet and CFROIMargin is the highest for all the
value based measures.
4.2
Components Included in the
Incremental Information Content Tests
The descriptive data of the winsorised CFROIMargin
components included in the incremental information
content tests pooled across time are provided in Table
2.
The correlations between the majority of the
CFROIMargin components are statistically significant at
the 1% level. The correlation between AccAdj and
InflAdj is significant at the 5% level, while the
correlation between CapChg and Accruals is
significant at the 10% level. Only the correlations
between MktAdjRet and InflAdj, AccAdj and
Accruals, and CFROIAdj and ATInt are not
significant.
5
Relative Information Content Tests
of CFROImargin
The relative information content of the measures
included in this chapter is evaluated by comparing the
adjusted R2 values obtained from seven separate
regressions based on the following equation:
Dt = b0 + b1 Xt / MVEt-1 + b2 Xt-1 / MVEt-1 + et.
(8)
where:
Dt = the market-adjusted return for period t.
X = one of the seven measures CFO, EBEI, RI,
EVAnom, EVAreal, CVAreal and CFROIMargin.
73
MVEt-1 = the market value of the equity three months
after the beginning of the financial year.
The results from the relative information content
tests are provided in Table 3:
Table 2. Descriptive statistics on the dependent and independent variables in the incremental information content
tests of the CFROIMargin components
Descriptive statistics
Dependen
t
Variable
MktAdjRe
CVAAdjrea
t
CFO
Accruals
ATInt
CapChg
AccAdj
InflAdj
l
CFROIAdj
Mean
0.141
0.297
-0.069
0.086
0.378
-0.053
0.009
0.096
0.031
Median
0.018
0.151
-0.022
0.029
0.169
-0.017
0.008
0.038
-0.017
Std. Dev.
0.761
0.647
0.589
0.175
0.650
0.215
0.346
0.195
0.667
Correlations
Dependen
t
Variable
MktAdjRe
t
CVAAdjrea
CFO
Accruals
MktAdjRet
1.000
CFO
0.165***
1.000
Accruals
0.054***
-0.505***
***
ATInt
0.094
CapChg
0.139***
AccAdj
InflAdj
CVAAdjreal
CFROIAdj
-0.068
***
0.004
0.112
***
-0.082
***
0.224
***
0.441***
-0.117
***
-0.078
***
0.446
***
-0.058
***
ATInt
CapChg
AccAdj
InflAdj
l
CFROIAdj
1.000
-0.088***
1.000
-0.035*
0.622***
-0.008
0.052
-0.263
***
-0.089
***
-0.165
***
***
0.208
***
0.561
***
0.012
1.000
-0.228***
0.051
***
0.518
***
0.282
***
1.000
0.040**
1.000
-0.181
***
0.264***
1.000
-0.337
***
-0.617***
-0.259***
1.000
Notes:
All the variables are winsorised at ± four standard deviations from the median values. All the independent variables are
deflated by the market value of the equity as measured three months after the beginning of the financial year.
***
Significant at the 1% level
**
*
Panel A of Table 3 contains the adjusted R2
values calculated for the seven separate regressions.
The measures are arranged in decreasing order based
on their adjusted R2 values. EBEI has a significantly
higher adjusted R2 value (0.0773) than the other
measures. The regression analysis based on the
CFROIMargin values yields the second largest adjusted
R2 value (0.0438). It is followed by RI (0.0375), CFO
(0.0319), EVAnom (0.0305), EVAreal (0.0139) and
CVAreal (0.0138) correspondingly.
In terms of
relative information content, EBEI appears to
outperform the other measures. In terms of the value
based financial measures, CFROIMargin yields the best
results.
According to Hayn (1995: 127), Burgstahler and
Dichev (1997: 192) and Collins, Pincus and Xie
74
(1997) profitable firms exhibit larger earnings
responses than loss-making firms. O‘Byrne (1997:
51) also recommends a distinction between positive
and negative EVA values. The tests for relative
information content are repeated after allowing
different coefficients for the positive and negative
values of the different measures. The results from
these regressions are provided in Panel B of Table 3.
All the measures exhibit higher adjusted R2 values.
The measure RI experienced the largest increase in its
adjusted R2 value (0.0375 to 0.1126), and it exhibits
the highest adjusted R2 value overall when compared
to the other measures. It is followed by EBEI
(0.0886), EVAnom (0.0855), EVAreal (0.0635), CVAreal
(0.0597) and CFO (0.0472) respectively.
Table 3. Tests of the relative information content of CFROIMargin, CVAreal, EVAreal, EVAnom, residual
income, earnings and operating cash flow
Relative information content
Rank
order of
R
2
Observatio
ns
(1)
(2)
(3)
(4)
(5)
(6)
Panel A: Coefficient of the positive and negative values of each performance measure constrained to be equal
(7)
a
CFROIMargi
All firms
2450
Adj. R2
EBEI
>
0.0773
n
>
0.0430
RI
>
0.0375
CFO
>
0.0319
EVAnom
>
0.0305
Panel B: Coefficient of positive and negative values of each performance measure allowed to differ
EVAreal
>
0.0139
0.0138
b
EVAno
All firms
Adj. R2
2450
RI
0.1126
>
EBEI
0.0886
>
m
0.0855
CVAreal
CFROIMargi
>
EVAreal
0.0635
>
CVAreal
0.0597
>
CFO
0.0472
>
n
0.0429
Notes:
a
In Panel A, the regression based on Equation (8) is conducted, where: Dt = b0 + b1 Xt / MVEt-1 + b2 Xt-1 / MVEt-1 + et. Dt
is the market-adjusted return for period t, X is one of the seven measures CFO, EBEI, RI, EVAnom, EVAreal, CVAreal and
CFROIMargin, and MVE is the market value of the equity three months after the beginning of the financial year.
b
In Panel B, the regression used in Panel A is adjusted to allow different coefficients for positive and negative values of
the independent variable: The regression based on the following equation is conducted, where: Dt = c0 + c1 Xt;pos / MVEt1 + c2 Xt;neg / MVEt-1 + c3 Xt-1;pos / MVEt-1 + c4 Xt-1;neg / MVEt-1 + et. Dt is the market-adjusted return for period t, X is one
of the seven measures CFO, EBEI, RI, EVAnom, EVAreal, CVAreal and CFROIMargin, and MVE is the market value of the
equity three months after the beginning of the financial year.
In the case of CFROIMargin, however, the
measure dropped from the second to the last position
overall in terms of the ranking of the adjusted R2
values. It is also the only measure where the adjusted
R2 value decreased when the distinction between
positive and negative values is allowed. A possible
reason for this decrease could be the variable nature
of the CFROI values. The cash flows included in the
calculation of a firm‘s CFROI values are estimated
based on the firm‘s profit figures. Relatively small
changes in the profit figures, however, could result in
CFROI values switching from a positive to a negative
value (and vice versa). These changes are not the
result of a pronounced difference in the firm‘s
financial performance, but rather the way in which
CFROI values (and IRR measures in general) are
calculated. Distinguishing between the positive and
negative values of the measure therefore reduces the
adjusted R2 value of the regression analysis.
6
Incremental Information Content
Tests Of The CFROImargin Components
contents of the CFROIMargin components, the
following regression analysis is conducted:
MktAdjRett = d0 + d1 CFOt / MVEt-1 + d2 CFOt-1 /
MVEt-1 + d3 Accrualt / MVEt-1 + d4 Accrualt-1 / MVEt1 + d5 ATIntt / MVEt-1 + d6 ATIntt-1 / MVEt-1 + d7
CapChgt / MVEt-1 + d8 CapChgt-1 / MVEt-1 + d9
AcctAdjt / MVEt-1 + d10 AcctAdjt-1 / MVEt-1 + d11
InflAdjt / MVEt-1 + d12 InflAdjt-1 / MVEt-1 + d13
CVAAdjreal; t / MVEt-1 + d14 CVAAdjreal; t-1 / MVEt-1+
d15 CFROIAdjt / MVEt-1 + d16 CFROIAdjt-1 / MVEt-1 +
(9)
The results of the incremental information
content tests of the CFROIMargin components are
provided in Table 4.
If the results from the incremental information
content tests are considered, it is observed that the
regression coefficients of all the current year‘s CFROI Margin
components except InflAdj are highly significant. If the
previous year‘s variables are considered, only the
correlation coefficient of ATIntt-1 is significant. The Fstatistic for the component InflAdj is not statistically
significant, indicating that it does not contribute significant
information content. The other F-statistics, however, are
all significant, indicating that the remaining CFROI
components contain statistically significant incremental
information content.
The adjusted R2 value for the multiple regression
analysis conducted to evaluate the incremental information
content of the CFROIMargin components in this study,
however, is much lower than the values obtained in
previous studies investigating the measures EVAreal,
CVAnom and CVAreal. An adjusted R2 value of 0.0628 is
observed in the case of the CFROIMargin components,
compared to values of 0.1861, 0.1880 and 0.1995
(respectively) when the components of the other measures
are investigated (Erasmus, 2008).
Although the
incremental information content of the CFROIMargin
75
components are statistically significant, it explains less of
the variation in the market adjusted share returns.
Table 4. Tests of incremental information content of CFROI Margin components: CFO, operating accruals, after-tax
interest, capital charge, accounting adjustments, inflation adjustments, real cash value added adjustments and
CFROI adjustments
All firms a
2450
0.060
0.218
-0.029
0.134
-0.048
-0.442
0.700
0.186
-0.101
-0.302
0.011
-0.154
0.030
-0.471
0.253
-0.208
0.042
t-stat
F-stat
p-value b
Observations
Constant
3.35***
CFOt
5.12***
13.36
<0.0001
CFOt-1
-0.62
Accrualt
3.46***
5.97
0.0026
Accrualt-1
-1.14
ATIntt
-2.43**
7.26
0.0007
ATIntt-1
3.79***
***
CapChgt
2.68
3.63
0.0265
CapChgt-1
-1.49
AccAdjt
-3.25***
5.51
0.0041
AccAdjt-1
0.12
InflAdjt
-1.94*
1.99
0.1364
InflAdjt-1
0.37
***
CVAAdjt
-3.02
4.82
0.0082
CVAAdjt-1
1.55
CFROIAdjt
-3.81***
7.39
0.0006
CFROIAdjt-1
0.72
Notes:
a
The regression based on the following equation is conducted: MktAdjRett = d0 + d1 CFOt / MVEt-1 +
d2 CFOt-1 / MVEt-1 + d3 Accrualt / MVEt-1 + d4 Accrualt-1 / MVEt-1 + d5 ATIntt / MVEt-1 +
d6 ATIntt-1 / MVEt-1 + d7 CapChgt / MVEt-1 + d8 CapChgt-1 / MVEt-1 + d9 AcctAdjt / MVEt-1 +
d10 AcctAdjt-1 / MVEt-1 + d11 InflAdjt / MVEt-1 + d12 InflAdjt-1 / MVEt-1 + d13 CVAAdjt / MVEt-1 +
d14 CVAAdjt-1 / MVEt-1 + d15 CFROIAdjt / MVEt-1 + d16 CFROIAdjt-1 / MVEt-1 + et. Dt is the market-adjusted return for
period t, while the independent variables are the CFROI Margin components (CFO, accruals, after-tax finance cost, capital
charge, accounting adjustments, inflation adjustments and cash value added adjustments). MVE is the market value of
equity three months after the start of the financial year.
b
p-values in parentheses represent non-directional F-test of the null hypothesis of no incremental
information content (Hypothesis HINC)
***
**
*
7
Summary
The value-based financial performance measures
economic value added (EVA), cash value added
(CVA) and cash flow return on investment (CFROI)
are proposed by certain research studies as
improvements over the traditional financial measures.
The objective of this paper was to evaluate the
relative and incremental information content of these
value-based measures compared to that of the
traditional measures earnings and cash from
operations. When the relative information contents of
the different value-based financial performance
measures are investigated, the results indicate that
they are not able to outperform earnings (EBEI) in
explaining market adjusted share returns. The results
from the incremental information content tests
indicate that the adjustments required in order to
calculate the various value-based measures do
contribute statistically significant incremental
information content. If the adjusted R2 values of the
76
multiple regression analyses conducted to evaluate the
incremental information content of the value-based
measures are compared to the adjusted R2 values
obtained for the traditional measures, however, a
much lower value is observed. The components of
the value-based measures therefore explain
significantly less of the variation in market adjusted
share returns than the components of the other
measures.
Although the contributions of these
components are statistically significant, they are not
economically significant when combined into the
various measures. Based on the results reported in this
study it appears as if the value based measures are not
able to outperform the relatively simple traditional
financial performance measure earnings (EBEI) in
explaining the variation in market adjusted share
returns. The incremental information content tests
conducted to evaluate the contribution of the
components of the value-based measures also yield
much lower results than for similar tests conducted
for the traditional measures.
References
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Thakor, A.V. (1997). The search for the best
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wealth. New York: John Wiley & Sons.
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information content of the value based financial
performance measure cash value added (CVA).
Management Dynamics, 17(2), (Forthcoming).
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Frank J. Fabozzi Associates.
10. Grant, J.L. (2003). Foundations of economic value
added (2nd ed.). Hoboken, New Jersey: John Wiley
and Sons.
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investment managers.
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MVA as performance measures and signals for
strategic change. Strategy and Leadership, 24(3), 3440.
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system approach to valuing the firm.
Boston:
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management: The corporate response to the
shareholder revolution. Boston: Harvard Business
School Press.
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of Applied Corporate Finance, 12(2), 92-96.
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Journal of Applied Corporate Finance, 9(1), 116-125.
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performance and measures of value added.
Charlottesville: The Research Foundation of The
Institute of Chartered Financial Analysts.
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Journal of Applied Corporate Finance, 7(2), 71-84.
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EVATM management guide.
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evidence considering the information content of
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value-based management: A practical guide to
implementation. New York: McGraw Hill.
77
MIGRATION TO ―NOVO MERCADO‖: DOES IT REALLY MEAN
IMPROVEMENT OF CORPORATE GOVERNANCE PRACTICES?
Andre Carvalhal*, Guilherme Quental**
Abstract
One of the most significant changes regarding the adoption of better corporate governance was the
creation of special trading segments, which impose tighter disclosure rules and listing requirements.
Most literature on the special trading segments focused on the European markets. Not much is known,
however, about the Brazilian “Novo Mercado” (NM). While most European new markets have failed to
attract IPOs and investors, NM has grown fast and reached 35% of the total number of listed companies
and 57% of the market capitalization of the Sao Paulo stock exchange. Despite its success, no research
has examined whether firms that list on NM really improve their corporate governance practices.
Further, there is no empirical evidence whether there is a reward for companies that list on NM without
improving governance practices. This paper addresses this question by investigating the stock market
reaction to the listing on NM without improving governance practices. We provide evidence that firms
that list on NM and improve governance practices earn positive abnormal returns, have higher liquidity
and lower volatility. On the other hand, firms that list on NM without improving governance practices
do not earn positive returns, but are rewarded with higher liquidity and lower volatility.
Keywords: Novo Mercado, corporate governance, valuation, liquidity, volatility, Brazil
*Coppead Graduate School of Business, Federal University of Rio de Janeiro (UFRJ), Rua Pascoal Lemme, 355 - Ilha do
Fundao, 21941-918 - Rio de Janeiro – RJ – Brazil, Tel.: (55-21) 2598-9878
Fax: (55-21) 2598-9872, E-mail: andrec@coppead.ufrj.br
**Coppead Graduate School of Business, Federal University of Rio de Janeiro (UFRJ), Rua Pascoal Lemme, 355 - Ilha
do Fundao, 21941-918 - Rio de Janeiro – RJ - Brazil
Tel.: (55-21) 2598-9878, Fax: (55-21) 2598-9872, E-mail: gquental@gmail.com
1. Introduction
Corporate governance has attracted considerable
attention following recent corporate scandals in
developed and developing countries. For the most
part, the literature compares corporate governance
mechanisms and standards among countries. La Porta
et al. (1997, 1998) examine the content and the
development of legal institutions in different
countries, and conclude that the common law systems
offer greater protection against managerial abuse than
do civil law systems.
Although most research on corporate governance
has been cross-country, more recent studies, such as
Klapper and Love (2004) and Gompers et al. (2003),
have shown that corporate governance choices can
vary a lot across firms within a country. Further,
recent research highlights the importance of corporate
governance and suggests empirical relation between
governance and corporate performance. Results
indicate that better corporate governance is associated
to better performance and higher corporate valuation.
La Porta et al. (1998, 2000, 2002) provide evidence
that better shareholder protection is associated with
higher valuation of corporate assets and with more
developed and valuable financial markets. When the
shareholders´ rights are better protected by the law,
78
outside investors are willing to pay more for financial
assets such as equity and debt.
One of the most significant changes of 1990s
regarding the adoption of better corporate governance
was the creation of special trading segments, such as
the ―Neuer Markt‖ (Germany), ―Nouveau Marché‖
(France), ―TechMark‖ (UK), ―Nuovo Mercato‖
(Italy), ―Novo Mercado‖ (Brazil), among others. An
important characteristic of these segments is that they
impose tighter disclosure rules and listing
requirements.
Most literature on the special trading segments
focused on the European markets. Not much is
known, however, about the Brazilian ―Novo
Mercado‖ (NM). The difference between the NM and
the European special segments is that the latter have
been designed to attract companies from fast-growing
markets and high tech areas, while the Brazilian NM
places no restriction on the field of activity, nor is
reserved for small companies. While most European
new markets have failed to attract IPOs and investors,
NM has grown fast and reached 35% of the total
number of listed companies and 57% of the market
capitalization of the Sao Paulo stock exchange.
Despite its huge success, only a few articles have
studied the Brazilian NM. Chavez and Silva (2006)
analyze the market price reaction and liquidity impact
of the firm‘s listing on NM and find significant
enhancement of stock return and liquidity. In a similar
study, Carvalho and Pennacchi (2006) provide
evidence that the listing on NM brings positive
abnormal returns, and an increase in share trading
volume.
Despite the trend on the study of the NM, no
research examines whether firms that list on NM
really improve their corporate governance practices.
Further, there is no empirical evidence whether there
is a reward for companies that list on NM without
improving governance practices. This paper addresses
this question by investigating the stock market
reaction to the listing on NM without improving
governance practices. We provide evidence that firms
that list on NM and improve governance practices
earn positive abnormal returns, have higher liquidity
and lower volatility. On the other hand, firms that list
on NM without improving governance practices do
not earn positive returns, but are rewarded with higher
liquidity and lower volatility.
This paper contributes to our understanding of
corporate governance in the following ways. First, it
adds to the scant literature on the Brazilian NM.
Brazil offers a unique case study given the prevalence
of a weak legal environment (La Porta et al. (1998))
and the presence of the NM, on which firms of
different sectors voluntarily decide to offer high
standards of transparency as well as better corporate
governance practices. Second, this paper examines
whether companies that do not improve governance
practices benefit from the listing on NM.
The paper is structured as follows. Section 2
shows the main studies on special listing segments
with enhanced corporate governance practices.
Section 3 provides the main characteristics of the
Brazilian market and NM. Section 4 describes the
data, methodology and contains the empirical results.
Section 5 discusses our findings and concludes.
2. Corporate Governance and Special
Listing Segments
Recent studies suggest that the Berle and Means
(1932) model of widely dispersed ownership is not
common even in developed countries. In fact, La
Porta et al. (1999) show that large shareholders
control a significant number of firms in the wealthier
countries as well. Moreover, the country legal
institutions differ from one another with respect to the
protections that they afford to shareholders. La Porta
et al. (1997, 1998) provide evidence that shareholder
protection is greater in common law systems when
compared to civil law regimes.
There have been efforts by countries with weak
corporate governance toward higher transparency and
better shareholder rights either by enacting legislation
reform or by creating new listing segments. Shleifer
and Wolfenzon (2002) argue that legal reform is
generally slow, because it faces political opposition
from controlling shareholders. Further, when the
legislation change passes, it is mandatory for all
public companies, so that the differentiation across
firms is lower when compared to voluntary actions
toward better corporate governance practices.
The other significant approach is the creation of
special trading segments with enhanced corporate
governance standards. Chavez and Silva (2006) show
that the differentiation signal is clear and more visible
when compared to legislation reform, because the
firm voluntarily chooses to list on the special
segment. Most importantly, a voluntarily set of better
corporate governance practices should induce a selfselection of valuable firms and overcome the
asymmetric
information
problems
between
controlling and minority shareholders.
Enhanced governance through voluntarily listing
on special segments should be characterized by better
performance, higher corporate valuation and lower
risk. This is consistent with La Porta et al. (1998,
2000, 2002), who document that investors would be
willing to pay more for financial assets when their
rights are better protected and the risk of
expropriation is lower. Further, Brockman and Chung
(2003) argue that better corporate governance
practices should enhance market liquidity.
focused on the European markets created in the 1990s
to attract companies from fast-growing markets and
high tech areas, such as the ―Neuer Markt‖
(Germany),
―Nouveau
Marché‖
(France),
―TechMark‖ (UK), and ―Nuovo Mercato‖ (Italy).
While most European new markets have failed1, the
Brazilian ―Novo Mercado‖ (NM) has developed
significantly.
However, only a few studies have analyzed the
Brazilian NM. Chavez and Silva (2006) and Carvalho
and Pennacchi (2006) provide evidence that listing on
NM enhances firm valuation and liquidity.
Nevertheless, none of them examine whether firms
improve their corporate governance practices when
they migrate to NM. This paper fills this gap and
investigates the stock market reaction to the listing on
NM without improving governance practices.
3. The Brazilian Corporate Market and the
―Novo Mercado‖
As shown by La Porta et al. (1998), the Brazilian
legal system follows the French code tradition and
seems to offer less protection to investors, both with
regard to the written laws and their enforcement. The
main characteristics of the Brazilian market are stated
by the Law 6404/76 (―Law of Corporations‖), which
had important amendments in 1997 and in 2001.
In Brazil, companies are allowed to issue nonvoting shares in an amount up to two-thirds of the
total capital2, which means that the control of a
company can be guaranteed with only one-sixth of its
total capital. In fact, the control can be kept with
much less than one-sixth of total capital through the
use of pyramidal structures.
79
Besides the voting rights, another difference
between voting and non-voting shares is the
mandatory bid rule for voting shares in the case of a
control transfer. This rule implies that the acquirer of
the control block is also obliged to offer minority
shareholders the same (or partially the same) price for
their shares. The Brazilian law establishes the
mandatory bid rule only for voting shares for at least
80% of the control block price.
The NM was created by the Sao Paulo stock
exchange (Bovespa) in 2000 and consists of three
listing segments: Level 1, Level 2 and Level 33. These
segments are designed for companies that voluntarily
decide to offer high standards of disclosure and
transparency, as well as better corporate governance
practices. The main objective of the NM levels is to
provide investors with corporate governance rights
beyond what is legally required. What distinguishes
the three levels is the adherence to the practices and
the degree of commitment assumed by the company.
The Level 1 requires that the companies improve
their methods of disclosure and increase the
dispersion of their shares. The main practices required
for the Level 1 are: maintenance of a free-float of at
least 25% of the capital; public offerings with
mechanisms to facilitate capital dispersion; disclosure
of consolidated financial statements and special audit
revision; monthly disclosure of trades of stocks by the
controlling shareholders and management; and
disclosure of an annual calendar of corporate events.
To be classified on Level 2, the company must
adopt all the obligations of Level 1 and a much
broader range of corporate governance practices: a
two-year unified mandate for the entire board of
directors, which must have at least 5 members, 20%
of whom must be independent; disclosure of annual
balance sheet according to the US GAAP or IFRS;
mandatory bid rule for voting shares at 100% of the
control block price; mandatory bid rule for non-voting
shares at 80% of the control block price; voting rights
granted to non-voting shares in relevant decisions
such as incorporation, spin-off, merger, and approval
of contracts between related parties; and admission to
the arbitration for resolution of corporate disputes.
To be listed on Level 3, the company is required
to adopt all the obligations of Level 1 and 2 and issue
only voting shares. Therefore, what distinguishes
Level 2 from Level 3 is the prohibition of non-voting
shares in the company‘s capital structure.
In July 2007, the NM reached 35% of the total
number of listed companies and 57% of the market
capitalization of the Bovespa. The performance of
these companies can measured by the evolution of the
IGC (Special Corporate Governance Stock Index),
designed to measure the return of a portfolio
composed of companies with good corporate
governance practices4. From its creation in June 2001
to July 2007, the IGC had a total return of 537%,
significantly higher than the Ibovespa5 return of
273%.
80
4. Empirical Analysis
4.1. Data
Our sample includes all firms that have migrated to
NM as of June 2006. We exclude companies with
incomplete or unavailable information and firms that
had no trade on the Sao Paulo stock exchange during
the 12 months before the migration to NM. The final
sample consists of 28 firms, distributed as follow: 20
on Level 1, 4 on Level 2, and 4 on Level 3.
Most of the data come from the Economatica, a
financial database that contains a wide coverage of
Brazilian stock market data, and Datastream. The
information on the corporate governance provisions
comes from the Brazilian Securities and Exchange
Commission (CVM), and the dates on which the firms
listed on NM are gathered from the Bovespa and the
provider of news Factiva.
4.2. Event Study for Abnormal Returns
We perform an event study to determine the return
reaction when the firm decides to migrate to NM. The
event study methodology requires the precise
identification of the event date. The problem in
performing an event study in the case of migration to
NM is that the event date does not necessarily
coincide with the date on which the information about
the migration become publicly available, because
firms may discuss over time with their shareholders
and market participants about the possibility of
migrating to NM.
Since the migration must be approved in a
shareholders‘ meeting, we consider two event dates:
the date on which the call for the shareholders‘
meeting becomes publicly available, and the date on
which the shareholders approve the migration.
To calculate the abnormal returns, we estimate
the market model using the Sao Paulo stock exchange
index and a 250-day estimation window from trading
day –255 to –6 relative to the event date (t=0)6. We
use an 11-day event window (t-5 to t+5) to allow for
information about the migration to be leaked in
advance or to have a slow effect on the stock prices.
On a particular day t, the abnormal return ARt is
defined as the stock return in excess of its expected
return calculated from the market model. For a multiday announcement window [t1 to t2], a cumulative
abnormal return CAR [t1 to t2] is defined as the sum of
the time-series of ARt within the event window.
Cumulative abnormal returns over days -1 to +1
(CAR [-1,+1]), -5 to +1 (CAR [-5,+1]), and -5 to +5
(CAR [-5,+5]) are calculated around the event date for
each share.
There are 8 (out of 28) overlapping and thus
non-independent event dates, which cause the partial
clustering of event windows. Since the cross-sectional
dependence in the data may cause downward bias in
the standard error (see Bernard (1987)), the results
assuming cross-sectional independence should be
interpreted cautiously. Therefore, due to event
clustering and possible event-induced volatility, we
compute a bootstrap p-value (see Boehmer,
Musumeci, and Poulsen (1991), and Aktas, DeBodt,
and Roll (2004)). We re-sample from non-clustered
abnormal returns in order to find the distribution of
the t-statistic assuming independent observations.
Then, we determine the p-value by the location of the
observed average abnormal return within the
bootstrapped distribution7.
The results of the event study are shown in Table
1. There are significantly positive abnormal returns
when the firms call the shareholders‘ meeting and
when the migration is approved. Although the AR0 is
not statistically significant, the cumulative abnormal
returns (ranging from 1.95% to 4.62%) are significant
in both statistical and economical terms.
We can note that the market reacts to both the
call for the shareholders‘ meeting and the
shareholders‘ meeting itself. One possible explanation
is that, although the call for a shareholder‘s meeting
does not necessarily mean that the migration is going
to be approved in the shareholders‘ meeting, it
conveys information about the probability of the
approval.
It is important to note that, since the control is
highly concentrated in most Brazilian companies, the
controlling shareholder must agree to migrate to NM.
Since the shareholders‘ meeting is called by the Board
of Directors, which is generally composed of
corporate insiders and controlling shareholders, the
inclusion of the migration to NM in the agenda of a
shareholders‘ meeting may imply that the probability
of approval by the controlling shareholder is high.
4.3. Regression Analysis of Liquidity and
Volatility
We now run regressions to analyze the effect of the
migration to NM on the share liquidity and volatility.
In our models, the liquidity (volatility) of share i in
day t depends on the liquidity (volatility) of share i in
day t-1, and on the liquidity (volatility) of the market
index in day t. The following regressions are
specified:
Voli,t = 0 + 1Voli,t-1 + 2Volm,t + 3NMi,t + 4NMi,t x
Voli,t-1 + 5NMi,t x Volm,t + i,t
Liqi,t = 0 + 1Liqi,t-1 + 2Liqm,t + 3NMi,t + 4NMi,t x
Liqi,t-1 + 5NMi,t x Liqm,t + i,t
where Voli,t is the volatility (annualized standard
deviation of daily returns in the last 250 trading days)
of share i in day t, Liqi,t is the liquidity (trading
volume throughout the previous 250 trading days
relative to the total market value of the firm) of share i
in day t, Volm,t is the volatility of the market index in
day t, Liqm,t is the liquidity of the market index in day
t, and NMi,t is a dummy variable that takes the value 1
if the firm i migrates to NM in day t,  and  are error
terms.
The results of the analysis of the liquidity and
volatility are shown in Table 2 and 3, respectively.
Table 2 indicates that the current share liquidity
depends strongly on the previous share liquidity. The
liquidity of the market does not seem to affect the
share liquidity. Most importantly, there is a strong
increase in the liquidity when the firms announces
and approves the migration to NM.
Table 3 indicates that the current share volatility
depends on the previous share volatility, and on the
current volatility of the market. Further, there is a
significant decrease in the volatility when the firms
announces and approves the migration to NM.
Overall, our results for the regression analysis provide
evidence that the migration to NM is positively
(negatively) related to the share liquidity (volatility).
4.4. Migration to NM and
Improvement of Corporate
Governance Practices
In Brazil, although all companies are subject to the
same legislation, their corporate governance practices
can differ substantially since corporate charter
provisions can establish additional rights for minority
shareholders. In order to measure the quality of the
firm‘s corporate governance practices before and after
the migration to NM, we use the corporate
governance index (CGI) developed by Leal and
Carvalhal (2007), who use an approach that has
recently become very popular in the literature (Black
et al. (2006), Klapper and Love (2004), and Gompers
et al. (2003)).
The index is composed of 15 questions. If the
answer is ―yes‖ to any given question they interpret it
as a pro-shareholder provision or action and attribute
it the value of 1. The negative answers get a null
value. The index is the simple sum of the values
assigned to each question. The questions are grouped
in four dimensions: disclosure, board composition and
functioning, ethics and conflicts of interest, and
shareholder‘s rights. The detailed description of the
CGI is presented in the appendix
Firms are divided into two groups: firms that do
and do not improve corporate governance practices
after the migration to NM. Table 4 shows whether
corporate governance practices are improved after the
migration for companies in all three NM levels. Most
companies (16 out of 20) that migrated to Level 1
have not changed their practices. Only two of them
have improved 1 point in the CGI, while two firms
have had a decrease of 1 point in the CGI. The
average CGI was 7.20 before the migration and
remained at 7.20 after the migration. On the other
hand, the CGI has increased substantially for the
companies that have migrated to Level 2 (from 6.25
to 10.00, an average increase of 3.75) and Level 3
(from 7.75 to 13.25, an average increase of 5.50). As
expected, the CGI increases more for Levels 2 and 3,
which require a much broader range of corporate
governance practices.
81
Table 5 shows the event study for abnormal
returns classifying the firms according to the
improvement (or not) of corporate governance
practices. The results indicate that the cumulative
abnormal returns (ranging from 3.00% to 7.04%) are
significantly positive for firms that improve the
governance practices (all the results are statistically
significant at 1%). In contrast, there are no abnormal
returns for firms that do not improve governance
practices. This result is consistent with a positive
relation between better corporate governance and
higher performance (La Porta et al. (1998, 2000,
2002)). Although the firms migrate to NM, their
governance practices do not improve, so there should
be no reward in terms of positive abnormal returns.
The results of the regression analysis for the
share liquidity and volatility are shown in Table 6 and
7, respectively. The results indicate that the share
liquidity (volatility) increases (decreases) for firms
that do and do not improve corporate governance
practices. These results are consistent with those of
Tables 2 and 3. Contrary to the abnormal return
analysis, there is an enhancement of liquidity and
decrease of volatility even for firms that migrate to
NM without improving governance practices.
There are two possible explanations. Although
the firms do not improve governance practices, they
must provide higher liquidity for their shares in order
to list on NM, which requires a free-float of at least
25% of the capital. Moreover, the migration to NM
implies that the firm´s commitment to governance
practices increases, because the stock exchange will
act as a certifier agent. A migrating firm‘s
commitment to improved information disclosure
would tend to reduce information asymmetries
between the firm (and its controlling shareholders)
and minority investors. Thus, minority investors are
less likely to be expropriated, thereby decreasing the
volatility.
Overall, our results show that there are positive
abnormal returns for firms that migrate to NM and
improve the governance practices. As expected, there
is no reward for firms that do not improve governance
practices. Further, we provide evidence that there is
an enhancement of liquidity and decrease of volatility
for firms that migrate to NM, even for those that do
not improve governance practices.
5. Conclusion
There have been efforts by countries with weak
corporate governance regimes toward higher
transparency and better shareholder rights by creating
new listing segments with enhanced corporate
governance standards. The voluntary migration to the
special governance segments should be characterized
by better performance, higher liquidity and lower risk,
because investors would be willing to pay more for
financial assets when their rights are more protected
and the risk of expropriation is lower.
82
focused on the European markets. Not much is
known, however, about the Brazilian ―Novo
Mercado‖ (NM), which, in contrast to most European
new markets, is not designed to attract companies
from fast-growing markets and high tech areas.
Further, there is no empirical evidence whether there
is a reward for companies that list on NM without
improving governance practices.
This paper addresses this question by
investigating the stock market reaction to the listing
on NM without improving governance practices. We
provide evidence that firms that list on NM and
improve governance practices earn positive abnormal
returns, have higher liquidity and lower volatility. On
the other hand, firms that list on NM without
improving governance practices do not earn positive
returns, but are rewarded with higher liquidity and
lower volatility.
References
1.
Aktas, N., De Bodt, E, Roll, R. (2004) Market
Response to European Regulation of Business
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Analysis, 39, 731-757.
2. Berle, A., Means, G. (1932) The Modern Corporation
and Private Property, New York: MacMillan.
3. Bernard, V. (1987) Cross-Sectional Dependence and
Problems in Inference in Market-Based Accounting
Research, Journal of Accounting Research, 25, 1-48.
4. Boehmer, E., Musumeci, J., Poulsen, A. (1991) EventStudy Methodology Under Conditions of EventInduced Variance, Journal of Financial Economics,
30, 253-272.
5. Brockman, P., Chung, D. (2003) Investor Protection
and Firm Liquidity, Journal of Finance, 58, 921-937.
6. Black, B., Jang, H., Kim, W. (2006) Does Corporate
Governance Affect Firms' Market Values? Evidence
from Korea, Journal of Law, Economics and
Organization, 22, 366-413.
7. Campbell, J., Lo, A., Mackinlay, A. (1997) The
Econometrics of Financial Markets, Princeton:
Princeton University Press.
8. Chavez, G., Silva, A. (2006) Improved Corporate
Governance: Market Reaction and Liquidity
Implications, Instituto de Empresa Working Paper,
06-08.
9. Carvalho, A., Pennacchi, G. (2006) Can Voluntary
Market Reforms Promote Efficient Corporate
Governance? Evidence from Firms' Migration to
Premium Markets in Brazil, in Proceeding of the VI
Brazilian Finance Conference, Rio de Janeiro.
10. Goergen, M., Khurshed, A., McCahery, J.,
Renneboog, L. (2003) The Rise and Fall of the
European New Markets: on the Short- and Long-Run
Performance of High-Tech Initial Public Offerings, in
McCahery, J., Renneboog, L. (eds), Venture Capital
Contracting and the Valuation of High Technology
Firms, Oxford University Press.
11. Gompers, P., Ishii, J., Metrick, A. (2003) Corporate
Governance and Equity Prices, Quarterly Journal of
Economics, 118, 107-155.
12. Klapper, L., Love, I. (2004) Corporate Governance,
Investor Protection, and Performance in Emerging
Markets, Journal of Corporate Finance, 10, 703-728.
13. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. (1999)
Corporate Ownership Around the World, Journal of
Finance, 54, 471-518.
14. La Porta, R., Lopez-de-Silanes, F., Shleifer, A.,
Vishny, R. (1997) Legal Determinants of External
Finance, Journal of Finance, 52, 1131-1150.
15. ________ (1998) Law and Finance, Journal of
Political Economy, 106, 1113-1155.
16. ________ (2000) Investor Protection and Corporate
Governance, Journal of Financial Economics, 58, 328.
17. ________ (2002) Investor Protection and Corporate
Valuation, Journal of Finance, 57, 1147-1170.
18. Leal, R., Carvalhal, A. (2007) Corporate Governance
and Value in Brazil (and in Chile). In: Chong, A.,
Lopes-de-Silanes, F. (eds). Investor Protection and
Corporate Governance: Firm-Level Evidence Across
Latin America. Palo Alto: Stanford University Press.
19. Schipper, K., Thompson, R. (1983) The Impact of
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and Equity Markets, Journal of Financial Economics,
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Endnotes
1
See Goergen et al. (2003) for a study about the rise and
fall of the European new markets. It is interesting to note
that the German ―Neuer Markt‖ gave way to the Prime
Standard segment, which requires transparency standards
higher than those regulated by law, but, similar to the
Brazilian NM, is not restricted to small and medium size
firms in high-growth industries.
2
In 2001, the law changed the maximum amount of nonvoting shares to 50% of total capital, but this rule is
mandatory only to non-public firms that decide to go public
after the law.
3
The Level 3 is called the ―Novo Mercado‖. In this paper,
we consider that all three governance levels are part of the
NM, so that we can analyze the market reaction to the
listing on each NM level separately.
4
Such companies should be traded on Levels 1, 2 or 3. The
shares are weighted according to their respective market
values and by a governance factor, which is equal to 2
(Level 3), 1.5 (Level 2), and 1 (Level 1).
5
The Ibovespa is the main indicator of the Brazilian stock
market performance.
6
We also use the constant-mean-return model (see
Campbell, Lo, and MacKinlay (1997)) to analyze the
potential biases of our results. The results (not reported, but
available upon request) are essentially identical to those
obtained using the market model.
7
Alternatively, we use the approach developed by Schipper
and Thompson (1983, 1985) and analyze the abnormal
returns using unaggregated security-by-security data. While
not reported in this paper, the results, although weaker,
yield similar conclusions.
Appendices
Table 1. Abnormal Returns and Migration to NM
Abnormal returns of firms that migrate to NM. Two event dates are considered: the date on which the call for the
shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The
abnormal returns are estimated through the market model using a 250-day estimation window. Abnormal returns during the
event date (AR0) and cumulative abnormal returns over days -1 to +1 (CAR [-1,+1]), -5 to +1 (CAR [-5,+1]), and -5 to +5
(CAR [-5,+5]) are calculated. Bootstrap p-values (in parentheses) account for event clustering and event-induced volatility.
