Shareholders' Access to Company's Information

Corporate Ownership & Control / Volume 6, Issue 4, Summer 2009

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EDITORIAL

Dear readers!

This issue of the journal Corporate Ownership and Control delivers to the reading audience the most important issues of corporate governance, such as corporate social responsibility, shareholders’ and stakeholders’ rights, board diversity and responsibility, ownership structure, executive compensation. From the point of view of the international comparision of the corporate governance practices we did our utmost to compose the issue of the journal of various countries. These are Japan, Germany, Spain, China, Taiwan, Malaysia, Jordan, Pakistan. An Asian perspective of corporate governance was considered by the authors with a deep concern. The financial crisis is not going to finish as fast as it was expected by experts. The year 2009 is the time for testing the new corporate governance standards which were failed during the crisis. The most critical issues to be reconsidered are the board committees’ practices, with application to the decision control, directors’ independence, with application to the new criteria of independence, executive compensation, with application to the control of the compensation practices, independent directors’ remuneration, with application to the committees’ remuneration, and stakeholders’ rights, wih application to searching for the mechanisms of participation of the stakeholders in corporate governance, especially in financial companies and banks. We are going to invite the authors to send us the papers which are entirely devoted to the issue of financial crisis. It is expected to publish a special issue of the journal describing the corporate governance practices during the crisis. Taking into account tha we have many institutional, corporate subscribers, more than 220 corporations and banks, from 32 countries of the world we guarantee that all new ideas how to overcome the crisis will be delivered to the corporate world immediately. Moreover, we expect to invite the corporate leaders to publish in our journal the most effective approaches to improve corporate governance practices during the crisis. This will concern both regulators and corporations. In general, this year is expected to be a test for abilities of academics and practitioners to unite their efforts to overcome the crisis. Our journal is going to be on a forefront of these efforts!


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CORPORATE OWNERSHIP & CONTROL Volume 6, Issue 4, Summer 2009

CONTENTS

Editorial 4

SECTION 1. ACADEMIC INVESTIGATIONS AND CONCEPTS RESPONSIBLE CORPORATE GOVERNANCE: TOWARDS A STAKEHOLDER BOARD OF DIRECTORS? 9 Silvia Ayuso, Antonio Argandoña The central question posed in this paper will be how to organize board composition in order to ensure a responsible corporate governance both from a CSR and a good governance perspective. Adopting a stakeholder approach to corporate governance, we analyze the arguments given by different theoretical approaches for linking specific board composition with financial performance and CSR, and discuss the empirical research conducted. Despite the inconclusive findings of empirical research, it can be argued that diverse stakeholders on the board will promote CSR activities within the firm, but at the same time will increase board capital (which ultimately may lead to a better financial performance). Finally, we propose a model for selecting board members based both on ethical and pragmatic arguments. SHAREHOLDERS’ ACCESS TO COMPANY’S INFORMATION: TOWARDS ENSURING SHAREHOLDERS’ MONITORING RIGHT AND MINORITY SHAREHOLDERS’ PROTECTION 20 Junko Ueda This article aims to revisit how minority shareholders’ right to company’s information can be secured under Japanese company law to execute their substantial rights (to collect proxies, to sue management, etc.) particularly in the process of mergers and acquisitions. Section I overviews the structure of shareholders’ monitoring rights under Japanese company law against their historical background. Section II focuses on the shareholders’ rights to company’s information and its significance amongst shareholders’ rights and its linkage with other shareholders’ rights. Section III analyses leading cases before the Japanese courts regarding shareholders’ rights of inspection. Section IV surveys the shareholders’ right under Japanese company law to have access to company’s information in parallel with their right to apply for the courts to appoint inspectors who investigate into company’s business activities and financial situations. Section V assumes an expected shareholders’ role in association with the other monitoring function ensured under company law and pursues a “good governance” system. THE DECREASE IN DIVERSIFICATION AND CORPORATE GOVERNANCE: EVIDENCE FROM JAPANESE FIRMS 28 Hidetaka Aoki This paper analyzes the effects of firm performance and governance factors on the decrease in diversification of Japanese firms in the 1990s. We focus on the cases of the decrease in diversification, because many previous studies proved that diversification caused firm value discount. Adjusting an


6

excessive unrelated diversification would be an important topic, because the problems of low synergy between business units, inefficiency in management and so on were more serious in this type of diversification. CORPORATE SOCIAL RESPONSIBILITY IN THE TOP SPANISH HOTEL COMPANIES 40 Eugenia Suárez-Serrano Corporate social responsibility (CSR) in tourism is particularly interesting given the fact that society is part of the service and companies should assume a responsibility with the places they are located in. Several studies analyse the reporting of CSR activities, however, there is modest research relating CSR practices in the hospitality industry. The purpose of this paper is to provide two case studies in the Spanish hospitality industry, Sol Meliá and NH, which are the only top hotel companies that offer information about their CSR practices in their web sites and Annual Reports. Although the tourism industry still has a long way to do in the reporting of CSR activities to become equal to other industries, in the two cases analysed a clear commitment to CSR matters it is observed within its various spheres of action. NEW ZEALAND CEO COMPENSATION FACTORS 47 Sam Hurst, Ed Vos This paper analyses a combination of factors to try and determine whether they explain CEO compensation, and in turn help determine what makes the board of directors more effective. Factors include busy boards, local or international board members, dependent and not independent board members, director’s pay and tenure variables. Of the new and old factors considered in this approach and using a sample size of 31 NZ firms over the 2006/2007 years, a correlation existed between firm size/firm performance and CEO compensation. Further distinctions in regards to busy boards showed no significant relationship to CEO compensation, differing from previous studies, and casting doubt on whether it matters how busy the board is. Also the locality of the board was not a determining factor in CEO compensation. OWNERSHIP AND CONTROL IN GERMANY: DO CROSS-SHAREHOLDINGS REFLECT BANK CONTROL ON LARGE COMPANIES? 54 Alberto Onetti, Alessia Pisoni

This paper aims to analyse the relationships (equity and non-equity) between German banks and German firms, which are the peculiarities of the German institutional system of corporate governance. Scholars agree on the fact that cross shareholdings among banks, insurance companies and institutional firms (Charkham 1994, Baums 1993), combined with long term shareholdings (Gerschenkron 1989), and close relationships and interlocking between board members of different companies (Tilly 1969, Hopt and Prigge 1998), are the main features of bank-firms relationships in Germany. Specifically the main purpose of the paper is to demonstrate, for the panel of German companies investigated, that bank-firm relationship relies not only on patrimonial linkages but also on personal relationships. THE IMPACT OF PROBLEM LOAN, OWNERSHIP STRUCTURE, AND MARKET STRUCTURE UPON THE BANK PERFORMANCE 78 Andy Chein Some research on the causes of bank failure finds that failing institutions had large proportions of problem loans prior to failure, and that the extra costs of administering these loans reduced the bank performance. At this moment, if bank management goes after maximizing one’s utility, not the bank performance, in addition confronting from rising competitive environment, it would be quite dangerous. So, this article studies the impact of problem loan, ownership structure, and market structure upon the bank performance with the basis of cost efficiency. Empirical results show that


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problem loan, ownership structure, and market structure have a significant effect upon the bank performance.

INFORMATION SHARES: EMPIRICAL EVIDENCE FROM THE FTSE CHINA A50 INDEX AND THE ISHARES FTSE A50 CHINA TRACKER 83 Yih-Wenn Laih, Chun-An Li We study the price discovery process and common factor weights of SS50 (the FTSE China A50 Index traded in Mainland China) and A50 (the iShares FTSE A50 China Tracker traded in Hong Kong) using daily open-to-open price pairs and close-to-close price pairs. Due to Qualified Domestic Institutional Investor (QDII) scheme (13 April 2006) and US subprime mortgage crisis (middle 2007), our sample, which covers from November 18, 2004 to October 31, 2008, is divided into three periods. We find A50 has a much larger common factor weight than SS50, and A50 dominants for both open and close prices during all periods. The QDII enlarges the contribution of SS50, but financial crisis reduces it. SECTION 2. OWNERSHIP STRUCTURE MANAGEMENT OWNERSHIP AND FIRM PERFORMANCE: EVIDENCE FROM AN EMERGING ECONOMY 88 Talat Afza, Choudhary Slahudin Due to the separation of ownership and control in modern corporation, the form of relationship between firm performance and insider ownership has been the subject of empirical investigation for last many decades. It is argued, that as managers' equity ownership increases, their interests coincide more closely with those of outside shareholders, and hence, the conflicts between managers and shareholders are likely to be resolved. Thus, management's equity ownership helps resolve the agency problem and improve the firm's performance (Jensen and Meckling, 1976; Agrawal and Knoeber, 1996; Chen et al., 2003). However, several studies suggest that management's ownership does not always have a positive effect on corporate performance (Demsetz and Villalonga, 2000; Cheung and Wei, 2006). Most of the empirical studies on this issue have focused on the developed economies and there is little empirical evidence on the emerging economies in general and almost no work has been done on emerging economy of Pakistan in particular. Therefore, present study is an effort to analyze the relationship between insider ownership and firm performance in emerging market of Pakistan while taking a sample of 100 firms listed on Karachi Stock Exchange. OWNERSHIP STRUCTURE, CORPORATE PERFORMANCE AND FAILURE: EVIDENCE FROM PANEL DATA OF EMERGING MARKET THE CASE OF JORDAN 96 Rami Zeitun This study investigates the impact of ownership structure (mix and concentrate) on a company’s performance and failure in a panel estimation using 167 Jordanian companies during 1989-2006. The empirical evidence in this paper shows that ownership structure and ownership concentration play an important role in the performance and value of Jordanian firms. It shows that inefficiency is related to ownership concentration and to institutional ownership. A negative correlation between ownership concentration and firm’s performance both, ROA and Tobin’s Q, is found, while there is a positive impact on firm performance MBVR. The research also found that there is a significant negative relationship between government ownership and a firm’s accounting performance, while the other ownership structure mixes have significant coefficients only in Tobin’s Q using the matched sample. Firm’s profitability ROA was negatively and significantly correlated with the fraction of institutional ownership, and positively and significantly related to the market performance measure, MBVR. The result is robust when indicators of both concentration and ownership mix are included in the regressions. The results of this study are, to some extent, inconsistent with previous findings.


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THE IMPACTS OF MANAGERIAL AND INSTITUTIONAL OWNERSHIP ON FIRM PERFORMANCE: THE ROLE OF STOCK PRICE INFORMATIVENESS AND CORPORATE GOVERNANCE 115 William Cheung, Scott Fung, Shih-Chuan Tsai This paper provides new evidence on the relations between managerial and institutional ownerships and firm performance. These relations are found to be affected by firm’s stock price informativeness and corporate governance. Based on a sample of US firms from NYSE, AMEX, and NASDAQ between 1989 and 2006, we document three important findings. First, managerial ownership and firm future performance are non-linearly related; the positive relation is stronger for firms with less informative prices or more agency problems. This finding suggests that poor governance and uninformative price increase the importance of managerial value creation for their firms by improving internal governance. OWNERSHIP STRUCTURE AND CORPORATE VOLUNTARY DISCLOSURE-EVIDENCE FROM TAIWAN 128

Grace M. Liao, Chilin Lu

In this study, we explore the association between ownership structure and voluntary information disclosure in Taiwan. Annual report index data from Information Disclosure and Transparence Ranking System (IDTRS) are used as the proxy of the firm’s voluntary information. The empirical results indicate that the level of information disclosure is likely to be less in “insider” or family-controlled companies. SECTION 3. CORPORATE GOVERNANCE: MALAYSIA CORPORATE GOVERNANCE IN FAMILY RUN BUSINESS – A MALAYSIAN CASE STUDY 135 C.H. Ponnu, C.K. Lee, Geron Tan, T.H. Khor, Adelyn Leong This paper addresses the debate on family run business and corporate governance before and after the Asian Financial Crisis in 1997. As there are only few studies on the corporate governance of family businesses in Malaysia, this paper aims to provide a broad view of the corporate governance practises of family run companies in Malaysia. The majority of family-run companies in Malaysia are operated by ethnic Chinese families in Malaysia. To understand the practices of corporate governance in these companies, this study selected 3 of the top 10 family run companies by market capitalization in Malaysia. CORPORATE GOVERNANCE COMPLIANCE VERSUS SYARIA’ COMPLIANCE AND ITS LINK TO FIRM’S PERFORMANCE IN MALAYSIA 148 Noriza Mohd Saad The purpose of this study is to investigate level of compliance by corporate governance (CG) code of best practices and sharia’ principles among public listed companies in main board of Bursa Malaysia and to provide insights view in determining significance association between the corporate governance and sharia’ compliance with firm’s performance. Corporate governance compliance was measured by three board of directors (henceforth; BOD) facets; (i) director’s remuneration, (ii) directors training and (iii) number of family members. Meanwhile, Syaria’ compliance is based on six proxies, (i) riba, (ii) gambling, (iii) sale of non halal product, (iv) conventional insurance, (v) entertainment and (vi) stockbroking. SUBSCRIPTION DETAILS 155


9

РАЗДЕЛ 1 НАУЧНЫЕ ИССЛЕДОВАНИЯ

И КОНЦЕПЦИИ

SECTION 1 ACADEMIC INVESTIGATIONS & CONCEPTS

RESPONSIBLE CORPORATE GOVERNANCE: TOWARDS A STAKEHOLDER BOARD OF DIRECTORS?

Silvia Ayuso*, Antonio Argandoña**

Abstract The central question posed in this paper will be how to organize board composition in order to ensure a responsible corporate governance both from a CSR and a good governance perspective. Adopting a stakeholder approach to corporate governance, we analyze the arguments given by different theoretical approaches for linking specific board composition with financial performance and CSR, and discuss the empirical research conducted. Despite the inconclusive findings of empirical research, it can be argued that diverse stakeholders on the board will promote CSR activities within the firm, but at the same time will increase board capital (which ultimately may lead to a better financial performance). Finally, we propose a model for selecting board members based both on ethical and pragmatic arguments. Keywords: board composition, corporate governance, corporate social responsibility, financial performance, stakeholders.