***, **, * denote statistical significance at the 1%, 5% and 10%, respectively.
Event
Abnormal Returns
AR0
CAR [-1,1]
CAR [-3,3]
CAR [-5,5]
Call for the
Shareholders‘
Meeting
0.18
(0.70)
1.95%**
(0.02)
2.20%**
(0.02)
4.62%***
(0.00)
Shareholders‘
Meeting
0.37
(0.47)
2.19%**
(0.02)
2.20**
(0.03)
3.41%**
(0.05)
83
Table 2. Liquidity and Migration to NM
The dependent variable in each regression is the liquidity (Liq), measured as the trading volume throughout the previous 250
trading days relative to the total market value of the firm. Liqm is the liquidity of the market index, and NM is a dummy
variable that takes the value 1 after the firm migrates to NM. Two dates are considered: the date on which the call for the
shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The pvalues are shown in parentheses. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively.
Variables
Liqt-1
Liqm,t
NM
NM x Liqt-1
NM x Liqm,t
Adjusted R2
Call for the
Shareholders‘
Meeting
0.54***
(0.00)
0.01*
(0.10)
-0.07
(0.75)
0.08***
(0.00)
0.00
(0.52)
0.33
Event
Shareholders‘
Meeting
0.52***
(0.00)
0.00
(0.41)
-0.02
(0.30)
0.10***
(0.00)
0.00
(0.69)
0.32
Table 3. Volatility and Migration to NM
The dependent variable in each regression is the volatility (Vol), measured as the annualized standard deviation of daily
returns in the last 250 trading days. Volm is the volatility of the market index, and NM is a dummy variable that takes the value
1 after the firm migrates to NM. Two dates are considered: the date on which the call for the shareholders‘ meeting becomes
publicly available, and the date on which the shareholders approve the migration. The p-values are shown in parentheses. ***,
**, * denote statistical significance at the 1%, 5% and 10%, respectively.
Variables
Volt-1
Volm,t
NM
NM x Volt-1
NM x Volm,t
Adjusted R2
Call for the
Shareholders‘
Meeting
0.19***
(0.00)
0.54***
(0.00)
-0.01***
(0.01)
0.01
(0.57)
0.06
(0.16)
0.09
Event
Shareholders‘
Meeting
0.19***
(0.00)
0.55***
(0.00)
-0.01***
(0.01)
0.00
(0.94)
0.06
(0.20)
0.09
Table 4. Improvement of Corporate Governance Practices and Migration to NM
List of firms that migrate to NM, and quality of corporate governance practices before and after the migration to NM,
measured by the corporate governance index (CGI) developed by Leal and Carvalhal (2007). The index is composed of 15
questions, and is the simple sum of the values assigned to each question.
Firm
Alpargatas
Aracruz
Bradesco
Bradespar
Confab
Duratex
Fras-Le
Gerdau
Gerdau Met
Globocabo
84
Migration Date
NM Level
15/Jul/03
16/Apr/02
26/Jun/01
26/Jun/01
19/Dec/03
05/May/05
11/Nov/04
26/Jun/01
25/Jun/03
26/Jun/01
1
1
1
1
1
1
1
1
1
1
CGI Before
Migration
6
7
9
8
7
9
4
6
8
6
CGI After
Migration
7
6
8
8
7
9
4
6
8
6
CGI
Change
1
-1
-1
0
0
0
0
0
0
0
Table 4 continued
Iochpe-Maxion
Itaubanco
Klabin
Randon Part
Sadia
Tran Paulist
Ultrapar
Unibanco
Unipar
VCP
Average Level 1
10/Nov/05
26/Jun/01
10/Dec/02
26/Jun/01
26/Jun/01
18/Sep/02
27/Oct/05
26/Jun/01
24/Nov/04
14/Nov/01
1
1
1
1
1
1
1
1
1
1
9
7
8
6
8
8
8
8
6
6
7.20
9
7
8
6
8
8
9
8
6
6
7.20
0
0
0
0
0
0
1
0
0
0
0
Celesc
Eletropaulo
Eternit
Marcopolo
Average Level 2
26/Jun/02
13/Dec/04
02/Mar/05
03/Sep/02
2
2
2
2
6
6
8
5
6.25
10
7
14
9
10.00
4
1
6
4
3.75
Perdigão
Rossi Resid
Sabesp
Tractebel
Average Level 3
12/Apr/06
27/Jan/06
24/Apr/02
16/Nov/05
3
3
3
3
9
6
10
6
7.75
14
14
14
11
13.25
5
8
4
5
5.50
Table 5. Abnormal Returns and Improvement of Governance After Migration to NM
Abnormal returns of firms that migrate to NM, divided into two groups: firms that do and do not improve corporate
governance, which is measured by the corporate governance index (CGI) developed by Leal and Carvalhal (2007). Two event
dates are considered: the date on which the call for the shareholders‘ meeting becomes publicly available, and the date on
which the shareholders approve the migration. The abnormal returns are estimated through the market model using a 250-day
estimation window. Abnormal returns during the event date (AR0) and cumulative abnormal returns over days -1 to +1 (CAR
[-1,+1]), -5 to +1 (CAR [-5,+1]), and -5 to +5 (CAR [-5,+5]) are calculated. Bootstrap p-values (in parentheses) account for
event clustering and event-induced volatility. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively.
Event
Abnormal Returns
AR0
CAR [-1,1]
CAR [-3,3]
CAR [-5,5]
Call for the
Shareholders‘ Meeting
Do Improve
Do Not Improve
Governance
Governance
0.85
0.13
(0.32)
(0.82)
3.72%***
1.14%
(0.01)
(0.24)
4.20%***
1.25%
(0.01)
(0.24)
7.04%***
3.52%
(0.01)
(0.11)
Shareholders‘
Meeting
Do Improve
Do Not Improve
Governance
Governance
0.67
0.38
(0.25)
(0.71)
3.03%***
0.18%
(0.00)
(0.92)
3.00%***
0.20%
(0.01)
(0.92)
4.51%***
0.44%
(0.01)
(0.89)
Table 6. Liquidity and Improvement of Governance After Migration to NM
The dependent variable in each regression is the liquidity (Liq), measured as the trading volume throughout the previous 250
trading days relative to the total market value of the firm. Liqm is the liquidity of the market index, and NM is a dummy
variable that takes the value 1 after the firm migrates to NM. Two dates are considered: the date on which the call for the
shareholders‘ meeting becomes publicly available, and the date on which the shareholders approve the migration. The pvalues are shown in parentheses. ***, **, * denote statistical significance at the 1%, 5% and 10%, respectively.
Event
Call for the
Shareholders‘
Variables
Meeting
Do Improve
Do Not Improve
Do Improve
Do Not Improve
Governance
Governance
Governance
Governance
Liqt-1
0.58***
0.53***
0.56***
0.51***
(0.00)
(0.00)
(0.00)
(0.00)
Liqm,t
0.01***
0.00
0.01***
0.00
(0.00)
(0.37)
(0.00)
(0.66)
85
Table 6 continued
NM
NM x Liqt-1
NM x Liqm,t
Adjusted R2
0.02
(0.39)
0.05***
(0.00)
0.00
(0.34)
0.42
-0.02
(0.70)
0.09***
(0.00)
0.00
(0.50)
0.32
0.00
(0.85)
0.03***
(0.00)
0.00
(0.52)
0.39
-0.02
(0.43)
0.10***
(0.00)
0.00
(0.78)
0.31
Table 7. Volatility and Improvement of Governance After Migration to NM
The dependent variable in each regression is the volatility (Vol), measured as the annualized standard deviation of daily
returns in the last 250 trading days. Volm is the volatility of the market index, and NM is a dummy variable that takes the value
1 after the firm migrates to NM. Two dates are considered: the date on which the call for the shareholders‘ meeting becomes
publicly available, and the date on which the shareholders approve the migration. The p-values are shown in parentheses. ***,
**, * denote statistical significance at the 1%, 5% and 10%, respectively.
Event
Variables
Volt-1
Volm,t
NM
NM x Volt-1
NM x Volm,t
Adjusted R2
Call for the
Do Improve
Do Not Improve
Governance
Governance
0.19***
0.19***
(0.00)
(0.00)
0.68***
0.49***
(0.00)
(0.00)
-0.01*
-0.01**
(0.07)
(0.02)
-0.05
0.02
(0.15)
(0.18)
0.02
0.08
(0.30)
(0.18)
0.08
0.09
Shareholders‘
Meeting
Do Improve
Do Not Improve
Governance
Governance
0.17***
0.19***
(0.00)
(0.00)
0.60***
0.54***
(0.00)
(0.00)
-0.01*
-0.01*
(0.07)
(0.08)
-0.06
0.00
(0.12)
(0.47)
0.01
0.09
(0.33)
(0.14)
0.07
0.09
Appendix. Description of the Corporate Governance Index (CGI)
Corporate governance index developed by Leal and Carvalhal (2007). Each question corresponds to a ―yes‖ or ―no‖ answer. If
the answer is ―yes‖, then the value of 1 is attributed to the question, otherwise the value is 0. The index is the sum of the
points for each question. The maximum index value is 15. Index dimensions are simply for presentation purposes and there is
no weighing among questions. All questions are answered from public information disclosed by listed companies and not by
means of potentially subjective interviews.
Disclosure
1. Does the company produce its financial reports by the required date?
2. Does the company use an international accounting standard (IASB/U.S. GAAP)?
3. Does the company use one of the leading global auditing firms?
4. Does the company disclose the compensation of the CEO and board members?
Board Composition and Functioning
5. Are the Chairman of the Board and the CEO not the same person?
6. Is the board clearly not made up of corporate insiders and controlling shareholders?
7. Does the company have board monitoring committees (audit, compensation, etc.)?
8. Is there a permanent Fiscal Board?
Conflicts of Interest
9. Is the controlling shareholder´s ratio of vote to cash-flow not higher than 1?
10. Is the company free of any inquiries or convictions by the Brazilian Securities and Exchange Comission
(CVM) for governance malpractices?
11. Does the company charter establish arbitration to resolve corporate conflicts?
Shareholder´s Rights
12. Does the company facilitate the voting process beyond what is legally required?
13. Does the company grant additional voting rights beyond what is legally required?
14. Does the company grant mandatory bid beyond what is legally required?
15. Does the shareholder agreements decrease the largest shareholder‘s control?
86
OWNERSHIP AND CONTROL OF ITALIAN BANKS: A SHORT INQUIRY
INTO THE ROOTS OF THE CURRENT CONTEXT
Leonardo Giani*
Abstract
This work does a short inquiry into the past experience of the Italian banking law and the ownership
structure of the Italian credit industry. The inquiry is especially focused on the role played by culture
and other historical events (e.g. political ones) in shaping the Italian economic framework. In other
words, this paper wants to trace a short and descriptive outline of the evolution of the Italian banks‟
ownership structure in order to show how political and social factors counted in determining the
present features of the system.
Keywords: corporate governance, ownership and control, banking law, banks, evolution, Italy.
*PhD Candidate in Law and Economics, University of Siena, Italy
1. The role of culture and history in the
evolution of systems of capitalism and
structures of ownership and control
Culture and history constantly play an important role
in the economy45. Even more, from the work for
which Douglass North was awarded of the Nobel
Prize can be learned that culture and history always
matter46. For instance, it must be always kept in mind
that economic incentives are not lonely suitable to
drive the world towards efficiency. In other words,
it‘s impossible to change the world just by legislative
reforms aimed to provided such incentives, because
they must be followed by a change in people‘s mind.
Moreover, beside the general cultural determinants,
also the dominant political attitudes deeply influence
the economy47 (and not always politics coincides with
culture). All these elements are part of the concept
well known as «path dependence»48.
For what especially concerns the matter under
analysis, it can be noticed that each national
ownership and control pattern is the result of the
historical evolution of the national economy to which
it pertains. However, it must be also said that
corporate ownership and control structures never
45
«By culture we mean the transmission from one
generation to the next, via teaching and imitation, of
knowledge, values, and other factors that influence
behaviours» [R. BOYD, P.J. RICHERSON, Culture and the
Evolutionary Process, Chicago, The University of Chicago
Press, (1985), p. 2].
46
«In the modern Western world, we think of life and the
economy being ordered by formal laws and property rights.
Yet formal rules, even in the most developed economy,
make up a small (although very important ) part of the sum
of constraints that shape choices; a moment‘s reflection
should suggest to us the pervasiveness of informal
constraints. In our daily interactions with others, whether
within the family, in external social relations, or in business
activities, the governing structure is overwhelmingly
defined by codes of conduct, norms of behaviour, and
conventions. Underlying these informal constraints are
formal rules, but these are seldom the obvious and
immediate source of choice in daily interactions. That the
informal constraints are important by themselves (and not
simply as appendages to formal rules) can be observed from
the evidence that the same formal rules and/or constitutions
imposed on different societies produce different outcomes.
(…) Where do informal constraints come from? They come
from socially transmitted information and are part of the
heritage that we call culture» [D.C. NORTH, Institutions,
Institutional Change and Economic Performance,
Cambridge, Cambridge University Press, (1990), p. 36-37].
47
For a wise analysis focused on the American context see
A Political Theory of American Corporate
Finance, Colum. L. Rev., Vol. 91, (1991), p. 10; M.J. ROE,
Strong Managers, Weak Owners: The Political Roots of
American Corporate Finance, Princeton, Princeton
University Press, (1994).
48
«Path dependence is a term that has come into common
use in both economics and law. In all instances that path
dependence is asserted, the assertion amounts to some
version of ―history matters‖. Path dependence can mean just
that: Where we are today is a result of what happened in the
past. (…) In biology, the related idea is called contingency –
the irreversible character of natural selection. (…) We must
caution, however, that the analogies are incomplete. If
turtles become extinct, they will not reappear suddenly
when circumstances change to make it advantageous to
have a shell. But if people stop using large gas-guzzling
engines because gasoline has become expensive, or extent
patent protection to the ―look and feel‖ of software, they can
always revert to their old ways if they come to regret the
switch» [S.E. MARGOLIS, S.J. LIEBOWITZ, Path Dependence, in
P. NEWMAN, (Edited by), The New Palgrave Dictionary of
Economics and the Law, Vol. 3, London, Macmillan
Reference Limited, (1998), p. 17-18]. See also L. BEBCHUK,
M.J. ROE, A Theory of Path Dependence in Corporate
Ownership and Governance, Stan. L. Rev., Vol. 52, (1999),
p. 127.
M.J. ROE,
87
stand alone. On the contrary, every work dealing with
corporate governance (included those about the
specific topic of national patterns of corporate
ownership and control) should start by looking at the
matter from a more general perspective.
Taking this perspective, let‘s start by quoting a
prominent scholar. He begins one of his most
significant works49 stating that the word «capitalism»
is commonly used for the definition of a particular
kind of economic organization traditionally pertaining
to Western Europe, North America and Japan. More
precisely, he states that this kind of economic
organization is normally defined as a system in which
the assets are owned by those people who invest their
capitals for the production of goods or the providing
of services. However, immediately after this first
statement, the scholar himself specifies that, in
practice, the ownership by investors is only a
contingent feature of the free market economies, even
if usually dominant. Indeed, in every free market
economy (United States included) a number of
different ownership structures coexist, involving
various kind of owners and having different degrees
of concentration.
In few words, claiming that several «systems of
capitalism» exist throughout the world only means
that different economic organizations sharing the
common trait of the ownership by investors as
dominant (albeit contingent) feature are in place.
Beyond the just mentioned common trait, all the other
specific features of firms (even within the same
system of capitalism) can vary a lot.
In general, many historical factors, cultural
elements and social relations are suitable to affect the
way in which an economy is driven and organized. In
this respect it must be remarked that, as already said,
corporate ownership and control structures don‘t
stand alone. However, the dominant way in which
firms are owned and controlled within a certain
country seems to be particularly important because it
somehow reflects the influence of all the other forces.
According to what explained above, it‘s possible
to say that each single country has its own peculiar
system of capitalism50 and, moreover, within the same
49
H. HANSMANN, The Ownership of Enterprise, Cambridge
Mass., The Belknap Press of the Harvard University Press,
(1996).
50
In some respects, it could be also said that different areas
within the same country may have their own specific system
of capitalism. Take for example the case of the north and
the south of Italy: it‘s self evident that a region like
Lombardy (one of the fastest growing and most
economically developed in the whole Europe) has an
economic organization completely different from Sicily
(one of the slowest growing and less economically
developed in the whole Europe). Moreover, take the
example of different parts of the United States: California
has an economic organization completely different from
Montana. The practice to consider countries as uniform
economic entities is correct and imposed for simplification,
so this footnote is maybe an excess of precision, however
88
country firms may have different structures of
ownership and control. Despite of this broad and
persistent diversity, the various systems share some
common elements that allow to group them under few
categories.
More
precisely,
the
economic
organizations of Western Europe, North America and
Japan can be generally grouped under two categories:
«market-centred systems» and
«bank-centred
systems»51.
Italy is usually considered as a «bank-centred
system». This categorization only catches one of the
main distinctive features of the Italian capitalism,
because it is characterized by many other very
specific elements. However, the categorization
stresses the important role that, also in Italy, credit
institutions played and still play in the economy. As
already said, corporate ownership and control
structures can‘t be studied apart from the general
economic context in which they have been developed,
but they are very important anyhow. In particular, the
ownership and control structures of the Italian banks
have some specific characteristics that are very
interesting to be analysed, in order to highlight how
they reflect the impact of many different forces
(cultural, historical and political ones) on this kind of
institutions.
2. The primary roots of the current
context: some notes about the initial
development of a modern credit industry
in Italy
Around 1861, the year in which the country was
politically unified, the Italian economy was stagnant
and still resembling a medieval one from both a
financial and an industrial perspective 52.
From a financial perspective, a prominent
scholar in banking observes four peculiar features of
the post-unitary Italian economy: i) frequent financial
crisis in pre-unitary States; ii) the scarcity of a
monetary field in the Italian economy (90% of legal
tender was hard money); iii) the absence of lending
institutions both on long and short term; iv) strong
elements of dualism and exposition to usury for a
large layer of population53. In addiction, any stock
exchange in a modern sense was in operation.
From an industrial perspective, it can be noticed
that in those years the Italian fabrics were still
it‘s only to specify that there can be an enormous difference
between economic borders and the geographical ones.
51
See, for instance, F. ALLEN, D. GALE, Comparing Financial
Systems, Cambridge Mass., MIT Press, (2000); R. LA PORTA,
F. LOPEZ-DE-SILANES, A. SHLEIFER, Corporate Ownership
Around the World, J. Fin., Vol. 54, (1999), p. 508.
52
See for example G. FUA‘, (Edited by), Lo sviluppo
economico in Italia, Milano, Franco Angeli, (1969).
53
M. ONADO, La lunga rincorsa: la costruzione del sistema
finanziario, on P. CIOCCA, G. TONIOLO, (Edited by), Storia
Economica d‟Italia, Bologna, Laterza, (2002), p. 384.
handmade by artisans54, except for the silky
production, which represented the «school for the
Italian industrial take off»55. In addiction, Italy had no
railroads at all (except for few hundreds of kilometres
built more for the noblemen‘s pleasure than for
economic purposes)56.
However, even if during the 1860s and the 1870s
Italy was still heavy economically injured because of
recent wars, it experienced a fresh economic growth 57.
This growth was especially boosted by a historical
event. Indeed, the unification of the country produced
expectations and enthusiasms that, for the first time in
the Italian history, led to the built of modern factories
and to the initial rise of an entrepreneurial class58.
At the same time, the credit industry was still
very segmented. Some different kind of banks
coexisted in Italy during that period, sometimes as a
heritage of the different pre-unitary systems. Firstly,
monti di credito su pegno: different kind of banks
dated back to the Middle Ages, variously called (e.g.
monti di pietà, monti frumentari, monti pecuniari) and
statutory aimed at lending small amounts of money on
pledge59. Secondly, casse di risparmio: savings banks
having
various
founders
(governments,
municipalities,
associations
of
citizens
or
ecclesiastical authorities) and different organization
(they could look like associations or foundations) but
always aimed to safeguard deposits more than lend
money60. Thirdly, banche popolari and casse rurali e
artigiane: two different kinds of mutual banks
chartered as cooperatives61. Finally, normal banks
chartered as corporations. All of them were universal
banks and all of them could be involved in activities
that were regulated by special laws like agrarian
lending or estate and construction lending62.
Moreover, due to the pre-unitary division of the
country in regional States, the credit industry
dominantly had a local dimension63.
Along with the regional dimension of banks,
their ownership structures were local too. The
literature seems to lack of precise and comprehensive
data about the ownership structure of monti di credito
su pegno and casse di risparmio in the nineteenth
century. Indeed, they were very particular institutions
in which different kind of players were variously
involved. Only about few important monti di credito
su pegno (e.g. Opere pie San Paolo di Torino, Monte
dei Paschi di Siena, Banco di Santo Spirito) is known
that at the end of the nineteenth century they were
controlled by the State64. For what concern casse
rurali e artigiane a similar lack of accurate data is
observable, but the background on which such
institutions were created undoubtedly allows to state
that they were cooperatives with local range of
activity and owners65. On the contrary, about banche
popolari and normal banks chartered as corporations
it‘s proven that, at the end of the 1870s, the
shareholders of the former were about 70,000 and the
shareholders of the latter were about 30,00066.
54
About Italy see F. BELLI, Legislazione bancaria italiana
(1861 – 2003), Torino, Giappichelli, (2004), p. 50-51.
55
See L. CAFAGNA, Dualismo e sviluppo nella storia
d‟Italia, Venezia, Marsilio, (1999).
56
According to a prominent Italian economist [G. TONIOLO,
Storia economica dell‟Italia liberale 1850-1918, Bologna, Il
Mulino, (1988), p.115], in 1860 Italy had just 2,000 km of
railways, while the United Kingdom had 15,000 km,
Germany 12,000 km and France 9,000 km.
57
For example, consider that in 1862 the Rattazzi‘s
government undertook a rail policy for the south of the
country, thanks to a network of Italian entrepreneurs and to
the stream of French and English capitals. In 1864 the
privatizations of the industrial government started: Italian
government farmed out the mechanic plant of Pietrarsa
(Naples) for the construction of railway assets. In the same
years the shipyard of Leghorn and La Spezia became
private. In 1865 a modern factory rose in Piombino (La
Magona d‘Italia sprouted for the initiative of an English
businessman Joseph Alfred Novello to exploit the mineral
resource of the contiguous Elba island).
58
The unification of the country took in Italy a wave of
commercial euphoria. A series of bank‘s initiatives bloomed
and a run to the exploitation of mineral took place. Even if
in 1864 many of the businessmen involved in this run saw
the failure of their expectations. See G. LUZZATTO,
L‟economia italiana dal 1861 al 1894, Torino, Einaudi,
(1968).
59
See M. PIPITONE, Monti di credito su pegno, on Digesto
delle Discipline Privatistiche – Sezione Commerciale,
Torino, UTET, (1994), p. 74.
60
See L. PONTIROLI, Cassa di risparmio, on Digesto delle
Discipline Privatistiche – Sezione Commerciale, Torino,
UTET, (1987), p. 513.
61
The first Italian banca popolare was chartered in Lodi
(Lombardy) in 1864 and 122 banche popolari existed in
Italy in 1878 [see F. BELLI, A. BROZZETTI, Banche popolari,
on Digesto delle Discipline Privatistiche – Sezione
Commerciale, Torino, UTET, (1987), p. 166]. The first
Italian cassa rurale and artigiana was chartered in a small
town near Padova in 1883 by Leone Wollemborg, an
economist who also became member of the Parliament and
Ministry of Finance [see S. GATTI, Cassa rurale e artigiana,
on Digesto delle Discipline Privatistiche – Sezione
Commerciale, Torino, UTET, (1987), p. 541].
62
It‘s important to notice the this market segmentation and
growth of new species of banks is the same phenomenon
experienced by the U.S. in that period. Also in Italy the
main difference was about commercial banks and thrifts
(e.g. casse rurali e artigiane and banche popolari). While
the first were profit-making corporations owned by
shareholders, the second originally were more charitableoriented institutions organized in a mutual form.
63
See, in general, G. CONTI, S. LA FRANCESCA, (Edited by),
Banche e reti di banche nell‟Italia postunitaria – Volume II.
Formazione e sviluppo di mercati locali del credito,
Bologna, Il Mulino, (2000).
64
See, for example, G. CONTI, Processi di integrazione e reti
locali: tipologie del credito e della finanza, on G. CONTI, S.
LA FRANCESCA, (Edited by), Banche e reti di banche
nell‟Italia postunitaria – Volume II. Formazione e sviluppo
di mercati locali del credito, Bologna, Il Mulino, (2000).
65
See S. GATTI, Cassa rurale e artigiana, on Digesto delle
Discipline Privatistiche – Sezione Commerciale, cit., p. 541
66
See A. POLSI, Alle origini del capitalismo italiano – Stato,
banche e banchieri dopo l‟Unità, Torino, Einaudi, (1993).
89
For what especially concern banche popolari,
being chartered as cooperatives, the number of shares
owned by each single shareholder was limited, thus
they can be described as a sort of public companies67.
More precisely, according to a statistic dated back to
that period, the shareholdings of banche popolari was
composed for more than 65% by small landowners,
farmers, artisans, shopkeepers and local notables or
professionals68. For what concern banks chartered as
corporations, on a total of 226, the 155 biggest ones
globally counted 3711 shareholders and the largest
part of them was Italian (3540 shareholders). Among
them, the 50% were other banks (14.53%) or private
bankers (35.47%), while the rest were merchants
(9.77%), industrialists and artisans (7.77%), shipowners (6.41%), large landowners (4.81%),
stockbrokers (4.22%), and lawyers (2.5%)69. The
category of private bankers, being the largest one,
need to be further explained. They were people whose
principal occupation was not banking. In few words
they were the evolution of the medieval bankersmerchants, who variously distributed their resources
between different activities such as banking and
trading70. Moreover, among private bankers, as well
as among the other categories, many shareholders had
more than one occupation, since they could also be
noblemen or politicians71. Thus the shareholdings of
Italian banks during the 1860s and 1870s was quite
various and tangled in different activities.
In those years, the role foreign investors was
quite limited, since they represent just 231
underwritings (less than 5% of the total)72. However,
foreign investors played an important role for the first
Italian industrial and economic development, also
affecting the ownership and control of Italian banks.
In fact, in line with the unification of the country, one
of the primary political objectives was to shift the
Italian industry from a regional to a national
dimension. In order to do so, a financially
underdeveloped economy such as the Italian one
needed banks large enough to drive the
industrialization by collecting and lending money on a
wide scale73. In this respect culture played an
67
See S. LA FRANCESCA, Storia del sistema bancario
italiano, Bologna, Il Mulino, (2004), p. 70.
68
banche e banchieri dopo l‟Unità, cit., p. 264.
69
banche e banchieri dopo l‟Unità, cit., p. 266, 274 and 277.
70
A description of the Italian medieval companies as
engaged in various kind of activities ranging from banking
to commerce and industry is given by C.M. CIPOLLA, Storia
economica dell‟Europa pre-industriale, Bologna, Il Mulino,
(1997), p. 196.
71
See, in general, the fourth chapter of A. POLSI, Alle origini
del capitalismo italiano – Stato, banche e banchieri dopo
l‟Unità, cit., p. 263.
72
See again A. POLSI, Alle origini del capitalismo italiano –
Stato, banche e banchieri dopo l‟Unità, cit., p. 267.
73
italiano, cit., p. 17 and 43.
90
important role. Indeed, without having its own
national model for such banks, the Italian ruling class
looked at countries which were perceived to be more
culturally similar. At the beginning, the country
perceived to be most culturally similar was France
and its model of banking was consequently adopted 74.
In accordance with that model, Credito Mobiliare was
chartered in 1863. It was a bank conceived following
the example (and resembling also the name) of the
French Crèdit Mobilier. Moreover, the shareholders
were also French for a large part. The bank in fact was
owned for a half by the previous shareholders of the
Cassa Torinese del Commercio e dell‟Industria (an
Italian bank merged into the Credito Mobiliare at the
time of its creation) and for the other half by people
linked with the French Crèdit Mobilier75. In addiction,
few years later, in 1872, Banca Generale was
chartered almost in the same manner. These two
banks, along with others, are considered as main the
drivers of the first Italian industrialization, as well as
their activity is viewed as the earliest sign of a bank
oriented system of capitalism76.
At the beginning of the 1880s the Italian
economy experienced an agricultural crisis 77,
worsened by the commercial war against France
(started when Italy became part of the anti-French
military alliance set by Germany and Austria) but at
the same time a construction fever took place in Italy.
The Italian banks, harmed by the agricultural crisis,
started to invest deeply in construction companies and
to speculate in estate businesses78. All those
speculations involved a large part of the Italian banks,
generating a financial bubble that started to explode in
1886 and a crisis culminated in the period of two
74
The French model can be roughly described as based on
the synergic interaction of three different kind of banks: the
elitist private bank, the investment bank, the savings bank
[see S. LA FRANCESCA, Storia del sistema bancario italiano,
cit., p. 85].
75
Among them can be listed also the Pereire brothers, two
renowned French businessmen who played a very important
role in the early Italian financial development [see S. LA
FRANCESCA, Storia del sistema bancario italiano, cit., p. 45].
76
italiano, cit., p. 43.
77
Agricultural crisis started in Italy in 1876 for production
stagnancy having reference to the contraction of cereals
prices due to the American competition. This crisis was
widely widespread in European countries and its effects
endured in Italian economy until 1890. Italian GDP in 1876
is analogous to the 1887‘s one, thanks to the development of
manufactured product‘s industries. See for example G.
FEDERICO, Per una analisi dell‟agricoltura nello sviluppo
economico italiano: note sull‟esportazione dei prodotti
primari (1863-1913), on Storia e società, No. 5, (1979).
78
Those years are commonly viewed as the first step of the
Italian industrialization: the economy grew at the
approximate rate of 8% per year and the total capitalization
of corporations increased as follows: 1,070 millions of lire
in 1878; 1,342 millions in 1881; 1,685 millions in 1885;
1,746 millions in 1887 (see S. LA FRANCESCA, Storia del
sistema bancario italiano, cit., p. 71).
years between 1893 and 189479. In those years, both
the main drivers of the early Italian industrial
development (Credito Mobiliare and Banca
Generale) collapsed.
Immediately after the collapse of Credito
Mobiliare and Banca Generale, they were replaced by
the creation of two other banks: Banca Commerciale
Italiana in 1894 and Credito Italiano in 189580. These
two banks replaced Credito Mobiliare and Banca
Generale not only as the main players in the Italian
credit industry, but also as drivers of the national
economy. However, in these cases, the model of
banking taken as example was not the French one, but
the German one81. The commercial war against
France (in consequence of the military alliance with
Germany and Austria) can be tentatively regarded as a
political determinant of this fact. Anyway, apart from
the tentative location of a political determinant, is
beyond doubt that the adoption of that model were
also influenced by cultural affinities and implied a
deep presence of German institutions in the ownership
structure of both banks. Indeed, the initial capital of
Banca Commerciale Italiana was underwritten by
German banks (78%), Austrian banks (13%) and
Swiss banks (9%), as well as the creation of Credito
Italiano was in part financed by German investors82.
The ownership of Banca Commerciale Italiana
and Credito Italiano (which remained both in
operation till few years ago) later gradually shifted in
Italian hands. For instance, in 1907 a director of
Banca Commerciale Italiana wrote to a German
colleague that, on a total of 210,000 shares, about
190,000 are held by Italians, therefore implying that a
process of «naturalization» was substantially
completed83. Later, the same process was also
completed for Credito Italiano (as well as for other
important banks not mentioned in this work) by the
wave of bids and takeovers which took place in the
first decades of the twentieth century.
79
In these two years, the four most important Italian banks
(Banca Generale, Credito Mobiliare, Banca Tiberina,
Banca di Sconto e Sete) were helped by the Banca
Nazionale del Regno d‟Italia, another important bank
(Banca di Roma) was saved by the Vatican Treasury and,
finally, the Banca Romana‘s financial scandal took place.
The crisis culminated between 1893 and 1894 when, in few
months, both Banca Generale and Credito Mobiliare
collapsed (see F. BELLI, Lesiglazione bancaria italiana, cit.,
p. 89 and 90).
80
G. TONIOLO, Storia economica dell‟Italia liberale 18501918, cit., p. 180.
81
Their main investment activity can be roughly described
as based on the acquisition of portfolios of shares held by
other intermediaries in order to place them later on the stock
market (see S. LA FRANCESCA, Storia del sistema bancario
italiano, cit., p. 86).
82
See G. TONIOLO, Storia economica dell‟Italia liberale
1850-1918, cit., p.180.
83
See A. CONFALONIERI, Banche miste e grande industria in
Italia – Volume I: L‟esperienza della Banca Commerciale e
del Credito Italiano, Milano, Banca Commerciale Italiana,
(1994), p. 47.
Indeed, at that time the model was the universal
bank and, most important, there was no separation of
banking and industry. This fact allowed for a very
active market for the corporate control and for wars of
bids between banks and industrial companies84.
Consequently, at the beginning of the 1920s banks
and industrial companies were braided in a complex
and unnatural way, constantly involved parallel
takeovers by which everyone attempted to gain the
control of the other85.
3. The shift from a private owned to a
largely state owned credit industry
The World War I had many important consequences.
The War in fact deeply influenced also the economy,
since the industry modified its production and made
important efforts in order to comply with the demand
of specific goods. In doing so, the industry enlarged
its scale and sectors underdeveloped or inexistent
until then finally became part of the economy.
However, many problems also resulted from the War.
Some areas of the country were almost completely
destroyed or deeply injured. Moreover, the scale
achieved by industries was no more supported by
State‘s orders, since the national debt raised in the
same years and the public finances were distressed.
Consequently, the industry faced several difficulties,
the attempts to reorganize the system implied a
reduction of the achieved scale and a consequent
growth of unemployment. At the same time, the rate
of inflation grew and prices increased86.
All these circumstances led to the emergence of
a strong and spread discontent among the people. In
particular, the traditional tools of the liberal economy
seemed unable to solve those problems. Such an
environment created the conditions for the birth of
illiberal ideologies and political parties proposing
authoritative solutions for the crisis. This is the
summarized background in which the fascist party
bore in 1919 and finally took the power in 1922 87.
The fascist approach towards the economy was
inspired by corporatism, protectionism and economic
nationalism. One of the main theorists of the fascist
84
See again A. CONFALONIERI, Banche miste e grande
industria in Italia – Volume I: L‟esperienza della Banca
Commerciale e del Credito Italiano, cit., p. 47-72.
85
A prominent author refers that an important Italian banker
of that period wisely called and regarded the weaving
between banks and industrial companies as a «Siamese
brotherhood» (see S. LA FRANCESCA, Storia del sistema
bancario italiano, cit., p. 132).
86
A short but effective description of the economic
consequences of the World War I in Europe and, more
precisely, in Italy can be found in V. ZAMAGNI, Dalla
rivoluzione industriale all‟integrazione europea, Bologna, Il
Mulino, (1999), p. 133 and 154.
87
The relation between the economic consequences of the
World War I and the rising of fascism can be found in V.
ZAMAGNI, Dalla rivoluzione industriale all‟integrazione
europea, cit., p. 154.
91
approach towards the economy was Alfredo Rocco, a
renowned lawyer finally also became Ministry of
Justice. In accordance with the fascist concept, the
main aim of the Italian industry should be «the
advantage of the Country» and «the supreme interest
of the Nation»88. In line with this idea, the interest of
«the Nation» was not the sum of the individual
interests of those who live in the nation. In other
words, for the fascist theorists the economy shouldn‘t
be driven in the interest of individuals but in the
interest of the community (i.e. «the Nation»).
Coherently with this line of thought, other traits of the
fascist government finally became autarchy, State
intervention in the economy and industrial planning.
The fascist attitudes towards the economy were
also fuelled by the Great Depression started in the
United States of America in October 1929. Indeed,
the deep contraction of business encouraged the
research of new economic models. Moreover, the
liberalist methods and ideas lost credibility, being
apparently unable to solve or even soften a crisis
which was prolonging for years. In that context, the
fascism was perceived able to offer a convincing and
feasible alternative to the free market economy89.
The first effect of the crisis of many banks
during the Great Depression was to give to the fascist
regime the opportunity to take some initiatives that
finally led to a wide nationalisation of banks. This
process started at the beginning of the 1930s with the
creation of IMI and IRI90.
In addiction, the centrepiece of the reforms
addressed to deal with the problems emerged from the
Great Depression was the Banking Law enacted in
two steps between 1936 and 1938.
The state managers on charge in IMI and IRI can
be also considered the architects of the Banking Law
of 1936-38 and in this circumstance is possible to find
the reasons why this regulation kept its utility and
effectiveness for over fifty years. Indeed, the state
managers mentioned before (leaded by Alberto
Beneduce91 and Donato Menichella92) didn‘t belong
88
See A. CARDINI, Cultura economica e governo
dell‟economia nella dittatura fascista, on A. MAZZACANE,
(Edited by), Diritto economia e istituzioni nell‟Italia
fascista, Baden Baden, Nomos Verlagsgesellschaft, (2002).
89
dell‟economia nella dittatura fascista, cit., p. 61.
90
IRI (Institute for the industrial rebuilding - Istituto per la
ricostruzione industriale) and IMI (Italian investment
institute - Istituto mobiliare Italiano) were two holding
companies totally owned by the State. IMI was created in
1931, in order to avoid the failure of the main important
Italian banks, and IRI (1933) became the owner of large part
of the Italian industrial system, originally owned jointly by
the failed banks. In particular IRI since 1940 to 1990 was
the main Italian industrial group. For a confirmation of the
fact that the Great Depression gave to the fascism the
opportunity to nationalise the Italian credit industry by
creating IMI and IRI see V. ZAMAGNI, Dalla rivoluzione
industriale all‟integrazione europea, cit., p. 177.
91
Alberto Beneduce was a well-known Italian scholar and
politician in the early years of the last century. In particular
92
to the anti-capitalistic and anti-liberalist circles then
ruling the fascist party. On the contrary, they were
high level experts, educated and grew up in the
liberalist atmosphere across the nineteenth and the
twentieth centuries, that always had a lukewarm
attitude towards the fascism93.
The Italian Banking Law of 1936-38 brought
some changes of historical importance in Italy and
two, in particular, are usually regarded as the most
revolutionary ones. The first one concerned the
separation of commercial banking from investment
banking94. The second one concerned the
classification of banks in different categories with an
element in common, that was the state ownership
(Sections 25-27 of the Banking Law)95.
It‘s important to stress other cultural
determinants lying behind the Banking Law of 193638. On the one hand, Italy never had an
entrepreneurial class disposed to tolerate risks tied
with financial activities just to maximize its expected
profits. Rather firms were really interested in
acquiring the control of banking activities solely to
obtain a chartered financial canal96. On the other
hand, during the 1920s we observe a financial market
ruled by speculation of a concentrated economic
power. Under these circumstances, the state
ownership could be a means to treat savings in the
«right hands»97.
However, it‘s also important to stress that the
nationalization of banks was wide but not complete.
Indeed, the abolition of private property was
unconceivable for the fascism, being jointly with
statism the main feature marking its approach as a
in 1933 Beneduce has been the main promoter and
organizer of IRI and its president until 1939.
92
Donato Menichella was an important name of the Italian
economic and political scene of the first part of the last
century. Previously, he was nominated governor of the
Italian central bank in 1948, he was since 1934 the general
director of IRI.
93
See F. BELLI, Legislazione bancaria italiana, cit., p. 149.