*Researcher, ESCI International Trade Business School, Pg. Pujadas, 1, 08003 Barcelona (Spain)

[email protected], Tel + 34 93 295 47 10, Fax + 34 93 295 47 20

**Professor, “la Caixa” Chair of Corporate Social Responsibility, and Corporate Governance, IESE Business School, Av. Pearson,

21, 08034 Barcelona (Spain)

[email protected], Tel + 34 93 253 42 00, Fax + 34 93 253 43 43

Introduction

As corporate social responsibility (CSR) has become

an increasingly prominent issue for companies,

corporate boards of directors are becoming more

involved in assessing and shaping company policies

and practices on a wide range of social and

environmental topics. At the same time that

companies‘ overall CSR performance has come under

the spotlight, a parallel ―good governance‖ movement

has put the structure, composition and behaviour of

corporate boards under scrutiny. Shareholder activists

and other stakeholders are demanding that corporate

directors be more active and independent of

management, and that corporate boards more

accurately reflect a broad range of constituents. But,

how does good corporate governance relate to CSR?

The present paper attempts to address this question.

Usually, the term corporate governance refers to

the system by which organizations are directed and

controlled and which specifies the distribution of

rights and responsibilities among shareholders and

managers and the rules and procedures for making

decisions on corporate affairs. However, in a wider




10

sense, corporate governance also includes the

relationships with a broader range of firm

stakeholders, both internal (employees) and external

(customers, suppliers, etc.). In this regard, Tirole

(2001, p. 4) proposes a definition of corporate

governance as ―the design of institutions that induce

or force management to internalize the welfare of

stakeholders‖. Broadly speaking, we can differentiate

between a shareholder perspective and a stakeholder

perspective of the firm (Letza et al., 2004;

Szwajkowski, 2000; Vinten, 2001). The shareholding

model regards the corporation as a legal instrument

for shareholders to maximize their own interests, i.e.

investment returns. More in line with the CSR

strategy is the stakeholding approach that views the

corporation as a locus of responsibility in relation to a

wide array of stakeholders‘ interests or, in words of

Tirole (2001, p. 24), as ―maximizing the sum of the

various stakeholders‘ surpluses‖.

This stakeholder approach to corporate

governance implies a shift in the traditional role of the

board of directors as defenders of shareholders‘

interests. As the highest governance body, directors

are responsible for setting the values and standards

within the organization through their decisions

regarding strategy, incentives and internal control

systems. Thus, a board that commits to CSR and

seeks to address the needs of diverse stakeholders

may have to adapt its composition and functioning to

this new role. However, as noted by Ricart et al.

(2005), little attention has been paid so far to the

implications of CSR for corporate governance.

Academic research has focused until now on two

aspects of socially responsible firms: CEO

compensation (e.g. Frye et al., 2006; Mahoney and

Thorn, 2006; McGuire et al., 2003) and board

structure (Ayuso et al., 2007; Hillman et al., 2001;

Webb, 2004). In this paper, we will only look at board

composition as a governance mechanism for taking

into account the stakeholder concerns.

The central question posed in this paper will be

how to organize board composition in order to ensure

responsible corporate governance both from a CSR

and a good governance perspective. This question will

be approached in the following way. First, we review

the stakeholder approach to corporate governance as

an alternative to the shareholder-focused conception

of the firm. Second, we focus on the composition of

the board of directors, and examine the

recommendations made by corporate governance

guidelines and codes of best practices. We analyze the

arguments given by different theoretical approaches

for linking specific board composition with financial

performance and CSR, and discuss the empirical

research conducted. Finally, we propose a model for

selecting board members based both on ethical and

pragmatic arguments.

The stakeholder approach to corporate governance

According to stakeholder theory, companies should

design their corporate strategies considering the

interests of their stakeholders – groups and

individuals who can affect or are affected by the

organization‘s purpose (Freeman, 1984). In this sense,

stakeholders of a firm can be defined as ―individuals

and constituencies that contribute, either voluntarily

or involuntarily, to its wealth-creating capacity and

activities, and who are therefore its potential

beneficiaries and/or risk bearers‖ (Post et al., 2002, p.

8). The company can pay attention to these groups for

at least two reasons (Donaldson and Preston, 1995).

First, it can be considered that their demands have

intrinsic value (normative approach), so that the

company has the responsibility to meet their

legitimate claims. Second, addressing the interests of

stakeholders who are perceived to have influence can

improve company profitability (instrumental

approach). Stakeholder theory is related to the

literature of corporate sustainability and CSR, since it

provides a convincing theoretical framework for

analyzing the relationship between company and

society (Clarkson, 1995; Harrison and Freeman, 1999;

Mintzberg, 1983). Some authors, like Freeman and

Velamuri (2006), even affirm that the main objective

of CSR is to create value for stakeholders and to fulfil

responsibilities towards them.

With regard to corporate governance,

stakeholder theory has led to an alternative approach

to the conventional shareholder-wealth-maximizing

firm. Compared to the singular goal of raising

shareholder returns, the stakeholder firm has multiple

objectives related with its diverse stakeholders. The

shareholder-maximizing model is premised on the

notion that owners risk their investment capital and

are the sole residual claimants, while other parties

(e.g., employees) are compensated on the basis of

their marginal products (i.e., paid wages set by

competitive labour markets). The governance process,

therefore, is controlling managers and other

organizational participants to ensure that they act in

the owners‘ interests. In contrast, one can argue that

multiple firm stakeholders risk their ‗investments‘ to

achieve their goals, and thus each of them has a

legitimate or moral right to claim a share of the value

created or the firm‘s residual resources (Blair, 1995).

Under this view, the governance structure shifts from

a principal-agent to a team production problem, and

the critical governance tasks become to ensure

effective negotiations, coordination, cooperation and

conflict resolution to maximize and distribute the joint

gains among multiple parties of interest. For a

stakeholder firm to be viable over time, it must

demonstrate its ability both to achieve the multiple

objectives of the different parties and to distribute the


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value created in ways that maintain their commitment.

According to the normative stream of

stakeholder theory, the consideration of the

company‘s different stakeholder groups can be seen as

an ethical demand. Consequently, some authors

propose the representation of diverse stakeholders on

corporations‘ boards in order to legitimize (Evan and

Freeman, 1993) and safeguard the interests of

corporate stakeholders (Freeman and Evan, 1990) and

to ensure that their concerns are considered in

corporate decision-making (Jones and Goldberg,

1982). According to Luoma and Goodstein (1999),

three dimensions of board structure and composition

are particularly important in reflecting the degree to

which concern about stakeholders has been integrated

into corporate decision-making: the presence of

stakeholders as directors, their appointment in

monitoring or oversight board committees (audit,

compensation, executive or nominating), and the

existence of a committee composed mainly of

stakeholders or dedicated to CSR.

Within the instrumental approach of the

stakeholder model, several economic arguments have

been proposed to justify this vision of the firm. One of

the main arguments is the recognition of the

firm-specific investments made by stakeholders.

Rajan and Zingales (1998) and Zingales (1998) argue

that the company has to safeguard the interests of all

who contribute to the general value creation, that is,

make specific investments to a given corporation.

These firm-specific investments can be diverse and

include physical, human and social capital. These

specific investments are of little or no value outside of

the firm and cannot be protected by full contracts ex

ante, nor evaluated independently from the firm‘s

functioning.

The problem with these firm-specific

investments is that they produce quasi-rents that can

be expropriated by some of the firm constituencies

(included the external stakeholders). Thus, they can

cause a potential conflict among stakeholders that

may shrink the cooperation and, therefore, the

creation of value. Blair and Stout (1999) claim that it

is the board that has to take on the task of governing

the firm-specific investments and mediating between

investors‘ possible conflicting interests in

firm-specific assets. Recently, Kaufman and

Englander (2005) used the team production model to

recommend that company board members should

represent all those stakeholders that add value,

assume unique risks and possess strategic information

for the corporation. In sum, the board must have

directors who can knowledgeably express the multiple

constituents‘ interests both for ethical and economic

reasons. But the question remains: How should the

board choose members to represent, either directly or

indirectly, the different stakeholder groups?

Board composition and its effect on financial performance and CSR

Board composition is a central issue in the

multiplicity of corporate governance guidelines and

codes of best practices that have been published at the

international and national level. Most of these

guidelines are directed at increasing board

accountability to shareholders and improving board

effectiveness. There have also emerged voluntary

codes of conduct that include governance as part of a

larger corporate social responsibility agenda. Usually,

these governance recommendations call for more

board independence, and in some instances also for

increased board diversity and better response to

stakeholders.

Board composition has also been a focus of

much of the academic research on corporate

governance, particularly with regard to its effects on

corporate performance. Compared to the extant

research on the board-financial performance

relationship, much less attention has been paid to the

question of how specific board attributes influence

CSR. Next, we review the arguments put forward by

different theoretical approaches (mainly agency

theory and resource dependency theory) for linking

specific board composition with financial

performance and CSR, and examine the empirical

research conducted so far.

Independent directors

A common recommendation in corporate governance

codes is to increase the proportion of independent

directors on the board. The vast majority of

governance research has argued for this prescription

from an agency theory perspective. Agency theorists

see the primary function of boards of directors as

monitoring the actions of managers on behalf of

shareholders (Eisenhardt, 1989; Jensen and Meckling,

1976). Board independence – the degree to which

board members are dependent on the current CEO or

organization - is considered key to the effectiveness of

board monitoring (Fama and Jensen, 1983; Jensen and

Meckling, 1976). Boards consisting primarily of

insiders (current or former managers/employees of the

firm) or dependent outside directors (directors who have

business relationships with the firm and/or family or

social ties with the CEO) are considered to be less

effective in monitoring because of their dependence on

the organization. Independent boards – those

primarily consisting of independent outside directors

– are thought to be the most effective at monitoring

because their incentives are not compromised by

dependence on the CEO or the organization. Although

some empirical support has been found for this

hypothesis linking independent boards with firm

performance, other research does not support this


12

position (see Table 1).

An alternative perspective would suggest that

inside directors have more and better information

which allows them to evaluate managers more

effectively (Baysinger and Hoskisson, 1990). This

approach fits with resource dependence theory.

Resource dependence theorists view a firm as an open

system, dependent on external organizations and

environmental contingencies (Pfeffer and Salancik,

1978). Proponents of this perspective see corporate

boards as providers of four types of resources: advice

and counsel, legitimacy, channels for communicating

information between the firm and external

organizations, and preferential access to commitments

or support from important elements outside the firm

(Hillman et al. 2000). By linking the firm with its

external environment, resources help reduce external

dependency (Pfeffer and Salancik, 1978), diminish

environmental uncertainty (Pfeffer, 1972) and lower

transaction costs (Williamson, 1984), and ultimately

improve firm performance. Both inside and outside

directors may bring important linkages and resources to

the board, but directors who have ties to the current

CEO/organization will be more motivated to provide

resources (Hillman and Dalziel, 2003).1 Despite the

empirical support for this assertion (e.g. Kesner, 1987;

Westphal, 1999), a recent meta-analysis of fifty-four

studies showed no statistically significant relationship

between board dependence and the firm‘s financial

performance (Dalton et al., 1998).

With regard to CSR, most recommendations

favour the role of independent directors because they

will tend to be more sensitive to society‘s needs

(Ibrahim and Angelidis, 1994; Ibrahim et al., 2003).

In addition, outside directors may be more

knowledgeable about the changing demands of

various stakeholders and may feel freer to advocate

costly or unpopular decisions, such as those that

involve compliance issues (Johnson and Greening,

1999; Zahra et al., 1993). Although some empirical

support has been found for a better CSR performance

of firms with independent boards, several studies

found no relationship between board independence

and CSR (see Table 1).

INSERT TABLE 1 HERE

Although similar in its discussion of the

relationship between board composition and financial

performance, agency theory may suggest the opposite

argument. Assuming that CSR offers no obvious direct

financial benefit to shareholders, agents are more

likely than principals to invest in CSR because they

have no direct residual claims on a firm‘s income

(Wang and Coffey, 1992). Furthermore, agents may be

driven by self-interests to pursue CSR activities, such

as membership of a social elite, immortality and

distracting from mismanagement (Coffey and Wang,

1998). Thus, following agency theory logic, inside or

dependent directors will have a stronger interest in

CSR than independent directors. In contrast, boards

dominated by independent directors will be more

effective in monitoring and limiting managerial

opportunism linked to CSR.

Female and minority directors

Numerous governance guidelines advocate increased

representation by women and minorities on corporate

boards of directors to better reflect the gender and

racial diversity of their customers, employees, and

other stakeholders. The request for greater boardroom

diversity is based primarily on normative grounds of

equity and fairness (Carter et al., 2007). Corporations,

organizations and individuals seldom publicly dispute

the proposition that women and ethnic minorities

deserve equitable opportunities to serve on the board

and in upper management positions. But at the same

time, several arguments are made for the business

case for board diversity. Agency theory suggests that a

more diverse board is a better monitor of managers

because board diversity increases board independence

(Carter et al., 2007). According to this view, diverse

directors are less likely to collude with other directors

to subvert shareholders than more homogeneous

boards are. Furthermore, board diversity can increase

board independence because people with different

gender, ethnicity or cultural background might ask

questions that would not be asked by directors with

more traditional backgrounds. Other propositions for

promoting board diversity can be supported by

resource dependence theory, since a more diverse

board appears to increase the resources brought in by

individual board members and the organization‘s

access to external resources. Hence, board diversity

has been advocated as a mean of providing new

insights and perspectives, increasing creativity and

innovation, enhancing board decision-making and

promoting more effective global relationships (Carter

et al., 2003; van der Walt and Ingley, 2003).

Consequently, most researchers assume a positive

relationship between board diversity and

organizational performance. However, empirical

studies analyzing the effects of the gender and

ethnicity characteristics of board members have

produced mixed results (see Table 2). Whereas Carter

et al. (2003) and Erhardt et al. (2003) found

significant positive relationships between the presence

of women and ethnic minorities (i.e. African,

Hispanic, Asian and Native Americans) on corporate

boards and their impact on firm performance or

shareholder wealth, other studies found negative or no

statistically significant relationships between board

diversity and financial performance.

Female and minority directors are also usually

assumed to play an important role in favouring CSR


13

strategies. Since resource dependence theory suggests

that board members bring resources to the

organization as a result of their individual background,

an increased representation of women and ethnic

minorities will increase board attention to CSR issues

of racial and gender imbalances. Some studies also

affirm that female directors tend to be more sensitive

to CSR than their male counterparts (e.g. Ibrahim and

Angelidis, 1994). In any case, as members of

underrepresented groups in corporations, women and

minority directors are expected to be more interested

in the welfare of various stakeholders. As shown in

Table 2, several studies support this view.