94
95
Other critical changes introduced by the Banking Law of
1936-38 concern the redefinition of the credit institutions‘
functions and the creation of the Ispettorato per la difesa
del risparmio e l‟esercizio del credito (IDREC), a
supervisory body chaired by the governor of the Banca
d‟Italia (Sections 1-24 of the Banking Law). Moreover, the
Banking Law regulated the process of chartering and
branching of the banks (Sections 28-40 of the Banking
Law). Finally, several provisions introduced controls and
tools aimed to ser the prudential supervision and the
regulatory supervision (Sections 31, 32, 33 and 35 of the
Banking Law).
96
See M.ONADO, La lunga rincorsa: la costruzione del
sistema finanziario, cit..
97
In this respect, it has been evidenced that such a cultural
attitude towards the economy can be even dated back to the
beginning of the century. See F. BARCA, Compromesso senza
riforme nel capitalismo italiano, on F. BARCA, (Edited by),
Storia del capitalismo Italiano, Roma, Donzelli, (1997).
«third way»98 between and the equally rival liberalist
and communist ideologies99. Thus, the State finally
controlled the 80% of the credit industry100, but some
private owned banks always remained in operation.
On the other hand, as a consequence of the just
described process, the Italian economy became
largely controlled by the State. Indeed, as mentioned
at the end of the previous paragraph, during the 1920s
banks and industrial companies were deeply tangled
in the control of each other. Thus, being banks the
shareholders of industrial companies, the rescue of
distressed banks achieved through their acquisition by
IMI and IRI implied that the State also became a large
shareholder of many industrial companies. More
precisely, after this process, the State totally
controlled the production of weapons; the 80-90% of
shipyards, shipping-lines, airlines and telephone
companies; the 40% of the iron and steel industry; the
30% of the electric industry; the 25% of the
mechanical industry and the 15% of the chemical
industry101.
4. The gradual retreat of the State from a
direct involvement into the economy
The World War II had a destructive impact on the
economy. For what especially concern Italy, after
1943 the final and harshest phase of the conflict,
being the south occupied by Anglo-American troops,
was fought in the central and northern regions (i.e. the
industrial heart of the country). During those years,
battles and bombardments almost completely
destroyed infrastructures, factories and cities.
At the end of the World War II Italy was totally
ruined from an economic perspective. However, at the
same time the war allowed for a deep influence of the
Anglo-American culture throughout the country and
freed many positive energies. Moreover, in 1946 the
result of a referendum repealed the monarchy and
established the republic. This vote gave the chance to
provide the people‘s refreshed spirit with a new
institutional framework which dismantled many of the
previous age-old structures and prerogatives.
Moreover, the first initiatives aimed to set a
cooperative framework between different European
98
dell‟economia nella dittatura fascista, cit., p. 61.
99
Moreover, a confirmation of what described above can be
found in an important paper [F. AMATORI, F. BRIOSCHI, Le
grandi imprese private: famiglie e coalizioni, on F. BARCA,
(Edited by), Storia del capitalismo Italiano, Roma,
Donzelli, (1997), p. 118] were is written that the direct
involvement of the State in the economy was not aimed to
suppress private groups or entrepreneurial initiatives, since
it was also practically hindered by the State‘s limited
resources and by the need to maintain some social and
political equilibriums.
100
See V. ZAMAGNI, Dalla rivoluzione industriale
all‟integrazione europea, cit., p. 189.
101
countries promoted trust and encouraged expectations
about the future. In this renewed context, thanks also
to the financial aid granted by the United States of
America102, Italy experienced an economic boom,
becoming one the world‘s most industrialized
countries. The Italian economic development during
the 1950s and 1960s has been wisely described by a
prominent
author
as
«an
extraordinary
compromise»103. In fact, it was a development
contemporarily marked by many uncontrolled private
entrepreneurial initiatives as well as a permanent
direct involvement of the State in the economy. In
other words, it was an original compromise between
hyper-liberalism and strong statism. Under this
compromise, both private and state owned firms
coexisted and succeeded in their respective
businesses104. About the role of culture, it‘s just
incidentally interesting to notice that the mentioned
coexistence of private and state owned firms occurred
also in France and Germany105, two European
countries perceived as culturally similar to Italy since
the nineteenth century. However, in Italy the situation
was quite different for what respectively concern
banks and industrial companies. Indeed, while many
and large industrial companies remained state owned,
the number and the size of private owned firms also
significantly increased106. On the opposite, most of
the Italian banks remained controlled by the State and
any new private bank was virtually chartered107.
The reasons lying behind the immobility of the
credit industry in those years could be found in the
specific features of the Italian industrial boom. In fact,
beside public or private huge industrial groups, the
economic development was mostly driven in Italy by
very small firms. These small industrial companies
simply were the modern evolution of workshops in
which the traditional handicraft was substituted by
mechanization108. Such a kind of small company was
102
103
See F. BARCA, Compromesso senza riforme nel
capitalismo italiano, cit., p. 12.
104
See, in general, F. BARCA, (Edited by), Storia del
capitalismo Italiano, Roma, Donzelli, (1997).
105
See G.M. GROS-PIETRO, E. REVIGLIO, A. TORRISI, Assetti
proprietari e mercati finanziari europei, Bologna, Il
Mulino, (2001), p. 153 and 293.
106
See, in general, F. BARCA, (Edited by), Storia del
capitalismo Italiano, cit..
107
This is definitely true at least for the major players
within the Italian credit industry. See G. FERRI, S. TRENTO, La
dirigenza delle grandi banche e delle grandi imprese:
ricambio e legami, on F. BARCA, (Edited by), Storia del
capitalismo Italiano, Roma, Donzelli, (1997), p. 421-423.
108
The main advantages of such an atomistic system were
to be highly dynamic and flexible. Moreover, these small
industrial companies, being the modern evolution of
traditional workshops, usually produced the typical good of
the area in which they were established. Therefore, small
companies producing a specific good were concentrated in
different areas of the country historically and traditionally
renowned for the production of that specific good (e.g.
93
(but in many cases it still is today) owned by
members of a single family who financed it with their
personal savings and with profits they reinvested in
the business. Being «auto-financed», small companies
didn‘t need any external financial assistance and
therefore banks were merely used by families as
custodians of savings. Moreover, the galloping
economy of 1950s and 1960s also allowed the large
industrial groups to be financed only by reinvested
profits109. In fact, even if the largest industrial
companies and banks always remained linked by
interlocking directorates110, the whole entrepreneurial
class of that time was basically autonomous in driving
business111. Things started to change in the 1970s.
Indeed, during the 1960s many opportunities to
reform the system were gone lost112 and, at the
beginning of the following decade, the galloping
years of the economic boom were definitely ended. In
those years, wages were growing and the rate of
inflation was increasing in a context of international
monetary turmoil and energetic crisis113. Under these
circumstances, firms (especially the largest ones)
could no more rely only on expected profits and their
own finances. However, the biggest banks were
mainly conceived as commercial banks, thus
subjected to rigid controls set by the Banking Law of
1936-38 and unable to help the system. Then,
Mediobanca, a semi-private bank chartered at the end
of the World War II, gained a prominent role acting as
merchant bank114.
Mediobanca was one of the very few private
owned banks at that time but, as already said, it was in
fact only semi-private owned. Indeed, it was founded
in 1946 by three of the biggest Italian banks which
respectively divided among themselves its ownership:
Banca Commerciale Italiana 35%, Credito Italiano
textiles in Biella and Prato, furniture in Monza). These areas
are still called «distretti industriali» (i.e. industrial districts)
and played a very important role in the industrialization of
Italy. Indeed, the organization in districts accounting several
small firms with the same kind of business allowed to
develop synergies among them which are able to supply to
the lack of economies of scale. See S. BRUSCO, S. PABA, Per
una storia dei distretti industriali dal secondo dopoguerra
agli anni novanta, on F. BARCA, (Edited by), Storia del
capitalismo Italiano, Roma, Donzelli, (1997), p. 265.
109
See F. AMATORI, F. BRIOSCHI, Le grandi imprese private,
cit., p. 131.
110
See G. FERRI, S. TRENTO, La dirigenza delle grandi
banche e delle grandi imprese: ricambio e legami, cit., p.
405.
111
cit., p. 131.
112
See M. D‘ANTONIO, La politica economica degli anni
Sessanta ovvero le occasioni perdute, on M. ARCELLI,
(Edited by), Storia, economia e società in Italia 1947-1997,
Roma-Bari, Laterza, (1997), p. 185.
113
cit., p. 131.
114
For a detailed description of the role played by
Mediobanca in those years see F. AMATORI, F. BRIOSCHI, Le
grandi imprese private, cit., p. 131.
94
35%, and Banca di Roma 30%. However, these three
banks were owned by IRI, thus controlled by the
State. Therefore, at the beginning Mediobanca was
also owned and controlled (albeit indirectly) by the
State. In 1956 Mediobanca was listed on the stock
exchange and the three founding banks decreased the
amount of shares they held: Banca Commerciale
Italiana to 24%, Credito Italiano to 24%, and Banca
di Roma to 20%. Consequently, during the 1970s
Mediobanca was owned for 32% by private
institutions or individuals, but it was still indirectly
controlled by the State through the three founding
banks mentioned above (collectively holding the 68%
of the bank‘s capital)115. Apart from Mediobanca and
few other banks, the Italian credit industry was still
widely controlled by the State. At the beginning of the
1980s Italy started to emerge from the recession and
during that decade the economy grew up again 116.
Notwithstanding the experienced crisis, then Italy was
no more a country at the eve of industrialization as it
was across the nineteenth and the twentieth century,
nor a young and fast-growing economy as it was
during the 1950s and 1960s. On the opposite, then
Italy was one of the most industrialized countries of
the world, a founder and main member of the
European
Economic
Community
and
an
internationally important commercial partner.
Moreover, Italy joined the European Monetary
System in 1979117. In the context shortly described
above, the model of banking set during the 1930s
entered in crisis. Since the creation of IMI and IRI
and the Banking Law of 1936-38, almost any
initiative or legislation of great consequence was
taken or enacted in Italy concerning the credit
industry118. At the beginning of the 1980s, the
processes of liberalization undertaken by the EEC, as
well as Italian market‘s internal factors, called for the
privatization of the credit industry and the
development of a more competitive system119.
The dismantlement of the system settled by the
creation of IMI and IRI and the Banking Law of
1936-38 was realised in three steps. Firstly, pressures
to comply with the European Directives forced some
initial regulatory changes. Secondly, the state
ownership of banks was slowly repealed through a
process of privatization started with the so called
115
For more information see www.mediobanca.it.
For a detailed statistical research concerning the
evolution of the Italian economy see M. DI PALMA, M.
CARLUCCI, L‟evoluzione dei principali aggregati economici
nell‟ultimo cinquantennio, on M. ARCELLI, (Edited by),
Storia, economia e società in Italia 1947-1997, Roma-Bari,
Laterza, (1997).
117
See M. ARCELLI, S. MICOSSI, Politica economica negli
anni Ottanta (e nei primi anni Novanta), on M. ARCELLI,
(Edited by), Storia, economia e società in Italia 1947-1997,
Roma-Bari, Laterza, (1997), p. 263.
118
119
See M. CLARICH, A. PISANESCHI, Le fondazioni bancarie –
Dalla holding creditizia all‟ente non-profit, Bologna, Il
Mulino, (2001), p. 34.
116
«Legge Amato» of 1990 and followed by the
Legislative Decree no. 153/1999120. Thirdly, the
system was completely and deeply reformed by the
approval of the Legislative Decree no. 385/1993
(Testo Unico delle leggi in materia bancaria e
creditizia - TUB)121.
For what concern the first step, the process of
privatization occurred in Italy during the 1990s was
preceded by a process of regulatory liberalization
aimed to cut down entry barriers having legal origin
and started to comply with the European Directives
enacted in the banking field. The just mentioned
elimination of entry barriers was needed because,
under the system designed by the Banking Law of
1936-38, new branches could be opened only after a
specific authorization granted by the Banca d‟Italia.
This system prevented from any form of competition,
being the authorization granted only in the respect of
a planned territorial distribution of branches,.
The mentioned elimination of entry barriers was
pursued by the Banca d‟Italia‘s «piano sportelli» of
1982 and by the legislative accomplishment of the
first EEC Banking Directive of 1985122.
For what concern the second step, the «Legge
Amato» started the privatization in 1990 by
authorizing the state owned banks to chart private
corporations (called «società conferitarie») to which
they should transfer their banking activities. At the
same time, the state owned banks should chart a
fondazione bancaria (also called «ente conferente»).
The fondazione bancaria is a particular type of
foundation afterwards regulated by the Legislative
Decree no. 153/1999 to promote the process of
privatization. The aim of these institutions was to own
all the shares of società conferitarie, in order to
gradually sell them. To pursue at this aim, Section 25
of the Legislative Decree no. 153/1999 stated that
every fondazione bancaria should sell all its shares by
31 December 2005 (or at least decrease its
participation under a control level). An administrative
committee would be settled to dispossess fondazioni
bancarie still not complying with this provision at the
mentioned deadline. Another intent of the Legislative
Decree no. 153/1999 was that, after the shares‘
dismissal, fondazioni bancarie would continue to
exist as mere non profit organizations.
For what concern the third step, the biggest
innovation brought by the TUB was the reintroduction
of the universal bank (Section 10) and the consequent
repeal of the separation between commercial and
investment banking. It also set specific provisions
about bank‘s ownership in order to pose limits to the
shares of banks that could be owned by industrial
companies, without completely prohibiting these
participations (Sections 19-24). More generally, the
mentioned law rearranged the system allowing for the
existence of only three different kind of banks
(Sections 19-37): ordinary banks chartered as
corporations and two different kind of banks chartered
as cooperatives (banche popolari and banche di
credito cooperativo). These provisions formally
privatized the system by ordering banks to assume the
legal form of private corporations or cooperatives (but
they practically remained out of the market as the
following paragraph will explain).
In addition, the TUB also designed the
supervisory system for the banking sector and charged
the Banca d‟Italia with its fulfilment. Indeed, the
Banca d‟Italia is still charged of the following tasks:
supervision of the financial and organizational
situations of banks and banking groups; prudential
control and validation of internal models for the risk
measurement; safeguard of intermediaries‘ sound and
prudent management (Sections 51-69).
Moreover, the TUB provided a specific and
detailed discipline of the banking groups (Sections
60-64). Finally, in 1996 the Legislative Decree no.
659/1996123 introduced in the TUB a new part
(Sections 96-96 quater) providing for a system of
deposits‘ insurance.
5. The final achievement of a (quasi) free
market oriented credit industry
At the mid of the 1990s the combined action of
«Legge Amato» and TUB formally privatized the
Italian credit industry. Banks were formally chartered
as private corporations and controlled by private
institutions (i.e. fondazioni bancarie). However,
despite this formal change, banks were still out of the
market. In fact, according to Section 4 of the
Legislative Decree no. 153/1999, the majority of each
fondazione bancaria‘s directors should be nominated
by local institutions listed by Section 114 of the
Constitution (i.e. municipalities, metropolises,
provinces, regions). In other words, this provision
implied a mere shift in the control of Italian banks
from a central level (i.e. the State) to a peripheral
level (i.e. local institutions). Under such
circumstances, local institutions had incentives to
maintain the control over banks through fondazioni
bancarie in order to preserve their headquarters
within the borders of the local community. Thus,
there was the possibility that local institutions would
compel fondazioni bancarie to avoid (or at least to
delay) the accomplishment with Section 25 of the
Legislative Decree no. 153/1999 (which imposed the
gradual sell of shares they held).
On the contrary, the majority of fondazioni
bancarie gradually complied with above mentioned
Section, while a few of them continued to control
their società conferitarie. In fact, since the mid of the
1990s until now, the market for the control of banks
120
D.lgs. 17 maggio 1999, no. 153.
D.lgs. 1° settembre 1993, no. 385.
122
See M. CLARICH, A. PISANESCHI, Le fondazioni bancarie –
Dalla holding creditizia all‟ente non-profit, cit., p. 36.
121
123
D.lgs. 4 dicembre 1996, no. 659.
95
has been very active in Italy124. There have been
several initial public offerings of banks and many
mergers which progressively diluted the initial
percentage of shares held by fondazioni bancarie. The
main poles of aggregation during this wave of
mergers have been the oldest, most famous and
already mentioned Italian banks125.
Firstly, around the old Credito Italiano (which
was privatized in 1993 without following the scheme
provided by «Legge Amato») Unicredito Italiano was
formed. More precisely, by the merger of Cassamarca
e Cassa di Risparmio di Verona, Unicredito was
initially created in 1995. Later, Unicredito Italiano
was created in 1998 by the merger of Cassa di
Risparmio di Torino, Credito Italiano, Rolo Banca
1473 and Unicredito.
Secondly, around the old Banca Commerciale
Italiana (which was also privatized in 1994 without
following the scheme provided by «Legge Amato»)
Banca Intesa was formed. More precisely, Banca
Intesa was initially created in 1997 by the merger of
Cassa di Risparmio delle Province Lombarde and
Banco Ambrosiano Veneto. Later, in 1999, Banca
Commerciale Italiana also merged in Banca Intesa.
Thirdly, Sanpaolo IMI was created at the end of
1998 by the merger of Istituto San Paolo di Torino
and IMI. Later, Sanpaolo IMI also acquired Banco di
Napoli and Banca Cardine (which was created in
2000 by the merger of several casse di risparmio).
Fourthly, Banco di Roma acquired some
important banks such as Banco di Sicilia and Banca
Nazionale dell‟Agricoltura. Later, Capitalia was
created in 2002 by the merger between Banca di
Roma and Bipop Carire.
Finally, Banca Monte dei Paschi di Siena
acquired some important banks such as Banca
Toscana, Banca Agricola Mantovana and Banca del
Salento.
In sum, at the mid of 2000s, five banks can be
regarded as the major players in the Italian credit
industry: Unicredito Italiano, Banca Intesa, Sanpaolo
IMI, Capitalia and Banca Monte dei Paschi di
Siena126. Beside them, Mediobanca still was
considered as the most renowned merchant bank of
the country127. The rest of the credit industry
accounted other banks chartered as corporations and
banche popolari (which could both range from very
124
See F. PANETTA, La trasformazione del sistema bancario
e i suoi effetti sull‟economia italiana, on F. PANETTA,
(Edited by), Il sistema bancario italiano negli anni Novanta
– Gli effetti di una trasformazione, Bologna, Il Mulino,
(2004).
125
See, also for data and information provided below, F.
TRIVIERI, Proprietà e controllo delle banche italiane,
Catanzaro, Rubettino, (2005).
126
Except for Banca Monte dei Paschi di Siena, which is
not included, see S. LA FRANCESCA, Storia del sistema
bancario italiano, cit., p. 270.
127
See G.M. GROS-PIETRO, E. REVIGLIO, A. TORRISI, Assetti
proprietari e mercati finanziari europei, cit., p. 260.
96
small to quite large dimensions) 128, along with tiny
local banche di credito cooperativo.
Given this context, it‘s possible to say that the
ownership and control structure of the Italian banks in
the first part of the current decade varied a lot.
Mediobanca was the first to change its ownership and
control structure in 1988. Then, the three founding
banks decreased the amount of shares they held from
about 57% to 25%. Part of the sold shares was
acquired by a group of private investors which jointly
held the same percentage of shares owned by the
founding banks. These two groups (i.e. founding
banks and private investors) formed a controlling
syndicate which has been renewed some times
(according to variations within the pool of
shareholders) but still now controlling the bank 129.
Among the other five most important Italian banks,
fondazioni bancarie progressively decreased their
shareholdings under a control level in four of them
(Unicredito Italiano, Banca Intesa, San paolo IMI and
Capitalia), whereas a fondazione bancaria maintained
more than 50% of Banca Monte dei Paschi di
Siena130. Beside banche popolari and banche di
credito cooperativo (which, being chartered as
cooperatives,
necessarily
had
atomistic
shareholdings), the rest of the credit industry was very
variously owned and controlled131. However, in a
wise book published in 2005, some prominent
scholars claimed that the Italian banks could be
mostly regarded as «quasi public companies» at that
time132. Indeed, fondazioni bancarie had the control
of the biggest part of the Italian credit industry since
their institution, but in 2006 foreign banks surpassed
fondazioni bancarie for the amount shares owned in
the Italian banks133.
However, in 2005 and 2006, financial scandals
coupled with the distress of some banks and political
oppositions to the acquisition of two Italian banks by
foreign institutions shaped the image of Italy as a
country that will never definitely overcome its lacks
128
See E. BONACCORSI DI PATTI, G. GOBBI, Piccole imprese e
cambiamenti strutturali nei mercati locali del credito, on F.
PANETTA, (Edited by), Il sistema bancario italiano negli
anni Novanta – Gli effetti di una trasformazione, Bologna,
Il Mulino, (2004), p. 205-207.
129
For more information see www.mediobanca.it.
130
Until 1999 see F. TRIVIERI, Proprietà e controllo delle
banche italiane, cit., p. 152, 155 and 158. Later see L. GIANI,
Profili di efficienza nel completamento della privatizzazione
del sistema bancario italiano: il caso delle fondazioni
bancarie, forthcoming on Studi e Note di Economia, (2009).
131
For what concern banks chartered as corporations and
banks initially chartered as banche popolari (which later
changed their form from cooperatives to corporations) see F.
TRIVIERI, Proprietà e controllo delle banche italiane, cit., p.
82, 92 and 100.
132
See M. BIANCHI, M. BIANCO, S. GIACOMELLI, A.M. PACCES,
S. TRENTO, Proprietà e controllo delle imprese in Italia,
Bologna, Il Mulino, (2005), p. 151.
133
See the article appeared on «La Repubblica – Affari e
Finanza» on 13 February 2006.
of economic liberalism134. In other words, corporatism
seemed still pervading the Italian system and
jeopardising the final and real achievement of a
private owned and free market oriented credit
industry. Indeed, in this context the Law no.
262/2005135 (approved on 28 December 2005)
changed the Section 25 of the Legislative Decree no.
153/1999 by stating that fondazioni bancarie were no
more compelled to sell their shares, but they couldn‘t
vote for more than 30% of shares owned in their
società conferitarie. This in practice would have
allowed the fondazioni bancarie not complying with
Section 25 of the Legislative Decree no. 153/1999 to
keep their banks definitely out of the market 136.
Fortunately that was not the case. Maybe due to
the fact that a free market oriented culture was more
established than believed, another Law approved on
the 1° December 2006137 repealed the Law no.
262/2005. In addiction, two foreign banks finally
managed to acquire their Italian targets. At the same
time, maybe in response to the couple of acquisitions
mentioned above, the credit industry continued its
process of concentration. In 2006 Intesa Sanpaolo
resulted from the merger of Sanpaolo IMI and Banca
Intesa and, the year later, Unicredit Group resulted
from the merger of Unicredito Italiano and Capitalia.
In this context, Banca Monte dei Paschi di Siena was
forced to increase its size or to become unable to
compete, consequently compelling the controlling
fondazione bancaria to sell its shares. Thus, in 2007
Banca Monte dei Paschi di Siena finally mobilized its
resources and took the control of Banca Antonveneta
(one of the two banks acquired by foreign institutions
few months before). Currently, Intesa Sanpaolo and
Unicredit Group are two of the largest banks of
Europe and they can be both (the second one in
particular) substantially considered public companies
for what concern their ownership structure. The third
largest bank of Italy (Banca Monte dei Paschi di
Siena) has reached a competitive size at a continental
or even global level. Nowadays very few fondazioni
bancarie (included that one which controls Banca
Monte dei Paschi di Siena) continue to keep the
control of some banks. However, at this time
fondazioni bancarie are part of a system that seems to
be effectively competitive, so that they are no more
privileged institutions, but normal players forced to
drive their businesses as any other one. In sum, apart
from some persisting lacks, the Italian banking system
seems to have finally took the shape of a free market
oriented one and the credit industry can now be
considered totally privatized.
This is not to say that the Italian model of credit
industry can be judged equal, for instance, to the
American one or viewed as completely free from
political and social influences. Italy, as every country
in the world, has its own and persisting peculiarities.
Notwithstanding this, it can be definitely said that, if
the U.S. credit industry represents the model of a free
market oriented system, a large part of the Italian
banks is crossing the Atlantic.
6. Conclusions
Culture and history always matter and, along with
path dependencies, they often represent the main
obstacles in changing a system of capitalism. As this
work tried to explain, culture and history have deeply
influenced the way in which the Italian economy has
been organized and, more specifically, the ownership
and control of the Italian banks.
Since the unification of the country in 1861
and the end of the World War I cultural attitudes
towards the economy were deeply marked by
liberalism. Moreover, cultural affinities along with
political strategies played an important role in shaping
the Italian institutional framework in resemblance of
the French or the German one. In this period, the
Italian credit industry was widely private owned.
Later, the social instances which fuelled the rise of
fascism pressed for a strong intervention of the State
into the economy and the credit industry became
almost totally state owned. After the World War II
and the fall of fascism, strong liberalistic attitudes
towards the economy rose again. Notwithstanding
this, the institutional framework settled during twenty
years of fascist rule was difficult to dismantle. In
addiction, also some of the most culturally similar
countries had in that period friendly attitudes towards
a certain degree of public intervention into the
economy. Thus the Italian economy evolved in the
second half of the previous century as a system in
which both private and state owned firms coexisted.
In this period, the credit industry was still largely state
owned. Only few years ago, at the mid of the 1980s,
political pressures (i.e. from the EEC), as well as
social and economic instances, called for the retreat of
the State from the economy. More than twenty years
are gone since then and just now the Italian credit
industry can be regarded as totally privatized.
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THE EFFECT OF THE SOUTH AFRICAN MARKET CONCENTRATION
ON PORTFOLIO PERFORMANCE
Jakobus Daniël (JD) van Heerden*, Sonja Saunderson**
Abstract
Portfolio risk is mainly a function of portfolio concentration and covariance between the assets in a
portfolio. This study shows that South Africa experiences a high level of market concentration and that
assets with large weights in the FTSE/JSE All Share Index (ALSI) have large covariances with each
other. Together these two phenomena suggest that a high level of portfolio risk can be expected. Active
portfolio managers in South African generally attempt to decrease portfolio concentration by deviating
from the benchmark‟s weighting structure in order to decrease their portfolio risk. The effect of such a
portfolio construction process on the measurement of relative performance, where the ALSI is used as
the benchmark, was investigated by means of a simulation process. The results indicated that during
times when those shares with larger weights in the index perform well, the probability of outperforming
the ALSI is very small, while the probability of outperforming the ALSI during times when those same
shares perform poorly is very high. These findings suggest that investors need to be educated about the
bias regarding relative performance measurement using broad market indices, while alternative or
additional methods of performance measurement need to be investigated to minimise this bias.
Keywords: stock market, South Africa, performance measures
*Senior Lecturer, Department of Business Management, University of Stellenbosch, Private Bag X1, Matieland, 7602
South Africa
jdvh@sun.ac.za
**Deputy Chief Investment Officer, Advantage Asset Managers, PO Box 330, Gallo Manor, 2052, South Africa
sonjas@advantage.am
Introduction
In general, "market concentration" is defined as the
tendency of a market to be dominated by a few big
companies. The literature suggests that emerging
countries show much higher levels of market
concentration than do developed countries (Du
Plessis, 1979, Roll, 1992, Bekaert et al., 1995,
Aggarwal et al., 1999, Bradfield et al., 2004). A study
done by Roll (1992), for instance, showed that South
Africa had the third highest level of market
concentration in the world as measured by the
Herfindahl-Hirschmann Index, following Mexico and
New Zealand. Together with this high level of
concentration, South Africa showed the highest level
of equity index variance as measured by the standard
deviation. In the literature it is suggested that a
positive relationship exists between the level of
market concentration and portfolio risk. Bradfield et
al. (2004) argue that owing to this relationship
between market concentration and portfolio risk,
portfolio managers are inclined to deviate from the
market‘s weighting structure in order to decrease
portfolio risk, where the market is defined as the
FTSE/JSE All Share Index (ALSI). During the time
period from 2002 until 2007 most of the South
African General Equity Unit Trust portfolio managers
outperformed the ALSI during the bear phase (a time
period during which security prices fall significantly)
while underperforming the ALSI during the bull
phase (a time period during which security prices rise
significantly). The objective of this study was to
investigate the possibility of a relationship between
the tendencies of portfolio managers to hold less
concentrated portfolios in order to decrease portfolio
risk, and their performances during different market
phases.
This paper is organised as follows: First an
overview of the literature on the relationship between
market concentration, covariance and portfolio risk is
provided. The approach followed in executing the
study is discussed in the research methodology
section, followed by the results of the empirical study.
From these results emanate recommendations
regarding the use of a broad market index such as the
ALSI as a relative performance measurement
technique, which is discussed in the conclusions
section.
Literature overview
According to Clarke (1985), market concentration
refers to the degree to which production for or in a
particular market or industry is concentrated in the
99
hands of a few large firms. Various measures of
market concentration are described by Clarke (1985)
of which the best-known and most widely used
measure in the literature is the Herfindahl-Hirschman
Index (HHI). The HHI index was the result of two
independent studies by Albert O Hirschman (1945)
and Orris C Herfindahl (1950), in which each of them
used their own version of what is now known as the
HHI index. Since the establishment of the HHI index,
some prominent economists have touted the HHI as
superior to other concentration measures (Laine,
1995). In 1982 the HHI was adopted by the United
States Department of Justice for measuring market
concentration in governmental merger analysis. In his
study on benchmark concentration regarding the
FTSE 100 Index, Tabner (2007) found that a range of
other measures discussed by Clarke (1985) showed
time series paths that were very similar to those of the
HHI index. For these reasons, it seems that the HHI
index is the most appropriate concentration metric to
be used in measuring market concentration, and was
therefore utilised in this study.
The HHI is calculated by summing the squares
of the market shares of all the participants in a given
market. In mathematical terms, the HHI index can be
formulated as follows:
N
HHI  Wi 2
(1)
i 1
where
Wi is the market share (or investment
weight) in the ith counter (or company listed on the
index in this case) and N is the number of securities
in the index. Thus, the higher the HHI, the more
concentrated the market is.
In his Nobel-prize-winning article, Markowitz
(1952) has described how to combine assets into
efficiently diversified portfolios. This approach
assumes that variance can be used to quantify the risk
of a portfolio. Against this background the terms
"portfolio variance" and "portfolio risk" will be used
interchangeably in this paper. Elton et al. (2003)
argue that the total risk of a portfolio, using variance
as the measurement, can be calculated using the
following formula:
N
N
i 1
i 1 j 1, j i
 p2   wi2 i2  
where
portfolio,
N
w w 
i
j
(2)
ij
wi is the weight of the ith security in the
i
is the variance of security i,
 ij
is the
covariance between securities i and j and N is the
number of securities in the portfolio. Covariance is a
measure of the degree to which two variables move
together (DeFusco et al., 2004).
Using formulas (1) and (2), assuming that the
securities are uncorrelated and have the same
variance, and applying algebra, Bradfield et al.
(2004)1 derived the following formula:
 p2   p2  HHI
100
(3)
where
 p2
is the average security variance.
Formula (3) indicates that, under these
assumptions, the degree of concentration as measured
by the HHI index has a direct impact on the portfolio
variance and therefore portfolio risk. When these
assumptions are relaxed, Elton et al. (2003) point out
that portfolio variance can be expressed as follows:
 p2 
1 2 N 1
i 
 ij
N
N
(4)
The above formula only holds, however, if the
securities in the portfolio are weighted equally, i.e.
when portfolio concentration is zero. The first term of
formula (4) indicates that as the number of securities
increase, the portfolio variance decreases, and for
large N values the contribution of individual security
variance to portfolio variance is insignificant. The
second term indicates that for large N values the
portfolio risk converges to the average covariance
across the securities.
Although some (rather unrealistic) assumptions
have been made by Bradfield et al. (2004) and Elton
et al. (2003) in deriving equations (3) and (4), these
equations show that portfolio risk is mainly a function
of concentration (weighting structure) and covariance
respectively (Bradfield et al., 2004). Understanding
the contribution of these two components to portfolio
risk and reverting back to the first term of equation
(2), it can be stated that if securities with larger
weights also have higher variances, portfolio risk will
increase. The second term of equation (2) suggests
that if securities with larger weights also have larger
covariances with each other, portfolio risk will
increase (Bradfield et al., 2004). In other words, if a
high level of concentration is combined with high
levels of variance and covariance associated with
those securities contributing the most to the high level
of concentration, portfolio risk will be higher. This
relationship was also examined and confirmed by
Bekaert et al. (1995).
Throughout the literature it seems that emerging
markets, like South Africa, experience a higher degree
of market concentration and therefore a higher level
of market volatility compared to developed markets
(Du Plessis, 1979, Roll, 1992, Bekaert et al., 1995,
Aggarwal et al., 1999, Bradfield et al., 2004). One of
the first studies done on the level of concentration in
South Africa was that by Du Plessis (1978) who
showed that economic power in South African
manufacturing was highly concentrated. Roll (1992)
showed that South Africa had the highest level of
volatility and the third-highest degree of
concentration in its national stock market out of 24
countries analysed (including both developed and
emerging markets). Looking back to equation (2),
these studies imply that one would expect South
Africa to show a higher-than-average level of
portfolio risk.
Markowitz (1952) tested the rule that the
investor does (or should) consider expected return a
desirable thing, and variance of return an undesirable
thing. He found that this rule is sound both as a
maxim for, and hypothesis about, investment
behaviour. Therefore it can be argued that a higher
degree of concentration, combined with higher
individual security volatility and covariances, leads to
investors (and portfolio managers) making an effort to
move away from these securities when constructing
portfolios, in an attempt to decrease portfolio risk.
As part of their research, Bradfield et al. (2004)
explore this proposition by comparing the
concentration level of the ALSI, which is defined as
the South African ―market‖ for the purposes of this
study, to the average concentration level of the equity
component of South African General Equity Unit
Trusts. They have found that the ALSI has a
concentration level (as measured by the HHI) of
nearly 1.5 times higher than the average concentration
of the unit trusts, which highlights the aversion South
African managers have to the high level of
concentration in the South African market, supporting
Markowitz‘s (1952) findings. Since active managers
are paid for both return enhancement as well as risk
management (or enhanced return adjusted risk
outcomes), the average South African General Equity
Unit Trust manager tries to move away from the
highly concentrated index by either excluding some of
the larger securities (measured on a market
capitalisation basis) or else underweights those
securities relative to the ALSI. The question is,
however, if portfolio managers deliberately move
away from the ALSI‘s weighting structure to
construct less concentrated (and therefore less risky)
portfolios, how will this decision affect relative
performance when maintaining the ALSI as the
benchmark to which portfolio results are compared?
Methodology
The research done by Du Plessis (1979), Roll (1992)
and Bradfield et al. (2004) has shown that South
Africa has a very high level of market concentration.
Following Bradfield‘s approach and extending the
period under review (a historical period of 3 years
was used by Bradfield et al.), the level of market
concentration in South Africa was measured by
applying the HHI method on the ALSI. The main
variable needed to calculate the HHI is the market
capitalisation for each company listed on the ALSI.
The data was sourced from I-NET Bridge and the
FTSE-JSE directly. The annual HHI was calculated
over a period of 6 years (2002 until 2007).
Next, a correlation matrix was produced over the
same period to provide an indication of the level of
covariance between those securities carrying the
largest weights in the index. Keeping in mind that
portfolio risk is a function of concentration and
covariance, the results of the first two steps can be
used to determine the expected level (expressed as
high or low) of portfolio risk for the ALSI.
Finally the impact of the portfolio construction
process, which is a function of the expected level of
portfolio risk (Bradfield et al., 2004) on portfolio
performance results relative to the benchmark (ALSI),
was measured by means of a simulation process.
Random portfolios were generated by assigning
random weights to the ALSI constituents, assuming a
specific tracking error (the allowed level of deviation
from the ALSI). This process was repeated a thousand
times each for different levels of assumed tracking
error during a bear market as well as during a bull
market, resulting in a thousand portfolios for each of
the assumed tracking errors within the specific market
phase. A distribution of the returns of these random
portfolios was generated for both the bull and bear
markets. The simulated portfolio returns were
compared to the ALSI return, making it possible to
determine whether the portfolio construction process
affects the range of possible returns relative to the
ALSI. For the simulation process, ALSI constituent
return figures were used as the main variable, and
were sourced from I-Net Bridge as well as the
FTSE/JSE.
Results
The HHI was calculated for the ALSI on a monthly
basis over the period 2002 until 2007. The HHI
ranged between 4% and 7.3%, with an average of
5.2% over the 6-year period. This result is very much
in line with the 5.3% HHI calculated by Bradfield et
al. (2004) over a 3-year period. Different
interpretations of the value of the HHI were found in
the literature (see for example Roll, 1992 and Laine,
1995). The basic ―rule‖ is that the higher the HHI, the
more concentrated the market is. The question is
whether 5.2% is high or not? Some interpretations
found in the literature might suggest that this is not a
meaningful number, but the following analysis of the
HHI which was done for the ALSI specifically, will
help to put this number into perspective.
Figure 1 shows the level of concentration as
measured by the HHI for the ALSI when omitting a
number of the top shares (where "top shares" are
defined by market capitalisation).
101
Figure 1
0.06
0.05
0.04
HHI 0.03
0.02
0.01
0
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38
Number of top companies omitted
Figure 1 shows that when all the shares in the
ALSI are included (this is on average 160 shares), the
HHI is 5.2%. When only the top 2 shares are omitted,
a steep drop in the HHI to a level of 3.2% is
experienced, indicating that the top 2 shares alone
contribute almost 40% to the total level of
concentration. Omitting the top 5 shares results in an
HHI of 2.7%, almost half of the HHI value when all
the shares are included, meaning that the top 5
companies contribute almost 50% to the level of
concentration found in the index. As the number of
shares that are omitted increase, the HHI decreases,
but at a slower rate, until it stabilises at around 30
shares. This means that the ALSI is dominated by
only a few shares, as indicated by the substantial
decrease in the level of concentration when the top
few shares are omitted. Table 1 was generated to
further assist in the interpretation of the calculated
HHI:
Table 1
Percentage of index weight
Number of
shares
1
2
3
4
5
10
15
20
30
40
50
100
100%
1
0.5
0.333
0.25
0.2
0.1
0.067
0.05
0.033
0.025
0.02
0.01
90%
0.81
0.405
0.27
0.203
0.162
0.081
0.054
0.041
0.027
0.02033
0.016
0.008
The values in Table 1 represent the HHI value
for a hypothetical index of 160 shares (similar to the
ALSI), assuming that a specific number of shares
(first column) represent a specific weight (first row)
in the index, while the remainder of the 160 shares are
equally weighted. For example, if it is assumed that
only one share out of a total of 160 shares carries
100% of the index weight (which is the extreme case),
the HHI will be 1 (or 100%). If the top 2 shares each
carry a weight of 50% of the index, the HHI will be
0.5 or 50%, and so on. The highlighted HHI is the
102
80%
0.64
0.32
0.214
0.16
0.128
0.064
0.043
0.032
0.022
0.0163
0.013
0.007
70%
0.49
0.246
0.164
0.123
0.098
0.05
0.033
0.025
0.017
0.013
0.011
0.006
60%
0.36
0.18
0.12
0.09
0.073
0.037
0.025
0.019
0.013
0.01
0.009
0.006
50%
0.252
0.127
0.085
0.064
0.052
0.027
0.018
0.014
0.01
0.008
0.007
0.0067
value closest to the actual HHI value calculated for
the ALSI (5.2%). The purpose of this table and the
highlighted values is to compare a concentration level
of 5.2% for the ALSI to different scenarios of a
similar index (consisting of 160 shares) where a
different number of shares contribute a specific
accumulated weight in the index. In other words, the
5.2% HHI found for the ALSI is comparable to a
similar index of which 20 shares (weighted equally)
contribute 100% of the index weight, or put
differently, the ALSI has a similar concentration level
of an equally weighted index consisting of only 20
shares. The last row shows the HHI level for an index
of which the top 5 shares (weighted equally) represent
50% of the index, while the remaining 155 shares
(also equally weighted) represent the other 50%. This
is the closest to the actual case for the ALSI, as the
top 5 shares of the ALSI (which is of course not
equally weighted) represent approximately 40% to
50% (depending on the time of measurement) of the
index, showing the same HHI value of 5.2% as the
hypothetical index.