INSERT TABLE 2 HERE

Stakeholder directors

Although codes of corporate governance increasingly

refer to stakeholders‘ interests, they seldom propose

including representatives of non-shareholder

stakeholders in the board. So far, not much attention

has been paid either to stakeholder directors in

corporate governance research. The dominant

theoretical perspective, agency theory, does not offer

many arguments for adding stakeholder directors to

the board. As Kassinis and Vafeas (2002) point out,

environmental (and CSR) policies give rise to a

different set of conflicts from the ―agency conflict‖:

management and shareholder interests are relatively

aligned and focused on maximizing profits, and

opposed to the interests of the community at large (or

other stakeholders). Following their argumentation, it

is not important to discern and separate directors who

are likely to protect shareholders over management,

but instead to discern those directors who are likely to

protect the community over management and

shareholders. Nonetheless, as in the case of female

and minority directors, it can also be argued that a

more plural board is a more independent board.

Resource dependency theory provides a better

argument for including stakeholder directors on the

boards. Different stakeholder directors can provide

valuable resources because of their business

relationships with the firm (for instance, customers,

suppliers and creditors) or non-business connections

(government officials, academics and community

representatives) (Luoma and Goodstein, 1999). Even

though this argument seems convincing, there has

been very little research examining the performance

effects of specific stakeholder directors (an exception

is Hillman (2005)). A particular case are employee

representatives on the board.2 Originally justified as a

form of industrial democracy or democracy at the

company level, today workers participation is mainly

emphasized as a contribution to value creating and

necessary organizational change (Hagen and Huse,

2006). While some authors argue that board employee

representation is dependent on executive managers

and contributes to managerial entrenchment (e.g.

Hollandts 2007), others highlight that employees, as

internal stakeholders, can provide exclusive company

information that may improve board efficiency (e.g.

Hagen and Huse, 2006). Empirical research on

employee representation on the board and its effect on

company performance has shown mixed and partly

contradictory results (see Table 3).

Although directors with a business background

can leverage their experience on CSR adoption from

other boards (Kakabadse et al., 2006; Kassinis and

Vafeas, 2002; Webb, 2004), the inclusion of

stakeholder directors will presumably lead to more

explicit recognition of stakeholder issues and thus

CSR. In addition to the argument of resource

dependence theory, some authors refer to stakeholder

theory in their call for board directors as

representatives and protectors of a broad range of

stakeholders (Hillman et al., 2001; Wang and

Dewhirst, 1992). Kassinis and Vafeas (2002) suggest

that stakeholder directors, such as academics,

members of the military and clergy, and politicians

have interests that are more closely aligned with the

interests of the community at large. Thus, the role of

stakeholders‘ representatives is to enhance not only

corporate financial performance, but also, more

important, corporate social performance. As shown in

Table 3, the few empirical studies that have been

conducted so far deliver mixed results for this

assertion.

INSERT TABLE 3 HERE

Towards a stakeholder board

Empirical findings on the effects of board

composition support different corporate governance

theories. The coexistence of different theoretical

approaches can be explained by the fact that each

perspective emphasizes a different role of the board of

directors. Whereas agency theory focuses on the

monitoring or control function of the board, resource

dependency theory stresses the role of the board as a

provider of resources (Hillman and Dalziel, 2003).

There is general consensus in the corporate

governance literature that outside directors, especially

those without any other affiliation with the firm, will

be more effective in evaluating management based on

their increased objectivity (Dalton et al., 1998). From

the literature reviewed, it becomes evident that

directors from a variety of constituencies and with a

variety of expertise will be more effective in

performing the resource provision function.3

Stakeholder theory introduces a new role of the

board: balancing stakeholder interests (Kakabadse and

Kakabadse, 2007). As referred earlier, stakeholder

theory has both normative (moral/ethical) and


14

instrumental (profit/wealth-enhancing) implications.

From the normative viewpoint, we can argue that if

the function of the board is to protect the interests of

the corporation‘s stakeholders, the board should

comprise members that are representative of these

stakeholders. Including stakeholders on corporate

boards can be a formal mechanism that acknowledges

the importance of their relationship with the firm

(Mitchell and Agle, 1997) and ensures that the

interests and well-being of constituents other than

shareholders are given legitimate consideration in

board decision-making (Luoma and Goodstein, 1999).

Furthermore, the institutionalization of stakeholders

inclusion on the board will become an important

element of the firm‘s CSR strategy, by formally

introducing non-economic considerations into

corporate decision-making.

Stakeholder directors are likely to be

knowledgeable about the interests of the groups from

which they are drawn and to bring a broader

perspective on the interests of stakeholders in general

(Hillman et al., 2001). At the same time, firms with

stakeholders on their boards are signalling their

commitment to stakeholders in a visible way. This

may in turn provide increased legitimacy for the firm

and increase a firm‘s linkages to important external

and internal contingencies. Hence, from the

instrumental viewpoint, including stakeholders on

corporate boards increases what Hillman and Dalziel

(2003) call board capital. This capital consists of both

human capital (expertise, experience, knowledge,

reputation and skills) and relational capital (ties to

strategically relevant organizations). Ultimately, the

presence of various stakeholder directors will secure

an increased provision of relevant resources by the

board and facilitate the firm‘s interactions with its

multiple stakeholder groups.

In our view, stakeholder theory suggests

incorporating various firm‘s stakeholders on the board,

both to give them a legitimate voice and to respond

better to the resource dependencies the firm faces. In

order to differentiate among stakeholder types, we adopt

the classification made by Rodriguez et al. (2002):

consubstantial, contractual and contextual stakeholders.

Consubstantial stakeholders are the stakeholders that

are essential for the business‘s existence (shareholders

and investors, strategic partners, employees).

Contractual stakeholders, as their name indicates,

have some kind of formal contract with the business

(financial institutions, suppliers and sub-contractors,

customers). Contextual stakeholders are

representatives of the social and natural systems in

which the business operates and play a fundamental

role in obtaining business credibility and, ultimately,

the acceptance of their activities (public

administration, local communities, countries and

societies, knowledge and opinion makers). Firms

must assess the stakeholders that are relevant to them

because of their specific business and environment

and select board members who represent them

adequately, also bearing in mind diversity issues such

as giving equal opportunities to women and ethnic

minorities. These stakeholders, in turn, will be able to

provide the needed board capital, i.e. human and

relational capital, to allow the firm to create value.

Table 4 shows the different types of stakeholder

directors and outlines the kinds of resources and

linkages which the director is expected to bring to the

board.

INSERT TABLE 4 HERE

Our proposal for stakeholder directors is similar

to Hillman et al. (2000) taxonomy of the resource

dependence role of directors. But while Hillman and

colleagues focus on a firm‘s need for resources from

the external environment, we also consider internal

resources. In this sense, our proposal for a stakeholder

board is more in line with Kaufman and Englander

(2005) board selection criteria based on a team

production model: the board should represent

stakeholders that add value, assume unique risks and

possess strategic information. However, we

emphasize that consubstantial, contractual and

contextual stakeholders of the firm contribute to its

wealth creation and should be included in the

governance board, and that the board also has the

responsibility to reflect societal diversity.

Conclusion

The present paper attempts to explore the question of

how to organize board composition in order to ensure

responsible corporate governance. Since CSR

suggests that companies have responsibilities that go

beyond the interests of their shareholders, it advocates

a stakeholder approach to corporate governance. In

contrast to the conventional shareholder-

wealth-maximizing firm, the stakeholder approach to

corporate governance views the firm as a

socio-economic organization built to create wealth for

its multiple constituencies, and, ultimately, calls for

representing the different stakeholders on the board.

From an ethical point of view, having stakeholder

directors on the board ensures that their rights and

legitimate expectations will be respected. From an

economic perspective, a board that replicates the

firm‘s internal and external stakeholders fosters their

commitment in contributing to value creation and

guarantees that their firm-specific investments will

not be ―expropriated‖ and their assumed risks will be

properly protected. Directors who represent the firm‘s

internal and external stakeholders will also bring

strategic information to the board. This argument

connects with the managerial perspective and, in

particular, resource dependency theory, since directors


15

from a variety of constituencies will be able to

provide important resources in order to assist the firm

in creating and sustaining competitive advantage.

Despite the inconclusive findings of empirical

research, it can be argued that diverse stakeholders on

the board will promote the firm‘s CSR activities, but,

at the same time, will increase board capital (which

ultimately may lead to a better financial performance).

The present paper makes several contributions.

First, it challenges the often-made assumption that

good corporate governance focuses exclusively on

shareholders‘ interests and argues for taking

stakeholders‘ interest into account. Second, it seeks to

reconcile different corporate governance theories and

connect economic and managerial argumentations.

Third, it makes a proposal that is relevant for both

researchers and practitioners. For scholars, it shows

the relevance of board directors as providers of

important resources and adds a new role of the board:

balancing stakeholders‘ interests. For practitioners, it

suggests a normative and strategic dimension when

selecting directors in order to ensure responsible

corporate governance, both from a CSR and a good

governance perspective.

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Footnotes 1 In line with Hillman and Dalziel (2003), we refer to

resource dependence theory in the sense of dependence of

the firm on both external and internal resources. This

interpretation is more in line with the resource-based theory

of the firm. 2 Many European countries have laws concerning

mandatory codetermination that allow employees to select

up to one third of the (supervisory) board members

(Osterloh et al., 2007). 3 Hillman and Dalziel (2003) argue that other board

roles considered in the corporate governance literature like

―strategy‖ and ―service‖, can be understood as part of the

provision of resources function.


18

Table 1. Empirical studies on the effects of independent directors on financial performance and corporate social

responsibility (CSR)

Positive findings Neutral or negative findings

Financial

performance

Baysinger and Butler (1985): Firms with

more outside board members performed

better than those with a majority of

insiders on the board.

Ezzamel and Watson (1993): Outside

directors are positively associated with

firm profitability.

Rosenstein and Wyatt (1990): An increase

in stock price was correlated with the

addition of outsiders to the board of

directors.

Agrawal and Knoeber (1996): More outsiders

on the board are negatively related to

performance.

de Andres et al. (2005): There is no

relationship between the proportion of

outsider directors and firm value.

Dulewicz, and Herbert (2004): There is no

relationship between the proportion of outside

or executive directors on the board and

company performance.

CSR Ibrahim and Angelidis (1995), Ibrahim et al.

(2003): Outside directors exhibit greater

concern about the philanthropic component

of corporate responsibility than inside

directors.

Johnson and Greening (1999): Outside

director representation is positively related

to corporate social performance.

Webb (2004): Socially responsible firms

tend to have boards with more outsiders.

Zahra et al. (1993): The percentage of

outside directors is positively associated

with corporate social responsibility.

Chapple and Ucbasaran (2007): The ratio of

outsiders/insiders on the board is not related

to CSR activity.

McKendall et al. (1999): The proportion of

inside directors to outside directors is not

related to environmental law violations.

Wang and Dewhirst (1992): Inside and

outside directors do not differ in their

stakeholder orientation.

Table 2. Empirical studies on the effects of independent directors on financial performance and corporate social



Financial

performance

Carter et al. (2003): Presence of women or

minorities on corporate boards positively

affects firm value.

Erhardt et al. (2003): Ethnic and gender

representation on boards increases firm

financial performance.

Shrader et al. (1997): Presence of women on

the board is negatively related to firm

financial performance.

Zahra and Stanton (1988): Female and ethnic

minority representation on boards is not

associated with firm financial performance.

CSR Coffey and Wang (1998), Wang and

Coffey (1992): Proportion of women (and

minority directors) is positively related to

corporate philanthropy.

Webb (2004): Socially responsible firms

have more women on the board.

Williams (2003): Firms with a higher

proportion of women on their boards

engage to a greater extent in charitable

giving.

Siciliano (1996): Firms with more women

on the board have higher levels of social

performance.

Stanwick and Stanwick (1998): The

percentage of women and minorities on the

board of directors is not linked to the firm‘s

corporate social performance.


19

Table 3. Empirical studies on the effects of stakeholder directors on financial performance and corporate social



Financial

performance

FitzRoy and Kraft (2005): Introduction of

parity codetermination has a slight

positive effect on productivity.

Hillman (2005): Firms with ex-politicians

on the board are associated with better

market performance, especially within

heavily regulated industries.

FitzRoy and Kraft (1993): Board

codetermination has a negative effect on

productivity and no significant effect on

profits.

CSR Kassinis and Vafeas (2002): The presence

of stakeholder directors decreases the

likelihood of firms violating

environmental laws.

Siciliano (1996): Firms with boards

representing diverse occupational

backgrounds have higher levels of social

performance.

Hillman et al. (2001): The presence of

stakeholder directors is not related to

stakeholder performance.

Webb (2004): Socially responsible firms are

not likely to have more board members

involved with non-profit organizations.

Table 4. Board capital of stakeholder directors

Director category Resources provided

Representative of consubstantial

stakeholders1

Expertise on the firm itself.

Firm-specific knowledge in areas such as finance, law, technology, science, etc.

Representative of contractual

stakeholders

Specialized expertise on law, banking, insurance, etc.

Channels of communication to product or supply market.

Access to resources, such as financial capital and legal support.

Representative of contextual

stakeholders

Non-business perspectives on issues, problems and ideas.

Channels of communication to community.

1 We refer to representatives of non-shareholder stakeholders since representation of shareholders‘ interests has been

extensively treated in corporate governance literature.


20

SHAREHOLDERS’ ACCESS TO COMPANY’S INFORMATION: TOWARDS ENSURING SHAREHOLDERS’ MONITORING RIGHT AND MINORITY

SHAREHOLDERS’ PROTECTION

Junko Ueda*

Abstract This article aims to revisit how minority shareholders’ right to company’s information can be secured under Japanese company law to execute their substantial rights (to collect proxies, to sue management, etc.) particularly in the process of mergers and acquisitions. Section I overviews the structure of shareholders’ monitoring rights under Japanese company law against their historical background. Section II focuses on the shareholders’ rights to company’s information and its significance amongst shareholders’ rights and its linkage with other shareholders’ rights. Section III analyses leading cases before the Japanese courts regarding shareholders’ rights of inspection. Section IV surveys the shareholders’ right under Japanese company law to have access to company’s information in parallel with their right to apply for the courts to appoint inspectors who investigate into company’s business activities and financial situations. Section V assumes an expected shareholders’ role in association with the other monitoring function ensured under company law and pursues a “good governance” system. Keywords: Japanese Companies Act of 2005, minority shareholders, right to inspect a register of shareholders, right to inspect books and records, right to appoint inspectors who investigate into company’s business activities and financial situations, internal auditors, expected shareholders’ role, good corporate governance, mergers and acquisitions (M&As)

*Professor, PhD (London), LLD (Nagoya), Shizuoka University, Shizuoka, Japan

Introduction

This article conducts a review of how shareholders

under company law can monitor management

(directors and officers) through executing their right

to inspect company‘s information on their own

initiative. The scope is limited to governance within

the company. Thus, disclosure of a company‘s

financial information from a public interest

perspective is not dealt with in this article.