The number of shares in the index also has an
impact on the level of the HHI. Table 2 below
represents the HHI for a different number of shares in
a hypothetical index which is comparable to the
ALSI, and the assumption is made that the top 5
shares represent 50% of the total index (which is
approximately the average aggregated weight of the
top 5 shares taken over the 6-year period under
review). Put differently, each row in Table 2
represents a hypothetical index, 50% of which is
represented by the top 3.125% shares. The 3.125% is
calculated under the assumption that the top 5 shares
represent 50% of the total index weight, i.e. dividing
5 by 160.
Table 2
Number of
shares in
index
10
20
30
40
50
100
160
HHI
0.8258
0.413
0.275
0.206
0.165
0.083
0.052
The first row in Table 2 shows that if an index of
10 shares were assumed of which the top 3.125% of
shares represented 50% of the index, the HHI would
have been 0.8258. According to some of the
interpretations in the literature, this would be regarded
as an extremely high level of concentration. If, for
example, an index consisted of 40 shares, and the top
3.125% of shares (or 1.25 shares) represented 50% of
the index, the HHI would have been 0.206, and would
still be regarded as very high. Keeping the percentage
of top shares representing 50% of the index constant
(on 3.125%), and increasing the number of shares in
the index, clearly shows (Table 2) that the HHI level
decreases and is therefore a function of the number of
shares in the index.
Taking the above analysis of the HHI into
account and keeping in mind that the HHI is a
function of a number of factors (for example the
number of shares), it would seem that an HHI level of
around 5.2% for the ALSI can be regarded as high,
implying that the level of concentration in the ALSI is
high. This means that the first component of portfolio
risk, namely concentration (refer to the earlier
literature overview), is expected to increase the
expected level of risk.
In order to investigate the second component of
portfolio risk, covariance, 6 shares that were
continuously in the top 10 shares (based again on
market capitalisation) over the 6-year period, were
identified. At the end of August 2007, these shares
represented approximately 41% of the ALSI. The
actual value of the covariance is not very meaningful
owing to its level of sensitivity to the scale of the
variables as well as its wide range of possible values.
It is therefore more useful to calculate the correlation
coefficient, which measures the strength of the linear
relationship between two variables (DeFusco et al.,
2004). The correlation coefficient ranges from -1 to
+1, where -1 indicates a perfect negative correlation,
0 indicate no linear relationship and +1 a perfect
positive correlation. Table 3 represents the correlation
matrix for the 6 variables identified, using monthly
returns over the 6-year period.
Table 3
AGL
AGL
BIL
SOL
RCH
SAB
OML
BIL
SOL
RCH
SAB
1
0.714985
1
0.542061 0.629087
1
0.560687 0.413939 0.472906
1
0.429364 0.30148 0.360472 0.436797
1
0.251487 0.340407 0.343229 0.598157 0.291276
Table 3 shows that most of the 6 shares
identified tend to move closely together, indicated by
the high correlation coefficients. Because of the high
correlation coefficients, it can be said that the second
component, namely covariance between the large
capitalisation shares, can also be expected to increase
the level of portfolio risk. Furthermore, these shares
also have high volatility, as measured by the standard
deviation, which ranges between 5.3% and 8.1%,
OML
1
contributing even more to a higher expected risk
level.
Of the two components of portfolio risk,
concentration and covariance, portfolio managers can
only control the concentration component by
deviating from the ALSI weighting structure when
constructing their portfolios (Bradfield et al., 2004).
The level of deviation from the ALSI weighting
structure is reflected in the tracking error. A higher
103
tracking error is an indication of the level and number
of ―bets‖ a manager takes by over- or underweighting
the shares in his or her portfolio relative to the ALSI
(in the extreme case, shares might be underweighted
by 100%, meaning that the share is not included in the
portfolio at all). Managers take these bets to generate
alpha, i.e. a return greater than that obtained by the
benchmark (or ALSI in this case). But managers also
deviate from the ALSI weighting structure to decrease
their portfolio risk. One way of achieving a lower
level of portfolio risk is by underweighting the large
capitalisation shares, and overweighting the smaller
capitalisation shares. Evidently from the analysis on
the two components contributing to the level of
portfolio risk, by underweighting the large shares, the
level of concentration will decrease, resulting in a
lower level of portfolio risk. Bradfield et al. (2004)
have shown that the ALSI has an HHI of nearly 1.5
times higher than the average General Equity Unit
Trust fund, which emphasises the tendency of South
African portfolio managers to deviate from the ALSI
weighting structure, specifically underweighting the
large shares, in order to obtain lower levels of
concentration and therefore lower levels of risk in
their portfolios. However, most of these portfolio
Figure 2
managers still use the ALSI as their benchmark
against which their portfolio performance is
measured. Using the ALSI as the benchmark creates a
concern, as it seems logical to expect that if the top
shares (in terms of market capitalisation) are
underweighted, the portfolio will underperform the
ALSI in periods during which those shares perform
well, while the opposite might be true during times
when those shares perform poorly.
To determine whether the deviation from the
market-weighting structure does indeed result in
portfolio under-performance during times when the
top shares perform well, and portfolio outperformance when the top shares perform poorly, a
simulation process was performed2. Random
portfolios were generated, and sorted into risk profiles
according to tracking error bands. One thousand
random portfolios were constructed to derive the
manager‘s opportunity set (i.e. the range of possible
returns for the manager, given the level of tracking
error) around the ALSI for 2005. This period can be
considered a bull phase, as the ALSI returned
approximately 47% for the year. The results are
presented in the boxplot in Figure 2.
Simulated Tracking Error Outcomes for Alsi 2005
0.7
Return Outcome
0.6
0.5
0.4
0.3
0.2
0.1
1
2
3
4
Tracking Error
In Figure 2 horizontal lines are drawn at the
median (the lines within each ―box‖) and at the upper
and lower quartiles (the top and bottom lines of each
―box‖). The vertical line is drawn up from the upper
quartile, and down from the lower quartile, to the
most extreme data point that is within a distance of
1.5 times the interquartile range (IQR).
The horizontal dotted line represents the ALSI
return for 2005. When a tracking error of one is
assumed, the boxplot shows that the ALSI return lies
within the upper end of the upper quartile of the range
of possible returns, indicating that there was a small
chance (less than 25%) for a manager to outperform
the ALSI, given that he or she does not deviate too
much (i.e. assuming a low tracking error) from the
ALSI weighting structure. The higher the assumed
104
tracking error, the smaller is the chance of
outperforming the ALSI. For a tracking error of 4, for
example, it is almost impossible to outperform the
ALSI during this period, shown by the ALSI return
lying at a distance of approximately 1.5 times the IQR
from the upper quartile. These simulation results
suggest that the more a fund manager is deviating
from the highly concentrated top performing shares in
the ALSI, the more likely it is that he would have
underperformed the ALSI.
The same simulation process was performed
during a bear phase. The ALSI showed a return of
approximately -8% during 2002, which is the period
chosen to represent the bear phase for the simulation
process. The results of this analysis are provided in
the boxplot in figure 3.
Figure 3
Simulated Tracking Error Outcomes for Alsi 2002
Return Outcome
0.05
0
-0.05
-0.1
-0.15
-0.2
-0.25
1
2
3
4
Tracking Error
Figure 3 shows that during a bear phase, the
opposite results from those obtained during the bull
phase analysis can be expected with regard to
manager performance. For an assumed tracking error
of one, the chance of outperforming the ALSI is more
or less the same as during a bull phase (refer Figure
2). However, even the median random portfolio
outperforms the ALSI when the tracking error is
assumed to be 2, while the number of random
portfolios outperforming the ALSI when the tracking
error is assumed to be 3, moves towards the 75%
mark. Figure 3 indicates that continuing to increase
the assumed tracking error results in an increasing
probability of outperforming the ALSI. Thus the more
the manager deviates from the large capitalisation
shares that are performing poorly (and therefore are
driving the bear phase), the higher the chance of
outperformance.
Conclusion
Following the approach by Bradfield et al. (2004),
this study shows that portfolio risk is mainly a
function of portfolio concentration and covariance
between the assets in the portfolio. Using the
Herfindahl-Hirschman Index as a measure of
concentration and the All Share Index as the market,
the first component, concentration, was investigated
and it was found that South Africa experiences a high
level of market concentration. The second component,
covariance, was investigated by means of a
correlation matrix, showing the correlation
coefficients of the top 6 shares (according to market
capitalisation) of the ALSI over a period of 6 years.
These coefficients were generally high, which means
that those shares with large weights in the index also
tend to move closely together. Combined, these two
components suggest that a high level of portfolio risk
(assuming the ALSI as the market portfolio) can be
expected. As was argued by Bradfield et al. (2004),
most South African portfolio managers underweight
the large capitalisation shares of the ALSI to decrease
their portfolio risk by holding a less concentrated
portfolio. The effect of such a portfolio construction
process on the measurement of relative performance,
where the ALSI is used as the benchmark, was
investigated by means of a simulation process.
Random portfolios were generated and sorted into risk
profiles according to tracking error bands. The
simulation process showed that managers find it very
difficult to outperform the ALSI during bull phases,
while almost any manager (even investors who are
not professional portfolio managers as suggested by
the random portfolios created) can outperform the
ALSI during a bear phase. These results imply that
using the ALSI as the one-and-only yardstick to
measure the performance of General Equity Unit
Trust portfolio managers is biased. Unfortunately this
is the most commonly used method for determining
manager performance and skill, as it is easy to
understand and very simple to interpret. If the
manager underperforms the ALSI, it is a reflection of
poor skill; if he outperforms, he gets praised for his
above-average ability to pick the right shares.
However, the simulation process illustrates that outor underperformance of the ALSI during a specific
phase doesn‘t have a lot to do with skill, but can
rather be ascribed to the manager‘s attempt to move
away from portfolio risk by holding less concentrated
portfolios. Therefore using an index such as the ALSI
as a measurement of performance, a manager can be
regarded as very skilful one year, but incompetent the
very next year. The question therefore is whether
using the ALSI as the main approach to measure
manager performance is fair, as it seems that portfolio
performance is dominated more by the effect of
market concentration than manager skill. To address
this bias, it seems necessary to educate investors
about this phenomenon and to investigate or create
alternative or at least additional methods that can be
used to measure manager performance. It also
highlights the inherent dangers in constructing active
mandates based on pre-specified tracking errors, since
these often force fund managers to take unintended
bets, resulting in unintended performance biases.
105
Footnotes
1
Permission was obtained from Professor David Bradfield to
quote their article ―Concentration – Should we be mindful
of it?‖ The article is unpublished and intended for clients of
Cadiz Financial Strategists only. Professor Bradfield is the
Team Leader of the Quantitative Research team at Cadiz
Financial Strategists.
2
The simulation process was performed by means of a
simulation model developed and used by Advantage Asset
Managers.
7.
8.
9.
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Herfindahl, Orris C. 1950. Concentration in the Steel
Industry. Columbia: Columbia University. [PhD
dissertation]
Hirschman, Albert O. 1945. National Power and the
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point of view. The Antitrust Bulletin, 423 – 432,
Summer.
Markowitz, H. 1952. Portfolio Selection. The Journal
of Finance, 7(1): 77 – 91, March.
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[Online].
Available:
http://ssrn.com/abstract=741144 [12 December 2007]
РАЗДЕЛ 2
ОПЦИОНЫ НА АКЦИИ
SECTION 2
STOCK OPTIONS
THE IMPACT OF EXPENSING STOCK OPTIONS IN BLOCKHOLDERDOMINATED FIRMS. EVIDENCE FROM ITALY
Andrea Melis*, Silvia Carta**
Abstract
Accounting for stock options and executive remuneration have been one of the most debated and
controversial issues in accounting regulation and corporate governance. The purpose of this study was
to explore the impact of the mandatory adoption of IFRS 2 for accounting of stock options in Italian
non financial listed companies. This paper has investigated the economic consequences of recording
the cost of stock options at its fair value, in terms of its impact on the companies‟ reported earnings,
and other key financial performance indicators, such as diluted earnings per share (EPS) and return on
assets. The impact of the mandatory recording of the cost of stock options measured at its fair value has
generally reduced the reported earnings and other key performance measures moderately. Despite
some evidence of creative accounting which was found concerning the elusion of the substance over
form principle for the accounting of stock options plans set up before 7 th November 2002, accounting
regulation has increased the level of disclosure by making companies report the “true” cost of stock
options in their Profit or Loss. Based on 2004 stock-based remuneration disclosures of the value of
options given to directors and employees, the expensing of options have a material negative impact on
nearly 30 per cent of the sample firms‟ reported income and diluted EPS. The mandatory adoption of
IFRS 2 seems to have relevant implications for corporate governance as it has reduced the information
asymmetry between corporate insiders and outsiders on the “true” cost of stock-based remuneration.
Keywords: stock options, blockholders, Italy
*Department of Ricerche aziendali, University of Cagliari, Viale S. Ignazio 17, 09126 Cagliari – Italy
melisa@unica.it,
**Department of Ricerche aziendali, University of Cagliari, Viale S. Ignazio 17, 09126 Cagliari – Italy
silviacarta@unica.it
Introduction
The use of stock options as remuneration device and
its accounting method has represented one of the
most debated and controversial issues during the last
decades, both in the accounting and in the corporate
governance literatures. Financial reporting and
corporate governance are highly interrelated systems
(e.g. Whittington, 1993; Bushman, Smith, 2001;
Melis, 2004). In particular, financial reporting
constitutes an important element of the corporate
governance system, as it may potentially reduce the
information asymmetry between corporate insiders
and outsiders.
The recognition of stock option plans (and
equity-settled share-based payments, in general) as a
cost in Profit or Loss is a recent outcome of a long
debate between standard-setter bodies and industrial
associations (Guay et al., 2003). In the US the final
result was the issue of a revised version of SFAS
123R (2004); in Europe, the outcome was the
mandatory adoption of IFRS 2 (2004) imposed by the
European Commission to the listed companies of its
Member States. Both the two standards have required
the mandatory recognition of a cost for stock options,
107
measured at the fair value of the equity instruments at
the grant date.
Accounting is concerned with how economic
actors process information and make decisions. It
cannot be considered simply a neutral technique for
economic decision-making as it is able to sanction
the distribution of wealth among corporate
stakeholders, including shareholders (e.g. Horngren,
1973; Rappaport, 1977). Both the issue of the SFAS
123R in the US and of the IFRS 2 by the IASB has
been the outcome of a significant lobbying activity
by constituents (e.g. Shelton, Stevens, 2002; Zeff,
2002; Giner, Arce, 2007). This was due to the
relevant economic consequences that the accounting
regulation of stock options could have had on the
wealth of corporate stakeholders, and on corporate
governance in general. In particular, the concerns
about executive remuneration represent a major
aspect of the rationale for enhanced corporate
governance (e.g. Core et al., 2003; Jensen et al.,
2004).
The main purpose of this study is to measure the
impact of the mandatory adoption of IFRS 2 for
accounting of stock options in Italian non financial
listed companies. This paper will investigate the
economic consequences of recording the cost of
stock options at its fair value, in terms of its impact
on the companies‘ reported earnings as well as on
other key financial performance indicators, such as
diluted earnings per share (EPS) and return on assets
(ROA). The empirical results will be analysed taking
into account the corporate governance implications
that stock options‘ expensing might have, in terms of
reducing information asymmetry between corporate
insiders and outsiders on such a key issue as the cost
of stock option-based remuneration.
As noted by Chalmers and Godfrey (2005), any
concern about the economic impact of expensing
stock options is settled if the change does not
significantly affect reported accounting measures
used by investors to assess companies‘ performance.
Using stock options disclosures, previous studies
have provided evidence that if stock option-based
remuneration was to be expensed, it would
significantly affect key financial performance
indicators of high-growth US companies (Botosan,
Plumlee, 2001), and of large non-US companies
listed on the NYSE and/or NASDAQ (Street,
Cereola, 2004). However, Street and Cereola (2004)
found that the materiality of the effect varied
significantly by country. Chalmers and Godfrey
(2005) found that the concerns about stock option
expensing was not material for most of Australian
listed firms.
This paper extends previous literature by
analysing Italian non financial listed companies, on
which there is a scant empirical evidence. As Italy is
one of the first countries, internationally, to adopt
fully IFRSs, Italian listed companies provide an
interesting sample and an early opportunity to
examine the impact of the mandatory IFRS 2
108
adoption. The choice of a non-Anglo-Saxon country
for a single country case study seems useful to extend
previous literature findings which mainly focused on
Anglo-Saxon companies (Botosan, Plumlee, 2001;
Chalmers, Godfrey, 2005), or on non-AngloAmerican companies listed in Anglo-Saxon stock
exchanges (Street, Cereola, 2004).
The remainder of the paper is organised as
follows. Section 2 summarises the Italian financial
reporting regulation on stock options before and after
the IFRS adoption in 2005. The research design and
methodology is discussed in Section 3. In Section 4
results are presented and analysed. Section 5
concludes.
The Italian regulation on stock options: a
synopsis
The adoption of IFRS 2 has completely changed the
accounting for stock options in Italy. Italian
accounting standards (CNDC-CNR, 2001, OIC,
2007) have never issued any standard on share-based
payments, nor do they deal specifically with it yet.
The accepted practice was driven by a 1998
CONSOB138 recommendation, which required Italian
listed companies to disclose the details of the stock
options given to directors and senior managers in the
notes of the accounts as well as to credit equity when
the options were exercised by the holders. Before
1998, information regarding stock options was not
publicly available. As a matter of fact, the diffusion
of stock options in Italy is relatively recent. Fixed
wages have been the main ingredient of executive
remuneration and, in general, equity-based schemes
were rarely adopted by Italian non financial listed
companies in the 1990s (Melis, 1999). Stock options
plans started to be more widely adopted since 19981999 (Bertoni, 2002; Zattoni, 2003). The event that
fostered the adoption of these plans by Italian
companies was the 1998 Tax Reform which provided
strong fiscal incentives for beneficiaries (Zattoni,
2007). The diffusion of stock option plans seems
dependent on ‗external‘ factors, such as a favourable
fiscal treatment in comparison to cash and other inkind remuneration (Di Pietra, Riccaboni, 2001;
Quagli et al., 2006; Zattoni, 2007), and the
accounting treatment of this transaction (Quagli,
2006).
Until 2005 the recording of the cost of stock
options was voluntary even for listed companies.
Stock-options were basically an off-balance sheet
operation, as almost none of the companies that gave
stock-options to its directors, senior management (or
other employees) as part of its compensation
recognised such cost in their Profit or Loss. This
creative accounting practice led to a reduction of the
costs reported in the Profit or Loss, and could have
138
CONSOB is the Italian public authority responsible for
regulating and controlling the Italian securities markets.
had economic consequences in the cases in which the
unrecognised cost was material.
In 2005 the mandatory adoption of IFRSs has
obligated Italian non financial listed companies to
recognise the fair value of stock options as an
expense in their Profit or Loss (IFRS 2, 2004). The
cost of stock option plans is to be measured at the fair
value of the equity instrument granted multiplied by
the number of instruments the company estimates
that will be exercised.
non-adoption of IFRS 2 for specific stock option
plans.
Hence, 45 companies comprise the final sample
(a list is reported in the Appendix). Among them,
three companies had chosen to record the fair value
of the stock options‘ cost in Profit or Loss before the
mandatory adoption of IFRS 2 required them to do so
(see ESOP 2004-No impact in table 1).
Research design and methodology
Data collection
For each company, data have been gathered from
consolidated financial statements referring to the
years 2004 and 2005. The period considered was
selected to allow to conduct a natural experiment to
measure the impact of the accounting regulation on
stock options‘ expensing. The same financial reality
referring to 2004 results has been measured twice by
each company: all the companies chosen for the
investigation have been required to prepare and
present their own 2005 consolidated financial
statements according to IFRSs, presenting, at the
same time, the 2004 data (which had been prepared
according to Italian GAAPs) according to IFRSs.
We investigated the impact of the mandatory
adoption of IFRS 2 on firms‘ key performance
indicators by comparing performance ratios
calculated using actual 2004 reported financial
figures with pro-forma ratios calculated using the
2004 reported numbers adjusted as if the stock
options were expensed over the period. Specifically,
we measured the impact of the unrecognised cost on
the reported income (unrecognised cost of stock
option / reported income) and we constructed the
pro-forma key financial performance measures
(ROA, and diluted EPS), based on the 2004 Italian
GAAP data, as follows:
Our study extends previous literature by examining
the impact of stock options‘ expense recognition for
non financial listed companies based in a non-AngloSaxon country. Specifically, the key research
question that this paper seeks to answer is: is the
impact of expensing stock option material in Italian
non financial listed companies?
The investigation has been conducted in terms
of the ability of IFRS 2 to improve the perception of
the cost of stock options to financial statements‘
users. This ability was explored in terms of impact of
the cost of stock option on the companies‘ reported
earnings and other key financial performance ratios,
such as diluted EPS and ROA.
Sample selection
This study focused on Italian non financial listed
companies (including real estate companies) which
has been required to adopt IFRSs since 2005. Banks
and insurance companies and other financial
institutions have been eliminated in view of the
peculiarities of the financial industry and its specific
regulation. Non domestic companies listed in the
MTA International segment139 have been discarded
as they were not required to prepare and present their
financial statements according to Italian GAAP. The
complete directory of Italian non financial companies
listed both in 2004 and 2005 that was required to
adopt IFRSs140 was analysed. Among them, 61
companies which adopt stock option plans in 2004
have been identified and analysed.
The great majority of the companies in the
sample that recorded the cost of stock options in their
Profit or Loss since 2005 used to treat stock option as
an off-balance sheet operation beforehand. Based on
an in-depth analysis of their consolidated financial
statements, sixteen companies were eliminated from
the sample as they recorded no cost as they choose to
use one of the transitional provisions (IFRS 1, 2004,
para 25b-c; IFRS 2, 2004, para 53-58) that allow the
INSERT TABLE 1 ABOUT HERE
139
MTA International is the segment within Borsa
Italiana‘s MTA regulated equity market dedicated to the
trading of shares of non Italian issuers already listed in
other EU regulated markets.
140
We excluded listed companies that were not required to
adopt IFRSs in 2005, in accordance to CONSOB
regulation. See CONSOB (2005, para 81bis, 82bis).
109
- impact on pro-forma diluted EPS ITA GAAP =
 (Diluted EPS PRO FORMA – Diluted EPS ITA GAAP ) 


| Diluted EPS ITA GAAP|


where diluted EPS PRO-FORMA is equal to:

 Unrecogniz ed cost of stock option 

Diluted EPS ITA GAAP - 
Weighted number of shares 


- impact on ROA ITA GAAP = (ROA PRO-FORMA- ROA ITA GAAP )
where ROA PRO-FORMA is equal to
 Reported income


- Unrecogn ised cost of stock option

Total Assets ITA GAAP

ITA GAAP
Impacts on IFRS-based figures has been measured accordingly, by taking into account that
diluted EPS PRO-FORMA is equal to:



Cost of stock option

Diluted EPS IFRS  
 Weighted number of shares 

and ROA PRO-FORMA is equal to
 Reported income IFRS  Cost of stock option


Total Assets IFRS


Data for the unrecognised cost of stock options,
reported income, and pro-forma diluted EPS and
ROA (i.e. the difference between 2004 Italian GAAP
figures and the IFRS-converted figures) were handcollected from the consolidated financial statements.
Results
Sample demographics
Table 2 provides a brief overview of the sample, in
terms of size (total revenues and assets), and
profitability.
The sample includes firms which are all controlled
by a block-holder, i.e. a (group of) shareholder(s) that
owns at least 10 per cent of voting rights, but have
diverse financial characteristics: some are (highly)
profitable, some others are loss making. Firms
analysed are at various growth phases. The
characteristics of the sample allow to extend the
findings of previous literature which mainly focused
on high-growth US companies (Botosan, Plumlee,
2001), large non-Anglo-American companies listed
in the US (Street, Cereola, 2004), or Anglo-Saxon
companies (Chalmers, Godfrey, 2005).
Impact of expense recognition
The mandatory adoption of IFRS 2 has increased the
perceived cost of stock options at the eyes of the
110
financial statements‘ users. The overall impact of the
cost of stock options on reported financial
performance is moderate, although sometimes
material. The impact on Italian GAAP income (proforma diluted EPS) is 8 % (14,13 %141) on average.
This result is influenced by few values that deviate
significantly from the mean. In fact, the median
impact is 2.34 % on Italian GAAP income (2.68 %
on diluted EPS142). Similar results have been
obtained on IFRS-based 2004 data (see table 3).
The framework of the IASB (1989, para 30)
considers that information is deemed to be material if
its omission, misstatement or non-disclosure has the
potential to adversely affect the decisions of financial
statements‘ users and/or management‘s discharge of
accountability. The materiality of an item in the
statement of performance may be judged by
comparing the item to the operating profit for the
current reporting period. Along with previous
literature on the subject (see Botosan, Plumlee, 2001;
Street, Cereola, 2004; Chalmers, Godfrey, 2005), we
adopted as a non-binding quantitative threshold
(more than or equal to 5 %) to assess materiality.
141
This value does not include the companies that already
recorded the fair value of the stock options‘ cost before the
mandatory adoption of IFRS 2.
142
See note 4.
Our findings suggest that the fair value of stock
options on the pro-forma Italian GAAP reported
income (pro-forma Italian GAAP diluted EPS) is
material for 31 % (29 %) of the Italian non financial
listed companies with stock option plans. The impact
on ROA is never material. Similar results are
obtained on IFRS-based data.
These results underestimate the materiality of
the impact, as our estimate is based on the costs that
have actually been disclosed in the consolidated
financial statements. In fact, nearly 50 % of the
companies whose reported impact is not deemed as
material (i.e. < 5 %) has underestimated the ―true‖
cost of stock options by adopting one of the
transitional provisions (IFRS 1, 2004, para 25b-c;
IFRS 2, 2004, para 53-58) that allows the nonadoption of IFRS 2 for specific stock option plans.
This choice may be considered creative in the sense
that it was in accord to what allowed by accounting
regulation, but elusive of the substance over form
principle. Future application of IFRS 2 will have to
be applied to all stock-based compensation, thus the
materiality of the cost might increase.
Impact of stock options’ expense
recognition and firms’ characteristics
We specifically investigate whether the impact of
expensing stock options on reported income and key
financial indicators is associated with companies‘
growth phases (Botosan, Plumlee, 2001), size
(Zattoni, 2003), or industry (Apostolou, Crumbley,
2005). We tested three main hypothesis through the
coefficient of Bravais-Pearson to measure the
correlation between cost of stock options and its
impact on ITA GAAP and IFRS reported income 143,
and a χ2 test with regards to industry.
Growth
Botosan and Plumlee (2001) argued that high-growth
firms tend to use stock option plans more extensively
than ―mature‖ firms. Thus, we expected that:
Hypothesis 1: The impact of stock option expensing
is positive related to firm‟s growth.
Growth was measured as the percentage variation of
the firms‘ total assets in 2002, 2003 and 2004. Table
4 shows that a relationship between the variables
does not exist (see table 4). The hypothesis may be
rejected. In Italy there seems to be no significant
difference between high- and non-high growth firms
concerning the impact of stock option expensing.
Size
On a sample of Italian (financial and non financial)
listed companies, Zattoni (2003) found that larger
firms tend to use stock option more extensively than
other firms. So we expected that:
is positive related to company size.
We choose total assets in 2004 as a proxy for
company size144. We found a weak positive relation
between size and the magnitude of the cost of stock
options (ρ–value = 0.2333), while there is a weak but
negative relation between size and the impact of the
cost on reported income (ρ–value = -0.1409) (see
table 4). This evidence may be explained by
considering that while it seems logical that larger
firms give greater stock-based remuneration
packages (as overall remuneration is usually linked
with company size, see e.g. Jensen et al., 2004), the
significance of the impact is deflated by the larger
amount of assets (revenues) that characterises large
firms.
INSERT TABLE 4
Industry
Firms in new-economy sectors are often considered
to make a significant use of stock options plans (see,
inter alia, Zeff, 2002; Apostolou, Crumbley, 2005;
Avallone, Ramassa, 2006). So we expected that:
is material in firms which operate in new-economy
sectors.
Firms have been grouped into three types of
industries (manufacturing, regulated market and neweconomy) because of the small number of firms in
several single industries. Manufacturing companies
are defined as companies that make tangible goods.
New-economy industry includes high-tech, services
and design industries, i.e. industries in which
intangibles play a major role in production.
Regulated industry includes companies where the
production of goods or services is supervised by the
State authorities to safeguard the public interest
(telecommunications, energy, and public utilities).
To examine the relation between industry and
impact of cost on reported income we used a χ2 test.
Evidence is mixed. We found that the materiality of
the impact of stock options on IFRS-based reported
income is significantly related to the sector in which
the firms belong to (χ2 = 5,8098, significant at 10%),
while its relation on ITA GAAP reported income is
not significant (χ2 = 4,4487) 145.
Concluding remarks and implications for
corporate governance
The economic consequences associated with the
mandatory expense of stock option in non-Anglo144
143
We also run the same tests using the impact on
diluted EPS as dependent variable, but we found no
significant difference. Given the very low impact on ROA
in all cases, we did not expect to find any relation with
firm‘s characteristics.
We also tried total revenues of the companies in
2004 as a proxy for size, and the relation is even lower (ρ–
value = 0.1586).
145
Same results were obtained on pro-forma diluted
EPS.
111
Saxon listed companies are largely unknown. This
paper has conducted an exploratory study on the
economic consequences of the mandatory adoption
of IFRS 2 among Italian non financial listed
companies, in terms of its impact on the companies‘
key financial performance measures.
Empirical evidence on Italian non financial
listed companies has shown that the impact of
expensing the cost of stock options measured at its
fair value was moderate on average, but sometimes
material. The findings indicate that absent
requirements that stock compensation expense be
recognized, a material upward bias was reflected in
performance indicators (reported income and diluted
EPS) of nearly 30 % of the Italian non financial listed
companies that had stock options plans in 2004. The
impact on ROA was never material
The mandatory adoption of IFRS 2 seems to
have relevant implications for corporate governance.
According to the so-called perceived-cost view (see
Murphy, 2002), the use of option-based remuneration
has arisen thanks to the favourable accounting
treatment, which has made the perceived cost of a
stock option much lower than its economic cost
(Hall, Murphy, 2003). Companies had strong
incentives to give stock options to their directors
instead of cash, because stock option did not
negatively affect their Profit or Loss.
The mandatory adoption of IFRS 2 has
improved the disclosure on the cost of stock options.
By reducing the information asymmetry between
corporate insiders (i.e. executive directors and
controlling shareholders) and outsiders, it allows
minority shareholders and other stakeholders to
improve their perception about the ―true‖ cost of
stock options plans. Although, some evidence of
creative accounting was found concerning the elusion
of the substance over form principle for the
accounting of stock options plans set up before 7th
November 2002, the ―perceived‖ cost of stock
options should be now more clear. The reduction of
the information asymmetry has implications for
corporate governance as corporate outsiders may
better safeguard their interests (Mallin, 2002).
We found no significant relation between the
magnitude of the impact of the cost of stock options
and firms‘ characteristics such as growth phases and
company size. This might be due to the fact
blockholder-dominated companies might adopt stock
options plans for reasons that are different from
Anglo-Saxon public companies (Alvarez-Perez,
Neira-Fontela, 2005; Zattoni, 2007). Further
investigation on this issue seems needed. As the great
majority of the listed companies around the world is
characterised by a concentrated ownership and
control structure (see La Porta et al., 1999; Barca,
Becht, 2001).
The study‘s limitations are acknowledged. This
paper focused on a single country analysis. This
choice fostered internal validity, however the extent
to which the results of this study may be applied to
112
other countries is limited. Future research could
investigate the impact of the mandatory adoption of
IFRS 2 across a wide range of countries.
Acknowledgements
The authors would like to express their gratitude to
Silvia Gaia for her research assistance. We also thank
all the participants at the 2007 EIASM in Siena, and
local seminars held at University of Cagliari and
University of Padua. The normal caveats on the
author‘s responsibility apply. This paper is the result
of a joint effort of the two authors. In particular,
Andrea Melis wrote the introduction and sections
―The Italian regulation on stock options: a synopsis‖
and ―Concluding remarks and implications for
corporate governance‖, while Silvia Carta wrote
sections ―Research design and methodology‖ and
―Results‖.
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Appendices
Table 1. Recording the cost of stock options plans
N.
3
13
3
42
61
ESOP (IFRS 1, para 25b-c)
ESOP (IFRS 2, para 53-58)
ESOP 2004 – No impact
ESOP 2004
Total
%
4.92
21.31
4.92
68.85
100.00
Table 2. Sample firms characteristics
Amounts are presented in thousands of euros.
Total asset (2004)
Total revenue (2004)
Reported income (2004)
Mean
7,084,289
4,885,148
293,620
2,542
Median
1,216,050
876,389
28,114
658
SD
16,894,653
13,644,506
1,263,186.57
5,597.69
113
Table 3. The impact of the (unrecognised) cost of stock option on key performance indicators
Key performance indicators
Mean
Median
SD
Max
Min
ITA GAAP Reported income
-7.99%
-2.34%
0.19676
-123.74%
-0.05%
IFRS Reported income
-13.71%
-1.76%
0.59158
-398.32%
-0.04%
ITA GAAP diluted EPS (1)
-14.13%
-2.68%
0.41975
-256.72%
-0.04%
IFRS diluted EPS
6.28%
1.75%
0.10552
51.32%
0.04%
ITA GAAP ROA (1)
-0.19%
-0.09%
0.00263
-1.22%
-0.0012%
IFRS ROA
0.17%
0.08%
0.00227
0.86%
0.0011%
Linear regression
Size (assets - 2004)
Size (revenues - 2004)
Reported income ITA GAAP
- 0.1409
- 0.1261
Reported income IFRS
- 0.0903
- 0.0782
0.2333
0.1586
-0.2720
-0.0715
-0.1062
Growth
(1) This value does not include the companies that already recorded the fair value of the stock options‘ cost before the
mandatory adoption of IFRS 2.
Table 4. ρ Bravais-Pearson
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
114
ASTALDI
AEDES
BENETTON
BULGARI
BUONGIORNO
CAMPARI
CDC
CLASS EDITORI
CREMONINI
DMT
DUCATI
EDISON
EL.EN
ENEL
ENI
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
ESPRINET
EUPHON
FIAT
FINMECCANICA
FULLSIX
GEOX
GRUPPO ESPRESSO
INDESIT
INTERPUMP GROUP
IRIDE
ITALCEMENTI
LOTTOMATICA
LUXOTTICA
MARR
MEDIASET
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
MONDADORI
PININFARINA
PIRELLI
PIRELLI RE
RCS MEDIAGROUP
RECORDATI
REPLY
SABAF
SAFILO
SAIPEM
SEAT PAGINE GIALLE
SNAM
SORIN
TARGETTI SANKEY
TXT
IS THERE A FIRM-SIZE EFFECT IN CEO STOCK OPTION GRANTS?
Bruce Rosser*, Jean Canil**
Abstract
Schaefer (1998) and Baker and Hall (2004) posit a firm size effect for regular executive compensation
but not specifically for executive stock option grants. They propose an inverse relation between payperformance sensitivity and firm size along with a positive relation between the marginal productivity
of executive effort and firm size. The product of pay-performance sensitivity and executive productivity
is „incentive strength‟. They find a weakly positive association between incentive strength and firm size.
We substitute Hall and Murphy‟s (2002) pay-performance sensitivity metric to detect a firm size effect
in CEO stock option grants. After adjusting for small-firm risk aversion and private diversification
„clienteles‟, we document evidence of a residual small-firm effect impacting on incentive strength
principally through grant size. Given lower small-firm deltas, grant size appears to have been increased
by compensation committees to ensure small-firm CEOs are not under-compensated relative to their
large-firm counterparts. We also find that firm complexity influences pay-performance sensitivity as
well, but not labor productivity (proxying for CEO productivity). No evidence is found that firm
smallness and complexity impact on labor productivity. However, we empirically confirm a negative
relation between pay-performance sensitivity and firm smallness and, by implication, firm complexity.
Keywords: stock options. CEO, firm size
*University of Adelaide, Business School, Australia
**corresponding author.
email: jean.canil@adelaide.edu.au, telephone: 61 8 8303 4510, fax: 61 8 8303 4368
This paper is derived from an earlier version presented at the Annual Meeting of the Southern Finance Association, Charleston,
November 2007.
1.
Introduction
Schaefer (1998) and Baker and Hall (2004) modify
the standard pay-performance sensitivity argument for
the marginal productivity of CEO effort (or pay-toeffort). They identify a trade-off between CEO
productivity and firm risk given that pay-performance
sensitivity (as measured) is inversely-related to CEO
risk aversion. Schaefer reports an inverse relation
between pay-performance sensitivity on salary and
bonus and the square-root of firm size, lending
empirical support to the positive relation suggested by
Jensen and Murphy (1990) when applying their dollar
definition of pay-performance sensitivity to firm
performance. Baker and Hall replicate the Schaefer
result on stock and option compensation combined
(linearly) but after modifying the sensitivity definition
for interaction between pay-performance sensitivity
and marginal productivity of effort (incentive
strength) and find that incentive strength is
approximately constant, or rises slightly, as firm size
increases depending on the assumption made
concerning CEO private wealth. The implication is
that the marginal productivity of CEO effort increases
with firm size at about the same rate as the level of
firm risk faced by CEOs.
Since neither of these studies explicitly
considers CEO stock option grants, there is a gap in
our knowledge concerning a firm size effect with
respect to the incentive strength of option grants. As
Baker and Hall (2004) admit146, option grants (along
with restricted stock grants) remain a key instrument
for reducing the agency cost of equity. To the extent
CEOs of small firms are closer to owner-managers
and because small-firm CEOs have lower risk
aversion than large-firm CEOs, option grants in small
firms are expected to have lower pay-performance
sensitivities than in large firms. Hall and Murphy
(2000, 2002) posit but do not test a relation between
CEO risk aversion, private diversification and payperformance sensitivity for stock option grants, but
omit to specify a firm-size effect. Hence, there is an
absence of direct evidence on the issue whether small
firms should tailor their stock option grants differently
from large firms. Further, neither the Schaefer (1998)
nor the Baker and Hall models accommodate the
private diversification of CEOs. Baker and Hall also
suggest that attributes of firm size may impinge on
optimal incentive contracting, such as the degree of
capital intensity, corporate diversification and
differences in organizational structure. We therefore
extend our analysis to embrace attributes that are
characteristic of small firms in the event that firm
smallness is proxying for at least one of these
146
Fn. 2, p.769.