Section I overviews the structure of

shareholders‘ monitoring rights under Japanese

company law and outlines their historical background

along each right. Section II focuses on the

shareholders‘ rights to company‘s information and its

significance amongst shareholders‘ rights and its

linkage with other shareholders‘ rights. Section III

analyses leading cases before the Japanese courts

regarding shareholders‘ rights of inspection. Section

IV surveys the shareholders‘ right under Japanese

company law to have access to company‘s

information in parallel with their right to apply for the

courts to appoint inspectors who investigate into

company‘s business activities and financial situations.

Section V assumes an expected shareholders‘ role in

association with the other monitoring function

ensured under company law and pursues a ―good

governance‖ system. The last part of this article draws

a tentative conclusion.

The new Japanese Companies Act has

introduced flexible governance structures particularly

for private companies.1 Therefore, companies whose

share capital is less than 500 million yen and total

debt is less than 20 billion yen, and which restrict

transfer of their shares wholly may have a most

simple structure of shareholders‘ meeting with one

director (one shareholder is one director). However,

this article considers the standard structure based on a

power balance between shareholders‘ meeting and

board of directors.

I. Structure of Shareholders’ Monitoring under Japanese Company Law

Shareholders are legally defined as owners of the

company. They subscribe shares in exchange for their

1 Until the new companies act came into being in 2006,

there was a special act for limited liability companies to

allow a one director one shareholder structure for that type

of a company. The new act no longer allows formation of a

limited liability company but a share company can adopts

the same structure instead. Most deregulating provisions for

private companies largely succeed to the former provisions

in the Limited Liability Companies Act (enacted in 1938).


21

money or assets. The fund collected as such is used

for the company‘s business activities. Thus, it is

natural that they manage the company to make profits

and distribute them among themselves. However,

modern share companies, in particular when they are

large enough to be financed by the public, do not

necessarily assume that they are run by shareholders

themselves. Division of power between shareholders

and management2 is inevitable as shareholders in

large companies have a reasoned apathy to company

management. Management does not necessarily

consist of shareholders but rather with professional

skills and care. Shareholders elect management and

have monitoring power over management. They

monitor management through general meetings, but in

addition they monitor through executing their specific

monitoring rights. The latter complements functional

limitation of general meetings which are subject to a

majority rule.

The monitoring rights can be divided into those

which are vested with every single shareholder

(regardless of whether he/she has voting rights), those

which can be executed by any single shareholder with

a voting right and those which are vested with

shareholders of specified percentage or number of

voting rights or shares. The line is drawn between the

three to consider the balance of ensuring shareholders‘

rights with protecting companies from shareholders‘

venomous or frivolous claims.

Under the 2005 Japanese Companies Act, right

to attend general meetings, to express opinions,3 to

raise questions,4 to raise motions

5, voting right

6 at

2 Expansion of management structure under Japanese

company law might be outside the scope of this report but it

might be worth noting here. Since 1950 when board system

was introduced into Japanese company law, share

companies, regardless of their size, must have boards which

consist of directors appointed at shareholders‘ meetings.

Board of directors must appoint representative director(s)

who have representing power. This type of company must

have internal auditors who organise the board of auditors.

However, since 2002 a new management structure has been

able to be adopted. This, roughly, follows Anglo-American

one-tier board system which has committees of directors

organised by at least three directors, the majority of which

are outside directors within the board and executive officers

(at least one of whom must be a chief executive officer)

who are appointed at board. Both types must have an

external auditor (a certified public accountant or accounting

firm). Under the 2005 new Companies Act, private

companies, share capital of which is less than 500 million

yen and debt of which is less than 20 billion yen, can have a

single director (no board and internal auditor)(see

Introduction). 3 There is no express provision but shareholders‘ voting

right is based on their right to express any opinion relevant

to agendas before making their decision by executing their

voting right. 4 Section 314. This right is provided as a directors and

officers‘ duty to answer shareholders‘ questions. 5 Section 304.

general meetings, right to inspect proxies,7 rights to

inspect a register of shareholders,8

financial

statements9 and minutes of general meetings,

10 right

to pursue injunction of directors‘ reckless or illegal act

which could drain company‘s assets out,11

right to

derivative suit,12

right to contest legality of

company‘s formation, issuance of new shares and of

share options, mergers, de-mergers, share exchanges,

etc.13

and legality and validity of resolutions of

general meetings before the courts14

are in the hands

of every single shareholder. It is conceivable that

except those regarding meetings every single

shareholder with or without a voting right executes

his/her monitoring right of this type.

Rights to submit agendas of general meetings,15

to convene general meetings,16

to apply for a court to

appoint an inspector(s) who will investigate

procedures and resolutions of general meetings,17

to

inspect books and records,18

to apply for a court to

appoint an inspector(s) who will investigate

company‘s affairs and financial status19

are executed

only by shareholders who meet the requirements of

prescribed shareholdings.20

As in the first type of

rights, those concerning general meetings can only be

executed by shareholders with voting rights. The

present act allows company‘s constitution to mitigate

6 Section 105 (1)(c). 7 Sections 310 (7), 311 (4) and 312 (5). 8 Section 125 (2) and (3). A register of shareholders shows

each shareholder‘s shareholdings; however, substantial

shareholders in any listed company who acquire more than

5 % of the issued shares of the company must report the fact

to the prime minister. The matter of substantial

shareholdings is regulated by the 2006 Financial Services

and Market Regulation as part of regulation for takeover

bids (Section 27-2). 9 Section 442 (3). 10 In contrast, minutes of board of directors, board

committees or board of internal auditors are open to

shareholders only with permission by the courts (see section

371 (2) and (3)). 11 Section 360. Directors‘ act beyond company‘s object is

also a matter for shareholders‘ injunction. 12 Section 847. 13 Section 828. 14 Sections 830 and 831. 15 Sections 303 and 305. 16 Section 297. 17 Section 306. 18 Section 433. 19 Section 358. 20 1% (voting right basis) threshold is provided for: the

right to submit agendas, the right to apply for the courts to

appoint an inspector(s) investigating into procedures or

resolutions of general meetings; 3% (voting right basis)

threshold is provided for: the right to convene general

meetings (also with the requirement for duration of

shareholding for public companies); 3% (both voting right

and share basis) threshold is provided for: the right to

inspect books and records, the right to apply for the courts

to appoint an inspector(s) investigating into company‘s

affairs and financial status.


22

the voting right or shareholding requirements (this

means more in the interest of shareholders).

II. Shareholders’ Rights to Company’s Information

From amongst the enumerated rights in the previous

section, this article focuses on shareholders‘ rights to

company‘s information. This sort of rights are most

commonly utilised prior to executing other substantial

monitoring rights such as voting right at general

meetings and the right to bring derivative suits. This

section deals with a shareholders‘ right to inspect a

register of shareholders as well as to inspect books

and records. These rights are on the subtle balance

between secrecy of the company‘s information and

shareholders‘ remedial actions against management. If

they are executed properly, it will be in the best

interest of all shareholders of the company and vice

versa. The balance is subtle but the conflict between

the company (as representing shareholders‘ common

interests) and a claiming shareholder(s) is severe.

Recently, some interpretative questions have been

raised revolving around these rights in the process of

hostile share acquisitions and managerial

restructuring.

Section 125 (2) of the Japanese Companies Act

provides that every single shareholder and creditor

with a statement of its purpose may request inspection

of a register of shareholders at any time within

company‘s business hours. Section 125 (3) stipulates

five reasons for the company to reject shareholder or

creditor‘s request. This was newly written into a

provision,21

but the wording may have been

transformed from Section 433 (2), which was

originally introduced by the 1950 amendment.

Therefore, the wording of the two provisions is given

concurrently in the following outline put for Section

433 (2).

Section 433 (1) of the Japanese Companies Act

provides that shareholders who hold at least 3 per cent

of the total voting rights or 3 per cent of all issued

shares (excluding the company‘s own shares22

) may

request inspection of books and records at any time

within its business hours. As noted, this percentage

can be lowered by the company‘s constitution. The

previous act only provided for the voting right

requirement but the new act adds the share

requirement to it under the consideration that this

right can be executed widely by those who do not

21 The previous act did not have an express provision but

the courts have supported company‘s rejection when the

right is abused by a right holder. However, there has not

been any case before the court that relates to a claim by a

right holder who runs a competing business of the company. 22 The company is not allowed to vote at its general

meetings for its own shares. Therefore this is relevant only

to the case with the share basis requirement.

have voting rights.23

The request by a shareholder

must be written and with reasons in a concrete manner.

Section 433 (2) also expressly provides reasons for

the company to reject shareholders‘ requests. Five

reasons are given in the present act almost in the same

manner as in Section 125 (3) that reads; (a) where the

shareholder has requested on the grounds other than

collecting information to secure his/her right or

execute his/her right; (b) where the shareholder has

requested for the purpose of impeding company‘s

businesses and of undermining common interests of

shareholders as a whole; (c) where the shareholder

who has made the request is doing materially

competing business with the company or an employee

of any such business; (d) the shareholder has

requested for the purpose of disseminating the

information from books and records to a third party

for a return; or (e) where the shareholder has

disseminated the information from books and records

to the third party for a return over the past two years.

Historically, this provision was introduced in

1950 under the GHQ‘s occupational policy; thus,

under the strong influence of states‘ business

corporations‘ legislation in the USA.24

But unlike in

the USA where causes for the rejection are not

expressly provided (developed in common law and

case law built up on the relevant provision), as noted

above regarding Section 433 (2), the Japanese

provision has written them ever since it was

introduced.

The questions that have been arising regarding

this provision are (1) what are the contents of books

and records which can be requested by a shareholder?,

(2) does a shareholder who is going to make a request

need to identify the name of books or records of the

company?, and (3) to what extent a shareholder who

wishes to make a request needs to clarify reasons for

the request in the form?

23 T.Aizawa,Ichimon-itto Shin-kaisha-ho (Tokyo:

Shoji-homu, 2005), p.154. This requirement has been

changeable. Before the amendments of June of 2001,

company law only provided for the 3% share requirement.

The amendment changed it to the 3% voting right

requirement. Now a company can widely issue shares

without voting rights for instance as a class of shares

(section 108(1)(c)). 24 For the historical background of the provisions, see for

example, H.Shinkai, ‗Kabunushi no chobo-etsuran-ken (1):

Shoho 293-6 wo chushin to shite‘, (1972) 13-3

Kurume-daigaku Sangyo-keizai-kenkyu 265ff;

M.Nagahigashi,‘ Showa 25-nen shoho-kaisei: GHQ-bunsho

kara mita seiritukeika no kosatsu (1)-(4)‘, (1995) 30-3

Chukyohogaku 1ff; (1996) 31-1 Chukyohogaku 129ff;

(1996) 31-2 Chukyohogaku 21ff; (1997) 31-3

Chukyohogaku 107ff; S.Fujita,‘ Chobo-etsuran-ken ni t

suite‘, (2005) 75 Takushoku-daigaku-keiei-keiri-kenkyu

38ff.


23

III. Some Cases before the Courts

To obtain a clue to solve the above questions, this

section refers to the relevant cases before the Japanese

courts. Until very recently, only a few cases regarding

the provisions, particularly the latter clause of the

same provisions regarding rejection25

, have been

brought before the courts. This is mainly because

onus of proof is imposed on the company when it

contests before the courts that it has any reason to

reject the shareholder‘s request. Normally, it is not

easy for the company to show shareholder‘s purpose

and intention. As for Section 433, most cases

contested the above three points. The courts have

given their views at least to these points. To question

(1), the courts have interpreted that the meaning of

books and records are confined literally to books and

records made and used in accounting practice.26

To

question (2), the courts have consistently held that

books and records which are permitted for the

inspection are confined to those closely related to and

identified by the reason and purpose of inspection.27

For the last question (3), the Supreme Court has given

that requesting shareholders must state clearly and

concretely the reasons for their inspection but they are

not required to show the facts behind the reasons.28

Reported cases regarding the rejection based on

Sections 125 (3) and 433 (2) have been to date all

grounded on (c). This section refers to these cases.

Case I Tokyo District Court Decision of 4 March 199429

This was the first reported case regarding the rejection

of shareholders‘ request to inspect company‘s books

and records based on statutory grounds. A shareholder

25 As noted, Section 125 (3) had not been in its existence

until the present Companies Act was enacted in 2005.

Before that, only a few cases relating to rejection by a

shareholder or creditor‘s request due to a claimant‘s

competing business. 26 Tokyo District Court Decision of 22 June 1989. The

similar statements were given again in Yokohama District

Court Judgment of 19 April 1991; Tokyo Court of Appeal

Judgment of 29 March 2006. 27 Sendai Court of Appeal Judgment of 18 February 1974;

Takamatsu Court of Appeal Judgment of 29 September

1986; Tokyo Court of Appeal Judgment of 29 March 2006,

appealed by both parties from Tokyo District Court

Judgment of 2 November 2005. 28 Supreme Court Judgment of 1 July 2006. 29 Reported at 1495 Hanrei-jiho 139; 875 Hanrei-times 265;

942 Kinyu-shoji-hanrei 17; 122 Shiryo-ban shoji-homu 135.

Case comments by N.Sakamoto, (1994) Kinyu-shoji-hanrei

1; H.Katagi, (1995) 1515 Hanrei-jiho 243; H.Kansaku,

(1995) 1068 Jurist (special issue) 104; N.Yoshida, (1995)

30-1 Asia-hogaku 97; U.Tamura, (1996) 12

Shiho-hanrei-remarks 100; M.Nakahigashi, (1997) 938

Hanrei-times 197;.Y.Ito, (1998) 1482 Shoji-homu 27;

R.Tsuchida, (1998) 1142 Jurist 108.

who had been holding approximately 13.1 per cent of

company A‘s all issued shares made a request to

inspect books and records of company A but was

rejected for the reason of its competing businesses.