115
attributes. The present paper seeks to establish
empirically whether (i) a firm-size effect applies to
CEO stock option grants, and (ii) whether any such
size effect represents underlining attributes of firm
size. To do this, we employ the option-specific
measure of pay-performance sensitivity of Hall and
Murphy (2000, 2002) in tandem with labor
productivity (proxying for executive productivity) to
yield an incentive strength metric. Pay-performance
sensitivity is the product of the option delta and
absolute grant size. Since delta and stock volatility
are positively related, the expectation is that large
U.S. firms (which typically are more risky than small
U.S. firms) will have higher deltas and hence payperformance sensitivity for a given grant size.
Contrary to the U.S., Australian small firms exhibit
higher stock volatility than large firms which is
attributable to the higher proportion of resource- and
tech-based stocks among small firms. Thus, a largefirm effect attributable to higher stock volatility in the
U.S. becomes a small-firm effect in Australia147.
Specifically, we would then expect the inverse
relation between pay-performance sensitivity (as
measured) and firm size to reverse for Australia,
effectively providing a robustness test of the Schaefer
(1998) and Baker and Hall (2004) firm size
propositions using a new dataset. Likewise, the
positive relationship between firm size and executive
productivity posited by these U.S. studies is also
expected to reverse for Australian firms.
Adherence to the Hall and Murphy (2002) payperformance sensitivity metric requires recognition of
CEO risk-aversion and private diversification. Their
model argues a positive relationship between payperformance sensitivity and an inverse relation with
private diversification. The intuition is that a less
(more) risk-averse CEO requires lower (higher)
incentive, while a less (more) diversified CEO
requires more (less) incentive. Small-firm CEOs are
arguably less-diversified and less risk-averse than
large-firm CEOs. The lower risk aversion of small
firm CEOs is therefore expected to drive a lower payperformance sensitivity relative to large firms, while
lower private diversification of small firm CEOs is
expected to drive a higher pay-performance
sensitivity. We document a small-firm effect in
incentive strength via the pay-performance sensitivity
component but not labor productivity (proxying for
CEO productivity). We therefore provide empirical
support for Baker and Hall (2004) but only with
respect
to
pay-performance
sensitivity.
Notwithstanding their higher stock volatility,
Australian small firms exhibit lower deltas and larger
grants implying that grant size is used at least to offset
the delta effect. One attribute of firm smallness, firm
complexity, is found to have a similar explanatory
power to that of firm size.
147
Hereafter, expectations concerning a large firm-size
effect are stylized in terms of small-firm effect.
116
The paper is organized as follows.
The
following section provides a summary of the relevant
literature that examines firm size and executive
incentive. Sample selection procedures, measurement
of key variables along with descriptive statistics are
discussed in Section 3.
Key relationships are
analyzed and the results reported in Section 4, with
the summary and conclusions following in Section 5.
2.
Literature review
Rosen (1992) and Holmstrom (1992) both challenge
the implicit assumption of Jensen and Murphy (1990)
that pay-performance sensitivity is independent of
firm size: Rosen, along with Murphy (1985) specify a
positive relation while Holmstrom proposes an
inverse relation.
Along with pay-performance
sensitivity, Schaefer (1998) and Baker and Hall
(2004) both recognize CEO marginal productivity for
effort in their optimal incentive arguments. The
optimal pay-performance slope (or sensitivity) is
given by the general form bi* 
1
, where k is a
1 k i i2
constant,  i is absolute CEO risk aversion in ith
firm,  i2 is the variance of the ith firm‘s stock return.
Baker and Hall define bi as the percentage of CEO
stock ownership following Jensen and Murphy while
Schaefer defines bi on salary and bonus. Baker and
Hall replace both unities with marginal productivity
2b*   2
of CEO effort (  i2  i i * i ), while Schaefer
1bi
2  
weights i i2 by a cost parameter (c) and St 1
,
where St 1 is beginning firm value,  is the marginal
rate of change in firm risk and  is the marginal return
to effort: CEOs trade off  for  .
Schaefer
hypothesizes and finds that pay-performance
sensitivity is higher for smaller firms, implying that
the marginal productivity of CEO effort increases
with firm size more slowly than the amount of risk
faced by the CEO (i.e.,    ). In other words, for a
given stock volatility, Schaefer attributes the lower
pay-performance sensitivities of large-firm CEO
salary and bonus to higher tenure risk that offsets the
CEO‘s increased productivity (being the product of
workload and ability), and also to conjectured higher
stock volatility of large firms. Although CEO
marginal productivity is likely higher in large firms
than small firms, a talented executive in a small firm
runs the risk of failing in a large firm owing to more
complex organizational and political structures.
Hence, larger firms are expected to have smaller payperformance sensitivities (as defined). On the other
hand, Baker and Hall find pay-for-effort ln(  i ) is
positively associated with firm size as measured by
ln(market value) across three assumptions concerning
CEO wealth148. An underlying inverse relation
between pay-performance sensitivity (as defined by
bi and consistent with Jensen and Murphy, 1990) and
firm size is also noted.
To summarize, Schaefer (1998) proposes and
finds that larger firms have smaller pay-performance
sensitivities on salary and bonus because the marginal
productivity of CEO effort increases more slowly than
the level of risk faced by the CEO. Modifying the
measure of the pay-performance sensitivity metric to
include the marginal product of CEO effort, Baker
and Hall (2004) also propose and find that larger
firms have smaller pay-performance sensitivities on
total CEO compensation. Baker and Hall note that
although CEOs of large firms typically own trivial
fractions of the firm‘s stock, in absolute terms their
shareholdings are larger than those of small firmCEOs, so higher small-firm pay-performance
sensitivity is economically less significant than the
leverage of large stock ownership in large firms.
They assume the marginal productivity of CEO effort
increases proportionately with firm size, such that
incentive strength can be measured by the CEO‘s
stock ownership in the firm.
They define
compensation as salary plus the change in CEO
wealth resulting from changes in the value of stock
and option holdings. They find that CEO incentive
falls slightly as firms become larger. A stronger fall
does not occur because the incentive-decreasing
decline in percentage equity ownership is offset by
the increase in marginal productivity.
The
implication is that lower pay-performance sensitivity
of large firms is almost neutralized by CEOs
increased productivity in large firms. Baker and Hall
further posit a positive relation between executive
incentive and firm size in more capital-intensive
industries and a negative relation for diversified firms.
Both Schaefer and Baker and Hall specify an inverse
relation between executive incentive and risk
aversion: thus, to the extent that CEOs of large firms
are more risk-averse, their optimal incentive is lower.
The results of the Schaefer (1998) and Baker and
Hall (2004) studies need to be qualified in three
respects. First, their pay-performance sensitivity
measures do not recognize grant size in the formation
of executive incentive. Although this circumvents
interpretative difficulties in relation to absolute and
relative incentive arguments, the omission deprives
their analysis of a major decision variable: grant size
is a key input in the optimal contracting models of
Hall and Murphy (2000, 2002) and Choe (2003). A
second qualification is that CEOs‘ private
diversification is omitted as a variable by Schaefer
and Baker and Hall owing to lack of data, but Baker
and Hall experiment with different assumptions on
how CEO wealth accrues.
Finally, and more
generally, their propositions with respect to the
148
The assumptions are that: (i) CEO wealth is proportional
to all CEO compensation, (ii) CEO wealth is proportional to
CEO stock ownership, and (iii) CEO wealth is constant.
relation between pay-performance sensitivity (as
defined) and CEO risk aversion and firm size hinge
on the underlying positive relation between stock
volatility and firm size.
Given that small Australian firms have higher
stock volatility than large firms, our aim is to test the
robustness of the Schaefer (1998) and Baker and Hall
(2004) models with respect to stock volatility when an
opposite firm size effect is implied. Since their
models rely on stock volatility and not firm size as a
basis of argument, their interpretations should reverse
when it is small firms that have higher stock
volatility, as long as small-firm CEOs have lower
absolute risk aversion than CEOs of large firms. It is
therefore of interest to test the robustness of their
results with a dataset where large firms exhibit lower
stock volatility than small firms. In Australia, the
resource sector which is characterized by high risk
constitutes a larger share of the economy than in the
U.S. A higher proportion of smaller Australian firms
is resource-related relative to larger firms, so smaller
firms exhibit higher stock volatility than larger firms.
As a consequence, and other things equal, for
Australian data we expect to observe an opposite
outcome to these U.S. studies: that pay-performance
sensitivity as defined by Hall and Murphy (2000,
2002) is expected to vary positively, and not
inversely, with firm size.
3.
Sample descriptives
Our sample comprises 168 stock option grants made to
65 CEOs made by 51 listed Australian companies
during the period 1987-2000. A wide array of
industries is represented, including 30 resource stocks
which are predominately small firms. Since no
Australian executive compensation databases are
available, all grant data were obtained from an
‗options‘ keyword search of all ASX-listed companies
included in Huntleys‟ DatAnalysis service. Deletions
were made for companies with quoted options, foreign
companies and data inadequacies or inconsistencies.
In Australia, as in the United States, shareholders must
approve CEO stock option plans put to them by
company compensation committees, usually in Annual
General Meeting. During the sample period covering
the late 1980s and the 1990s, ASX Listing Rule 10.14
prescribed shareholder approval by special resolution
for issues of securities to related parties (which
includes CEOs) by way of employee incentive
schemes. The resolution must have been passed at a
general meeting held no earlier than the last annual
general meeting of the company. Issues of ordinary
securities (the American equivalent is common stock)
or claims thereon through such schemes and without
ordinary shareholders‘ approval were capped at 15%
of outstanding ordinary share capital (Listing Rule
7.1). Irregular grants outside such schemes similarly
required shareholder approval (Listing Rule 10.11), but
the 15% cap did not apply. The Corporations Act
(s.205G) sets a maximum period of 14 calendar days
117
within which a company was to notify the ASX of any
change, acquisition or disposal of company-issued
securities held by directors, including stock options.
Once shareholder approval is given, the compensation
committee usually has discretion as to the frequency,
size and timing of awards, as well as determination of
the strike price. CEOs are invariably not members of
their compensation committees, but this does not
preclude CEO influence over their deliberations 149.
Measures of key firm and CEO characteristics
are as follows. Firm size is measured by the book
value of total assets rather than firm value because
asset sub-group values are available only at book. A
firm is classified as small when total assets are ≤ $500
million, else it is classified as large. Capital intensity
is the proportion of plant, property and equipment (at
net book value) represented in the book value of total
assets.
This
measure
is
preferred
to
depreciation/earnings before interest and tax because
of variations in earnings due to non firm-specific
events and differing accounting treatments. Similar to
Coles, Daniel and Naveen (2007) firm complexity is
the product of ln(1+Number of segments), ln(Total
assets) and (1+Total assets/Total debt)150.
Firm
complexity is increasing in the number of segments
(Rose and Shephard, 1997), total assets (Booth and
Deli, 1996) and leverage (Klein, 1998). A firm is
classified as diversified (=1) if its operations straddle
two or more ANZSIC codes at the two-digit level.
CEO risk aversion and private diversification are both
proxied and measured on a relative scale. Risk
aversion is MRP/5(σ2) where the market risk premium
(MRP) is set at 7 per cent and σ is the standard
deviation of stock returns for a given company (stock
volatility). This metric is based on a measure
commonly used by investment managers151. Private
diversification is proxied in relative terms
by ln1 (1 Percentageof stock owned beneficially by theCEO)
, relying on the intuition that private diversification
increases as the percentage of firm stock beneficiallyowned by the CEO decreases. Labor productivity is
given by the coefficient on labor inputs obtained from
a two-stage Cobb-Douglas estimation, where output is
measured by Value-added, capital input is measured
by net Property, Plant & Equipment (PPE) and labor
input is measured by Total Assets less PPE; value
added is ln(Market-to-book of assets  Total assets) 1. Following Baker and Hall (2004) incentive strength
is the product of labor productivity and payperformance sensitivity. Table 1 describes the
characteristics of small versus large firms. The book
value of total assets is preferred to firm market value
as a size sorting variable for two reasons. First,
fluctuating stock price volatility during the sample
period often causes firms to move from one category
to the other as the market value of equity fluctuates
and, second, firm market value is influenced by the
same factors that enter into the pay-performance
sensitivity measure. Panel A shows that our small
firms are less than one-tenth the size of our large
firms, whichever size measure is used. The most
consistent distinguishing characteristics are stock
volatility and firm age. Small firms exhibit about
double the stock volatility of large firms and are less
than half the listing age of large firms. The stock
volatility difference is attributable to the presence of a
higher proportion of resource and high-tech stocks in
the small-firm sub-sample. The relation between stock
volatility and firm size is opposite to that exhibited by
U.S. firms (Baker and Hall, 2004). Small firms also
exhibit higher market-to-book of assets ratios
(suggesting more growth opportunities) but have lower
free cash flow which suggests a higher need than large
firms for external financing. Market-to-book of assets
and stock volatility are positively correlated for small
firms (r = 0.21, p = 0.07) but inversely correlated for
large firms (r = -0.40, p = .03). Interest coverage
(representing financial risk) does not discriminate.
The two remaining panels of Table 1 look at CEOrelated factors. Panel B shows conclusively that
CEOs‘ relative risk aversion and private
diversification are lower in small firms compared with
large firms. This is an expected outcome because
more risk-averse CEOs will tend to migrate to large
firms which, in Australia, have comparatively lower
stock volatility.
Likewise, relative private
diversification is higher in large firms than small firms
because CEO shareholdings tend to be tiny in large
firms.
Panel C describes five option grant
characteristics. Option grant value/total assets and
option grant value/market value of equity are both
consistently higher for small firms than for large firms.
Analysis shows that both inequalities are influenced
by higher small-firm grant sizes. In other words,
option grants in small firms are worth more than
option grants in large firms principally as a result of
the higher stock volatility of small firms in the present
sample. The option delta for small firms is
significantly lower than that of large firms,
notwithstanding their higher stock volatility. Grant
size (as a percentage of the number of outstanding
common) is significantly higher for small firms
relative to large firms, while pay-performance
sensitivity is lower152. The latter inequality is due to
the relatively larger grants of small firms.
149
152
Yermack (1997) cites two examples of companies
acknowledging management CEO influence over the terms
and conditions of CEO awards, but no such instances were
observed during collection of our sample.
150
The three components are unequally weighted because
there are no a priori grounds for equal weights.
151
See Bodie, Kane and Marcus (2005).
118
As hypothesized by Hall and Murphy (2002), payperformance sensitivity and CEO risk aversion are
positively related (ρ = 0.224, p=.001), implying that more
risk-averse CEOs require higher pay-performance
sensitivity to maintain given incentive. Pay-performance
sensitivity and CEOs‘ private diversification appear
inversely related as hypothesized, but not significantly so.
To discriminate the characteristics of Australian
firm smallness, firm complexity, capital intensity and
corporate diversification, Table 2 reports four
regressions on selected firm characteristics.
In
regression (1) small firms are shown more likely to
have higher stock volatility, market-to-book and
interest coverage but lower free cash flow and are
more likely to be younger than large firms. Apart
from stock volatility, the remaining descriptors are
consistent with those of U.S. firms (Coles, Daniel and
Naveen, 2008). Diversified firms are shown to have
lower stock volatility and are older than more focused
firms in regression (2). Regression (3) shows that
more capital-intensive firms have higher stock
volatility, interest coverage but lower free cash flow
than less capital-intensive firms, while more complex
firms are shown in regression (4) to have lower
volatility, market-to-book and older in firm years.
These relations are broadly consistent with those
documented by Coles, Daniel and Naveen. More
generally, corporate diversification, capital intensity
and firm complexity exhibit different loadings on firm
characteristics relative to small firms.
4.
Analysis
To determine labor productivity, a two-stage CobbDouglas model is estimated in which labor input is
measured by ln(Total assets less PPE). Book values
are used because market value is not available for
PPE and all asset balances are measured at the latest
pre-grant balance date. Since labor input is inferred
from the balance of non-PPE assets, the complement
(PPE) which measures capital input cannot be
included in the same regression, so a two-stage
estimation is performed to account for collinearity
(refer Table 3). Output is measured by Value-added
which is ln(Market-to-book of assets  Total assets)-1.
Labor productivity is given by the coefficient
attaching to labor input. The two-stage model is
estimated separately for four sectors: engineering &
construction,
agriculture,
chemicals
&
pharmaceuticals, mining & energy and services,
financial & retailing. The results are reported in
Table 3. Labor productivity varies from 0.885 per
cent for services, financial & retailing to 1.100 per
cent for mining & energy for a 1.0 per cent change in
labor input. In the remaining three sectors the valueadded change is below 1.0 per cent, but this is
sustainable when combined with capital productivity.
The high ranking of mining & energy is expected.
As a preliminary step, the construct ‗incentive
strength‘ and its components is regressed on CEO
risk aversion and private diversification, along with a
dummy variable for firm smallness which is included
to capture any overlap with the former variables. A
least squares specification assumes all the
explanatory variables are exogenous. While this is
true of firm size, there may be a degree of
endogeneity in risk aversion if more risk-averse
CEOs are attracted to large firms, but such an
argument is thought unlikely to extend to private
diversification. Stock volatility is not included owing
to strong association with the both the small firm
binary variable and CEO risk aversion, as measured.
Results of three least square regressions reported in
Table 4: in regression (1) the dependent variable is
pay-performance sensitivity, in regression (2) it is
labor productivity and in regression (3) it is incentive
strength. Regression (1) shows that pay-performance
sensitivity is unrelated to any of these variables. This
result is contrary to Baker and Hall (2004) and
Schaefer (1998) who posit a negative relation with
risk aversion, and also Hall and Murphy (2002) who
posit a positive relation with risk aversion. Thus, a
neutral result does not constitute a problem. The
negative relation between private diversification and
pay-performance sensitivity posited by Hall and
Murphy is also not found. Regression (2) is a rerun
of regression (1) with labor productivity substituted
as the dependent variable. Small firms are shown to
have significantly lower productivity, in accord with
Baker and Hall‘s (2004) observation that small-firm
executives increase their productivity when moving
to a larger firm. In addition, labor productivity is
positively related to CEO risk aversion (and to a
lesser extent private diversification) implying that
CEOs are more productive as risk aversion increases,
consistent with Baker and Hall. Following Baker and
Hall, incentive strength is the product of payperformance sensitivity and labor productivity.
Incentive strength (regression (3)) exhibits a similar
relation with firm smallness and risk aversion.
Hence, the suggestion is that labor productivity and
not pay-performance sensitivity drives incentive
strength through risk aversion (positively) and firm
smallness (negatively). Private diversification appears
unrelated, but this could be attributable to the proxy
status of our measure. Given that Australian small
firms have higher stock volatility than large firms, a
robustness test is appropriate to determine whether
incentive strength is determined by stock volatility or
firm smallness. Since our measure of CEO risk
aversion is highly correlated with stock volatility a
substitute measure of risk aversion uncorrelated with
stock volatility is employed in which beta risk is an
instrument for stock volatility. The resulting measure
is ln(1/CAPM-required return), which is uncorrelated
with stock volatility (r = -0.090, p = 0.245).
Regression (4) of Table 4 shows that even though
stock volatility is significantly negatively associated
with incentive strength, firm smallness retains its
inverse significance with incentive strength as
documented in regression (3). A potential problem
with a least squares specification is that any
endogeneity with respect to the explanatory variables
is not corrected. Since there is a likelihood that less
risk-averse CEOs prefer smaller firms that (in
Australia) are less risky, to this extent firm smallness
becomes endogenous. Likewise, as suggested by
Hall and Murphy (2002) the degree of CEOs‘ private
diversification also determines the level of pay119
performance sensitivity and indirectly a firm size
preference if pay-performance sensitivity varies
systematically with firm size.
Following this
reasoning, a series of two-stage least squares
estimations is performed in which firm smallness is
replaced with CEO risk aversion and private
diversification plus an explanatory variable that is
complementary to the dependent variable. In Table 5
we regress incentive strength and its components on
firm smallness, CEO risk aversion and private
diversification after allowing for the simultaneous
association of firm smallness with CEO risk aversion
and private diversification. Regression (1) shows that
incentive strength (following Baker and Hall, 2004) is
strongly negatively related to firm smallness. When
pay-performance sensitivity is substituted for
incentive strength as the dependent variable
(regression (2)) the negative relation persists, but
disappears when labor productivity is the dependent
variable (regression (3)). The implication is that
labor productivity is independent of firm size within
an incentive context. Thus, for small firms it appears
compensation committees need to focus on grant size
for a given delta, to the extent the latter is exogenous.
To determine whether it is grant size or option delta
driving the negative relation between payperformance sensitivity and firm size, the option delta
and grant size are added separately to the instrument
set of regression (2). The results are reported in
regressions (4) and (5). Both estimations confirm a
firm size effect operates both through the option delta
and grant size. The small firm coefficient is larger in
regression (5) than either regressions (2) and (4)
(small firm coefficient = -3.079 versus -2.234 and 2.280, respectively). This regularity suggests that
grant sizes for small-firm CEOs are adjusted upwards
to compensate for their lower deltas relative to large
firms. In the absence of such an adjustment and other
things equal, small-firm CEOs would be undercompensated relative to large-firm CEOs and migrate
to large firms. We therefore advocate that executive
option compensation models need to recognize a firm
size effect. In the event that firm smallness proxies
for attributes of small firm size, a robustness test is
applied. Three such attributes are identified for
analysis: firm complexity, capital intensity and
corporate diversification.
The latter two are
suggested by Baker and Hall (2004), while the former
is suggested by Coles, Daniel and Naveen (2007).
The three attributes are subtly different. Complex
firms are typically multi-segment and have a complex
debt portfolio.
Consistent with Hermalin and
Weisbach (1988) and Yermack (1996), Coles, Daniel
and Naveen (2007) argue that complex firms which
are typically large are more difficult to manage and
therefore require a broader range of executive inputs.
Likewise, capital-intensive firms imply a broader
skill set for CEOs compared with labor-intensive
organizations. In both cases, we expect to observe
stronger executive incentives. Diversified firms are
likely larger than focused firms but need not be
120
complex or may not be capital-intensive and are
expected to exhibit lower risk (stock volatility), so
lower executive incentive is expected to be observed.
The three attributes are discriminated by
regressing (again in a two-stage framework) incentive
strength separately on the three attributes while
specifying CEO risk aversion, private diversification
and firm smallness as instruments. Regressions (1)
through (3) are reported in Table 6. Regression (1)
on firm complexity is the only successful estimation.
Given these results, we conclude that for a given level
of CEO risk aversion incentive strength is influenced
by firm complexity rather than capital intensity and
corporate diversification. To determine how firm
complexity interacts with pay-performance and labor
productivity further two-stage estimations are
performed, the results of which are reported in Table
7. Regressions (1) and (2) show that firm complexity
is positively related with pay-performance sensitivity,
but unrelated to labor productivity by virtue of the
inadequate Durbin-Watson statistic.
Thus, payperformance sensitivity (along with incentive
strength) is also found influenced by firm complexity
over and above firm smallness. To determine
whether delta or grant size is driving payperformance sensitivity within the present structure
for a given firm complexity, regression (1) is reestimated with delta and grant size independently
added to the instrument set. The results reported as
regressions (3) and (4) of Table 7, which show
minimal differences from regression (1) indicating
that the relation between pay-performance sensitivity
and firm complexity is not affected by delta and grant
size differences. The robustness of our findings is
further established with respect to alternative
measures of firm size, including market value of the
firm and firm sales. Likewise, closely similar results
are produced when substituting the alternative firm
size measures in the measure of firm complexity.
Instead of using a composite measure for complexity,
we use the individual variables in our regressions and
find that, as expected, the coefficients on all three
variables are significantly positive with respect to
pay-performance sensitivity and incentive strength,
but not labor productivity. An alternative measure of
private diversification that introduces benchmarking
to absolute CEO private wealth specific to the host
firm is also tried, being 1 ln(W) where W is the
market value of firm stock beneficially-owned by the
CEO. As with the relative measure, the intuition is
that private diversification is more likely as
investment in the host firm increases.
5.
Summary and conclusions
Baker and Hall (2004) and Schaefer (1998) propose a
firm-size effect in relation to recurring executive
compensation. Baker and Hall document empirically
a weakly positive relation between firm size and
various measures of incentive strength, comprising
the product of pay-performance sensitivity (as
measured) and the marginal productivity of CEO
effort. We test for the presence of a firm smallness
effect on executive incentive in the context of CEO
stock option grants.
Our test metric is payperformance sensitivity as measured by Hall and
Murphy
(2002),
which
is
option-specific.
Descriptively, small (Australian) firms are
characterized by higher stock volatilities and lower
option deltas than large firms. Given lower smallfirm volatility, lower risk aversion of small-firm
CEOs is to be expected. Relying on a proxy for
private diversification, small-firm CEOs are also less
privately-diversified
than
their
large-firm
counterparts. Executive productivity is proxied by
labor productivity coefficients obtained from a twostage estimation of a Cobb-Douglas production
function across four identifiable industrial sectors.
There are several empirical findings. First,
incentive strength is found strongly inversely related
to firm smallness where the latter is characterized by
instruments for CEO risk aversion, private
diversification, pay-performance sensitivity and labor
productivity. Our result therefore exhibits a stronger
inverse relationship with respect to small firms than
that posited by Baker and Hall (2004). Second, the
small-firm effect persists when observing payperformance sensitivity as defined by Hall and
Murphy (2002), but has no impact on labor
productivity in the same incentive structure. The
former result is consistent with the expectation of
Baker and Hall and also Schaefer (1998) that small
firms have lower pay-performance sensitivities, while
the insignificance of a small-firm effect with respect
to labor productivity does not support the U.S.
studies. Pay-performance sensitivity is unaffected
when the option delta and grant size are
independently substituted as small firm instruments.
Second, incentive strength is also impacted positively
by firm complexity for given CEO risk aversion, but
not by capital intensity and corporate diversification.
Finally, we show that firm complexity, although
correlated with firm size, exists separately as an
incentive argument irrespective of the option delta
and grant size. The implication of our findings is that
executive compensation models need at least to
recognize the small-firm effect and firm complexity
when
determining
optimal
compensation.
Operationally, further research is required on the
issue of whether optimal executive incentive models
require adjustment for the joint productivity of labor
and capital inputs.
Specifically, the apparent
insensitivity of labor productivity to firm complexity
and firm smallness requires elaboration.
2.
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Appendices
Table 1. Characteristics of small versus large firms
A firm is classified as small when total assets are ≤ $500 million, else it is classified as large. All financial variables relate to
the fiscal period prior to grant. Firm value is the sum of market value of equity and the book value of debt. Market-to-book of
assets is the sum of the market value of equity at grant plus the book value of debt, both divided by total assets of book. Stock
volatility is measured by the annualized standard deviation of pre-award monthly stock returns over a minimum of 36 months
prior to grant. Free cash flow is the ratio of operating cash flow less preferred and equity dividend payments to the book value
of assets. Interest coverage ratio is the natural logarithm of earnings before net interest and tax on net interest. Firm age is the
number of years since the date of listing. Relative CEO risk aversion is MRP/5(σ2) where the market risk premium (MRP) is
set at 7 per cent and σ is the standard deviation of stock returns for a given company. Relative private diversification is
proxied by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . Option grant value is the number of granted options
multiplied by the Black-Scholes call value adjusted for dividends. The Option delta is the partial derivative of the call value
with respect to the stock price adjusted for dividends. Grant size is the number of granted options divided by the number of
outstanding ordinary shares. Pay-performance sensitivity is delta multiplied by the number of granted options.
Mean
Small firms Large firms
103
65
Number of grants
Median
t difference Small firms Large firms Z difference
103
65
Panel A: Firm characteristics
Total assets ($m)
Firm value ($m)
Market-to-book (assets)
Stock volatility (%)
Free cash flow
ln(Interest coverage ratio)
Firm age (years)
Resource stocks (%)
210.1
262.9
1.58
15.60
-0.02
1.46
12.7
36.9
2,791.4
2,954.4
1.07
7.29
0.01
1.85
29.4
12.3
-11.37***
-8.66***
2.69***
9.25***
-2.31**
-1.23
-11.29***
181.4
212.3
1.13
12.20
-0.01
1.67
11.0
2,462.9
2,376.2
1.00
6.80
0.01
1.71
33.0
-10.92***
-10.50***
1.95*
8.41***
-2.30**
-0.89
9.02***
Panel B: CEO characteristics
Relative CEO risk aversion
Relative private diversification
1.26
2.76
3.14
5.43
-9.01***
-6.05***
0.96
2.27
3.03
5.55
-8.54***
-5.14***
0.26
1.50
0.24
0.38
2.50**
3.25***
0.04
0.06
0.01
0.02
3.70***
4.10***
1.33
0.48
0.35
2.69
0.13
0.67
-5.75***
4.19***
-2.38**
1.39
0.24
0.16
2.34
0.05
0.21
-5.49***
5.08***
-2.21**
Panel C: Option characteristics
Option grant value/Total assets (%)
Option grant value/Market value of
equity (%)
Option delta
Grant size (%)
Pay-performance sensitivity (/million)
***
**
*
denotes two-tailed significance at the 1% level or better.
denotes two-tailed significance between 1% and 5%.
Table 2.
Regressions of firm ‗smallness‘ and associated properties on selected firm characteristics
A firm is classified as small when total assets are ≤ $500 million, else it is classified as large. A firm is classified as diversified
(=1) if its operations straddle two or more ANZSIC codes at the two-digit level. Capital intensity is the proportion of PPE
represented in Total assets. Firm complexity is the product of ln(1+Number of segments), ln(Total assets) and (1+Total
assets/Total debt). Stock volatility is measured by the annualized standard deviation of pre-award monthly stock returns over a
minimum of 36 months prior to grant. Market-to-book of assets is the sum of the market value of equity at grant plus the book
value of debt, both divided by total assets of book. Interest coverage ratio is the natural logarithm of earnings before net
interest and tax on net interest. Free cash flow is the ratio of operating cash flow less preferred and equity dividend payments
to the book value of assets. Firm age is the number of years since the date of listing. z (t) statistics are shown in parentheses
for the logit (least squares) regressions. Logit (least squares) regression results are Huber/White-corrected (White corrected)
for heteroskedasticity.
Logit regressions
Least squares regressions
Dependent variable:
Small
Corporate diversification
Capital
Firm
firm (=1)
(=1)
intensity
complexity
(1)
(2)
(3)
(4)
n=168
McFadden R2
0.611
0.469
Adjusted R2
0.099
0.477
122
Table 2 continued
Log likelihood
F-statistic
probability
-43.590
-60.622
0.000
0.000
4.683
0.000
31.435
0.000
Constant
-3.625**
(-2.010)
-0.816*
(-1.817)
4.625***
(9.664)
8.020***
(9.114)
Stock volatility
50.537***
(3.568)
-4.730**
(-2.002)
3.770**
(2.456)
-17.970***
(-4.669)
Market-to-book (assets)
1.602**
(2.350)
-0.123
(-1.097)
0.157
(1.386)
-0.431***
(-3.720)
ln(Interest coverage ratio)
0.796**
(2.116)
-0.075
(-1.029)
0.258***
(2.741)
-0.168
(-1.031)
Free cash flow
-13.378**
(-2.249)
0.846
(0.567)
-5.925**
(-2.263)
3.058
(0.868)
Firm age (years)
-0.179***
(-3.015)
0.115***
(4.735)
0.011
(0.792)
0.164***
(6.129)
***
**
*
Table 3. Two-stage least squares regressions of Value-added on labor and capital inputs
Output is measured by Value-added which is ln(Market-to-book of assets  Total assets)-1. Capital input is measured by
ln(Property, Plant & Equipment) and labor input is measured by ln(Total Assets less Property, Plant & Equipment). All asset
balances are measured at the latest pre-grant balance date. The simultaneous equations are:
ln(Laborinput)  0  1 ln(Capitalinput) 
ln(Value - added)  β0  1 ln(Laborinput) 
where the estimation of the second equation is reported below. t statistics are shown in parentheses. Regression results are
White-corrected for heteroskedasticity.
Industry classification:
Mining & energy
Services, financial &
retailing
51
0.835
1.746
Agriculture,
chemicals &
pharmaceuticals
34
0.530
1.950
31
0.907
1.909
52
0.843
2.195
Constant
0.035
(0.148)
0.737
(1.257)
0.188
(0.655)
0.253
(0.703)
Labor input
0.986***
(21.08)
0.950***
(7.954)
1.110***
(17.564)
0.885***
(17.136)
N
Adjusted R2
Durbin-Watson
***
Engineering &
construction
Table 4.
Least squares regressions of incentive strength and its components on firm smallness, CEO risk
aversion and private diversification
Pay-performance sensitivity is delta multiplied by the number of granted options, where delta is the partial derivative of the
call value with respect to the stock price adjusted for dividends. Labor productivity is the coefficient on labor inputs obtained
from a two-stage Cobb-Douglas estimation, where output is measured by Value-added, capital input is measured by net
Property, Plant & Equipment (PPE) and labor input is measured by Total Assets less PPE; value added is ln(Market-to-book of
assets  Total assets) - 1. All asset variables are measured at the latest pre-grant balance date. Incentive strength is the product
of Pay-performance sensitivity and Labor productivity. A firm is classified as small when total assets are ≤ $500 million, else
it is classified as large. t statistics are shown in parentheses. In regressions (1) through (3) relative CEO risk aversion is
MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock returns for a
given company, whereas in regression (4) relative risk aversion is proxied by the natural logarithm of the inverse of the
CAPM-required return. Relative private diversification is proxied by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . Stock
123
volatility is measured by the annualized standard deviation of pre-award monthly stock returns over a minimum of 36 months
prior to grant. t statistics are shown in parentheses. Regression results are White-corrected for heteroskedasticity.
Dependent variable:
Pay-performance
sensitivity
(1)
Labor
productivity
(2)
Incentive
strength
(3)
Incentive
strength
(4)
0.040
3.333
0.021
0.580
77.731
0.000
0.110
7.916
0.000
0.103
5.777
0.000
Constant
0.470
(0.438)
5.649***
(26.154)
7.166*
(1.727)
4.312
(0.729)
Small firm (=1)
-0.607
(-1.205)
-2.310***
(-12.531)
-7.713**
(-2.412)
-8.967***
(-2.285)
CEO risk aversion
0.519
(1.532)
0.154***
(2.892)
2.145**
(2.034)
5.125**
(2.064)
Private diversification
0.074
(0.458)
0.047*
(1.886)
-0.002
(0.005)
0.125
(0.254)
n=168
Adjusted R2
F-statistic
Probability
-20.287**
(-2.499)
Stock volatility
***
**
*
Table 5.
Two-stage least square regressions of incentive strength and components on firm smallness
from a two-stage Cobb-Douglas estimation, where output is measured by value added, capital input is measured by net
Property, Plant & Equipment (PPE) and labor input is measured by Total Assets less PPE; value added is (Market-to-book of
assets – 1) multiplied by Total assets, where both variables are measured at the latest pre-grant balance date. Incentive
strength#1 is the product of Pay-performance sensitivity and Labor productivity. CEO risk aversion is MRP/5(σ2) where the
market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock returns for a given company. Relative
private diversification is proxied by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . A firm is classified as small
when total assets are ≤ $500 million, else it is classified as large. Delta is the partial derivative of the call value with respect to
the stock price adjusted for dividends. Grant size is the number of granted options divided by the number of outstanding
ordinary shares. t statistics are shown in parentheses. Regression results are White-corrected for heteroskedasticity.
Estimation of the second of the following pairs of simultaneous equations is reported below:
Regression (1):
Small firm  β0  β1 CEO risk aversion β2 Privatediversification 3Pay  performance sensitivity   4 Laborproductivity  ε
Incentivestrength  0  1Small firm   2 CEO risk aversion 3Privatediversification 
Regression (2):
Small firm  β0  β1 CEO risk aversion β2 Privatediversification  3Laborproductivity  ε
Pay  performance sensitivity   0  1Small firm   2CEO risk aversion 3Privatediversification 
Regression (3):
Small firm  β0  β1 CEO risk aversion β2 Privatediversification  3Pay  performance sensitivity  ε
Laborproductivity   0  1Small firm   2CEO risk aversion 3Privatediversification 
Regression (4):
Small firm  β0  β1 CEO risk aversion β2 Privatediversification  3Laborproductivity   4Optiondelta ε
Regression (5):
Small firm  β0  β1 CEO risk aversion β2 Privatediversification  3Laborproductivity   4Grant size  ε
124
Dependent variable:
Incentive
strength
n=168
Adjusted R2
Durbin-Watson
Constant
Small firm (=1)
CEO risk aversion
***
**
*
Labor
productivity
(1)
Payperformance
sensitivity
(2)
(3)
Payperformance
sensitivity
(4)
Payperformance
sensitivity
(5)
0.083
1.907
15.187***
(2.892)
-15.568***
(-3.417)
1.080
(1.321)
-0.343
(-0.703)
0.024
1.990
2.132***
(3.095)
-2.234***
(-2.838)
0.298
(1.271)
0.004
(0.027)
-1.193
0.266
11.977*
(1.677)
-8.507
(-1.234)
-0.685
(-0.665)
-0.222
(-0.723)
0.023
1.988
2.178***
(3.194)
-2.280***
(-2.816)
0.292
(1.269)
0.002
(0.013)
0.003
1.952
2.994***
(3.495)
-3.079***
(-3.017)
0.184
(0.879)
-0.033
(-0.248)
Table 6.
Two-stage least square regressions of incentive strength on properties of firm smallness
assets – 1) multiplied by Total assets, where both variables are measured at the latest pre-grant balance date. CEO risk
aversion is MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock
returns
for
a
given
company.
Relative
private
diversification
is
proxied
by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . Firm complexity is the product of ln(1+Number of segments),
ln(Total assets) and (1+Total assets/Total debt). Capital intensity is the proportion of PPE represented in Total assets. A firm
is classified as diversified (=1) if its operations straddle two or more ANZSIC codes at the two-digit level. t statistics are
shown in parentheses. Regression results are White-corrected for heteroskedasticity. Estimation of the second of the
following pairs of simultaneous equations is reported below:
Regression (1):
Firm complexity  β0  β1 CEO risk aversion β2 Privatediversification   3Pay  performance sensitivity 
 4 Laborproductivity   5Small firm  
Incentivestrength  0  1Firm complexity  2 CEO risk aversion 3Privatediversification 
Regression (2):
Capitalintensity β0  β1 CEO risk aversion β2 Privatediversification   3Pay  performance sensitivity 
 4 Laborproductivity   5Small firm  
Incentivestrength  0  1Capitalintensity  2CEO risk aversion 3Privatediversification 
Regression (3):
Corporatediversification  β0  β1 CEO risk aversion β2 Privatediversification   3 Pay  performance sensitivity 
 4 Labor productivity   5Small firm  
Incentivestrength  0  1Corporate diversifcation  2CEO risk aversion 3Privatediversification 
(1)
(2)
(3)
0.182
1.900
-0.399
1.525
0.311
1.689
Constant
-8.015**
(-2.249)
67.422***
(2.866)
-6.187**
(-2.057)
Firm complexity
1.680***
(3.171)
n=168
Adjusted R2
Durbin-Watson
Capital intensity
Corporate diversification
-11.499***
(-2.825)
17.065***
(3.175)
125
Table 6 continued
CEO risk aversion
0.794**
(2.026)
0.457
(0.488)
1.438**
(2.515)
-0.267
(-0.800)
2.258**
(2.454)
0.021
(0.051)
***
**
Table 7.
Two-stage least square regressions of incentive strength and components on firm complexity
assets – 1) multiplied by Total assets, where both variables are measured at the latest pre-grant balance date. CEO risk
aversion is MRP/5(σ2) where the market risk premium (MRP) is set at 7 per cent and σ is the standard deviation of stock
returns
for
a
given
company.