Company A‘s main business was to provide

broadcasting services; however, it also had planning

film, music, art and sporting events, consulting

services regarding intellectual property rights and

providing information about politics, economy,

culture and living plans, etc. in its object clauses. The

shareholder had been a representative director of

company A and retained a position of director after

retirement from a representative director due to

hegemony between the directors, and was well known

among broadcasting entrepreneurs and had

considerable knowhow of broadcasting businesses as

well as economic power. At the time of making a

request as a shareholder, he was still a substantial

shareholder but had already retired as a director of

company A and established his own company B,

having taken its representative directorship. Company

B‘s objects were similar to those of company A except

broadcasting services, though company B had not yet

started actual business.

Tokyo District Court held that, although company

B had not yet started its business, since possibility of

the information so collected would be disseminated in

favour of any future competing business was not zero

it must be interpreted as a competing business. In

light that the cause for the rejection had been

introduced in order to protect a company from any

risks of misappropriation of the financial information

by shareholders regardless of whether they are actual

or potential, predictability of unfair or distorted

competition was enough to reject the request.

Case II Nagoya Court of Appeal Decision of 7 February 199630

Company A held half of all issued shares of company

B which had run golf courses. Company A requested

inspection of books and records of company B but

was rejected. A director of company B was a

representative director of company A. Company B

was set up by dividing company A into two and

company A had run sporting facilities including

developing and managing golf courses. The case was

brought against the background that there had been a

growing conflict between a director and a

representative director of company B, who once

jointly set up new businesses. The reasons for the

rejection invoked were that (a) reasons for the

inspection were not clearly and concretely given; (b)

books and records it wished to inspect were not

30 Reported at 938 Hanrei-times 221. Case comments by

K.Kobayashi, (1998) 978 Hanrei-times 168; M.Mori, (2000)

18-1 Matsuzaka-seikei-kenkyu 97.


24

identified; and (c) a requesting shareholder itself had

been conducting competing businesses with company

B. Company A in its capacity as a shareholder of

company B and its representative director in his

capacity as a director of company B jointly brought an

action against company B.31

In the argument

concerning the reason (c), Nagoya District Court

rejected plaintiff company A‘s argument that company

B must permit company A‘s inspection as long as

company A shows its intention not to misappropriate

the information.32

Company A appealed to Nagoya

Court of Appeal. It again rejected company A‘s

argument and said that company B only showed the

fact of requesting shareholder‘s competing businesses

in rejecting the request. Or, even if it could be

interpreted as what the plaintiff had argued, it had not

shown enough to ensure the lack of its intention not to

misappropriate the information.

Case III Tokyo District Court Judgment of 20 September 200733

This case was also related to the rejection grounded

on (c). But its significance was to regard the holding

company‘s competing business as requesting

shareholder‘s competing business and supported the

rejection of the company. Company B was set up in

1951 as a broadcasting company and its shares were

traded on the main board of the Tokyo Stock

Exchange, Inc. Company A set up an internet

technology (IT) venture business in 1997 (changed its

business name to its present one in 1999) whose

shares were traded on JASDAQ (originally a market

for OTC securities), and had shown rapid growth.

Company A and its group companies had acquired

company B‘s shares for the purpose of proposing joint

businesses pursuing the fusion of broadcasting

services with internet providing services. However,

company B did not welcome company A‘s proposal.

A wholly-owned subsidiary of company A

(company C) was a substantial shareholder of

company B. Company C requested an inspection of

books and records of company B. The reasons for the

inspection were to (a) check up how company B had

invested in other companies which would be white

knights to prevent company A and its group

companies including company C from more

acquiring; that (b) if directors of company B

31 The court also referred to director‘s eligibility to request

an inspection of his/her company. However, this point is not

within the scope of this report and not to be dealt with. 32 Nagoya District Court Decision of 20 February 1995. 33 Reported at 1985 Hanrei-jiho 140; 1253 Hanrei-times 99;

285 Shiryo-ban-shoji-homu 135; 1276 Kinyu-shoji-hanrei

28. Case comments by K. Toriyama, (2008) 637

Hogaku-seminar 116; M.Yanaga, (2008) Hanreijiho 205;

J.Ueda, (2008) 1354 Jurist (special issue) 113, J.Yamada,

(2008) 37 Shiho-hanrei-remarks 100; M.Yanaga, (2008)

1357 Jurist 164.

purchased other companies‘ shares only to protect the

company (ultimately to protect themselves by

securing their positions) from share acquisitions by

company A, such directors‘ activities could be

assessed as inappropriate management activities,

information was necessary to pursue directors‘

liability, etc.; and (c) there had been a real threat for

company C because company B would decide to take

defensive measures against company C and group

companies by modifying its anti-share acquisition

rules at general meetings, thus, company C needed to

collect information before voting against such

modification at general meetings.

Tokyo District Court held that company A and

company C were in the wholly parent-subsidiary

relationship and inseparably connected. They were

not only regarded as having financially the same

personality but also the latter has been perfectly

commanded by the former. The court also recognised

the fact that they jointly collected proxies from

company B‘s shareholders to control company B‘s

general meetings. In conclusion, the court found that

company C‘s request could be rejected for the reason

that wholly subsidiary‘s request could be regarded as

parent‘s request which run competing businesses with

company B. Tokyo District Court held in the same

direction that once the objective fact of competing

businesses of the requesting shareholder (or its parent

company) was confirmed, the request had to be

rejected without any further proof of shareholder‘s

intention not to misappropriate.

The above cases all rejected the shareholders‘

request. On the one hand, the court has interpreted

competing business as recognisable only by proof of

the fact of possibility of competition. Burden of proof

is on the company but this is not too difficult. On the

other hand, this is attributable to the nature of

information itself. Once information leaks, no one can

block its flow. Who knows who utilises it and when,

where and how it is utilised? An overly protective

approach to the threat of misuse of inside information

is quite natural.

From the perspective of minority shareholders‘

protection, criticisms have been made of this series of

courts‘ judgment or decisions. If the courts followed

another interpretation that shareholders could prove

their intention not to misappropriate the information

for their success, some of them should have drawn the

opposite conclusions.

By contrast a very recent case concerning the

ground of competing business for rejection under

Section 125 (3) is worth attention. Because it was the

first case that accepted shareholder‘s right to request

an inspection of a register of shareholders. Soon after

the introduction of this ground of rejection, one case

was brought before Tokyo District Court.34

This was

34 Tokyo District Court Decision 15 June 2007, (2007) 280


25

the first-ever case regarding rejection grounded on

125 (3). Despite practical concern, the Court

interpreted the provision almost in parallel with 433

(2) and rejected a shareholder‘s request to inspect a

register of shareholders. Another case was brought in

June 2008, which will be noted below.

Case IV Tokyo Court of Appeal Decision 12 June 200835

Company A is a real estate agent, developer and real

estate asset manager and Company B runs almost the

same businesses. Shares of the two companies are

listed on the second board of Osaka Stock Exchange,

Inc. and the second board of Tokyo Stock Exchange,

Inc, respectively. Company A intended to jointly run

businesses with Company B and for this purpose it

started to acquire Company B‘s shares on or

off-market. However, Company B never agreed on

joint businesses with Company A. Company A and its

wholly subsidiary acquired 16.16% of Company B‘s

shares and Company A made a request to inspect

Company B‘s register of shareholders. Company A‘s

subsidiary submitted agenda items on 10 April 2008

to the proposed annual general meeting (AGM) of

Company B which was scheduled on 27 June 2008,

through executing its minority shareholder‘s right.

The purpose of inspection was to identify

shareholders with voting rights at that AGM and to

win a proxy fight with Company B‘s management and

the other shareholders friendly to the management.

Company B rejected Company A‘s request for

the reason that a) Company A runs competing

businesses with Company B (on a ground listed in

Section 125 (3)) and b) violating shareholders‘

privacy without any reason undermines shareholders‘

common interest and brings disbenefit to Company B.

Company A sought a interim relief before courts.

Tokyo District Court made a decision on 15 May

2008 to reject Company A‘s claim by literally

interpreting ―competing businesses‖. By contrast, on

appeal, Tokyo Court of Appeal took a different

approach to Company A‘s claim. Whilst recognising

Company A‘s competing businesses with Company B,

it held that Company B was successful to show that it

had no intention to abuse the information it assumed

to obtain from a register of shareholders. When

Company A made a request, it submitted a statement

that Company A would only check shareholders‘

Shiryobanshojihomu 220. Case comments by K.Toriyama,

(2007) 641 Hogaku-seminar 121; S.Masai,(2007) 1294

Kinyu-shoji-hanrei 2. 35 Reported at (2008) 1836 Shoji-homu 104; (2008) 292

Shiryo-ban-shoji-homu 104; (2008) 1295

Kinyu-shoji-hanrei 12. Case comments by K.Toriyama,

(2008) 645 Hogaku-seminar 129; M. Shintani, (2008) 1297

Kinyu-shoji-hanrei 6; M. Yanaga, (2008) 1361 Jurist 146;

K.Shimada, et al., (2008) 1841 Shoji-homu 59.

names for the purpose of collecting proxies. Thus, it

was the first case to uphold a right holder‘s request

and has attracted attention to date as its real impact on

the business world should be serious.

To ensure an effective minority protection

scheme within a company law framework, the courts

should pursue each right of minority shareholders in

the consistency with all other shareholders‘ schemes

and ultimately, so to say, within a governance system

of the company as a whole. The next two sections

relate to this.

IV. Harmonisation with Minority Shareholders’ Right to Apply for the Courts to Appoint Inspectors for Company’s Business Activities and Financial Situations

As noted above, Japanese company law has had

minority shareholders‘ right to apply for the courts to

appoint inspectors since its original document‘s

version in 1890.36

This was introduced by referring to

some model legislation particularly that of Europe. A

German drafter Hermann Roesler, employed by the

then government, noted that he modelled on British

companies legislation.37

Appointing an inspector or a

verifier who is external and neutral to the company to

collect information to correct malpractice of

management was originated in Europe and differed

from a USA idea of obtaining the same effect by

companies‘ autonomous corrective interactions (but

often with the court‘s intervention).

This is a typical example of the inconsistency

within Japanese company law due to its following the

Continental model during the pre-war period and the

USA model after World War II. To harmonise (and

even avail from) this right with the above right to

inspect books and records, being derived

coincidentally from the different models, it should be

interpreted that right to inspect company‘s books and

records and right to appoint inspectors are not

competing with each other and shareholders who meet

3 per cent threshold (both have the same requirement)

can rely on both rights. However, the right to appoint

inspectors is not only to investigate financial

situations of the company but also to investigate the

whole of the company‘s affairs. In this sense, the

36 Section 239, the Draft Commercial Code and

Commercial Code of 1890; Section 198, the Commercial

Code of 1899 (the same provision remains renumbered to

date). 37 See Shiho-sho, Roesler-shoho-soan (1)(reprinted)

(Tokyo: Shinsei-shuppan, 1995), pp. 443ff; H.Roesler,

Entwurf eines Handelsgesetzbuches für Japan mit

Commentar (reprinted), 1 Band 1996, S. 61, 348. For the

historical background and legislative process for the original

Commercial Code, see J.Ueda, ‗Kabushiki-gaisha ni okeru

keiei no kantoku to kensayaku-seido (1)‘, (1997) 116-1

Minsho-ho-zasshi 47.


26

scope of the latter is broader than that of the former.38

Therefore, if shareholders who are suspicious of

directors‘ financial statements, they primarily rely on

their right to request an inspection of company‘s

books and records. This is an indoor matter of the

company and the courts will intervene only if

unsolvable conflicts arise between the company and

the requesting shareholders. By contrast, the right to

appoint inspectors is to rely on the courts to control

over the company which has been unable to expect

sound management by its self autonomy. Whatever

the background is, the two systems could be

harmonised within the Japanese company law

framework and advantage should be taken of them to

strengthen shareholders‘ rights.

V. An Expected Role of Shareholders in Corporate Governance

Japanese company law has struggled for a ―good

governance‖ system. Since its introduction of board

system in 1950, strongly influenced by USA business

corporation law, board has been expected primarily its

monitoring function against directors. Through board

meetings, directors monitor other directors, regardless

of whether they are representative or

non-representative, or executive or non-executive.39

However, in practice most companies were not

accustomed to the idea of outside (or more precisely

independent) directors and have only internal

executive directors. They were deeply committed to

the company‘s daily affairs, while at the same time

they were expected to have a monitoring function.

Who could imagine that they ―bark‖ at reckless or

illegal findings for the act of directors?

Instead, Japanese company law has rather put

more emphasis on the roles of an internal auditor(s).

Internal auditors are appointed at general meetings.40

They do not need any professional qualifications.41

38 For the argument suggesting to the possible combination

of these two provisions for effective inspection, see

K.Yamada, ‗Kabunushi no kaikei-chobo-etsuran-seikyuken

to kensayaku senninseikyu-ken‘, in C.Suzuki, Kaisha to

sosho (Tokyo:Yuhikaku, 1968), pp.553, 568. 39 The Supreme Court has interpreted that directors have

duty to mutually monitor themselves through board

meetings (they have power to convene board meetings and

they are expected to monitor other directors‘ activities

outside the boardroom by executing that power)(see

Supreme Court Judgment of 22 May1973). Right to

convene board meetings vested to each director (Section

361) may give actual effect to perform this duty. 40 Section 329(1). 41 They do not need to be professionals. However, certain

matters which disqualify them (e.g. being a corporate body,

a person with limited legal capability, etc.) are provided and

also because of the nature of their auditing duty, they are

subject to a prohibition that they cannot be at the same time

a director, an employee, etc. of the company and its

subsidiary (see Section 335).

Their expected function is to check the legality of

directors‘ business activities and of financial

statements.42

They can act as independent watch dogs

barking at directors. Japanese company law has

amended duties, powers and liability of internal

auditors over the decades. Their longer duration than

that of directors,43

duty to attend board meetings,44

veto to personnel matters of internal auditors at

board,45

submit agendas of appointing new internal

auditors to board, 46

statement of reasons and

opinions for their appointment, resignation and

removal at general meetings47

have been introduced

into company law since the 1970s. However, in

corporate practice directors are at the top end and

auditors are at the second top of the ladder for

employees and they share the feeling of same family

members of a corporate house. What is worse is that,

albeit the introduction of various manoeuvres

strengthening and widening internal auditors‘ powers,

auditors have been regarded just as being subservient

to directors. Retiring directors and those who failed to

hold the position of director have often been

appointed as internal auditors. The long-standing

practice has shown that they cannot play any

supervisory role over directors.

Shareholders‘ function becomes significant in

particular to supplement auditors‘ function. As long as

shareholders are owners of the company, they should

manage and control the company as they wish.

Directors are only delegated by shareholders to

manage the company. Shareholders‘ monitoring rights

are derived from this delegator-delegated relationship.

If minority shareholders‘ interest collides with that of

directors (majority shareholders), the courts should

not take a strict interpretation against minority‘s

interest.

Conclusion

Although the world financial crisis occurred in the

middle of 2008 has considerably reduced the total

number of proposed mergers & acquisitions (M&As)

at global level, Japan still retains a good number of

42 The scope of auditors‘ auditing function is controversial.

Many commentators have argued that auditors are unlike

directors not expected to audit validity of business judgment

by directors. They just audit whether or not directors‘

business judgment is legal. 43 The duration of auditors is four years (336(1)) while that

of directors is two years (332(1)) unless company articles

stipulate any shorter period (in case of a company having

board committees one year (332(3))). A company whose

shares are not allowed to transfer freely may extend the

duration of directors and auditors up to ten years if it

provides so in its articles (332(2) and 336(2)). 44 Section 383(1). 45 Section 343(1). 46 Section 343(2). 47 Section 345(4).


27

M&A cases, particularly in-out M&A cases.48

M&As

as an extravagant, social phenomenon posed again hot

discussions about ―of whose interest management

takes account in running the company?‖. In the arena

of M&As, money makes power. Shareholders who

have suddenly appeared by acquiring certain

percentage of the company‘s shares obtain power to

control management through their voting rights,

monitoring rights as above, etc (It should be

remembered that the most notable, recent cases above

were brought before the courts in the process of

hostile M&As). This may inevitably lead to

management activities to run the company in the best

interest of its shareholders for the two very different

reasons: (a) in order to protect the company and its

management from hostile bidders, management takes

into account the best interest of friendly shareholders

for their long-term investment; and (b) management is

forced to listen to strong voice of hostile major

shareholders who vote for maximisation of the

company‘s short-term profits. Interests of employees,

creditors, customers, communities, etc. are

disregarded, or are at best behind those of

shareholders. As a counterargument to this, a

traditional idea about ―shareholders‘ supremacy‖ has

ever been strongly proposed to be replaced. However,

this article is not to contribute to such an argument.

Rather, the article aims to warn that before

considering other stakeholders‘ interests even

shareholders‘ interest and rights under the law have

not been appropriately ensured.

Japanese companies are said to have taken great

care of employees. Each company has its own trade

union and negotiation and co-decision of management

with its union is common. By contrast, yearly

distribution of profits to shareholders stays almost at

the same level no matter how much it earns. The

M&A trend has gradually changed this practice. Not

an approach of ―shareholders‘ supremacy‖ but that of

―enlightened shareholders‘ supremacy‖ should be

explored in the harmonisation with all other

stakeholders of the company.

48 At international level, the period 1 January 2008-20

October 2008 saw the cancellation of 1,203 M&A cases.

The statistics for Japan shows that target assets involved in

M&A cases during the period 1 January 2008-31 October

2008 went 39 per cent up compared to those involved in

M&A cases during the same period of the previous year. See,

e.g., The Nihon Keizai Shimbun, 6 November 2008.


28

THE DECREASE IN DIVERSIFICATION AND CORPORATE GOVERNANCE: EVIDENCE FROM JAPANESE FIRMS+

Hidetaka Aoki*

Abstract This paper analyzes the effects of firm performance and governance factors on the decrease in diversification of Japanese firms in the 1990s. We focus on the cases of the decrease in diversification, because many previous studies proved that diversification caused firm value discount. Adjusting an excessive unrelated diversification would be an important topic, because the problems of low synergy between business units, inefficiency in management and so on were more serious in this type of diversification. The findings of this study are as follows. In the first half of the 1990s, immediately after the collapse of bubble economy, lower firm performance and main bank relationship encouraged firms to decrease the level of diversification of their businesses. On the other hand, in the latter half of the 1990s when the decrease in diversification itself was activated, higher performing non-manufacturing firms and manufacturing firms with lower profitability but facing higher growth in their main business tried to decrease diversification in order to strengthen the competitiveness in main businesses. Also, this kind of decrease in diversification was supported by the governance characteristics such as insider majority smaller boards of directors and the pressure from capital market. Keywords: Decrease in diversification, Corporate governance, Business portfolio restructuring, Selection and concentration, Diversification, Capital market

*Associate professor, Chiba University of Commerceб E-mail:[email protected]

Mailing address:1-3-1,Konodai, Ichikawa-shi, Chiba 272-8512, Japan

Phone:+81-47-372-4111б Fax:+81-47-375-1105

+ This research was partially supported by the Ministry of Education, Culture, Sports, Science and Technology, Grant-in-Aid for

Young Scientists (B), 19730262, 2008.

1. Introduction

While many studies investigated the effects of

business diversification, most of recent studies found

the negative relationship between diversification and

firm value. It is almost common that diversification

results in firm value discount. Basically, this research

also takes the stance that diversification causes the

firm value discount. From the viewpoint of this basic

consideration, in order to enhance firm value, it is

meaningful for companies to restructure their business

portfolio, with decrease in diversification.

Accordingly, the research questions of this study are

as follows. What facilitated Japanese firms‘ business

portfolio restructuring? More concretely, what effects

did firms‘ governance structure have on the decrease

in diversification as a business portfolio restructuring?

This paper does not discuss the reason why

diversification causes firm value discount, but

considers the leading factors, especially governance

factors that facilitate the decrease in diversification.

The targets of this study are Japanese businesses in

the 1990s, because they experienced drastic change,

both in corporate strategy and corporate governance.

For corporate strategy, in the background of the

collapse of bubble economy in the early 90s, selection

and concentration of business and reorganization of

group companies became more and more important.

In particular in the latter half of the 1990s,

concentration of resources on a core business and

withdrawal from an unprofitable business were

simultaneously required. Also, it was a time when

strategic alliances and strengthening group

management were actively utilized.

For corporate governance, while the discipline

from main banks that had played an important role in

Japanese corporate governance so far had become

weaker, the pressure from capital market had become

stronger. This shift could be confirmed by some facts

as follows; in the latter half of the 1980s, excellent

companies that had good market reputation shifted

their financing pattern from indirect to direct one. In

the 1990s, while the ratio of cross shareholding

decreased, institutional investors including foreigners

increased their influence. Besides, the 1990s was the

time when companies actively worked on the reform


29

of internal governance, especially the reform of top

management showed progress. While the downsizing

of board of directors had been progressed through the

1990s, the introduction of the executive officer system

and outside directors accelerated the reform of

managerial organization. These reforms were intended

to strengthen the effectiveness of strategic decision

making and monitoring. The incentive of corporate

managers also tried to be enhanced by the

introduction of stock option. Therefore, it was a

turning point for the Japanese companies that they

experienced a great change both in corporate strategy

and corporate governance in the 1990s.

This paper proceeds as follows. Section 2

reviews the previous studies and clarifies the

meanings of the decrease in diversification. Section 3

presents the method of analysis including hypotheses,

estimation model and variables. Section 4 outlines the

decrease in diversification in the 1990s. Section 5

shows the estimation results and discuss the effects of

governance structure. Section 6 presents conclusions.

2. Diversification and performance

For the relationship between diversification and

performance, Rumelt(1974) found that

Dominant-Constrained and Related-Constrained

showed high performance. Since then, many studies

investigated the correlation between them. For the

recent studies, the results of Berger and

Montgomely(1988), Wernerfelt and

Montgomery(1988), Lang and Stulz(1994), Berger

and Ofek(1995) clarified that excessive diversification

causes the inefficiency of management, and results in

the firm value discount. For the results from Japanese

companies, Lins and Servaes(1999) confirmed the

diversification discount from the results of cross

section analysis of 1992 and 1995. Hiramoto(2002)

also confirmed the same result using the cross section

data of 1995.

Concerning the type of diversification, while

positive evaluation is usually given to the related

diversification, negative evaluation is absolutely

given to the unrelated diversification. For example,

Wernerfelt and Montgomery(1988) showed that

related rather than unrelated diversification had the

positive effects on firm performance. Markides and

Williamson(1994) pointed out that related

diversification had an advantage from the viewpoints

of economies of scope and accumulation of resources.

In addition, Morck,Shleifer and Vishny(1990) found

that while related diversification had a positive effects

on shareholder value, unrelated diversification had a

negative effects. Furthermore, Rumelt(1982),

Varadarajan and Ramanujam(1987) also positively

evaluate the related diversification. On the other hand,

Hiramoto(2002) found the firm value discount not

only in unrelated diversification but also in related

diversification. Therefore, the synergy effect is

expected by using management resources, especially

informational resources such as know-how,

simultaneously among business divisions in related

diversification. On the contrary, disadvantage caused

by less synergy, decreased specialty in management,

increased coordination costs among business divisions,

asymmetries of information between top management

and divisional managers etc. is stronger than

advantage in risk dispersion in unrelated

diversification. Accordingly, a negative variation on

unrelated diversification is almost a common

understanding. Then, this paper basically considers

that unrelated diversification has a lot of problems,

and focuses on business portfolio restructuring that

may contribute to dissolving the excessive

diversification.

On the other hand, Kikutani et.al.(2007)

approached diversification from the viewpoints of

entry to new business and exit from existing business.

They showed that Japanese companies have done

many new entries and withdrawals in gross than

observed in net, companies with many entries did a

number of exits, and companies with simultaneous

entry and exit achieved high performance. However,

the influences of corporate governance structure on

business portfolio restructuring had not been so

clarified. This research tries to contribute to this point

by estimating the effects of governance factors on

business restructuring. By the way, because many

previous studies limited their sample only in

manufacturing companies, this paper included

non-manufacturing companies also. If the inefficiency

in unrelated diversification originates in the low

professions and relations, it is very important to

comprehend the business expansion beyond the

manufacturing and nonmanufacturing section. And it

is meaningful to analyze the effects of corporate

governance on business portfolio restructuring

including the withdrawals from different types of

business.

3. Method 3.1. Definition of business portfolio restructuring

Our research interest is how governance factors

influence the strategic decision making of business

portfolio restructuring. Here, we define the decrease

in diversification as the business portfolio

restructuring, based on the negative evaluations on

diversification in many previous studies49

. We

comprehend the decrease in diversification whether

the reduction in number of business sections occurred

or not. Because, previous studies concerning

49 See Denis,Denis and Sarin(1997), Berger and

Ofek(1999) etc.


30

diversification discount showed the tendency that the

negative influence of diversification became stronger

as the number of business increase. Therefore,

downsizing the number of business attempted by

―selection and concentration‖ would contribute to

improve the firm value50

.

Concerning the business portfolio restructuring,

its concrete contents are important. Kikutani and

Saito(2006) investigated the change in a qualitative

business composition for this respect. They found the

shift to main business related type, by the

combination of withdrawals from unrelated business

and new entry to related business. They also found

this tendency was accelerated in the latter half of

1990s.

By the way, it is necessary to specify the

business field itself to comprehend the reduction in

the number of business. In this study, we allocated the

3-digit(detailed) and 2-digit(middle) standard industry

codes based on the Japanese standard industry

code(Nihon Hyoujun Sangyo Bunrui) to all business

sections that had positive sales, using the segment

data. Then, we identified the code of each business

section and classified into one single business if they

had the same code. In the end, we set up the database

of the number of business based on the 2digit and

3digit code. Concerning the types of diversification,

we may consider unrelated diversification as the case

that had two or more business sections beyond the

2digit code, and related diversification as the case that

had two or more 3-digit code business sections within

one 2-digit code business section51

. Considering the

decrease in diversification by the context of

withdrawal from unrelated business fields, it would be

adequate to specify the business by using the 2-digit

code rather than the 3-digit code. Therefore, this study

considers the effects of corporate governance on the

decrease in diversification, in case companies have

two or more unrelated businesses, measured by the

2-digit code criteria.

3.2. Hypotheses Firm performance

It is thought that the strength of a pressure to decrease

diversification depends on the firm performance.

Intuitively, if the inefficiency caused by an excessive

diversification results in the deterioration in firm

performance, the pressure to reform would be

increased and the probabilities of decrease in

diversification would increase. On the other hand,

diversification contributes to lessen the volatility of

50 Hiramoto(2002) indicates that selection of business

without concentration within core business field does not

contribute to enhance firm value. 51 This way of identification is basically the same as

Hiramoto(2002) which used Nikkei NEES classification.

performance and stabilize the profitability according

to the risk dispersion hypothesis. Thus, in case that

the business risk is high, decrease in diversification

which lessens the effects of risk dispersion would

hardly occur. Therefore, we consider the profitability

and risk as a firm performance, and set the following

hypothesis.

H1. Decrease in firm performance and increase in

business risk increase the probability of decrease in

diversification.

Governance factors

We consider top management characteristics,

ownership structure, main bank relationship, debt, and

employee as governance factors. A basic idea is that,

if a certain governance factor works effectively as a

disciplinary mechanism against management, this

factor restrains diversification and encourages the

decrease in diversification. Therefore, we set the

following hypothesis and explain the backgrounds of

each factor.

H2. Governance factors that work as a disciplinary

mechanism increase the probability of decrease in

diversification.

Board of directors

As characteristics of a typical Japanese board of

directors, a large number of directors, the low

percentage of outsiders, those who promoted within a

firm make up the majority could be pointed out.

Those characteristics, supplying ample positions in

the boards of directors for corporate insiders, had an

incentive effect on employees in terms of increasing

their chances of promotion and motivations to

accumulate firm specific skills. The characteristics of

boards of directors were complementary to the

long-term employment system, in a sense that it

enhanced an incentive in promotional competition

through ranking hierarchy(Miyajima and Aoki,2002).

On the other hand, Japanese board of directors had

problems in terms of strategic decision making and

monitoring(Aoki,2004). It would be difficult to carry

out active debate with an oversized board of directors.