Relative
private
diversification
is
proxied
by ln1 (1 Percentageof stockownedbeneficiallyby theCEO) . Firm complexity is the product of ln(1+Number of segments),
ln(Total assets) and (1+Total assets/Total debt). Capital intensity is the proportion of PPE represented in Total assets. A firm
is classified as diversified (=1) if its operations straddle two or more ANZSIC codes at the two-digit level. t statistics are
shown in parentheses. Regression results are White-corrected for heteroskedasticity. Estimation of the second of the
following pairs of simultaneous equations is reported below:
Regression (1)
Firm complexity  β0  β1 CEO risk aversion β2 Privatediversification  3Laborproductivity   4Small firm  
Pay performance sensitivity   0  1Firm complexity  2CEO risk aversion 3Privatediversification 
Regression (2)
Firm complexity  β0  β1 CEO risk aversion β2 Privatediversification  3Pay  performance sensitivity   4Small firm  
Laborproductivity   0  1Firm complexity  2CEO risk aversion 3Privatediversification 
Regression (3)
Firm complexity  β0  β1 CEO risk aversion β2 Privatediversification  3Laborproductivity   4Small firm   5Delta 
Regression (4)
Firm complexity  β0  β1 CEO risk aversion β2 Privatediversification  3Laborproductivity   4Small firm   5Grant size  
Dependent variable:
(1)
Pay-performance
sensitivity
(2)
Labor
productivity
(3)
Pay-performance
sensitivity
(4)
Pay-performance
sensitivity
0.064
2.008
0.751
0.768
0.069
2.014
0.067
2.012
Constant
-0.741
(-0.927)
1.936***
(11.488)
-1.027
(-1.032)
-0.853
(-1.042)
Firm complexity
0.136***
(2.731)
0.311***
(15.154)
0.202***
(2.639)
0.162***
(3.180)
CEO risk aversion
0.407
(1.429)
0.023
(0.553)
0.312
(1.480)
0.370
(1.364)
0.052
(0.351)
0.036*
(1.723)
0.029
(0.217)
0.043
(0.293)
n=168
Adjusted R2
Durbin-Watson
***
*
126
РАЗДЕЛ 3
КОРПОРАТИВНОЕ
УПРАВЛЕНИЕ В АВСТРАЛИИ
SECTION 3
NATIONAL
CORPORATE
GOVERNANCE: AUSTRALIA
A PRINCIPLES-BASED ANGLO GOVERNANCE SYSTEM IS NOT A
SCIENCE BUT AN ART
Suzanne Young*, Vijaya Thyil**
Summary
Anglo governance systems rely of a number of controls to align shareholder and boards of director‟s
interests. In general they are referred to as market control, regulatory control, and political and cultural
control. Agency theory proposes that these control mechanisms are necessary as human nature is such
that directors and managers act in a self-interested and boundedly rational manner in decision-making
that can result in sub optimality. Notwithstanding that each country within the Anglo system accepts
such controls are necessary they have their own foci and priorities, being a product of their own
system‟s characteristics. This paper through interviewing a number of Australian business executives
adds to the academic literature by providing evidence from the field of the important characteristics of
the Australian governance system, the drivers of change and the effectiveness of the principles-based
approach. It argues that debate needs to move beyond the principles versus rules approach to look at
how firms can be provided with more guidance in operationalising some of the principles that appear to
be key to governance effectiveness. It concludes that there is a need for a holistic model of governance
that is broader than that focusing on the control/legalistic approach; that top management is important
in setting and driving the in-firm governance agenda; that the public needs to be informed and
educated about governance and its importance; and that disclosure still requires an improvement in
quality.
Key words: Corporate governance, Australia, regulation, principles
* Corresponding Author
Graduate School of Management, La Trobe University, Melbourne Australia 3086
s.h.young@latrobe.edu.au
** Graduate School of Management, La Trobe University, Melbourne Australia 3086
Introduction
Anglo governance systems rely of a number of
controls to align shareholder and boards of director‘s
interests. Various models (see Robins, 2006;
Easterbrook, 1996) are put forward in discussing
these controls but generally we can refer to them as
market control, regulatory control, and political and
cultural control. Agency theory (Eisenhardt, 1989;
Fama & Jensen, 1983) proposes that these control
mechanisms are necessary as human nature is such
that directors and managers act in a self-interested and
boundedly rational manner in decision-making which
can result in sub optimality.
Each country within the Anglo system uses
different control mechanisms to differing degrees.
Each also has its own foci and priorities,
characteristics and drivers of change. For instance in
127
discussing the types of regulatory controls, the USA
governance system is referred to as rules-based
whereas the Australian and UK system is referred to
as principles-based (Clarke, 2007). Clarke (2007:162)
argues that rules require all members to act according
to minimum standards of practice, which to gain
broad acceptance however become minimum
acceptable practice; adding though that the
introduction of tougher rules in USA has believed to
have improved reporting and governance behaviour.
In contrast a principles-based approach works to
influence a broad set of practices designed to meet
stakeholder needs. Some argue that a reliance on rules
and compliance is fraught with peril whilst at the
same time arguing that objective standards are
required to facilitate meaningful comparative analysis,
to bring about discipline and to ensure shareholders
receive fair share of rewards (Dallas, 2004:23). This
paper through describing the Anglo governance
system and in particular the Australian system focuses
on regulatory control and the various changes that
have occurred over the last decade and contributes to
the debate surrounding rules versus principles. In
addition the paper through interviewing business
leaders adds to the academic literature by including
business-leaders‘ perspectives on governance, why
and what is changing and whether the changes that
have occurred will lead to improved effectiveness.
Anglo Governance Systems
Anglo governance systems operating in USA, UK and
Australia have specific characteristics that in total are
referred to as a market-based system. Corporations
operating in this system, focus on shareholder
primacy, and are subjected to the market, which
operates to ensure both efficiencies and effectiveness
of managerial and board decisions. The market
evaluates the willingness and ability of corporations
to pay investors and adjusts the current price of stock.
As firms raise new money through debt they must pay
the rate of return appropriate to current strategies and
risk as judged by the market. This assumes that the
general populace has faith in the market, and that
shareholders are willing to invest. In this process it is
assumed that managers make rational decisions and
choose whether to make investment decisions and
raise funds through debt or equity; and if shareholders
have faith in the market they will purchase shares. As
such it is believed that the discipline of the market is
greater than the discipline of formal ‗governance‘
devices.
Market control aligns shareholders, directors and
managers interests in a number of ways: through the
market for corporate control; through product markets
and through labour markets. Corporate control
operates in such a way that inefficient operating is
reflected in share price and in takeover activity. It
proposes that shareholders can exit the market if they
lose faith in the market, and in particular can sell their
shares in corporations if directors and managers make
128
decisions that reduce their wealth. In addition product
markets also exhibit controls over managerial
behaviour ensuring that corporations compete
effectively in market for goods and services or risk
losing business. Moreover labour markets act as a
control device as any reduction in shareholder value
due to management inefficiencies may lead to
decreases in their employment opportunities.
But in practice inefficiencies in market control
have led to other actors in the governance system such
as professional associations and government
introducing professional and regulatory controls to
broaden and strengthen the controls over the
behaviour of directors and managers so that their
focus on shareholder wealth is maintained and selfinterest pushed aside. Easterbrook (1996:70) explains:
―Entrepreneurs make promises to investors [and] if
these promises are not optimal…then investors pay
less and entrepreneurs …bear costs of sub-optimality.
…[However} this mechanism depends on investors
being able to evaluate promises made to them…so
when markets are inefficient some substitute must be
found‖. These include legislation, and professional,
accounting and auditing standards, and organisational
codes of conduct and ethics. Managerialists argue that
strong legal rules are necessary to temper the
enormous power that managers have and to ensure
power is exercised consistently with the interests of
shareholders (du Plessis, Mc Convill & Bagaric
2005:122-3). Clarke (2007:130) further explains that
the Anglo governance system based on disclosure
uses regulation to ensure that full information is
provided to dispersed shareholders so that they can
make informed investment decisions.
But even with these varied controls, we have
witnessed numerous frauds, corporate scandals, and
failures of standards and codes. We have seen stock
options being used as a vehicle for huge personal
gains, profits being inflated to placate stock market
analysts and, deception used to allay commentary by
analysts on less than expected performance. Indeed
researchers (see Robins 2006 for a full discussion)
have claimed that governance structures actually lead
to deceptive practices, with legal but unethical
accounting tactics, and a belief that the ‗ends‘ justify
the ‗means‘. As Paul Volcker US Federal Reserve
(2002) stated ―in light of the Enron Affair and the
seemingly endless barrage of news about other firms
restating profits, artificially embellishing revenues
and creating obscure ―special purpose vehicles‖
conveniently off their balance sheets, no one can
reasonably doubt that there is a crisis in the
accounting and auditing profession‖ (Robins
2006:36). Waring (2008) writes of corporate
governance failures in liberal market economies as
being based on organisations having a short-term
business focus, perverse incentives and questionable
managerial decision-making.
Many examples of such activity have been
written of over the past decade (see Robins 2006):
Enron‘s auditor Arthur Andersen guilty of obstructing
a SEC investigation into Enron‘s collapse; deficient
auditing practices evident with Arthur Andersen
audits of Enron and HIH; internal audit of WorldCom
finding top executives engaged in massive accounting
fraud inflating company profit by at least US$7b;
information about One.Tel‘s defective billing system
withheld from the board and the resultant company
collapse with a $2.4b debt; Harris Scarfe‘s voluntary
liquidation after 6 years of inflated asset values and
accounting irregularities; HIH‘s collapse with debt of
A$5.3b with auditors claiming ignorance and
executives being jailed.
Regulatory Control
A strong consensus emerged amongst policy makers
and industry observers that existing management
practices and government oversight were insufficient
to promote a well-functioning and sound security
market (Bertus, Jahera Jr. & Yost (forthcoming). This
resulted in tightening of regulatory control in USA
through the Sarbanes Oxley Act (SOX) 2002 and in
amendments to the Corporations Act – Corporate Law
Reform Act 2004 (CLERP 9) in Australia. The SOX
has numerous features to strengthen control focusing
on three areas: executive compensation, shareholder
monitoring, and board monitoring (Holstron &
Kaplan, 2005:71). Specific features include tightening
of accounting standards and enhancing external
auditor independence from management; improving
the responsibility of CEOs and senior management;
greater disclosure of internal controls and codes of
ethics; certification by the CEO and CFO of all annual
and quarterly reports; requirements of auditor
independence; establishment of the Public Company
Accounting Oversight Board (PCAOB); and new
standards for company audit committees. In general
the SOX Act 2002 is quite prescriptive in its approach
in response to the failures mentioned above. In
particular the CEO and CFO are required to give up
any profits from bonuses and stock sales during the 12
months that follows a financial report that is then
restated due to misconduct; executives have to report
sales or purchases of stock within 2 days; greater
disclosure is to be made of off-balance sheet
financing and special purpose entities; improvements
made in board monitoring; and overall increases in
management and board responsibility for financial
reporting and criminal penalties for misreporting.
Commentators (Holstrom & Kaplan 2005:83) in
speaking of the SOX Act 2002 have argued that board
behaviour will be effected through heightened
monitoring, and though not necessarily adversarial
should lead to more independence and inquisition by
the board of managerial actions. They conclude that
despite the problems, the US corporate governance
has performed very well and that any more regulation
would be overtly costly and counterproductive and
lead to inflexibility and fear of experimentation.
Although others have questioned the effects, with
Clarke (2007:161) reporting a survey of 274 finance
managers which found that whilst 55% agreed that
SOX increased investor confidence in financial
reports, 44% agreed that financial reports were more
reliable and 32% agreed that it helped prevent or
detect fraud, only 14% agreed that the benefits
exceeded costs. Indeed Zhang (2005, cf. Thomsen
2008:187) reports that in the first year of
implementation there has been an increase in costs of
at least 53% comprised of both internal and external
costs plus audit fees. And it has been reported (see
Thomsen, 2008:188) that additional costs has spurred
organisations to delist from American exchanges and
that regulation costs have led to reduced
competitiveness in the US capital markets. Waring
(2008:158) summarises the debate succinctly in
stating ―there is an ongoing debate in the corporate
governance literature as to whether Sarbanes-Oxley
was an appropriate legislative response to these
failures; a question only time and experience seem
capable of resolving‖.
In Australia, CLERP 9 has focused more
narrowly on auditor independence, enhanced
disclosure, transparent shareholder meetings and
whistleblowing (Clarke, 2007:168). The legislation
has strengthened financial reporting, ending an era of
self-regulation in favour of the Financial Reporting
Council; has introduced International Accounting
Standards; has established the Corporate Governance
Council; has reviewed the performance and
accountability of regulatory authorities such as ASIC
and APRA; and has established the group of 100
CFO‘s Code of Conduct (Robins 2006). The Act in a
focus on audit reform provides auditing standards
with the force of law; enhances disclosure of
remuneration and links to corporate performance,
with shareholders having a non binding vote and
approval of termination payments; legislates for
continuous disclosure of information that may
materially effect share price; enhances shareholder
participation through embracing technology, notice of
annual general meetings, electronic proxy votes, and
disclose of directors pre-positions; provides for
protection of whistleblowers; and improves
information in the prospectus.
In addition, in 2002 the Australian Stock
Exchange
(ASX)
introduced
guidelines
notwithstanding that these are not mandatory, listed
companies must disclose the extent they are followed
(see ASX 2007). These include statements of matters
reserved to the board and delegated to senior
management; independence of directors and Chair;
disclosure of directors‘ tenure; establishment of code
of conduct; and that non-executive directors should
consider meeting independent of management.
But even so, questions have been raised about
whether legislative changes and voluntary guidelines
such as these will bring about improvements in
behaviours and conduct. Phil Chronican, CFO
Westpac stated that technically, ―it has made no
material difference. Previously I wrote to the Westpac
board personally certifying the accuracy of the
129
company‘s accounts. Now that document is public
and US criminal sanctions apply if I break the law.
My workload has increased only slightly‖ (Schmidt
2003). A survey conducted by Deloitte Consulting of
CFO‘s found that 50% said regulatory changes had
not had a big effect on finance function and new rules
were insufficient to prevent repeat of big corporate
collapses like Enron and HIH (Robins 2006). Greg
Larsen CEO Australian Society of Certified
Practicing
Accountants
(ASCPA)
argued:
―Fundamentally there is nothing wrong with
Australia‘s financial system, which, in some cases is
leading world best practice‖ (Harris 2002). Indeed
accountants and auditors have resisted any external
tightening of rules and regulations and criticised the
rotation of audit teams (not firms) every 5 years, audit
independence, and reporting of non-audit services
(Robins 2006). Furthermore the Australian Directors
of Corporate Governance International rejects the use
of the ASX as a model and argues that it has a poor
record on proposing governance reform. Others have
commented that difficulties arise as ASX listing rules
are non-binding and there are conflicts of interest as it
is a listed company itself (Robins 2006).
Robins (2006) adds more generally that
Australian responses to corporate scandals are
considered to be ―ill-coordinated and weak, when
compared with apparent rigour of Sarbanes-Oxley‖.
Explanations provided relate to the voluntary nature
of codes of conduct compared to prescriptive
legislation and the longer time-lines and incorporation
of public debate and input from the accounting
profession, businesses, shareholder organisations. Du
Plessis, McConvill and Bagaric (2005:125) argue that
whilst Australia‘s regulatory framework satisfies the
OECD principles of good corporate governance on
the two bases of promotion of transparent and
efficient markets, and consistency with rule of law
principles, it fails on the third which is clear
articulation of division of responsibilities among the
different supervisory, regulatory and enforcement
authorities. Clarke (2007:147-8), and Digman and
Galanis (2004:26) add that there is some evidence that
this continuing division of regulatory powers has
diminished the power of regulation, limited the
pressure on company disclosure relative to other
countries and resulted in a hands-off approach to
infringements.
Notwithstanding, Clarke (2007:162) argues in
support of the historical principles-based system of
UK, Canada, Hong Kong and Australia over the rulesbased system of USA. The former sets minimum
standards of practice which it is claimed simply leads
to the creation of new and imaginative ways to get
around the rules; whereas the latter, in not setting
standards, encourages improvement over time in order
to meet the expectations of the stakeholder
community at large. Although Clarke (2007:167-8)
does add that Enron, HIH and One-Tel failures did
lead to further reforms of corporate governance
through CLERP 9. In addition, in questioning
130
whether further reforms will reduce the frequency and
extent of corporate failure, he concludes (p.169) ―the
capacity of the system for reform and regeneration is
very real, but also the apparently inherent instability
and volatility in this increasingly market-based
system‖.
Clarke (2007) also adds that the increasing
demand for Corporate Social Responsibility (CSR) is
another pressure on the governance system. Support
for this comes from Waring (2008) who argues that in
the Anglo governance systems, legal duties and
responsibilities of directors should be enlarged to
include enhancing and balancing stakeholder
interests.
Others (Robins 2006; Buffini 2002) in arguing
for a broader, but not regulatory, approach claim that
Governance has to move beyond checklist templates;
and that it is impossible to regulate for ethics. Graeme
Samuel (ACCC) states that governance requires the
right mix of personalities, expertise, commitment and
leadership;
that
over-regulation
will
kill
entrepreneurial spirit, crush innovation, shift
resources towards compliance rather then staying
ahead (Samuel 2003). Clarke (2007:266) concludes
that ―as pressures to conform to international
standards and expectations increase, the resilience of
historical and cultural differences will continue‖. On
the same theme, Young and Thyil (2007; 2008) argue
that in attempting to understand governance models
an holistic view is more appropriate; one which
reflects its multidisciplinary nature, reflecting macro
factors such as cultural, historical, legal and national
frameworks as well as micro factors such as vision
and strategy, behaviours and codes, leadership and
stakeholders. And Mayer (2000) concludes that ―there
is no single dominant system [and]… there may
indeed be benefits to diversity, particularly in light of
our current state of ignorance about the comparative
merits of different systems [and] … regulators should
be …encouraging the emergence of different types of
financial and corporate arrangements rather than
being restrictive‖. Whether based on rules or
principles, each country‘s governance system reflects
its own history, culture, legislature, social systems
and environment.
Method
The sample for this study consists of seven interviews
in six Australian corporations in public, private and
government enterprises, operating in the brewing,
mining, accounting and superannuation industries.
The choice of the companies was based on
convenience sampling. Simultaneously, a broad
representation was ensured. Senior key executives in
these organizations were interviewed using a semistructured interview schedule. (Appendix A contains
the schedule used). Interviewees were first phoned to
explain the research, and a plain language statement
and consent form, as approved by the Ethics
Committee, were forwarded to them. The questions
were exploratory in nature and Patton (1990:424) has
summarized the importance of qualitative enquiry:
―The emphasis is on illumination, understanding, and
extrapolation rather than causal determination,
prediction, and generalization‖. Questioning was used
to uncover deeper meanings and underlying reasons
and interpretations from multiple sources. Each
interview lasted for approximately one hour and was
audio-taped. The transcriptions were sent to the
interviewees for verification of accuracy. The
verification fulfilled the need for credibility checks
and ensured that the information was reflective of the
participants‘ meanings and the interviewer did not
introduce bias. Table 1 presents the sample used.
Table 1. Sample of organizations and position of
executives interviewed
1
Category of
Organisation
Mining Company A
2
3
Mining Company B
Superannuation Fund
4
Australian Government
Enterprise
Brewery A – 1
5
6
7
Brewery A – 2
Accounting &
Consulting Firm
Position of Executives
interviewed
Principle Advisor on
Environment
Company Secretary
Executive Manager –
Investments &
Governance
Corporate Secretary
Director of
Communications
Company Secretary
Executive Director
AABS –RCIP
As the information produced by qualitative
methods is voluminous, content analysis, as proposed
by researchers such as Patton (1990:381), was used to
identify, code and categorize its primary patterns. The
data was coded according to the major themes,
namely, perception of Australian corporate
governance systems, the factors driving the evolution
of corporate governance in Australia, the current
governance models, factors that impacted on the
governance systems of the organization, the nature
and extent of the influence of the international
environment on the Australian corporate governance
system, effectiveness of existing corporate
governance structures in Australia, and major
concerns among the public regarding governance
issues. Several minor themes emerged from the
coding based on the major themes and they are
presented in the findings and discussion.
Findings and Discussion
The Principles-based Nature of the
Australian Governance System
Generally respondents spoke in favour of the
principles-based system of Australia with additional
comments such as: „there seems to be a greater
emphasis on the spirit of the law rather than the
letter‟ (Brewery 1); and whilst it is continuously
evolving, currently it is ‗a mix of what is prescribed in
legislation and the principles-based approach of the
ASX‟ (Australian Government Enterprise).
To explain the principles-based approach
further, managers remarked:
We tend to be a little bit more of, „you need to
do these things and provided that you do these
things within these boundaries you will be okay‟ (in
Australia), if we don‟t comply we are happy to
explain why, whereas theirs (USA) is you must
comply. There is no debate (Mining Company B).
The US system is dominated clearly by
Sarbanes Oxley and the legislation that takes that
name and sections which require certifications or
sign offs. The design, operation or effectiveness of
internal controls is assessed in some detail. The
level of work required to comply with the SOX
regime is far greater than what would be required in
alternative systems, as I say in the UK or in
Australia (Accounting & Consulting Firm).
In formulating their governance frameworks,
initially the firms interviewed simply followed the
basic tenets and structures required by the ASX and
the regulatory bodies, but over time, have realized the
flexibility inherent in the system and started to
customize it according to their own requirements. The
following remark by one respondent portrays the
learning process the firms went through (and are still
going through) during the period of evolution of
governance in Australia.
I mean the biggest pain was when everyone
had to write their corporate governance statements.
They all looked the same. I think that is starting to
change. I do think that people are starting to get the
confidence that they can break out a little bit of the
formula‟ (Mining Company B).
The changing and fluid nature of governance
was highlighted by all respondents in an unanimous
view that governance evolves as the market evolves
and it is not possible to reach a state where it could be
termed as being ‗exactly right‘. As one respondent
said, „it is not a science it‟s more of an art‟ (Brewery
A1). This also links with the inherent flexibility of a
principles-based approach in that principles are able
to be interpreted to suit the firms‘ situation.
However, in integrating governance with the
firm‘s operations a challenge is to see it as a valueadd to business operations rather than simply being an
underpinning structure based on a check-box system.
For instance the government business enterprise
manager stated:
basically governance is embedded in the
system so we don‟t really have to think about it. But
as a check each year the board audit committee or
the risk committee will get a report which indicates
what the requirements are, how and when they
where met, just to make sure that nothing has been
overlooked.
In this vein, even though the two large mining
companies had an established governance model, the
131
remaining 5 firms did not have a specific governance
model; although they emphasized that governance
was part and parcel of their regulatory, administrative
and financial frameworks. Industry characteristics
may be a driver in the formalization of the mining
industry‘s governance system with risk management
being so important alongside stakeholder and
environmental concerns which are often played out in
the media. Mining companies are well aware of the
risks associated with not being proactive in this area,
and simply responding to concerns as they arise is
fraught with danger.
In summary, although the respondents were clear
that Australian governance was more principles than
rules-based, findings confirm that the businesses are
unclear about the connotation and scope of
governance agenda. Whilst some were of the opinion
that the Australian governance system was ‗quite
narrow‟ (Superannuation Fund), others felt that ‗it
probably leads the world‟ (Mining Company B). The
remark of one respondent echoes the general
perception of current governance systems.
I mean, it depends on what you are talking
about with governance. Are you talking about the
ASX corporate governance council stuff? Are you
talking about the fears? Are you talking about social
perceptions of companies? It really is a difficult
thing to ask (Brewery A2).
These remarks highlight the fact that firms are
clearly missing an holistic viewpoint of governance,
thereby pointing to the relevance and timeliness of
this paper. The flexibility accorded by the principlesbased approach whilst often lauded by firms, also
means that firms need to go through a trial-and-error
process until they identify a system that is right for
them. Based on the data, at this stage the firms, bar
those operating in the mining industry, are unsure
about the need for a governance system that is greater
than that prescribed as a minimum by regulation and
accounting controls and lack a pro-active response to
heightened calls for an increasing emphasis on
governance. The view of it being ‗narrow‘ for
instance shows that firms are not looking for a wider
stakeholder perspective of governance but focusing
on regulation and accounting controls as the basis of
their framework.
Effectiveness
In general, respondents were of the opinion that
Australian governance processes and implementation
are far better than in the USA, although they tended to
believe that the regulation path of the USA was in
response to the severe collapses that occurred and
hence understandable.
In discussing whether the rules-based approach
will achieve the intended outcome one Consulting
Firm observed,
I doubt it. Cost benefit analysis suggests that
the costs far outweigh the benefits of it. An
American company will fail again and SOX is not a
132
guarantee that, that won‟t happen. An interesting
point of debate will be what will happen when that
company does fail and was it fully SOX compliant or
was it not? Contrast that with the Australian system
where I think there is only one mandatory
requirement within the governance rules there and
that‟s the composition of the audit committee for an
ASX 300 listed entity. And beyond that, Australian
companies are free to find their own solution… I
think it is the more realistic approach. As I say,
there is no silver bullet or no magic wand that will
prevent failures happening. And I think the
American approach is very much tick- the-box. I
think the approach followed by the „comply or
explain‟ countries is more realistic and more flexible
for the different needs of different organizations, at
different stages of their development‘ (Accounting &
Consulting Firm).
The flexibility of a principles-based approach
means that it lends itself open to interpretations by the
firms. This means that the implementation and
outcomes can be extremely varied and problematic.
This phenomenon is explained by the Accounting &
Consulting Firm.
Let me give you an example. The Remuneration
principle is asking you to make sure that you have a
remuneration strategy properly embodied through a
committee. There is external benchmarking that
would go on there. But there needs to be a clear link
between reward and recognition. How that is
transpired is that we now have remuneration reports
within annual reports which run up to 10-12 pages,
which at times you might need a degree in Quantum
Mechanics to understand. The question is, are these
reports adding any value? Is anyone reading the
detail of them? Certainly executive pay is a hot
topic. And people want to make sure that, especially
if a company is struggling, that failure is not
rewarded. But whether that translated to, as I say,
a12 page remuneration report full of graphs and
statistics than actual real models, I don‟t know. So, I
would question whether that has been an effective
interpretation of the principles.
Respondents suggested that one way to ensure
increased effectiveness was for the regulatory bodies
to highlight lapses and present them for public
discussion. For instance, notice this viewpoint,
ASX may have rules but it waives it too easily
or it does not actually follow up on them. …same
with the likes of ASIC. But even if they do not take
the punitive route, talking about it at least and
highlighting these issues more will be an advantage
(Superannuation Fund).
Disclosure and Transparency
In discussing the specifics of governance, disclosure
was the primary factor discussed even though its
influence was seen to be problematic. Disclosure has
been highlighted in the previous section as being an
important consideration in operationalising the
Remuneration Principle and in bringing important
issues to the notice of the public. Another firm
highlighted the importance of disclosure and
transparency in adapting their governance system for
firm-specific factors.
We looked at what other companies were
doing… market leaders and other fast-movingconsumer-goods (FMCG) companies around
disclosure, and …also how they were integrating
those considerations into their enterprise
management framework… And I think what we have
ended up with … is the most relevant bits of that
external experience and married it with our own sort
of approach... We have not just cut and pasted it, we
have grafted bits onto our own fundamental
governance process…which is very much built
around the board and the board committee and the
enterprise risk framework…We haven‟t altered the
fundamental structure but we have introduced some
new agendas and some new criteria…(Brewery A1).
But in the case of proactively providing greater
transparency and disclosure, the findings reveal that
even though there is a push from investors is not
necessarily being picked up by firms. Whilst on one
side, „investors are demanding higher standards both
individually and institutionally‟ (Accounting &
Consulting Firm), on the other side, the findings point
to quite a bit of apathy. Respondents mentioned that
there is not much incentive for firms to become more
transparent and provide greater disclosures than what
is mandated by law, as the customers and general
public do not seem to be interested in knowing more
about governance, nor do they want to actively
participate in the running of the firm. As the
Superannuation Fund states,
None of our members except for one or two
companies have any interest in how we vote. And
therefore why am I incurring this additional cost if
my members aren‟t actually interested… We have
enough trouble getting them to look at their
statements … I think that the vast majority of them
quite frankly just have too many other things in their
life. .. there is a whole group of people who probably
don‟t even read the financial section in The Age (an
Australian newspaper). ..As long as they are getting
their dividends, the vast majority will probably be
happy. .. but if they see something that is not
specifically aimed at improving the profitability of
their company in a specific visible sense than that‟s
when you get people arching up against it.
Notwithstanding this comment, there is a change
that is occurring in this arena with more active
participation in the horizon, as Australian
shareholders realize that their voice matters. As
Mining Company B observed,
I think shareholder activism has definitely
become a much bigger thing in this country. I mean
more people own shares, it is just the bottom line. I
think that the Australian Shareholders Association
has done a lot. I think that people actually
understand now that they can have a significant
influence.
And in regard to specific issues around
disclosure of executive remuneration there is evidence
of demands and impetus for action arising from the
public due to media exposure on specific acts of
companies. For instance, five out of the seven
respondents mentioned that excessive compensation,
remuneration and retirement payouts were one area
where the public outcry was greatest, and that it was
invariably a result of the media coverage and
information dissemination. And in this area the
comment presented earlier of the 12 page
Remuneration Report highlights the problematic
nature of disclosure in this area. The investors and
public appear to be reactive, rather than proactive,
with quite a narrow focus. Their activism is limited to
issues after their occurrence and after they have been
highlighted, rather then exhibiting voice in
influencing aspects of governance that effect business
value and then through that the remuneration of
executives.
Holistic Nature of Governance
These views are in line with other comments in this
paper that urge the regulators and experts to discuss
governance issues in the public forum or through the
media to educate the general public and increase their
awareness. Findings reveal that governance should be
viewed in a more holistic perspective reflecting a
multitude of firm-specific factors and not just simply
as a regulations/ principles conundrum. For instance,
interviewees believed that it is leadership that drives
the corporate responsibility agenda top-down, and that
organisational culture, strategy and committee
structures are important in achieving this. As the
Superannuation Fund observed,
If the CEO and the directors don‟t believe in
the environment‟s importance then why would you
expect them to say to their staff it is important.
Sustainable Development (SD) was driven by
the chairman. It would not work unless it was driven
from the top. And now I guess as the SD committee
is responsible, it is almost like part of the business.
We have the committee up the top to continue to
drive it. But, you really needed that person, that
character to drive it (governance)…You needed that
top level commitment‟ (Mining Company B).
The governance systems and processes should
also align with the culture of the firm. Respondents‘
remarks on the above themes are detailed below.
I defy anyone to put in any set of rules that
would have stopped those idiots… Basically the fault
of HIH was that they had a board of dorks… and no
amount of corporate governance rules, regulations,
reporting, no amount of checks and balances you
could have put over the top to avoid those problems.
Those people and (their) organisation culture
(mattered) (Brewery A2).
133
The ethical stance and moral codes of conduct of
individuals, especially top management are also
important in this regard.
If you have got the right sort of people in the
place you are not going to have a problem. If they
have the right moral fibre, you are just not going to
have a problem (Brewery A2).
I mean like the HIH. All that behavior was
already illegal. It was already outside the rules of
listed companies and good disclosure and ethical
business management practices. It is not as if that
was perfectly acceptable behavior and attitudes
have moved on. The fact is the rules were there but
they weren‟t being followed (Brewery A1).
Governance systems need to be customized to
the firm, taking into consideration factors such as firm
size. Whilst large firms find that instituting the
governance systems is worth the effort, small firms
perceive it as a burden. For example, an executive
from Mining Company B, a large Australian firm with
global operations, remarked:
I think from our perspective (we are) a big
company. It (our firm) has been able to do those
things without any problems. I think that for smaller
companies, I would have found it difficult. People
have struggled.
And another consideration spoke of was the
importance of board structures in implementing
effective governance.
There is still the vast majority of companies
that have flawed board structures, in particular. And
I think if you have a flawed board structure it is
unlikely the best things are going to flow through.
You are unlikely to have best practice governance
deeper within the business (Superannuation Fund).
This section highlights the broad nature of
characteristics that practitioners believe effect and
influence the governance framework. Best practice
governance needs to expand from an either/or
‗regulation-only‘ approach or a ‗principles-only‘
approach, and incorporate behaviours, values and
ethics.
Key drivers of Australian governance
systems
Governance systems are not static and their fluidity is
influenced by many factors in the environment.
Firstly, from a control perspective, the new
corporations law (CLERP 9) is clearly an impetus for
change and has put greater liability on companies and
greater focus on governance. As Mining Company A
states there is ‗liability for directors, for our board to
be liable for not implementing the policies that the
companies espouse‘.
Secondly, moving away from compliance,
broadening the perspective from the shareholder
primacy to a stakeholder view of the firm has been an
important recent development. This is considered to
be a „relatively embryonic driver‟ (Superannuation
Fund) and as the respondent explains, there appears to
134
be an active approach by firms to communicate such a
perspective to other firms they deal with, ‗to get them
to realize that there is a broader issue rather than just
the shareholders‟ (Superannuation Fund).
But, the interesting point to note is that
this issue isn‟t actually driven by any moral or
ethical type guidelines, but it is because the
landscape has actually changed in that companies
can no longer act solely for their shareholders with
complete disregard for other stakeholders because
of what we now term the social license… If they
actually undertake activities which endanger that
social license then it actually creates quite a real
risk to their business (Superannuation Fund).
Thirdly, firms are being held accountable for
putting rhetoric into practice. As Mining Company A
mentions, there is a „reputational driver in terms of
whether or not the policies that we talk about are
actually being implemented and are we improving our
performance‟. This driver is the cause for
sustainability reporting according to this firm.
Another advantage of this reputational driver lies in
the outcomes, such as being regarded as an employer
of choice and from being recognized as a leader in
their sector. As Mining Company A explains further,
it will give us access to land for us to develop
mines on, to people who might want to work for the
company who actually understands about
environmental degradation and is doing something
about it, or understands about how to minimize
climate change impact, or understand about water
use. The young people today want to work with
companies who actually are doing what they say and
are contributing more broadly to society, in fact
contributing to society‟s transformation to
sustainable development.
I think one thing is that we are an Australian
icon therefore you know that makes a big difference.
We are very conscious of the fact that we are
watched and that we are to lead, and that people
will follow or criticize. The size of a company and
who you are makes a very, very big difference
(Mining Company B)
If this firm is regarded as a responsible water
manager we will be invited in because we might
have some solutions to contribute … For any new
strategies, they are not about doing good in the
world they are about business driver. Certainly
there is the quid pro quo, by doing your business
well and being a responsible water manager. That is
the benefit to the environment. But the actual real
purpose of it is access to water for this firm. These
expectations on business are a big driver (Mining
Company A).
This emerging public pressure is evident as
‗investors demand higher standards both individually
and institutionally‘ (Accounting & Consulting Firm,
Brewery A1 and Brewery A2). But, it is as yet unclear
as to the whether their demands will metamorphose
into action on the part of both companies and
investors. As Brewery A1 mentioned,
there is a large disconnect in terms of what
people say they are interested in and what their
behaviour indicates that they‟re interested
in…whether or not they are genuine reflections of
genuine interest, it‟s a bit hard for me to say. I have
a strong sense, that there is a reasonable dose of
fashion on the CSR side.
Even though firms appear to be in the process of
assessing what actions are considered socially
responsible, there is a lack of consensus on what is
socially acceptable.
I think there is a risk that we will be saying a
company should be doing one thing and the retail
investor will be saying another…So, the hard part
for any company, and anyone else trying to factor
that in, is what is now socially acceptable and what
will evolve and not be. That‟s the key issue.
Something might be legal here in Australia but will
there be other pressures which stop it being a
sustainable business structure…it is all about
assessing risk and factoring it into your company,
rather than saying this is right and this is wrong,
and if it is wrong you just don‟t touch it
(Superannuation Fund).
Fourthly, the normal evolution of firms and the
growth and maturity of societies and economies they
operate in push changes in governance. As one
respondent mentioned while discussing governance
drivers,
I think it‟s the normal evolution of
corporations and the corporate structure. And I say
that because if you go back to the start of the last
century and companies and company meetings,
board meeting and relations between senior
members and junior management and the workers
are formal and very structured. As the century wore
on… and as… we are now much more informal, no
less structured in a way. And governance is just part
of the same. It‟s the way corporations and societies
develop over time (Brewery A1).
The company has grown up and realized that
there is a need for checks and balances (Brewery
A2).
Interesting, the well publicized corporate
collapses did not get mentioned as key drivers, to the
extent expected. There were a couple of responses to
the effect that, „I think there is a combination… I
suppose of domestic and international collapses‟
(Australian Government Business Enterprise). But in
general, the view is summed up by one respondent, „I
think the (international) influence has actually been
pretty low, pretty light‟ (Superannuation Fund).
In summary, a range of drivers are pushing the
evolution of governance systems. As one respondent
stated,
it comes from governments, it comes from
shareholders, it comes from the initiative of a
country, it came out of HIH. I think we are very
much part of the global economy and the Enrons
and things like that. That being said it is quite
different in America to the way it is in Australia but I
certainly think it was pushed more by accountability.
About, you know, boards having to be accountable
to their shareholders... (Mining Company B).
It is interesting to note the range of factors
influencing governance and that the changes are not a
simplistic and reactive approach to company
collapses.
Implications and Conclusion
An important implication is the need for organizations
to operate from a holistic perspective on corporate
governance, moving beyond the tick box mentality to
analyzing key drivers and variables that are key to
governance effectiveness in their own contexts. As
Letza et al. (2008) argue, corporate governance is a
social, processual and relatively enduring reality
driven by both internal impetuses and external
environmental dynamics, rather than a pure economic
or fixed reality, and hence cannot be studied in
isolation from non-economic factors such as power,
legislation, culture, social relations and institutional
contexts. This paper illustrates this crucial perspective
in several instances, with interviewees talking of the
importance of taking into account factors such as the
organization type and stage of development, ethics,
reputation, and the media and public in developing
their own governance framework. Young and Thyil
(2008:102) have elaborated on this holistic
perspective of governance and argued that a multidimensional approach is required that extends the
analysis from a prescriptive regulatory approach that
limits actions, to one that is more descriptive and
provides an explanation of why actions occur and
decisions are made. They argue that an emphasis on
control and regulation will not stop governance
failures if not set within a governance framework that
encapsulates regulation, labour product and capital
markets, and behavioural, cultural and ethical
considerations.
The next important implication is the evolving
nature of governance and need for customization by
the firms. It is important that firms understand their
environment, both internal and external, and map the
implications of environmental change on their
governance frameworks. As emphasized clearly in the
ASX
corporate
governance
principles
and
recommendations (2007:3), „corporate governance
practices evolve in the light of the changing
circumstances of a company and must be tailored to
meet those circumstances‟. It is evident from these
interviews that the mining companies understand the
implications of their environment and the increasing
importance of corporate social responsibility on risk
and reputation and embed these considerations in their
governance frameworks.
In this vein, the findings highlight the debate
around the importance and effect of CSR and
sustainability as a driver of governance, and raises
questions about the level and practicability of
incorporating CSR into the principles-based approach
135
to governance. We have seen principles formed
around the stakeholder perspective in governance
codes in UK and Australia, but operationalising them
and integrating into the governance framework and
the firm‘s strategy and operations still is problematic.
Whilst Waring (2008) argues for the stakeholder
approach to be given more weight through regulation
and incorporation into directors‘ duties such an
approach is not supported by the interviewees in this
research.
Another important conclusion that emerged from
this study is that the principles-based approach is
clearly favoured in Australia over the rules-based
approach. As Solomon (2007:169) argues in talking
about the UK principles-based approach: ―there is a
persisting belief that genuine changes in corporate
ethicality and attitude can only be achieved through a
voluntary framework, which allows individuals to
think about issues at hand‖. Interviewees were clear in
not wanting further regulation over and above that
required in areas of financial and auditing controls.
But the interview data lacks conclusive evidence
of the causal chain between principles and
effectiveness possibly due to the small sample or due
to a lack of knowledge or understanding on the part of
the interviewees. More research with a larger sample
is required to understand the right mix of rules and
principles and whether principles could be broadened
to include more direction on behaviors, culture,
leadership, values and ethics. In driving governance
from the top and integrating it with the company‘s
culture, governance practices would prove to be more
robust. Here leadership styles and role modeling of
behaviour are considerations raised in the interviews
as important in operationalising and embedding
governance practices. Moreover in considering the
link that interviewees discussed between board
structural models and ethical behaviour it is worth
noting the lack of best-practice models in the
Australian principles-based approach.
Furthermore the position of ASX and ASIC are
found to be confusing in their roles as both guiders
and monitors. In Australia the Corporations Act
focuses on compliance and rules (albeit not as wide
reaching as SOX 2002) whereas the role of other
bodies is problematic. And when debate occurs in the
media and business circles on the topic of
strengthening ASX and ASIC‘s monitoring activities,
it always reverts to a discussion of whether more rules
are actually required.
This paper has highlighted the very narrow view
of governance held by the general public with their
focus on excessive compensation, unreasonable
remuneration and unethical behaviour. Furthermore,
expansion of the public‘s knowledge of governance is
limited by the information asymmetry between those
within the organisation and the public who rely
principally on the media as their information source.
This phenomenon is not limited to Australia and can
be observed in many other countries. More guidance
on disclosure is worth considering as a way to inform
136
the public, in particular shareholders, to enhance their
involvement before catastrophic and noteworthy
events occur.
Other questions then arise such as who should
take responsibility for accurate and relevant
disclosures? Benston, Bromwich and Wagenhofer
(2006) observed that when an accounting principle
requires
judgment
and
interpretation
the
implementation will vary, hence it is difficult to state
it as a standard. The authors similarly recommended
that firms be provided with more guidance and
concluded that the ‗optimal standards‘ are somewhere
in the continuum between ‗principles-only‘ and
‗rules-only‘, and thus not an ‗either-or‘ approach.
Moreover, Eccles et al. (2001, cf. Boesso and Kumar,
2007) observed that a company with an effective
corporate governance system would, by providing
access to relevant and high quality information, make
an effort to invite new forms of stakeholder
engagement. Boesso, G., and Kumar, K (2007) further
argued that whilst investors' information needs, which
were based on business complexity, appeared to affect
the volume of voluntary disclosures across country
contexts, they did not appear to affect the quality of
disclosures. Thus the onus appears to be squarely on
the company to not only provide timely disclosures
but also to increase the quality and range of
disclosure. Taking responsibility themselves at the
company level for the quality and relevance of
disclosure is likely to quieten the call for greater
regulation.
If we are not to proceed along the path of more
regulation then, in discovering what leads to best
practice in a principles-based approach, research is
warranted on the effects of the drivers, including
shareholder voice and public perception, on the
evolution and effectiveness of corporate governance
systems. Also a greater understanding is needed of the
effects of top management styles and organizational
culture on in-firm governance practices, as well as
best-practice board structures and its impact on board
and management behaviour. In addition, company
disclosure and its relationship to governance
effectiveness and stakeholder engagement is an
important area of further study. In conclusion the
debate needs to move beyond the principles versus
rules approach to look at how firms can be provided
with more guidance in operationalising some of the
principles that appear to be key to governance
effectiveness.
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Appendix A. Interview schedule
1)
2)
3)
4)
5)
6)
7)
8)
9)
How would you describe the Australian corporate governance system?
What are the factors driving the evolution of corporate governance in Australia?
What corporate governance models have been useful for you in your organization?
To what extent have existing corporate governance structures concerning listed companies in Australia been found to
be ineffective? On what grounds?
How has the Australian governance system been influenced by the international environment?
What is the level of public awareness over the importance of effective corporate governance?
What are the major concerns among the public regarding corporate governance issues?
Can you describe the factors that have impacted on your organizational corporate governance system?
Can you describe the evolution of governance in your organization?
137
THE IMPACT OF CORPORATE GOVERNANCE LEGISLATION ON THE
MARKET FOR CORPORATE OWNERSHIP
Joseph Canada*, Tanya Benford**, Vicky Arnold***, Steve G. Sutton****
Abstract
Over the past few years, the number of corporate scandals and failures throughout the world has
escalated, prompting new legislation designed to enhance corporate governance. While the efforts to
legislate corporate governance policies are designed to protect the public interest, they have altered the
relationship between shareholders and management (Canada et al. 2008). Rather than be subjected to
new corporate governance requirements, many companies have indicated an interest in not being
traded on the various stock exchanges and have chosen to alter their corporate structure. The purpose
of this study is to examine how a company‟s decision to shift corporate ownership and/or corporate
control in the face of new corporate governance legislation and regulatory requirements can alter the
traditional markets for ownership and control. In order to examine this issue, the paper first develops
a typology for predicting the type of organizational restructuring that might occur. This typology
incorporates factors from prior research and disentangles the market for ownership from the market
for corporate control. The typology is then used as a basis for an in-depth examination of an
organization whose corporate structure changed in response to mandated changes in corporate
governance. The results provide evidence that corporate governance legislation can potentially induce
incumbent management to voluntarily compete in the market for ownership, notwithstanding the
associated exposure in the market for managerial control.
Keywords: corporate governance, legislation, corporate ownership
*University of Central Florida
**University of Central Florida
***University of Central Florida and The University of Melbourne
****University of Central Florida and The University of Melbourne
Introduction
In the face of growing corporate scandals and
corporate failures on a global basis, governments and
regulatory bodies are increasingly weighing corporate
governance legislation and other regulatory standards
to help alleviate similar problems in the future. For
instance, in the United States (U.S.) the failures of
Enron and WorldCom fueled new corporate
governance requirements under the mandates of the
Sarbanes-Oxley Act of 2002 (SOX). In Australia,
similar failures like HIH and OneTel led to the
passage of Corporate Law Economic Reform
Program, review number 9 (CLERP 9) with its new
corporate governance requirements. In Europe, a
similar reaction evolved from the European Union in
the face of the Parmalat and Cirio scandals with a
number of regulations and directives—most notably
the Transparency Directive, the Market Abuse
Directive, and the Prospectus Directive (Ivaschenko
and Brooks 2008).
All of these efforts to legislate corporate
governance policies made under the auspices of the
public interest have altered the relationship between
shareholders and management (Canada et al. 2008). In
138
many cases, the regulations have altered firm‘s
business models; and, particularly in the U.S., there
have been concerns raised regarding the impact of
SOX mandates on global competitiveness (Arnold et
al. 2007; Katz 2006; Reason 2006). A number of
companies have indicated an interest in not being
traded on the various stock exchanges rather than be
subjected to the corporate governance requirements
articulated under this new legislation. Research
confirms the presence of a number of related concerns
that appear to have led to a significant increase in
delisting activity on U.S. exchanges (Graham et al
2005; Leuz et al. 2008). The evidence suggests that
new corporate governance regulation is altering
company ownership decisions.
The purpose of this study is to examine how a
company‘s decision to shift corporate ownership
and/or corporate control in the face of new corporate
governance legislation and regulatory requirements
can alter the traditional markets for ownership and
control. The research reported in this study focuses on
the SOX legislation in the U.S. and its impact on
corporate ownership and corporate control.
Within the U.S. stock exchange environment,
publicly traded firms wishing to delist their stock can
either go-dark or go-private. Firms that go-dark can
continue to trade in over-the-counter markets, but to
qualify, they must (1) have less than 300 shareholders
at the current time, or (2) have had less than 500
shareholders and less than $10 million in assets for
each of the prior three years. Firms that meet either of
these criteria can delist without changing their current
ownership, management team, or corporate
governance structure. However, for larger firms,
going-dark is not an option; these firms must goprivate if they wish to delist, meaning the company‘s
shareholders forego their ownership interest in a
broad sale of ownership to a private individual or a
private group of owners.
Much of the prior research that has examined
factors impacting public to private transactions (PTP)
as well as more general corporate ownership change
transactions employs a market for corporate control
perspective, where management teams compete to
gain managerial control of a firm (Fama 1980; Jensen
and Ruback 1983; Robbie and Wright 1995; Weir et
al. 2005; Leuz 2008). The market for corporate
control incents incumbent management to maximize
shareholder value as a means of securing their
(incumbent managers) control rights and serves as an
external
corporate
governance
disciplinary
mechanism for poorly performing management or self
interested management (Walsh and Kosnik, 1993).
However, the market for corporate control models
prevalent in the extant literature do not explicitly
distinguish between competition for ownership and
competition for managerial control. For example,
management buy-out decisions (competition for
ownership) are viewed as a defensive measure to
forestall hostile takeovers (i.e. competition for
managerial control) (Jensen and Ruback 1983).
However, not all management buy-out decisions are a
function of competition for managerial control as
some may be in response to new corporate
governance regulations; thus corporate governance
regulation arguably influences ownership transfer
decisions. Analysis of the impact of new corporate
governance regulations necessitates adopting a
broader view that considers the interplay between the
market for managerial control (where incumbent and
potential management teams compete for managerial
control) and the market for ownership (where
incumbent and potential owners compete for
ownership rights).
The theoretical contribution of this paper lies in
distinguishing a market for ownership and its impact
on the market for managerial control. By
disentangling the market for ownership from the
market for corporate control (i.e. separately
considering the market for ownership and the market
for managerial control), we provide a general
typology for predicting the type of organizational
restructuring. This typology incorporates the
differential impact of various factors that prior
research has shown to impact these markets. Using an
in-depth case study, we explore how SOX has
changed the competitive landscape within the market
for ownership. The results provide evidence that SOX
can potentially induce incumbent management to
voluntarily compete in the market for ownership,
notwithstanding the associated exposure in the market
for managerial control.
The remainder of this paper is presented as
follows. The following section reviews prior research
that informs the markets for managerial control and
ownership, as well as provides the theoretical
development for the overall research typology. The
third section reports the findings of the case study
within the framing of the research typology. The
fourth and final section summarizes the findings and
discusses the implications for future research.
Literature Review
Corporate governance structures are presumably
designed to align managerial interests with those of
the owners through corporate control (Jensen and
Meckling, 1976; Fama and Jensen, 1983). These
governance structures may be either internal (i.e.
composition of the board of directors, type of
ownership and incentives) or external (i.e. the market
for corporate governance). However, just as there is a
market for managerial control, there is also a market
for ownership (e.g. initial public offerings (IPOs),
management buy-outs, management buy-ins) (Robbie
and Wright 1995). The interaction between the market
for corporate ownership and the market for
managerial control dictates the degree of
organizational restructuring that occurs with shifts in
either control or ownership (Figure 1).
[Insert Figure 1 about here]
The Market for Managerial Control
The market for managerial control is often described
as the market where management teams compete for
control of firm resources (Jensen and Ruback, 1983).
The managerial competition model shown in Figure 1
suggests that the more competitive the market for
managerial control the more likely a change in
management will occur. For example, owners will
consider alternative management teams more
attractive
when
current
management
is
underperforming or acting too self-interested (i.e. a
mis-alignment between management and owners as
depicted in Figure 2). This same rationale has been
used by corporate raiders as a justification for hostile
takeovers (Walsh and Kosnik 1993). Hostile
takeovers involve unwanted changes in ownership;
however, the market for managerial control does not
require a change in ownership to achieve a change in
management, as current owners may replace
incumbent managers just as easily as new owners.
When the market for managerial control is less
competitive due to barriers to entry (e.g. substantial
managerial ownership), effecting management change
becomes more difficult.
139
[Insert Figure 2 about here]
The Market for Ownership
Just as owners can shop for new management,
management can shop for new owners. The more
competitive the market for ownership the more likely
such a change in ownership will occur. For example,
large blocks of family stock ownership weaken the
market and make ownership change less likely, while
large blocks of institutional stock ownership make the
market more competitive and ownership change more
likely. This relationship is depicted in Figure 2. A
change in ownership is generally effected in one of
three ways, incumbent management purchases the
firm (management buy-out), a new management team
purchases the firm (management buy-in) through a
hostile take-over, or a synergistic merger occurs
where the acquiring firm retains incumbent
management (Robbie and Wright 1995; Jensen and
Ruback, 1983; Walsh and Kosnik 1993; Weir 1997).
Management buy-outs represent an effort on the part
of incumbent management to use ownership as a
means of neutralizing competition in the market for
managerial control (Weir et al, 2005, Jensen and
Ruback, 1983). Management buy-outs are not always
easily accomplished, though, as announcements of
management‘s intention to take a company private
may trigger competing bids from outside interests.
Announcements of potential management buy-ins or
synergistic mergers may similarly trigger competing
bids. Thus any signaling of an increase in the market
for ownership can escalate competition in the market
managerial control through an increased pool of
prospective owners (Weir et al. 2005; Schwert 2000).
To broaden the understanding of the interaction
between the markets for managerial control and
ownership, it is necessary to consider factors that can
impact the relative competitive strength of these
markets. Extant research suggests that company
performance, owner/management misalignment,
ownership structure, board independence, free cashflow, and growth potential are factors that
differentially affect the markets for managerial control
and ownership (Jensen and Ruback, 1983; Weir et al,
2005). Using two lenses, the market for managerial
control and the market for ownership, can broaden the
understanding of how these various factors impact
takeovers, buyouts, public to private transactions, and
other forms of organizational restructuring.
Company Performance
The market for managerial control plays a role in the
disciplining of poor managers (Walsh and Kosnik,
1993). Poor performance weakens management‘s
position in the market for control as well as the
shareholders‘ position in the market for ownership.
The impact of performance on the market for
managerial control is easily established. Poor
performance conflicts with the maximization of
shareholder wealth and provides owners with a
significant motive to find new management.
Conversely, strong performance incents current
140
owners as well as any potential new owners to retain
the skills and expertise of the incumbent management
team, thus, weakening competition in the market for
managerial control (shown in Figure 2).
Company performance and stock price are
closely correlated. Poor performance reduces both the
stock price and the cost of taking over ownership of
the firm, while also reducing the wealth of the
existing owner and their ability to fend off hostile
bids. As prices reflect poor performance and potential
owners believe performance can improve, the firm
becomes attractive, which increases competition in
the market for ownership. Strong performance, on the
other hand, weakens competition in the market for
ownership as stock prices reflect firm value.
Owner/Manager Misalignment
As shown in Figure 2, misalignment between
managers and owners increases competition for both
managerial control and ownership. When conflicts of
interest become apparent, owners look for new
managers while management may seek new owners.
This type of misalignment often leads to a change in
management, ownership, or both. Examples can be
found in Bruining et al (2004), where strategic
disagreements between a parent company and its
subsidiary led to a management buyout, and in Virany
and Tushman (1986), where the owners desiring new
strategies brought in new top management to provide
that new strategy. Strategic disagreements create
competition in both the managerial control and
ownership markets.
Ownership Structure
Large blocks of ownership improve the market
position of the owners who possess them. With
Family Ownership, large blocks of family ownership
will increase owners‘ ability to oppose acquisition
attempts; and, the commensurate desire by such
owners to retain control of a family business can
further tighten control and fend off ownership
competitors. Thus, family ownership of large blocks
of stock is inversely related to competition in the
market for ownership (Figure 2), which is consistent
with Davis and Stout‘s (1992) finding that family
ownership is inversely related to acquisition.
As shown in Figure 2, with Managerial
Ownership, large blocks of managerial owned stock
improves the position of managing owners while
weakening the position of outside owners in the
market for ownership. Accordingly, inside ownership
can escalate the competition for ownership by
increasing the probability of management buyouts
(Weir et al, 2005). Inside ownership also improves
management‘s position in the market for managerial
control reducing the risk that owners will make
decisions that are deleterious to management.
With Institutional Ownership, institutional
owners invariably choose the highest offer; and,
abnormal returns are consistently associated with
acquisitions and mergers (Jensen and Ruback, 1983).
Accordingly, large blocks of institutional ownership
are associated with a higher probability of acquisition
(Shivdasani, 1993), thereby escalating competition
within the market for ownership.
Board Independence
The primary purpose of the board of directors is to
align the performance of senior management with
owners‘ interests (Fama, 1980). Independent directors
reduce information asymmetry and improve the
position of outside owners, while boards that are
controlled by insiders are far more likely to serve the
interests of management as opposed to shareholders.
Independent board chairs and directors are also found
to decrease hostile takeovers and management
buyouts (Weir 1997; Luez et al., 2008). Thus,
independent directors reduce competition within the
market for ownership, while simultaneously
escalating competition within the market for
managerial control, also shown in Figure 2.
Growth Potential
The literature has consistently found that growth
potential is inversely related to changes in ownership
(Weir et al, 2005; Coles, 2008; Luez, 2008),
suggesting that poor growth potential increases the
competition in the market for ownership. Why would
owners compete to buy a firm with low growth or
future prospects? Weir et al. (2005) explains that
Tobin‘s Q (their proxy for growth potential)
represents the growth potential as perceived by the
market and Luez et al. (2008) proxies for growth
potential with past asset growth. This is where the
growth paradox takes hold. These proxies are strong
indicators of the growth potential perceived by the
market, but neither of these proxies represents the
growth potential as perceived by the buyer. If
potential buyers believe that the market is
undervaluing a firm‘s growth potential, the result is
the creation of a desirable buy situation and explains
the association between low growth variables and
ownership changes. As shown in Figure 2, growth
potential also indirectly impacts the market for
managerial control through the market for ownership.
Market perceptions of weak growth potential escalate
competition in the market for managerial control as
new owners will likely replace incumbent
management in an effort to realize the firm‘s growth
potential.
Free Cash Flows
Free cash flows153 signal a misalignment between
owners and managers interests (Jensen, 1986).
Owners would normally prefer that excess cash flows
be redistributed to owners in the form of dividends.
Managers, on the other hand, have incentives to invest
in expansion projects (even at unfavorable discount
rates since top management pay usually increases
with sales growth (Murphy, 1985)). Thus free cash
flows signal a misalignment between owners and
management interests which can escalate competition
153
Jensen (1986) defines free cash flows as those in excess
of the cash needed to fund all projects with positive net
present value when discounted at the relevant cost of
capital.
in the market for managerial control (shown in Figure
2).
Jensen (1986) argues that managers of firms
with free cash flow will use it as a hedge against
hostile takeovers. To avoid a hostile takeover,
management may use free cash flows to pay
dividends, thereby reducing the misalignment
between owners and management interests, or they
may use free cash flows to facilitate a management
buy-out (Lehn and Poulsen, 1989). If management
announces their intent to take the firm private, there
are typically counter bids by other interested
purchasers, which then escalates competition in the
market for ownership (Weir et al. 2005). There is also
anecdotal evidence that managers with inside
information on the true value of the firm participate in
these leveraged buyouts at seemingly high premiums,
only to quickly increase the firm‘s value beyond that
of the buyout premium (Bruining et al. 2004; Lehn
and Poulsen 1989).
Corporate Governance Regulation and the Market
for Ownership
Evidence regarding the impact of SOX on ownership
is paradoxical. On the one hand, corporate concerns
regarding the cost of SOX compliance and its impact
on global competiveness are well documented
(Arnold et al. 2007; Katz 2006; Reason 2006; Graham
et al. 2005). Consistent with these concerns is
evidence suggesting SOX may have caused increased
corporate deregistrations (Marosi and Massoud 2007;
Leuz et al. 2008) which in turn supports theory that
corporate governance regulation can change
ownership decisions as shown in Figure 2. However,
there is also evidence that foreign firms that cross list
on U.S. exchanges (voluntarily incurring SOX related
costs) increase firm value (Doidge et al., 2004;
Karolyi 2006). Thus, if global competiveness is a
concern for U.S. firms, why would foreign firms
voluntarily cross list on U.S. exchanges?
Arnold et al. (2007) find evidence that SOX can
negatively impact an organization‘s supply chain
response time. For firms who primarily compete with
other domestic U.S. firms, the increased response
time should not change the firm‘s competitive
position (i.e. supply chain response time increases
across all firms and all supply chains). However, for
firms whose major competitors are not subject to the
same corporate governance regulation (i.e. in the case
of SOX, firms not listed on U.S. exchanges),
increased response time can degrade the U.S. listed
firm‘s financial performance. When there is a gap
between a firm‘s actual financial performance and
their potential financial performance (e.g. supply
chain performance absent SOX), there is an increased
likelihood of a change in ownership (i.e. escalating
competition in the market for ownership).
Analysis of Competing Market Forces
This study employed a case methodology to
investigate contextual factors that may induce
incumbent management to voluntarily compete in the
141
markets for ownership and managerial control. The
organizational restructuring typology presented in the
prior section was used to inform the data collection
and analysis of case data. This study used a
combination of publicly available data and semistructured interviews. Interviews were conducted with
a member of senior management and an independent
director.
Overview
Smith Company154 was a medium-sized company in
an industry where supply chain performance had a
direct and significant impact on financial
performance. Smith Company was an accelerated filer
and, like most companies facing the new corporate
government regulations, incurred substantial SOX
related start up costs. Smith Company‘s founder was
the CEO, chairman of the board of directors, and the
single largest shareholder (approximately 20%).
During the 1st quarter in the year of the buyout, the
CEO proposed a leveraged buy-out of Smith
Company, advising the board of directors that he felt
SOX compliance was too costly. The board formed a
special committee to review the offer and the special
committee proceeded to hire an investment banking
firm to both review the current offer and to solicit
additional offers. Although the initial offer fell apart
and was replaced with a management buy-out offer,
Smith Company was ultimately sold to the highest
bidder, a private equity firm.
Case Results
The following analysis systematically considers each
of the factors in the developed typology for analysis
with the intent of understanding the predictive ability
of each factor on the markets for managerial control
and ownership for Smith Company during the time
period immediately following the painful corporate
governance regulatory compliance process. Each
market is analyzed in isolation and then applied in
concert to derive expected outcomes (type of
restructuring). Finally, the predicted outcome and
actual outcome are compared and analyzed in detail.
Free Cash Flows and the Market for Ownership
As noted earlier, free cash flows represent cash that
should be distributed to shareholders, but is retained
by management and invested in unprofitable projects.
Jensen (1986) explains that free cash flows arise when
firms reach their optimal size; however, Smith was
forced to outsource some of its business due to a lack
of resources. Furthermore, using the Weir et al (2005)
formula for free cash flows, Smith‘s percentage of
free cash flows is 1.0%, which is below the 4.56%
mean of Weir‘s non-acquired sample. Although Smith
improved its cash position three consecutive years, no
dividends were distributed and neither the interviews
nor the publicly available data hinted that
154
We use Smith Company to refer to our case study
company in order to protect the identity of the individuals
and organization that voluntarily participated in the study.
Anonymity is required under institutional review board
agreements in regard to the participating human subjects.
142
shareholders were unhappy with the investment of
cash. This suggests that free cash flows did not impact
Smith‘s market for ownership..
Ownership Structure and the Market for Ownership
Large blocks of institutional ownership are often
directly associated with acquisitions, but in the case of
Smith Company there were not any institutional
investors who owned large blocks of shares. In fact,
the CEO owned the largest number of shares—
increasing the probability of a management buyout.
Smith‘s CEO is also the founder, distinguishing Smith
Company as a family owned business. Prior research
generally finds that family owned businesses are less
likely to sell. The lack of large blocks of institutional
ownership
combined
with
substantial
managerial/family
ownership
provides
the
CEO/founder a distinct advantage in the market for
ownership (i.e. reducing competition).
Owner/Manager Mis-alignment and the Market for
Ownership
Smith Company displayed no signs of owner/manager
misalignment prior to entering the bidding process.
The initial offer by the CEO followed a lackluster
quarter in which the stock price dropped dramatically.
An analyst following the company estimated the
initial offer was undervalued approximately 25%. The
initial offer was later withdrawn when financing fell
apart and it was replaced with a management buy-out
offer that was 5% higher than the initial offer but less
than a competing offer acquired from a private equity
firm. The board accepted the management buyout
offer, but an institutional shareholder and the private
equity firm sued Smith Company for ignoring the
better offer. The private equity firm won the suit and
acquired Smith Company after several additional
rounds of bidding. Thus, in this case, competition in
the market for ownership contributed to an
owner/management mis-alignment that had not
previously existed.
Corporate Governance Regulation and the Market
for Ownership
SOX compliance, a requirement for most publicly
held firms in the U.S., negatively impacted Smith‘s
supply chain performance and response time. Prior to
the CEO‘s decision to take Smith Company private,
senior management had indicated that SOX
compliance placed the organization at a distinct
competitive disadvantage in the global marketplace.
As a result of these challenges, the regulatory
environment of SOX enhanced the appeal of private
ownership.
Expected Growth and the Market for Ownership
Smith Company consistently grew with increasing
profit margins until the year immediately preceding
the acquisition. During the year prior to the
acquisition, the prognosis for future performance
faltered as Smith endured limited growth in revenue
and declines in earnings, profit margins and stock
price. Low growth potential increases competition for
ownership when potential buyers believe that the
growth potential is undervalued. As noted earlier, one
analyst viewed the initial offer for Smith Company as
undervaluing the firm by 25% even though the offer
placed a 20% premium on the current market price.
Board Independence and the Market for Ownership
Two indicators of board independence are well
established. First, CEO‘s that also hold the chairman
of the board position pose a significant threat to board
independence. Second, a high proportion of executive
board members indicates a lack of board
independence. There are mixed signals coming out of
Smith Company. Smith‘s CEO also held the board
chairman
position,
weakening
the
board‘s
independence. However, all other board members
were independent, including the existence of a
financial expert, providing evidence of a fairly
independent board. An independent board should
decrease the probability of a successful opportunistic
bid and thereby dampen the competition for Smith‘s
ownership.
Company Performance and the Market for
Ownership
As discussed earlier, although Smith Company‘s prior
performance was strong, with solid growth in sales,
earnings and profit margins, the performance in the
two quarters preceding the initial offer were relatively
weak. This weak financial performance was reflected
in poor stock performance, enticing potential bidders
to enter the market for ownership.
Smith Company’s Overall Market for Ownership
Review of the various factors within the typology
suggests that Smith Company‘s market for ownership
was competitive, especially during the two quarters
preceding the initial offer. The escalated competition
for ownership was primarily driven by the market‘s
undervaluation of Smith Company‘s growth potential,
which was associated with the lackluster performance
of the prior two quarters. Based on the typology,
vulnerability in the market combined with large
managerial ownership should prompt a management
buyout attempt in an effort to protect managerial
control. The fairly independent board was the only
defense to this type of expected takeover.
Independent Board and the Market for Managerial
Control
The discussion on market ownership established that
Smith Company‘s board was fairly independent,
which should escalate the competition for managerial
control. Smith Company‘s poor performance, in the
two quarters preceding the initial offer, should
motivate shareholders to look for better management.
However, the CEO‘s role as chairman of the board
indicates some trust in his judgment. A bad quarter or
two, given the past performance, should not prompt
an active search for new management.
Owner/Manager Misalignment and the Market for
Managerial Control
Prior to the solicitation of bids for acquisition of the
company, there were no signs of owner/management
misalignment, thus minimizing competition in the
market for managerial control. Indeed, even after
competitive bidders were brought into the process,
such bidders were not interested in replacing the
senior management team, further minimizing
competition in the market for managerial control.
Strong Company Performance and the Market for
Managerial Control
Smith Company‘s financial performance was stellar
during the previous five years. Even during the two
lackluster quarters, Smith Company did not lose
money—rather they just underperformed in
comparison to analysts‘ expectations. Accordingly,
long-time shareholders had experienced substantial
gains in stock price over this robust period. Even with
the relatively poor recent performance, shareholders
who had owned their stock for the full five year
period saw 400% growth in the valuation of their
stock. Overall, such performance should generally
satisfy owners and solidify management‘s control.
Managerial Ownership and the Market for
Managerial Control
By virtue of management‘s large ownership position
in Smith Company, management‘s interest would be
well-represented among the interests of owners.
Combined with influence the CEO possessed as the
chairman of the board, the CEO‘s interests were also
very well-positioned. Given the CEO was the founder,
there was clearly no desire to relinquish control even
if there was tremendous monetary gain to be had. This
overall influence should dampen much of the
competition for managerial control.
Smith Company’s Overall Market for Managerial
Control
Most of the factors in the typology suggest that the
competitive pressure for control of Smith Company
should be very docile. However, given that Smith
Company‘s market for ownership is highly
competitive, this docile position does not necessarily
indicate that the market for managerial control is
static. Entering the market for ownership directly
impacts the likelihood of change in the market for
managerial control. Thus, it would not be surprising
for Smith Company‘s management to be at a risk
notwithstanding the factors supporting incumbent
management‘s control.
Predicted Organizational Restructuring
Given the interacting market forces shown in Figure
1, a highly competitive market for ownership
combined with a docile competition in the market for
managerial control should result in a change in
ownership while management is retained. The most
popular form of this type of change is the
management buyout. Recall that large managerial
ownership, poor growth potential (as perceived by the
market), and a non-independent board increase the
probability of a management buyout. In this case the
board is the x-factor. Almost the entire board is
independent, yet there are signs that the CEO may
have considerable influence. This suggests a
management buyout, but there are other possible
acquisitions that could produce a similar type of
restructuring. Another firm could acquire Smith
Company and keep the current management team.
143
Smith Company‘s difficulty with SOX would provide
private buyers the ability to offer a higher premium
than buyers that have to comply with SOX. Overall,
the typology suggests a public to private transaction
that would retain management, most likely a
management buyout.
Predicted Outcome versus Actual Outcome
The typology depicts conditions that are consistent
with a management buyout.
However, Smith
Company was actually acquired by a private equity
firm other than the group led by the CEO. With the
factors so strongly predicting a management buyout,
the resulting private acquisition raises questions as to
how Smith Company became an acquisition target.
The process that produced this acquisition is
complicated and provides a rich environment to
discuss the interplay of the market forces. Board
independence, managerial ownership, growth
potential and regulatory compliance drove the
competition for Smith Company‘s ownership. Strong
performance, on the other hand, secured most
management positions within the firm as five of the
eight senior managers were retained after the
acquisition was completed.
After two disappointing quarters for Smith
Company, the CEO/founder put together a team of
equity investors to purchase Smith Company back.
The combination of large managerial ownership and
low growth potential spawned this bid. The market
appears to have overreacted to the apparent halt in
Smith Company‘s growth.
Amidst a spurt of
acquisitions in the industry, the CEO became
concerned that this undervaluation would make Smith
Company a takeover target. Interviews with key
members of Smith Company revealed that the CEO
was very concerned with retaining control. His
response to the threat of takeover was to attempt a
management buyout. As the typology suggests, the
forces in the market for ownership resulted in a
management buyout attempt.
The success of such a buyout is contingent upon
the board agreeing to the terms. Non-independent
boards suffer from managerial influence and hence
may accept a buyout offer that does not maximize
shareholder value. Smith Company‘s board was
largely independent and acted independently in
setting up a special committee to handle the
acquisition bidding process. The special committee
proceeded to hire an independent investment firm to
analyze the offer. Despite the aura of independence,
the CEO‘s influence as board chairman was apparent
when the board approved the CEO‘s offer and agreed
to termination fees. The offer, which was an increase
over the CEO‘s initial offer, gave a 30% premium
over the recent trading price, but the trading price was
at its lowest point in a year. However, this offer still
undervalued the firm by approximately 20%. The
competing bidder sued Smith Company alleging that
the CEO abused his influence to stifle the competing
bid. The courts upheld the competing bidder‘s case
and terminated the acceptance.
144
Subsequent to the buyout termination, a bidding
war commenced. Understanding that going private
held strong potential for substantial operating gains as
SOX compliance could be avoided, both bids rose
dramatically. The private equity firm outbid the CEO
led buyout group. On the other hand, no public firm
ever entered the bidding process even though mergers
and acquisitions were rampant in the industry. The
most plausible reason for the absence of a public
company bidder is the fact that it was highly unlikely
that a public firm could have outbid a private firm in
this scenario. Avoiding SOX compliance provided
gains to the private bidder that a public bidder could
not incorporate into their offer.
After such a conflicting battle for ownership,
management turnover would seem inevitable. This
expectation of management control changes was
further supported by the fact that the private equity
bidder owned a competitor company that could also
manage Smith Company. However, the private equity
firm valued Smith Company‘s industry expertise and
current business relationships.
The strong
performance of the management team secured
management‘s positions within the firm despite the
hostile change in ownership, although the
CEO/founder did resign.
Conclusions
This paper posits a market for ownership that interacts
with the market for managerial control. Prior studies
on takeovers, management buyouts, and management
succession have approached each activity as a single
action with conflicting results. For example, Jensen
(1986) posits that management buy-outs are a defense
mechanism within the market for corporate control,
while Weir et al (2005) find that the market for
corporate control does not impact public to private
ownership restructuring decisions. The current paper
argues that private to public restructuring is a function
of the market for ownership rather than the market for
managerial control. The two market perspective
provides an umbrella under which evidence from
different research streams can be unified.
The case employed in this study provides some
evidence that the typology holds predictive validity.
Case archival materials supplemented by interviews
provide evidence that the theoretical explanations are
valid. Specifically, the case sheds light on the
explanation of association of growth potential and
ownership changes. Weir et al (2005) support the
theory that undervaluation plays a role in this
association and calls for evidence to better understand
its role. The case analysis explicitly finds that the
undervaluation of Smith Company contributed to the
competition for its ownership and provides additional
contextual explanations for this outcome.
The case study also demonstrated the ability of
corporate governance regulation to affect the market
for ownership. The proponents of SOX did not intend
to provide private equity owners with an advantage in
the market for ownership. Indeed, the passage of
SOX was intended to increase the public confidence
in the stock market and maintain the flow of
investment funds to the market (Canada et al, 2008).
An analysis of the available data reveals that no
publicly held firms participated in the market for
Smith Company‘s ownership even though the
industry was rampant with mergers at the time. The
most plausible explanation is that public buyers had to
contend with potential SOX avoidance gains as a
barrier to entry.
The paper has several limitations. As with all
case study research, generalizability is an issue and
hindsight is almost always better than foresight.
However, the authors strove to be objective, knowing
that the outcome of the case could influenced the
structure of the interviews and evaluation of the case
data if the research team was not careful to construct
interview questions a priori and maintain a somewhat
structured approach to the interview based on predefined questions. Still, we have a sample of one
company and future research should seek to
supplement this study utilizing a larger sample of
companies as archival data becomes more readily
available. Future research should also consider the
potential phenomenon that higher premiums are paid
when restructuring types differ from those expected
based on existing market forces at the time.
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Appendices
Competitive
Market for Ownership
Owners Change
Owners Change
Management Retention
Management Change
Owners Remain
Owners Remain
Management Retention
Management Change
Docile
Docile
Competitive
Market for Managerial Control
Figure 2. Type of Organizational Restructuring
Figure 2. Antecedents of Organizational Restructuring
146
РАЗДЕЛ 4
УГОЛОК ПРАКТИКА
SECTION 4
PRACTITIONER’S
CORNER
THE SOX 404 PROCEDURE; IS IT STILL SO REPELLING TO
FOREIGN ISSUERS?
Marina Stefou*
Abstract
The need for effective and competitive financial markets is reflected in the internal control procedures
of listed companies. The recent banking crises and the famous financial scandals have revealed the
need for strong internal control mechanisms. Such mechanisms improve firms performance, reduce
information asymmetry and are expected to raise firms value. However, due to the inherent limitations
of internal control achievement of the financial reporting objectives cannot be absolutely ensured. A
great reform in the internal control mechanism was introduced by the controversial Article 404 of
Sarbanes-Oxley Act of 2002. This paper lays out the internal control provision described in SarbanesOxley Act, presents the extraterritorial effects on foreign issuers, compares and summarizes overall
findings towards ensuring a better financial environment with regard to the international and
European corporate governance framework applied.
Keywords Corporate Governance, Sarbanes-Oxley Act 2002, internal control mechanism,
extraterritoriality, foreign issuers and effective implementation
*ECGTN Marie-Curie Fellow Researcher, ECGI, University of Genoa-Genoa Centre for Law and Finance (CLFGE),Ph.d Candidate Panteion
University of Athens, LL.M 2005, LL.B 2003 Law School of Athens
Via Balbi 22, 161 26 Genoa, Italy
marina.stefou@unige.it,
I would like to thank Professor Guido Ferrarini for his important comments and guidance. This paper was accomplished under the scope and the
financial support of the European Corporate Governance Training Network (ECGTN) research project.
Introduction
The Sarbanes-Oxley Act of 2002, also known as the
Public Company Accounting Reform and Investor
Protection Act of 2002 or ‗SOX‘, is a much-discussed
and controversial law of the United States. It was
issued as a rather strict yet prompt response of the
American Congress to scandals like Enron and
WorldCom, that caused the decline of public trust in
accounting and reporting practices155. The SarbanesOxley Act includes provisions for the financial
instruments and their trading as well as requirements
on additional disclosure. It has been characterized as
155
―This failure of corporate governance, [compounded by]
an enduring bear market, approaching mid-term elections
and uncertainty about terrorism and war, placed the federal
government under extraordinary pressure to act‖ according
to Greene, E. & Boury, P.M., (2003) ‗Post Sarbanes Oxley
Corporate Governance in Europe and the USA:
Americanisation or Convergence?‘, 1 INT L J. Disclosure
and Governance 21,22.
147
the ―most far-reaching reform of American business
practices since the time of Franklin Delano
Roosevelt‖156.
SOX established new law, amended the existing
one and created the Securities and Exchange
Commission (hereinafter ―the SEC‖) rule making and
stock market listing standards. The passing of the
SOX marks the departure from the lenience that
foreign issuers had enjoyed in the past towards the
general trend consisting in making the U.S. capital
markets more attractive to foreign issuers 157. The
Act‘s implementation, as Armour and McCahery
outline158, aims at restoring the integrity of the audit
process by strengthening the oversight of accounting
profession while, at the same time, it establishes
measures especially designed to address corporate
governance counter failures. The Act contains 11
articles ranging from additional corporate board
responsibilities to criminal penalties and requires SEC
to implement rulings on the requirements related to
the compliance with the new law. It includes many
reforms aiming at improving and enhancing financial
reporting, as well as at regulating the accounting and
auditing profession. One of the major key provisions
of the Act is the creation of the Public Accounting
Oversight Board ( hereinafter ‗PCAOB‘), a quasi–
public accounting board 159 that oversees audits of
public companies, subject to the securities laws 160. Its
principal purpose is to protect the interests of
investors and to safeguard public interest in the
preparation of ―informative, accurate and independent
audit reports‖. Another key provision, article (or
section) 404 of SOX, became effective on November
15, 2004 for domestic issuers whereas for non-US
issuers, it became effective on July 15, 2007 161 (after
SEC‘s permission for expansion162). Section 404 is
SOX‘s most controversial new provision and it is so
much-discussed that it has become a synonym for
SOX itself163.