Also, the objective evaluation would be difficult

because the insiders monitor the insiders. The reform

of top management system activated in the 1990s

tried to recover those functions. The introduction of

the executive officers system and outside directors

intended to strengthen strategic decision making and

objective monitoring by dividing directors and

officers and including outsiders.

Therefore, the board with a large number of

directors could be considered to have a negative effect

on strategic decision makings because of high

coordination costs among directors who is

representative of each business section, less activated


31

discussions on the boards and so on. Then, a large

board of directors could have a negative effect on the

strategic decision making of decrease in

diversification. On the other hand, insider dominated

board of directors may have a weak monitoring

system, thus outsiders on the board of directors would

strengthen the monitoring function. Accordingly, the

higher ratio of outsiders on the board would increase

the probability of occurring decrease in

diversification.

Ownership structures

In contrast to the ratio of cross shareholding gradually

decreasing in the 1990s, the presence of institutional

investors such as the increase in foreign investors.

When companies hold shares each other, both of them

are silent partners. This situation contributed to

releasing managers from the pressure of capital

market and enabled to avoid the myopic management.

However, it had a problem of weakening discipline on

management, even if corporate performance declined.

In contrast to the influence of cross shareholding,

foreign investors that are known as an active investors

gave pressures to management by opposing in the

general meetings. Therefore, it could be thought that

cross shareholding mitigates the pressure of

restructuring when diversified companies face the

firm value discount. On the contrary, foreign investors

would enhance the pressure of decrease in

diversification.

Main banks and debt

As is well known, main banks played an important

disciplinary role in Japanese corporate governance,

differently from the takeover mechanism in an Anglo

American countries. The relationship that main banks

intervene in management depending on the

performance of client companies was characterized in

contingent governance by Aoki(1994a,b). However,

with the decline in bank financing, it is often said that

the role of main banks stepped back. We take into

account this change, and confirm the effects of main

bank relationship on the decrease in diversification, in

the sense to confirm whether bank-centred

governance structure had transformed into the

market-based structures. If main bank monitoring was

effective, the probabilities of decrease in

diversification would be increased.

Concerning the role of debt, the function of

reorganization is important(Aghion and Bolton,1992).

High ratio of debt increases the risks of default that

verifiably proves the moral hazard of managers. The

pressures of restraining excess diversification would

be increased under the situation that the ratio of debt

is high, because the control rights would transfer from

managers to debt holder in case the company defaults.

Therefore, the higher debt ratio reinforces the

discipline on management, and would increase the

probabilities of decrease in diversification.

Employee commitment

Lastly we discuss the effects of employees‘

commitment on decrease in diversification. It is often

pointed out that there is the difference among

companies in employees‘ commitment, and the

change in long-term employment system takes place

in the 1990s. Although it is difficult to find the

appropriate variable that directly represents the

strength of employee‘s commitment, we consider the

effects of the average tenure of employees as a proxy

of employees‘ sunk costs for their firm. According to

Allen and Gale(2000), the longer the employees

worked for a firm and the more they invested their

resources in firms specific skill, the stronger incentive

of voluntarily reforming instead of exiting they had

when firms performed badly. Therefore, the strong

commitment of employees to their firm would restrain

the excess diversification. Accordingly, the

probability of decrease in diversification would be

increased in firms with longer average tenure of

employees where employees are more cooperative for

enhancing firm value.

3.3. Data

In order to test the hypotheses mentioned above, this

study used the sample of firms listed on the first

section of Tokyo stock exchange except firms in

financial sections52

. Especially concerning the effects

of corporate governance, it is important to consider

the situation in big businesses where the agency

problems are relatively serious. That is the reason

why we used the firms listed on the first section of

Tokyo stock exchange. Here, the average number of

firms is 918 and its standard deviation is 30 during the

year from 1990 to 1998. We divided our sample into

two periods, from 1990 to 1993, and from 1994 to

1997, and confirmed the change in factors that

triggered the decrease in diversification.

The information about each segment that was

used for specifying business fields, the information

about financial performance that was used for making

variables of corporate performance, main bank

relationship, and the information about ownership

structure and employment were all obtained from the

Development Bank of Japan‘s ‗Company Financial

52 Strictly, even if a company was categorized in a

non-financial section when downloading data, in case that

the company had financial businesses as a result of new

entry or as a second business, the standard industry codes

were assigned to those business sections. Therefore, our

data set captured those financial businesses.


32

Affairs Data(non-consolidated base)‘53

. The

information about top management was obtained from

the Toyo Keizai directors‘ handbook and the annual

reports of each company. The information about cross

shareholding was obtained from NLI Research

Institute‘s ‗database of cross shareholdings‘.

3.4. Estimation model and variables

The estimation method for testing the hypotheses is

the logistic regression model with the dependent

variable is weather the decrease in diversification was

occurred or not. The estimation formula is as follows.

],,,,,[1 YDIDFRMMKTGOVPEFfDID ttttttt

Dependent variable

Here, the dependent variable DIDt→t+1 is a dummy

variable that equals to 1 if the decrease in the number

of business section was confirmed in the 2-digit basis

of Japanese standard industry code, and is equal to 0

if it was not confirmed. Here, the decrease in

diversification in the year t is defined as the case

when the decrease in the number of business sections

comparing the number of business in the end of fiscal

year t to the counterparts in the end of fiscal year t+1.

It is not necessary that the condition of firm

performance and the features of governance structure

at the end of a certain fiscal year immediately trigger

the decrease in diversification. It could be considered

that there is a certain time lag between the strategic

decision making and its implementation. In order to

take this possibility into account, and to confirm the

stability of estimation results, we tested the models

using not only one-year-base change(from t to t+1)

but also two-year-change(from t to t+2) in decrease in

diversification.

Independent variables

For the performance factors(PEFt), we adopted the

following three variables. First, we used the

standardized return on asset(roa;operating plofit/total

asset) as a performance variable that represents the

profitability of the firm. For standardization, the

remainder in roa between raw data and the industry

average is divided by industry standard deviation.

Here, we captured the industry by the 2-digit standard

industry code. Accordingly, we confirm basically the

effects of the level of profitability compared to the

rival companies within the same industry on the

decrease in diversification. Second, we generated the

growth rate of main business(gmain) that represents

53 The fiscal year of 1998(the end of March in 1999) was a

final year that we could use the nonconsolidated data in

JDB database.

the growth of main business. Here, we specified the

business section that had the maximum sales as a

main business in the 2-digit standard industry code

base, and calculated the average growth rate in the

past three years54

. Finally, we adopted the coefficient

of variation in sales of past three years(salecv) as a

variable that represents the business risk.

For the governance structure(GOVt), we used

the following variables. As a characteristics of top

management, the number of directors(nod) and the

ratio of outside directors(outr;number of outside

directors/total number of directors) are adopted. As an

ownership structure, the ratio of shareholding by

foreign investors(foreign) and the ratio of

shareholding by cross shareholders(cross) are adopted.

For the main bank relationship, we made a dummy

variable by the following procedures. At first, we

specified the bank with the largest amount of

financing measured by bank loan as main banks. Then,

we gave the dummy variable 1 in case that these main

banks are the largest shareholder among banks. In

order to confirm the effects of debt, the ratio of

debt(debt;(debt+bond)/total liability) is used. Lastly to

check the effects of employee‘s commitment, an

average tenure of employees(emptenu) is adopted.

Control variables

The following factors that may have influences on the

decrease in diversification were controlled. Many

previous studies that had tested the relationships

between diversification and firm performance, had

pointed out the possibility that market structure and

the industry factors would intervene the relations

between them55

. As factors of a market structure, we

made the growth rate of the whole market(mgrowth)

and the concentration in top 3 companies(mctop3) in

main business based on a 2digit industry code. The

mgorwth is an average growth rate(one year change)

of total sales of each main business in the past three

years. The mctop3 is the sum of sales shares of sales

top three companies in each main business. Here, the

total market sales of each main business used in the

calculation process of those two variables are

aggregated data of all listed companies not only in the

first section of Tokyo stock exchange but also all the

stock market in Japan(except financial sections). Then,

we added the industry dummy(ID) specified by the

2-digit industry code of the main business to the

estimation model. In addition, we included the

number of business based on the 2-digit industry

code(nob). According to the discussion on the

inefficiency of diversification, enlarged number of

54 In case when a main business changed, we captured the

sales of the business section in the former year, and

calculated the growth rate of the main business. 55 For example, see Cristensen and Montgomery(1981).


33

business sections makes it serious the problems of

coordination costs and asymmetry of information,

thus the probability of the decrease in diversification

would be increased in the company with many

business sections. Lastly, in order to control the

effects of macro shock, year dummy(YD) is included

to the estimation model.

Therefore, this estimation model considers the

effects of performance and governance factors at the

end of fiscal year t on the probability of the decrease

in diversification in the year t+1(in addition t+1 and

t+2) , after controlling the effects of market structure

and industry and so on.

Table 1

Because this paper analyzes the leading factors

on the decrease in diversification, we excluded the

cases of single business, when a company has only

one business section at the end of year t. Besides,

concerning the strategic decision making on business

portfolio restructuring, it would be doubtful that a

company makes decision independently when it has a

parent company. Then, we excluded the cases when

more than 50% of shareholding by nonfinancial

company is confirmed. We also excluded the cases

when the number of business increased compared to

the former year, because these cases would not be the

same as the case of no change.

Table 1 shows the basic statistics of each

variable. For the governance factors, while the

number of directors had decreased, the ratio of outside

directors had increased comparing the period of

1990-93 with 1994-97. This is consistent with the

direction of top management reforms in Japan. For the

ownership structure, the ratio of shareholding by

foreign investors increased especially in a

manufacturing section, from 4.8% to 7.3%. The

average tenure of employees became a slight longer in

manufacturing section.

4. Decrease in diversification―Outline in 1990s

Let us confirm easily about the transition of business

development in the 1990s. As usual, a diversified firm

is considered to have multi-business fields. Here, we

identify the firms with two or more business sections

based on the 2-digit and 3-digit Japanese standard

industry code as a diversified firm. Table 2 panel 1

shows the change in percentage of diversified firms.

The ratio of a diversified firm is 59.9% based on the

2-digit industry code, and 71.1% based on the 3-digit

industry code on average. As is expected that the ratio

of diversified firm decreases when the number of

business based on the 3-digit criteria is reclassified

into the 2-digit base, however its difference is not so

large as expected. This result means that

approximately 85% of diversified firms with the

criteria of the 3-digit industry code develop their

businesses beyond the 2-digit industry code. When we

see the change in the 1990s, although its magnitude is

small, decline in 1997 to 98 could be confirmed. This

indicates that the decrease in diversification

progressed in the latter half of the 1990s, and the

number of firms with single business increased.

Table 2

Then we confirm the number of business the

diversified firms have on average. Table 2 panel 2

shows the change in the number of business in

diversified firms. Here, the sample is limited to the

firms with more than two businesses, in order to

eliminate the effects of increase and decrease in the

number of single business firm. The average number

of businesses is 2.60 based on the 2-digit industry

code and 2.90 based on the 3-digit industry code.

Therefore, diversified firms had two or three

businesses on average. Although the fluctuation in the

time series was stable, this was a net result of new

entry and withdrawal from existing business. We

should pay attention to the fact that firms engaged in a

lot of entry and exit if we see the gross results behind.

Now, we confirm the frequency of the decrease in

diversification that this study pays attention. Table 3

shows the change in the decrease in diversification

based on the 2-digit industry code divided by

manufacturing and non-manufacturing sections56

.

First, it could be confirmed that the decrease in

diversification activated in the latter half of the 1990s.

The number of the decrease in diversification was

increased from 22 cases, 1.59% of the first half of the

1990s to 51 cases, 3.60% in manufacturing firms, and

from 12 cases, 1.65% to 39 cases, 5.15% in

non-manufacturing firms. Second, the decrease in

diversification was more activated in

non-manufacturing firms compared to manufacturing

firms. Table 4 shows the decrease in diversification by

industries. In the manufacturing section, the decrease

in diversification was generally seen widely across the

industries. It was also confirmed that the ratio of the

decrease in diversification was almost under average

in the first half of the 1990s; however, the number of

industries with the ratio more than average, such as

food, precision machine, increased in the latter half of

the 1990s. In this sense, the decrease in diversification

in manufacturing section was activated over

comparatively wider industries in the latter half of the

1990s. On the other hand, the ratio of the decrease in

diversification in non-manufacturing section was kept

highly through the 1990s. In particular, it is

56 The distinction between manufacturing and

non-manufacturing is based on a 2digit industry code of

the business section with largest sales.


34

remarkable that the decrease in diversification was

activated in industries that had suffered from the

problem of excessive liability, such as construction,

distribution, and real estate in the latter half of the

1990s.

Therefore, the decrease in diversification was

activated in the latter half of the 1990s when the

selection and concentration became strongly

conscious as an important task for corporate

management. Also, this tendency was obvious in

non-manufacturing section rather than in

manufacturing section.

Tables 3-4 5. Determinants of Decrease in Diversification

Table 5 shows the estimation results concerning the

effects of performance and governance factors on the

decrease in diversification. At first, for the effects of

firm performance, standardized roa did not have any

significant correlation with the decrease in

diversification in the first half of the 1990s. However,

in the latter half of the 1990s, standardized roa

showed the contrast results over industries. It was

negatively correlated to the decrease in diversification

in manufacturing section(model 3,4). On the contrary,

it was positively correlated to the decrease in

diversification in non-manufacturing section(model 8).

For the growth of main business, gmain was

statistically significant only in manufacturing section.

It showed the negative correlation with the decrease in

diversification in the first half of the 1990s(model 1,2),

but it showed the positive correlation in the latter half

of the 1990s(model 3). For the risk, we could not find

any significant correlations. Therefore, for the effects

of firm performance on the decrease in diversification,

hypothesis 1 is partially supported, but it is more

important that the results showed the different

influences from first and latter half of the 1990s and

from manufacturing to non-manufacturing section.

This indicates that the main player that forwarded the

decrease in diversification had changed. In the first

half of the 1990s, manufacturing firms that had faced

the moderation of the growth rate of its main business

would forward business portfolio restructuring. On

the other hand, in the latter half of the 1990s, good

performing non-manufacturing firms with high

profitability, and manufacturing firms with low

profitability but facing high market growth of its main

business, aiming at reinforcing the competitiveness in

their main business, would forward the decrease in

diversification.