The enactment of Section 404 requires SEC
registrants to report on the effectiveness of the
internal controls over financial reporting, the
management to assess and evaluate the annual internal
financial reports and lastly, the auditors to attest the
validity of these reports. Section 404 requirement for
management evaluation and reporting on the internal
controls had also been proposed by the SEC (to be
later withdrawn) in 1979 in the Securities Exchange
Act Rel.164. At that time -as the case is presently- this
requirement for management assessment was faced
with wide controversy and criticism. Objections
concerning Section 404 derive from the compliance
costs that companies had to bear during the first two
years, as a minimum, of the implementation of the
Act. However, as research has shown165, after three
years of enforcement, the resulting financial burden is
greater for small companies, whereas as regards large
companies, Section 404 is claimed to be a much
needed reform that generates more accurate internal
company control which finally supports a costeffective internal control procedure.
An important aspect concerning internal control
requirements is that, whether federal or state, these
requirements are incoherent unless and until it is welldefined for whose benefit they exist and to what
161
156
Finch, J. (2002), ―US clean-up angers Hewitt‖, Guardian
October
8,
available
at:
www.guardian.co.uk/
0,3858,4517263-103676,00.html
157
Shin, S.J., (2007), ‗The effect of the Sarbanes-Oxley Act
of 2002 on foreign issuers listed on the U.S. capital
markets‘, 3 NYU J. Law and Business, 706
158
Armour J. and McCahery, J. ‗ After Enron: Improving
Corporate Law and Modernizing Securities Regulation in
Europe and the US, Amsterdam Center for Law and
Economics Working Paper 2006-07 available also at :
http://ssrn.com/abstract/=910205
159
According to Prof. Cunningham, the PCAOB reveals a
flaw in the corporate governance system as a result of a
mixture of state and federal law regulations, see
Cunningham, L. , (2004), ‗ A new Product for the State
Corporation Law Market: Audit Committee Certifications‘1
Berkeley Bus. L. J. 327, 331. Also for a legal criticism for
the process of PCAOB standard setting see Nagy, D.,
(2005). ‗Playing Peekaboo with Constitutional Law: The
PCAOB and its Public/private Status‘, 80 Notre Dame L.
Rev. 975
160
‗The PCAOB is a sort of a new federal watchdog for
regulation of the accounting profession‘, see Eisenberg, M.,
(ed), (2004), Corporations and Other business
organizations statutes, rules, materials and forms,
Foundation Press, 747.
148
SEC 404 Release. Non domestic private issuers are
considered non-accelerated filers, where accelerated filers
are defined in 1934 Act, and because they had greater
difficulty in preparing the management report on internal
control over financial reporting at first they were expected
to fill in the 404 report by the end of July 15, 2006. But
finally the SEC permitted one more year of expansion in
order for them to meet all the necessary requirements.
162
See Securities and Exchange Commission Releases
Nos.33-8760;34-54942, Internal Control over Financial
Reporting in Exchange Act Periodic Reports of NonAccelerated Filers and Newly Public Companies, (Dec 15,
2006), 71 FR 76580 (Dec 21, 2006).
163
Congress reached the conclusion that executive
certification would be more meaningful and persuasive to
investors if those executives had reasonable grounds to
believe that the internal financial controls on the process are
solid.
164
Securities Exchange Act Rel. No. 15772,44 Fed. Reg.
26702 (April 30, 1979).
165
Prentice, R.A., (forthcoming), „Sarbanes-Oxley: The
Evidence Regarding the Impact of Section 404‘, Cardozo L.
R, available at : http://sssrn.com/abstract=991295, also
Skouvakis, A. (2005), ―Exiting the Public Markets: A
difficult choice for Small Public Companies Struggling
With Sarbanes-Oxley‖, 109 PENN.St. L. R. 1279. As it is
commonly expressed, the small companies at the time SOX
was issued were not expected to be able to afford the cost of
compliance and therefore, they might have preferred to go
private or dark.
end166. Shareholders should be the beneficiaries of
internal accounting controls legislation and it is
claimed that the Act was released in accordance to
their needs167. Another difficult question to answer is
the extent to which controls relating to reporting blur
into controls over general legal compliance or
operational decision making168.
This paper presents in brief the basic provisions
of Section 404, as already applied in practice; Section
404 benefits are balanced against costs, while an
effort shall be made to answer the question whether
the wide controversy raised with regard to foreign
issuers listed in US is well-justified. Simultaneously,
three main objectives are emphasized:
i) the main aspects of internal control procedures
after implementation of Sarbanes-Oxley Act 2002
from a legal and a critical perspective,
ii) the extraterritoriality of the internal control
provision for foreign issuers listed in the US and their
reaction to the Sarbanes-Oxley provision after the first
year of its implementation and
iii) the positive and negative aspects of the
effectiveness of internal controls, the measures
undertaken by foreign issuers and the possible ways
in which European firms can benefit from a strong
internal control regime.
A. Section 404 Procedure
1. Section 404 Provisions ni General
Regardless of their size, companies are exposed to
risks in order to realize high profits 169; It is selfevident that the larger and more complex a firm is, the
more are the risks that the firm is faced with. Firms
are also required to manage the risks involved in their
long -term operation. To efficiently manage these
risks, companies must firstly assess the risks taken,
then measure and control them and finally, monitor
them170. Risk management is the company tool for
assessing risks. Financial reporting render risk
management possible and reveals eventual material
weaknesses of the company. Revealing and reporting
material weaknesses is one of Sarbanes-Oxley‘s Act
primary concerns171. In Statement on Auditing
166
Langevoort, D.C., (2005), ‗Internal Controls After
Sarbanes-Oxley: Revisiting Corporate Law‘s Duty of Care
as responsibility for systems‘ available at: http:
//papers.ssrn.com/sol3/papers.cfm?abstract_id=808084.
167
Clark,R.C., (1986), Corporate Law, Little Brown (ed.)
168
Ibid.
169
Deloach, J., (2004), The new risk imperative –an
enterprise wide approach, Handbook of business strategy .
170
Selim, G. and McNamee, D., (1999), ‗The risk
management and internal auditing relationship: Developing
and validating a model‘, 3 Int. J. of Auditing, 163
171
According to SEC, material misstatements is one of the
principal ways of inducing readers of financial reports in
taking wrong decisions concerning investments in a
company, lending money to the company or any other
Standards No. 60 ‗material weakness‘ is defined as a
reportable condition in which the design or operation
of one or more of the internal control components
doesn‘t reduce to a relatively low level the risk that
misstatements caused by errors or frauds in the
amounts that they would be material in relation to the
financial statements being audited may occur and not
be detected within a timely period by employees in
the normal course of performing their assigned
functions172. The SEC hasn‘t taken any position
whatsoever on how many significant deficiencies
constitute a material weakness; this is left entirely to
the companies and their auditors to judge on a caseby-case basis depending on the particular facts and
circumstances. However, the PCAOB, through the
new Auditing Standard No. 5, which replaced the
much-discussed Auditing Standard No. 2 (see
analysis below),tries to limit the meaning of material
weaknesses to the most evident weaknesses that can
seriously affect the company‘s performance and lead
to a ‗non-depicting the reality‘ financial reporting of
the firm.
Section 404 vested the management with the
obligation to assess the financial report, certify the
disclosure and control the reliability of periodic
financial reports. Issuers are required to publish in
their annual reports information concerning the scope
and adequacy of the internal control structure and the
financial reporting procedures. The effectiveness of
such internal controls and procedures is also assessed.
Ιn the same report, following management‘s
assessment, the registered public accounting firm
attests and reports on the assessment of the
effectiveness of the internal control structure and the
financial reporting procedures. The relevant
procedures used by most companies are IT-based,
while companies rely on electronic management of
the data, documents and key operational processes.
Therefore, it is obvious that Information Technology
plays a vital role in internal control evaluation. To
determine the IT control system which should first be
included in the procedure, management must identify
and document control at process level. Companies
tend to adopt evaluation criteria in order to improve
comparability between the standard used by the
companies to conduct their annual internal control
evaluations. Chief Information Officers (―CIO‘s‖) are
responsible for the security, the accuracy and the
reliability of the data analysing systems.
The scope of Section 404 is to ensure that
management is efficient when assessing internal
controls and is informed in detail on the internal
control procedures, adopted by the internal control
committees, the auditors and the IT section.
financial decision, see http://www.sec.gov/rules/pcaob/3449544.htm
172
See also PCAOB release 021/ 2006-2007 (19/12)
available
at:
http://www.pcaobus.org/Rules/Docket_
021/2006-12-19_Release_No._2006-007.pdf
149
According to Section 404, the evaluation of internal
expenditures of the registrant are being made only in
control financial reporting and the identification of
accordance with authorizations of management and
any material weaknesses must be assessed by the
directors of the registrant and
management. The elimination of any material iii. Provide reasonable assurance regarding prevention
weaknesses which could keep the company away
or timely detection of unauthorized acquisition, use or
from meeting the financial targets set at the beginning
disposition of the registrant‘s assets that could have a
of the year constitutes the management‘s
material effect on the financial statements‖.
responsibility. In order to avoid such misstatements at
The definition of ICFR is in accordance with the
an early stage, management must gather sufficient
description of accounting controls in Section 13 (b) 2
evidence, so as to address the risks related to:
B of the 1934 Securities Act 175. The procedure
i. each financial reporting element, and
includes, at first, the financial reporting whereby the
ii. controls underlying each element173.
financial statements of the company are certified and
any existing weaknesses, material and trivial ones, are
2. Internal Control over Financial
depicted. Consequently, the management‘s task
Reporting (ICFR)
involves the assessment of this financial reporting that
(i) Definition of Internal Control over
specifically covers the matters referenced in Section
Financial Reporting (ICFR)
103 of SOX. Then, the company‘s public registered
accounting firm attests and reports over the financial
Internal control concerns the accuracy of the financial
statements. The reference made to the assurances
statements produced174 and the provision of greater
regarding the use of disposition of a company‘s assets
assurance to the investors regarding the integrity of
in clause (iii) clearly proves that the safeguarding of
the firm‘s management. The definition of internal
assets constitutes an element of ICFR.
control was traditionally focused on the accounting
The company‘s management, with the assistance
profession. Under Section 404, it received a broader
of the CEO and CFO, evaluates the effectiveness of
meaning focused on clarifying the company‘s internal
the company‘s internal control over financial
control that an auditor should consider when planning
reporting as of the end of every fiscal year. The
and performing an audit of the company‘s financial
annual 404 report on IFCR should include 176:
statements .
- a statement of the management‟s responsibility for
According to Section 404, internal control over
establishing and maintaining adequate internal
financial reporting (hereinafter ―ICFR‖) is: ― a
control over financial reporting for the company;
process designed by, or under the supervision of, the
- a statement identifying the framework used by the
registrant‘s principal executive and principal financial
management in order to perform the required
officers, or persons performing similar functions, and
evaluation of the effectiveness of ICFR as of the end
effected by the registrant‘s board of directors,
of the company‘s most recent fiscal year;
management and other personnel, to provide
- the management‘s assessment of the effectiveness
reasonable assurance regarding the reliability of
of ICFR as of the end of company‘s most recent fiscal
financial reporting and the preparation of financial
year, including a statement as to whether the
statements for external purposes in accordance with
company‘s internal control over financial reporting is
generally accepted accounting principles and includes
indeed effective. The assessment must include
those policies and procedures that:
disclosure of any material weaknesses in the ICFR
i. Pertain to the maintenance of records that in
detected by the management177.
reasonable detail accurately and fairly reflect the
- a statement that the registered public accounting
transactions and dispositions of the assets of the
firm that audited the financial statements included in
registrant
the company‘s annual report has issued an attestation
ii. Provide reasonable assurance that transactions are
report on the management‘s assessment of the
recorded as necessary to permit preparation of
company‘s internal control over financial reporting 178.
financial statements in accordance with generally
The role of the management is crucial for the
accepted accounting principles, and that receipts and
compliance with Section 404. The management is
responsible for including in its annual statement
(usually the 20-F for foreign and domestic issuers and
173
Gaynor, M., ‗Improving Sarbanes-Oxley Section 404
Implementation‘, SEC, available at www.sec.org
174
Empirical studies confirm this theory by indicating that
firms with poor internal controls tend to restate earnings
more often, be the subject of more SEC accounting and
auditing enforcement releases, face more frequent SEC
enforcement actions and be worse performers and
systematically riskier than comparable firms, seeBryan, S.
& Lilien, S., (2005), ‗Characteristics of Firms with Material
Weaknesses in Internal Control: An Assessment of Section
404 of Sarbanes Oxley 24‘ available at :
http://sssrn.com/abstract=682363 . See also, Prentice, R.
supra ftn.11.
150
175
As also mentioned in SEC‘ s 404 release.
According to Item 308 of Regulations S-K and S-B.
177
If there is at least one material weakness the
management is not allowed to conclude that the company‘s
overall internal control over financial reporting is effective.
178
17 C.F.R §§228.308 and 229.308, Item 15 of Form 20-F,
17 C .F.R. §249.220f (2005) and Form 40-F, 17 C.F.R.
§249.240 f, General Instruction B (6) (2005)
176
the 10-K for domestic issuers179) an internal control
report that:
- states the responsibility of the management for
establishing and maintaining an adequate internal
control structure and procedures for financial
reporting
- includes the assessment of the most recent fiscal
year of the issuer on the effectiveness of ICFR.
To fulfil these requirements, the management
should undertake a comprehensive approach that
includes thorough planning and evaluation of its
internal controls system. There are a number of
methods that a company can choose in developing
and fulfilling the aforementioned responsibilities. The
company‘s relevant documentation varies as Section
404 does not prohibit any form of documentation,
thus, enabling use and combination of many different
forms of documentation which could guarantee a
more complete internal control and an accurate and
up-to-date assessment of the management. The SEC
hasn‘t provided any checklist to follow as it
encourages flexibility in the documentation and the
reporting procedure, in general. The form of the
documentation depends on the company‘s size,
complexity and documentation approach policy.
Some indicative forms of documentation are:
 the company‘s policy manuals
 the accounting models
 process models
 memoranda
 flow charts
 procedural write-ups
 self-assessment reports
 job descriptions
 forms and decision tables and generally, any other
item that the company considers as appropriate
documentation.
This evidence should document the company‘s
controls while its effectiveness should also be tested.
It is important that management allows sufficient time
for the completion of this process, so that the
appropriate basis may be created in view of ensuring
an assessment which responds to any identified
deficiencies. Early identification of deficiencies
provides the management with sufficient time to
correct them and determine the operating
effectiveness of the controls prior to year-end
reporting.
For the evaluation of the evidence of ICFR, it is
proposed that evidence is gathered from on-going
179
The management‘s assessment in practice is usually
placed near the management‘s discussion and analysis
(MD&A) disclosure or immediately preceding the financial
statements. Most companies include the report either in Item
9A of form 10-K or in their glossy annual report either
immediately before or after the financial statements or
immediately after MD&A. Section 404 does not require the
assessment to be signed by the CFO and CEO of the
company. However, some companies are having their CFOCEO‘ s sign their management report.
monitoring activities whereas the internal control is
deemed more effective when there is centralized
operation of controls and the number of the personnel
involved is limited180. Apart from the documentation
itself, the language used should be more generally
understandable in order to avoid possible problems
arising from foreign filers181 .
(ii) The Auditing Standards used for the
ICFR
In 2004, PCAOB issued Auditing Standard No. 2
(hereinafter ‗AS-2‘), which requires auditors to
perform their own independent assessment related to
internal controls over financial reporting and issue a
report verifying the management‘s prior assessment
over ICFR. AS-2 defines auditor obligations with
respect to the opinion and evaluation of
management‘s ICFR. AS-2 also sets ―de facto
standards‖182 with respect to management‘s own
evaluation, since should the management fail to
adhere to these standards, this would result in a
negative auditor opinion. AS-2 was very expansive in
breadth and depth of the internal controls audit 183 as
testing was expanded on all base-level data, generated
by daily business operations, as well as on the
corporate governance process. It is clear that internal
control must have a broad and in-depth operation;
however, there has been question on whether limits
should be set in testing, since AS-2 provides for the
execution of all kinds of internal control testing, thus,
generating overwhelming costs for the companies184.
As a reaction to compliance costs and the burdensome
application of Audit Standard AS-2, PCAOB recently
adopted Audit Standard-No.5 (hereinafter ‗AS-5‘)
with the aim to guide auditors towards verifying more
effectively internal control weaknesses during
financial statement audits, and at the same time,
eliminate unnecessary costly procedures. The SEC
180
Supra. ftn.9.
The language used may also create a problem in the
documentation of 404 as accelerated filers with locations
outside US have experienced challenges in addressing
languages differences, see Deloitte‘ s report on SarbanesOxley Section 404: Compliance Challenges for Foreign
Private Issuers (2005).
182
Supra ftn.5.
183
Ibid.
184
As Langevoort analyzes : ―Perhaps the key sentence in
the entire standard, however, comes in paragraph 9 of AS-2:
a significant deficiency in controls arises when there is one
or more flaws in the control system such that ―there is more
than a remote‖ likelihood that a misstatement of the
company‘s annual or interim financial statements that is
more than inconsequential. Something is considered remote
only when chance of its occurrence is ―slight‖- amore than a
remote risk, then, is anything more than a slight one.
According to paragraph 10 of AS-2, a material weakness is
one or more significant deficiencies that create a ―more than
remote‖ likelihood that a material misstatement in the
financials will not be prevented or detected‖, supra ftn.12.
181
151
was much in favour of the new auditing standard 185 as
it makes audit scalable, it eliminates unnecessary
controls and, consequently, costs less, since it detects
only significant deficiencies. The PCAOB observed
that the audit of internal control had significant
benefits under AS-2, including higher quality of
financial reporting, while it also noted that the effort
to conduct an effective audit appeared greater than
necessary.
As a result, AS-5 is now designed to achieve the
following objectives:
 to have the audits on internal control focused on
the most important matters, i.e. evaluating the areas
where there is reasonable possibility of containing a
material misstatement, pointing out the significance of
fraud risk and anti-fraud measures and explaining the
impact that entity-level controls can have on the
evaluation of other controls
 to include only the most necessary requirements
for an effective audit, i.e. focusing on the multilocation of risk rather than risk coverage, risk
assessment at assertion rather than at control level and
finally, not requiring
auditors to evaluate the
management‘s assessment process
 to have audit properly fitted to the size and the
complexity of the company audited
 to simplify the text of the Standard, by providing
more general principles rather than detailed
requirements in English language for ensuring general
understanding of the meaning of the key terms and of
important concepts.
Consequently, due to the experience gained until
the present day and the cost-related complaints about
over-controlling and exceeding costs, PCAOB issued
the new standard, so as to enable auditors and
management to focus on the most important matters
that have to be tested, i.e. those matters which could
eventually lead to material weaknesses. The provision
of general principles instead of detailed guidance is
also in favour of the companies, since it is strongly
connected with the size, the complexity, the internal
function of the company and its perception of the
control system. The ultimate goal of the new standard
is to eliminate unnecessary work and ―right-size‖ the
audits of internal controls, thus, succeeding in making
them more cost-effective.
The 404 internal control procedure renders the
management responsible for the picture drawn by the
internal control testing of the company. The purpose
of the procedure is to increase the reliability of
financial reporting and to improve the balance
between compliance costs and benefits.
The
efficiency of the internal control is promoted by
allowing management to focus on material control
items, including the role of entity–level and general
information technology controls.
185
See SEC Release 144-2007, ‗SEC Approves PCAOB
Auditing Standard No. 5 Regarding Audits of Internal
Control Over Financial Reporting; Adopts Definition of
"Significant Deficiency.
152
3. Management’s Assessment and
Evaluation 0f The Preferred Frameworks
The decision on the evaluation framework to be used
lies on the management. This is a key-element for
management‘s assessment and it is important that the
control framework on which the evaluation was based
is clearly specified. The Management is responsible
for using a suitable and well-recognized, commonly
accepted control framework, established by a body or
group that has followed due-process procedures,
including the broad distribution of the framework for
public comment186. The appropriate documentation
concerning the management‘s decision and
assessment of ICFR will enable the independent
auditor to understand the management‘s process as
well as to plan and perform the related audit
procedures. Although every firm can, based on its size
and objectives, apply whichever control framework
seems more appropriate for it, provided that it is
widely recognized as trustworthy, the SEC did note
that the Committee of Sponsoring Organizations of
the Treadway Commission‘s Internal Control
Integrated Framework (1992), also known as COSO
framework-report), satisfies the SEC‘s criteria. In
addition, SEC noted that there are also other suitable
and acceptable evaluation standards outside the US,
such as The Guidance on Assessing Control,
published by the Canadian Institute of Chartered
Accountants, and the Turnbull Report, published by
the Institute of Chartered Accountants in England and
Whales. An evaluation framework is suitable when:
 it is free from bias
 it permits reasonably consistent qualitative and
quantitative measurement of a company‘s internal
control
 it is sufficiently complete and more specifically,
the factors that could alter a conclusion about the
effectiveness of the company‘s internal controls are
not omitted from the evaluation framework
 it is relevant to an evaluation of internal control
over financial reporting.
Moreover, Section 404 rules do not purposely
specify the method or the procedures which should be
followed for an accurate evaluation. The SEC
recognizes that these methods should vary from
company to company. The assessment of ICFR must
be based on procedures sufficient to evaluate firm‘s
design and test its operating effectiveness.
In September 2004, COSO released a draft of a
document entitled ―Enterprise Risk Management
Framework‖. This framework doesn‘t replace the
commonly used 1992 COSO report; it incorporates it.
It is designed to raise a consistent risk and control
awareness throughout the enterprise and to become a
commonly accepted model for discussing and
evaluating the organization‘s risk management
processes. “The Enterprise Risk Management
186
E.g. 17 C.F.R. §§240.13°-15 (c) and 240.15 (d)-15 (c)
(2005).
Framework expands on internal control providing a
more robust and extensive focus on the broader
subject of enterprise risk management. While it is not
intended and does not replace the internal control
framework but rather incorporates the internal
control framework within it, companies may decide to
look to this enterprise risk management framework
both to satisfy their internal control needs and to
move toward a fuller risk of management process”
187
.
B. The Debate about Section 404 and The
Foreign Issuers
1. Do They Finally Deregister Because of
404?
Listing in the US used to be, among other reasons, a
matter of prestige 188 for EU issuers. The main
benefits consisted briefly in:
 the increased liquidity 189
 the decreased expose to domestic market risk 190
 the increased visibility 191
 the reduction of the cost of capital (with uncertain
duration of this effect though) 192
 obtaining acquisition currency
 the financial benefits offered by US public market
and
 the notion that listing in a stricter disclosure
environment than that of the home country exchange
could guarantee future earnings 193.
Section 404 is the cornerstone of internal control
for US-listed companies. Companies have reported
that SOX 404 improved the accuracy of their financial
statements, while it also increased their reliability,
thus, protecting investors‘ and shareholders‘ interests.
187
Enterprise Risk Management Framework-Integrated
Framework, Executive Summary, released by COSO in
September 2004, available at : http://www.coso.org/
Publications/ERM/COSO_ERM_ExecutiveSummary.pdf.
188
Jackson, H. and Pan, E.,B( forthcoming) ‗Regulatory
Competition in International Securitities Markets: Evidence
from Europe in 1999- Part II ‘, Bus.Law and Pagano, M. et
al, (2001) ‗ The Geography of Equity listing: Why do
companies list abroad? ‘ Centro Studi in Economia e
Finanza , W.P. No 28.
189
Karolyi, A., (1996), ‗ What happens to stocks that list
Shares Abroad? A survey of the evidence and its managerial
implications‘, 34 NYSE W.P. N096-04.
190
Karolyi, A., ibid and , Foerster,S.R., and Karolyi, A.,
(1999) , ‗ The effect of market segmentation and Investor
Recognition on Asset Prices: Evidence from Foreign Stock
Listing in the United States‘, 54 J. FIN. 981
191
Baker, K. et al., (1999), ‗ International cross-listings and
visibility‘
192
Errunza, V.R. and Miller,D.P., (2000), ‗Market
Segmentation and the Cost of Capital in International
Equity Markets‘, 35 J.Fin & Quantitative Analysis , 577,
Stulz, R. M., (1999), ‗Globalization of Equity Markets and
the Cost of Capital‘ NYSE W.P. No. 99-02
193
Cheung, S. and Lee, J., (1995) „Disclosure environment
and Listing on Foreign Stock Exchanges‘, 19 J. Banking
and Finance, 347
It involves rationalizing internal controls and
evaluations, i.e. which controls are important to keep
and which to remove, standardizing and centralizing
key controls in view of increasing efficiency and
redesigning the control structure.
As much-discussed in theory and in practice,
Section 404 created new control environment
requirements for companies without, however,
setting, in a direct manner, clear discriminations
depending on the company size. Indirectly, it reveals
the dilemma for a company whether it is large enough
to bear the costs of the new internal control
requirements or whether it is small enough and stay
private or even go dark. Section 404 was, at first, a
threat to the companies‘ annual costs but, as time has
shown, this is not the one and only reason that
companies delist from NYSE or do not go public or
prefer another stock market for issuing an IPO.
The controversy about Section 404 shed light to
the deregistrations from NYSE and NASDAQ. Yet
the results are still not clear enough in order to
support that SOX and Section 404 are the primary
reasons for which companies prefer other public
markets or delist from US exchanges.
There has been significant research about the
impact of SOX οn companies. What seems to be
evident in more research papers is the fact that the
companies which delist from the US exchange are the
smaller and the weaker ones, i.e. the ones which
cannot bear the costs created by SOX. SOX 404
undoubtedly imposed new compliance costs to the
firms; Zhang 194 concludes that SOX has imposed
significant net costs on firms. However, the picture is
far more vague with regard to the companies which
go private or dark following SOX‘s implementation.
It should be noted, however, that NYSE and
NASDAQ had already changed their requirements by
the time SOX was passed as well as that many
changes to US corporate practices would have taken
place independently of the enhancement of SOX , due
to the market pressures and the changes caused by the
scandals.
According to Kamar et al.195, it is clear that the
burden imposed by SOX mainly induced small
companies to go private, while large companies were
little affected. Small firms are expected to have more
ineffective internal controls than larger companies 196
and lack of in-house staff to respond to more complex
194
Zhang, I., (2007), ‗The Economic Consequences of the
Sarbanes-Oxley Act of 2002‘, Carlso School of
Management W.P., University of Minnesota.
195
Kamar, E. et al., (2006), ‗Going Private Decisions and
the Sarbanes/Oxley Act of 2002: A Cross Country Analysis,
Univ. S. Calif. Ctr. In Law, Econ & Org. Research Paper
No.
C06-05
also
available
at:http://ssrn.com/
abstract=901769
196
Doyle, J. et al, ( forthcoming), Determinants of
weaknesses in internal control over financial reporting and
the implications for earnings quality‘, Journal of
Accounting Research.
153
internal control procedures. Leuz et al 197 show that
going dark firms are smaller, more distressed, have
weaker performance and governance than public and
private companies. As Leuz et al show, the increase in
SEC deregistration after SOX is primarily driven by
firms that went dark rather than private and this was
much a result closely linked to the extension of the
compliance with the 404 procedure. On the other
hand, there is no significant increase shown in going
private in the months after the passage of SOX.
Moreover, Litvak 198 outlined that SOX reduced
the value of cross-listed firms, especially in the event
of small ones, while lower returns to cross-listed firms
regardless of the firm size were observed. However,
the major weakness of the research on the impacts of
SOX is the difficulty to separate the effect of SOX,
and especially of Section 404, from that of
contemporaneous factors, such as the financial market
liquidity as Kamar et al. mention in a recent paper 199.
As a result, the multitude of reasons affecting the
deregistration decisions of the firms makes it difficult
to cite SOX as the only factor of deregistrations. The
concerns about the results that 404 would have were
smoothed over with time; immediately after the
release of SOX, small firms went private in order to
avoid the initial compliance costs, while investors,
shocked by the innovative nature of the Act, reacted
with fear, especially during the first year of its
implementation. For foreign issuers though, the
experience of US companies and the foreseen
expansion time contributed to ensure adequate
preparation for the 404 filing and better scheduling of
internal control mechanisms. The reaction to the 404
implementation is also relative; the higher the firm‘s
level of disclosure and corporate governance regime
is, the less benefit from externally imposed regulation.
However, European cross-listed companies did not
state that they already had the same disclosure level
with the level required by SOX, while US had,
traditionally, even before SOX, through the Securities
Acts and the class action enforcement, better investor
protection. Berger et al 200 show that stock market
reaction to SOX is more positive for firms from
countries with poor enforcement of investor rights
underlining that SOX improves the protections of
outside investors in those firms.
After SOX‘s implementation, auditor industry
specialization constrained the significant increase in
audit fees that arose during the first year of SOX‘ s
implementation201. Auditor industry specialization
reduced the cost burden of SOX during the first year
of implementation and consequently, lead industry
expertise to efficiencies. The American experience
gained until the present day was valuable for foreign
issuers. Moreover, according to Prentice arguments,
“the harshest criticism of SOX are overblown” 202 as
empirical studies so far indicate that together Sections
302 and 404 are providing investors in US markets
with the most reliable financial statements in history
which benefits issuers by reducing their capital costs
and benefits investors by reducing their risk.
The establishment of Section 404 enables
achievement of the goals of SOX, aiming at
diminishing managerial opportunistic behaviors, by
interposing independent
directors on audit
committees, company lawyers and other parties in this
process 203.
2. Challenges to Foreign Issuers
Since the passage of SOX, Karmel 204 pointed out two
possible directions; either foreign issuers deregister
and move to London or corporate governance
standards converge into US models, something which
could lead to a worldwide harmonization of standards.
It could be maintained that until the present day,
foreign issuers have taken, for different reasons, both
directions. Nevertheless, the latter scenario seems
more likely. The fact that the majority of foreign
issuers did fill in the 404 management assessment
over internal control report reflects their will to stay in
the US stock markets and bear the costs, anticipating,
probably, long-term benefits. Firms have, by now, the
knowledge, the background and the proper in-house
staff to implement a timely and accurate internal
control procedure, while it should also be underlined
that 404-related costs are significantly lower after the
first year of implementation. On the other hand,
delisting from NYSE and NASDAQ or preferring to
launch an IPO in a stock market outside the US
should not be considered as SOX‘s only consequence.
The Paulson Committee‘s Interim Report of 2006
concluded that US is losing its competitive leading
position as compared to stock markets and financial
197
Leuz, C., Triantis, A. and Wang, T., (forthcoming).
‗Why Do Firms Go Dark?‘Causes and Economic
Consequences of Voluntary SEC Deregistrations, Journal
of Accounting and Economic
198
Litvak, K., (2007), ‗Sarbanes-Oxley and the crosslisting premium‘ 105 Michigan Law Review.
199
Kamar, E. et al., (2007), ‗ Sarbanes-Oxley‘s Effects on
Small Firms: What is the Evidence?‘, In the Name of
Entrepreneurship? The Logic and Effects of Special
Regulatory Treatment for Small Business, S. Gates and K.
Leuschner (eds.) RAND 2007.
200
Berger, P.H., Li, F. and Wong, M.H.F., (2006) ‗The
Impact of Sarbanes-Oxley on Cross-listed Companies‘,
W.P. University of Chicago and University of Michigan
154
201
Fleming, D.M. & Romanus, R.N., (2007), ‗Auditor
Industry Specialization and Audit Fees Surrounding Section
404 Implementation‘, Texas Review
202
Supra ftn. 3.
203
Hazard, G. & Rock, Ed., (2004), ‗ A New Player in the
Boardroom: The Emergence of Independent Directors‘
Counsel‟, 59 Bus.Law 1389, Fisch, J. & Gentile, C., (2003),
‗The Qualified Legal Compliance Committee: Using
Attorney Conduct Rules to Restructure the Board of
Directors‘, 53 Duke L.J. 517.
204
Karmel, R., (2004), ‗ The Securities and Exchange
Commission
Goes abroad to Regulate
Corporate
Governance, 33 Stetson L. REV. 849
centers abroad and the main reason is the ‗shift of
regulatory intensive balance‘ towards what might be
deemed ‗excessive‘ regulation of US markets 205.
According to this report, the 404 compliance costs
have been excessive and have reduced US markets
competitiveness. The picture is mixed and that is
supported by Kamar, Berger and Litvak.
Firms with strong internal controls reduce their
capital costs significantly. It is noted that the
disclosure regime should not strive for breadth and
completeness, since these costs are unnecessary and
are simply targeted towards problems in the
framework of which transparency helps overcome
principal-agent problems. As a result, the benefits of
the internal control system are measured based on
how well it helps monitor and control the behavior of
the firm‘s senior managers206. Furthermore, due to its
various benefits, additional investment in internal
controls may be justified207.
Until issuance of Section 404, small firms, in
particular, did not use to report their internal control
weaknesses. SOX enables the creation of a
compliance culture in modern financial reporting
methods. However, according to Kahan, if the law
tries to change accepted norms too significantly, this
hard shove may well be self-defeating where a gentle
nudge it might have been the best solution208 . Under
Section 404, there are challenges for foreign issuers;
for SOX supporters, the overall Act constituted a
chance to enhance financial reporting and disclosure
and to render executives more accountable towards
the shareholders. Before Section 404, the
management did not require extensive internal control
expertise and, thus, companies were much exposed to
possible financial risks and frauds.
With respect to foreign issuers, the beneficiaries
of the internal control procedures should be specified.
Independent directors are responsive mainly to the
current generation of shareholders contrary to debtholders or outside investors. The beneficiaries of a
strong system of internal control include outside
investors interests, to whom neither the directors nor
the management have any loyalty whatsoever. As it
was noted in paragraph 6 of AS-2 PCAOB‘ s
standard, government regulators are specific
beneficiaries of internal control system as well.
The challenges that foreign issuers are faced
with regarding 404 have been diminished after foreign
205
Committee on Capital Markets Regulation (Paulson
Committee) Report of 30 November , 2006.
206
However, this system is far narrower than the system
proposed by PCAOB‘ s AS-2 standard, though the standard
has an agency cost embedded in it.
207
The question of whether securities regulation affects
non-investor constituencies as well as investors is shown in
Williams, C.,(1999), ‗The Securities and Exchange
Commission and Corporate Social Responsibility‘, 112
Harvard L. Rev 1179.
208
Kahan, D.M, (2000), ‗Gentle Nudges vs. Hard Shoves:
Solving the Sticky Norms Problem, 67 U. Chi. L. REV. 607,
614
issuers first 20-F filing. However, it is significant to
introduce appropriate audit committees, independent
from the management overseeing financial reporting
as required by AS-2. Another significant issue is that
IT and internal control mechanism and evaluation
framework be designed in such as way so as to
respond to the geographical multi-location of a
foreign issuer‘s subsidiaries. Nevertheless, what is
more crucial about foreign issuers is the duplicative
reporting standards for foreign firms. The SEC
requires all listed corporations to report in conformity
with US GAAP or to reconcile IFRS with US GAAP
if they use IFRS as many foreign chartered
corporations and all EU-based corporations do. As a
result, foreign companies bear also significant
additional reporting or reconciliation costs. The SEC
recently proposed that foreign issuers be allowed to
file financial statements, prepared in accordance with
IFRS, without any reconciliation with US GAAP and
has issued a ‗concept release‘ on allowing US firms to
do the same 209.
The SEC has taken many steps in order to keep
foreign issuers in US markets, with the AS-2 and the
concept for IFRS and US GAAP being its most
significant steps until the present day. The gained
experience on SOX 404 and the fear of loosing its
competitiveness made SEC and PCAOB react in a
timely manner. Another proposal of financial
economists group roundtable210 is the adoption of a
statutory amendment for turning 404 into a voluntary
provision; if a company chooses not to comply with
the market, its explanation of non-compliance and the
value of the company will be assessed accordingly.
Τhen, it is estimated that investors will put a lower
value on a non-compliant company, a fact which will
constitute an incentive for the company to meet the
404 requirements if the expense is worthwhile 211.
Conclusion
Listing in US is not as much prestigious as it used to
be in good old times. US competitiveness was not
exempted from the latest financial banking crisis. The
decline in US stock markets should not be attributed
only to SOX and especially to Section 404. There is
evidence that foreign issuers delist, do not go public
at all or go dark; although there is evidence that the
compliance costs were higher than expected, a
company‘s decision to deregister is driven to a great
extent by many financial and strategic management
reasons rather than merely by SOX. The SEC is by
now well-aware of the situation and is now prone to
209209
SEC Concept Release ‗Allowing US issuers to Prepare
Financial Statements in Accordance With International
Financial Reporting Standards, Release No. 33-8831
(August 7, 2007) available at: http://www.sec.gov/
rules/concept/2007/33-831.pdf
210210
Financial Economists Roundtable (FER), Statement on
the International Competitiveness of US Capital Markets,
September 7, 2007.he
211
Ibid.
155
more regulatory openness and flexibility with regard
to foreign issuers. SEC‘s international strategy should
draw a distinction between the healthy aspects of
regulatory competition and regulatory arbitrage 212.
The next challenge should be the transatlantic
regulatory dialogue in accounting and auditing. As
marked by Khachaturyan and McCahery213, measures
should be left sufficiently flexible in order to
accommodate the wide range of firms and corporate
law regimes; the more innovative and adaptable a
legal system is, the more likely it will be to supply
firms with measures that they require while ensuring
an adequate level of investor protection.
Deregistration in 2003, after the implementation
of SOX, was much observed in London as well as in
other stock exchanges. LSE gained a relevant
competitive advantage as a pioneer of the ‗comply or
explain rule‘ in corporate governance, however NYSE
and NASDAQ offer the advantage of better
enforcement of the rule, public and private. In the EU,
there is considerable wariness about giving regulators
strong powers in the area of corporate governance as
this could lead to rigidity and destroy flexibility 214 .
Section 404 of SOX is the Act‘s most criticized
article; however, if the internal control is carefully
scheduled in advance following performance of
thorough tests and use of the necessary mechanisms,
the financial disclosure of the firm is of high quality,
and, consequently, of better corporate governance.
The aim related to maximizing the firm‘s value and
having an efficient market is met as market efficiency
has profound implications on disclosure policy. It is
also argued that the real benefits of disclosure are
better depicted in the process of capital allocation
among firms 215 .
There is much literature on 404 SOX and it will
continue to be, as the need for obtaining a clearer
picture on its benefits is well discernable. Every
change is costly, even for large capitalization
companies. 404 created many costs, however, the
firms which have complied with SOX enjoy a valid
and accurate internal control system, which can be
beneficial for the market performance of the firm,
212
Tafara, E. and Peterson, R. (2007), ‗ A Blueprint for
Cross-Border Access to US investors: A new International
Framework‘, 1 Harvard International Law Journal, Vol. 48
213
Khachaturyan, A. and McCahery, J. (2006),
‗
Transatlantic Corporate Governance Reform: Brussels
Sprouts or Washington Soup?‘, Amsterdam Centre for Law
and Economics W.P. 2006-02 also available at :
http://ssrn.com/paper=893790
214
See Ftn. 149 in Cearns, K. and Ferran, E. (2008), ‗NonEnforcement Led Public Oversight of Financial and
Corporate Governance Disclosures and of Auditors, ECGI
W.P. No. 101.
215
Fox, M., (1997), ‗Securities Disclosure in a Globalizing
Market: Who Should Regulate Whom?, 95 Mich. L. Rev.
For a contrary argument see Stout, L. (1988), ‗The
Unimportance of Being Efficient: An economic analysis of
Stock Market Pricing and Securities Regulation‘, Mich. L.
Rev 613.
156
while the sound application of SOX seems to turn into
a benefit also for foreign issuers.
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