Table 5

For the governance factors, the estimation results

are as follows. First, for the effects of top

management factors, the number of directors(nod) and

the ratio of outside directors(outr) showed negatively

significant correlation with the decrease in

diversification in manufacturing section in the latter

half of the 1990s(model 3). Although it is not

statistically significant, these variables show mostly

the same tendency as in two-year change in the

decrease in diversification, so these results are

comparatively reliable. Therefore, manufacturing

firms with smaller boards of directors, and with less

outside directors on the board decreased

diversification actively in the latter half of the 1990s.

Second, for the ownership structure, the ratio of

shareholding by foreign investors(foreign) showed a

strong positive correlations with the decrease in

diversification at significant level of 5% and 1% in

manufacturing section in the latter half of the 1990s,

though it showed a negative correlation in the first

half of the 1990s(model 3,4). Therefore, firms with

high ratio of shareholding by foreign investors

decreased diversification more actively in the latter

half of the 1990s. On the other hand, the ratio of cross

shareholding(cress) showed a significant negative

correlation at the 10% level with the decrease in

diversification in non-manufacturing section in the

first half of the 1990s(model 5,6). Therefore, firms

with less cross shareholding decreased diversification

more, and this implies that the situation of less stable

shareholder would increase the pressure of reforming

businesses on managers. This result is consistent to

the negative view of cross shareholding that it

weakens the discipline.

Third, strong relationship with a main

bank(mbdum) was positively correlated to the

decrease in diversification, in non-manufacturing

section in the first half of the 1990s(model 5,6). It was

significant at the 10% level based on one-year change

and at the 1% level based on two-year change. It is

important that this relationship is confirmed in the

section where cross shareholding mitigates the

pressure of decrease in diversification. Therefore,

main banks would have a kind of disciplinary effects

that encouraged the decrease in diversification on

non-manufacturing firms in the first half of the 1990s.

However, this significance had lost in the latter half of

the 1990s when a financial crisis became serious.

Finally, the average tenure of

employees(emptenu) showed significant negative

correlations at the 1% level with the decrease in


first half of the 1990s(model 5,6). Accordingly, the

probability of the decrease in diversification decreases

the average tenure of employees gets longer. This

result implies that comparatively young firms would

be more active in restructuring businesses. When we

see the tenure of employee as a proxy of accumulation

of firm specific skills, the costs of withdrawal would

be low before accumulating firm specific skills, so it


35

would be easier for firms to engage in restructuring

businesses.

Discussion

Here, we consider the implications obtained from the

estimation results concerning governance factors.

The effects of board of directors

The characteristics of typical Japanese type of board

of directors, such as a large number of directors, and

an insider majority structure were important for

enhancing the incentive effects on Japanese type of

employment system such as long term employment

and promotional competition trough ranking

hierarchy57

. On the other hand, the Japanese boards of

directors also had problems such as lack of leadership,

or obscure managerial responsibility. Many Japanese

firms begum to reform of top management, facing the

globalization and changing business chances, and

those cost became serious in the 1990s.

Here, it is interesting that the reform of top

management in Japan had two directions. One is to

strengthen the strategic decision making, through

activation of discussion on the board by decreasing

the number of directors. Another is to strengthen the

monitoring, by increasing the number of outside

directors58

. The estimation results of this study that

the probability of the decrease in diversification is

significantly high in firms with smaller boards of

directors implies that the conflicts among directors

who represents each business section and the

coordination costs of diversification strategy are more

serious in firms with larger boards of directors.

Accordingly, it is indicated that downsizing the boards

of directors would contribute to strengthen strategic

decision making. Therefore, the result concerning the

size of the boards of directors is consistent with the

direction of actual top management reform in Japan.

In contrast, the estimation results concerning

outside directors were the opposite from our

expectation. We had expected that the stake and the

bond were stronger for insiders rather than outsiders,

especially in the cases of the decrease in

diversification usually accompanied by withdrawal

from existing business sections. Thus, we had

expected that boards of directors with higher ratio of

outsiders could show stronger leadership in

decreasing diversification. However, the estimation

results of this study showed that boards of directors

with higher ratio of insiders were more active in

decreasing diversification. This result indicates the

probability that insiders have higher ability of

interpreting the firm specific managerial information.

57 See Miyajima and Aoki(2002). 58 See Aoki(2004).

Also, it is implied that the autonomous governance by

insiders had begun to work in the 1990s59

.

The effects of foreign investors

It was an outstanding change in Japanese corporate

governance that the foreign investors increased their

presence in the 1990s. Then, its increase was more

obvious in manufacturing firms. It could be seen that

the influence of foreign investors on restructuring

businesses of manufacturing firms worked as a

pressure to forward the decrease in diversification

activated in the latter half of the 1990s. Actually,

Miyajima and Inagaki(2003) showed that foreign

investors preferred the stocks of firms with less

diversified. Hiramoto(2002) confirmed the positive

correlation between the ratio of shareholding by

foreign investors and firm value based on a cross

sectional analysis of the year 1995, and showed the

viewpoint that foreign shareholders invested highly

performing firm rather than that they enhanced firm

value. However, the results of this study may show

the opposite causality that foreign investors prompt to

decrease the level of diversification, and accelerate

the selection and concentration. As a result, firm value

would be enhanced.

The effects of main banks The estimation results that main bank relationship

worked as a pressure to prompt the decrease in


first half of the 1990s are important. In the latter half

of the 1980s, the financing pattern shifted from

indirect financing to direct financing. This tendency

was obvious in excellent firms. As a result, banks

facing the deterioration in the pool of client firms

increased the new loan to firms in non-manufacturing

industries such as construction and real estate. At this

time, in order to lessen the monitoring costs, banks

lend out with collateral land60

. In this sense, the main

bank loan lacked in strict ex ante monitoring. Despite

of these facts, main banks had a certain effects on the

decrease in diversification for new client firms. The

main bank monitoring stepped back in the 1990s, but

in the non-manufacturing section in early 1990s, main

banks would have a kind of disciplinary effects.

Hiramoto(2002) also reported that main bank

relationship had a positive influence on firm value.

Therefore, it is indicated that, disciplinary mechanism

of main banks and the situation that less cross

shareholding, in other words, the pressure from

capital market coexisted in the non-manufacturing

section in the first half of the 1990s. However, the

59 Miyajima and Aoki(2002) approached this possibility by

the analysis on CEO turnover. 60 See Miyajima and Arikawa(1999), Hasimoto et.al.(2006).


36

relationship that main banks accelerate the decrease in

diversification lost statistical significance in the latter

half of the 1990s when the decrease in diversification

activated. Main bank monitoring would step back

because of their bad debt problem and financial

distress in 1997 and so on.

6. Conclusions

This paper analyzed the determinants of the decrease

in diversification for Japanese firms in the 1990s,

based on the well-known fact that diversification

resulted in firm value discount. Concerning the types

of diversification, it would be important for business

portfolio restructuring that unrelated diversification

was corrected, because the problems of low synergy,

inefficiency and so on were more serious in this type

of diversification. So, we analyzed the cases when the

number of businesses specified by the 2-digit

Japanese standard industry code was decreased.

Concerning the leading factors for business portfolio

restructuring, we could confirm that some of

governance factors and the conditions of firm

performance had positive effects on the decrease in

diversification. As a result of our estimation that

analyzed the hypotheses concerning the determinants

of the decrease in diversification, it was remarkable

that the effects of governance ware not universally

invariable assumed theoretically. The governance

factors showed the different effects between periods

of the first and the latter half of the 1990s, and

between manufacturing and non-manufacturing

sections. Therefore, the effects of corporate

governance were contingent. Here, we summarize the

estimation results.

At first, the decrease in diversification was

activated in the late 1990s. And it was more activated

in the non-manufacturing section rather than the

manufacturing section. This indicates that the

decrease in diversification was activated especially in

industries where the problem of excess liability was

serious, such as construction, distribution, and real

estate. The proportion of diversified firms with two or

more businesses declined in the late 90s. However,

the average number of business sections was almost

fixed throughout the 1990s. These results indicate that

the restructuring businesses including new entries not

only the withdrawals were activated in the 1990s.

Second, the backgrounds of the decrease in

diversification had changed through the 1990s. In the

first half of the 1990s, manufacturing firms facing low

growth of their main business forwarded to decrease

diversification. This would be close to our general

image that low performance firms advance

restructuring desperately. On the other hand,

non-manufacturing firms with high profitability and

manufacturing firms with low profitability but facing

high market growth of their main business advanced

the decrease in diversification in order to strengthen

the competitiveness in main business in the latter half

of the 1990s. This was an offensive decrease in

diversification by high performing firms. This trend

would contribute to the recovery of macro economics

in the first half of the 2000s. However, seen from the

different viewpoint, the fact that firms with higher

performance forwarded the decrease in diversification

actively implies the possibility of strategic fixation in

firms with lower performance. This possibility would

enlarge the difference between winners and losers.

Accordingly, the governance problems would become

more resinous for firms whose performance became

worse and worse steadily.

Finally, we here summarize the effects of

governance factors on the decrease in diversification.

For the top management characteristics, firms with

smaller boards of directors showed a positive attitude

toward the decrease in diversification. This result

indicates that the downsizing board of directors

contributes to reduce the coordination costs among

business sections and strengthen strategic decision

making. On the other hand, firms with boards of

directors consist of fewer outsiders showed a positive

tendency in decreasing diversification. This result

implies that insiders have an advantage in interpreting

the firm specific information. It also indicates a

possibility that the autonomous governance led by

insiders began to work. In contrast, it indicates that

the problems of strategic decision making and

incentives and so on still remain for the role of

outside directors. Concerning the effects of ownership

structure, the possibility that stable shareholders based

on cross shareholdings mitigates the pressure on the

decrease in diversification, for the non-manufacturing

firms in the first half of the 1990s. On the other hand,

foreign shareholders that increased their presence in

the 1990s would encourage the ‗selection and

concentration‘ especially in manufacturing firms. The

main banks gave pressures on the decrease in

diversification for non-manufacturing firms in the

first half of the 1990s. In this sense, main banks

would have kept some degree of influence on the

restructuring business in their client firms. However,

main bank influence was stepped back in the latter

half of the 1990s when their bad debt problem became

serious.

Therefore, the decrease in diversification in

Japan, as a whole, could be summarized as follows. In

the first half of the 1990s, the factors such as low firm

performance(in manufacturing section) and main bank

relationship(in non-manufacturing section) rather than

the pressure from capital market encouraged the

decrease in diversification. In the latter half of the

1990s when the decrease in diversification itself

activated, high performing non-manufacturing firms

and manufacturing firms with low profitability but

high growth in their main business tried to decrease


37

diversification in order to strengthen the

competitiveness in main business. And this decrease

in diversification was supported by the governance

characteristics such as insider majority small boards

of directors and the pressure from capital market,

mainly from foreign shareholders.

Finally, we mention about the future tasks. First,

we need to complement our estimation results by

using the consolidated data. We used

non-consolidated data because it was better to capture

the strategic decision making such as spin-offs

activated in the latter half of the 1990s aiming at

reinforcing the incentive of subsidiaries by

empowerment. However, it is very important to use

the consolidated base data especially in the analysis of

after the year 2000 because the non-consolidated base

accounting became popular. Second, although we

have discussed the cases of the decrease in

diversification, based on the assumption that

diversification result in firm value discount,

diversification also had the positive effects of risk

dispersion, seeking synergy and so on. Accordingly, it

is also needed to discuss about the cases of new

business entry, from the viewpoint of corporate

management. The governance factors discussed in this

paper may not only encourage the decrease in

diversification but also promotes the new entry, thus

encourage the business portfolio restructuring61

.

Therefore, it would be important to analyze the effects

of corporate governance from the viewpoints of

change in strategic decision making.

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Appendices


39


40

CORPORATE SOCIAL RESPONSIBILITY IN THE TOP SPANISH HOTEL COMPANIES

Eugenia Suárez-Serrano*

Abstract Corporate social responsibility (CSR) in tourism is particularly interesting given the fact that society is part of the service and companies should assume a responsibility with the places they are located in. Several studies analyse the reporting of CSR activities, however, there is modest research relating CSR practices in the hospitality industry. The purpose of this paper is to provide two case studies in the Spanish hospitality industry, Sol Meliá and NH, which are the only top hotel companies that offer information about their CSR practices in their web sites and Annual Reports. Although the tourism industry still has a long way to do in the reporting of CSR activities to become equal to other industries, in the two cases analysed a clear commitment to CSR matters it is observed within its various spheres of action. Keywords: corporate social responsibility, hospitality industry, hotel companies, Spain *Oviedo University, Spain

1. Introduction

Corporate social responsibility seems to be a matter of

increasing interest among scholars and practitioners.

The World Bark defines CSR as ―a term describing a

company´s obligation to be accountable to all of its

stakeholders in all its operations and activities.

Socially responsible companies consider the full

scope of their impact on communities and the

environment when making decisions, balancing the

needs of stakeholders with their need to make a

profit‖. The European Commission affirms that ―CSR

is about enterprises deciding to go beyond minimum

legal requirements and obligations stemming from

collective agreements in order to address societal

needs‖. In the same line, the United Nations defend

that ―corporations have a social responsibility and

moral duty to use the power of markets to make

globalization a positive force for all‖. As it can be

seen, the raison d‘être of CSR is that firms have other

responsibilities beyond financial and commercial

conscientiousness (Hopkins, 1999). Furthermore,

these definitions include business ethics and the

relevance of stakeholders beyond owners

(Schmidheiny et al., 1997). In other words, CSR is

related to the triple pillars of sustainable development:

social, environmental and economic returns (Zadeck,

2002) and it has become a core activity in many

corporations as there is a general view that CSR is

―the right thing to do‖ (Gan, 2006).

Despite the positive effect of CSR practices on

the society is undeniable, the relationship between

CSR and firm performance is arguable (Knox and

Maklan, 2004). Porter and Kramer (2006) affirm that

if corporations were to analyse their options for CSR

using the same view that guides their core business

choices, they would discover that CSR can be a

source of competitive advantage. However, the

strategic value of CSR is questionable as neoclassical

theories do not easily reconcile social welfare with

firm performance because imperfect markets do no

maximize social welfare (Allison, 2004). In fact,

studies conducted in order to analyse this relationship

offer diverse results (Barnett, 2007; Vogel, 2005;

McWilliams and Siegel, 2006; Nicolau, 2008).

According to Maxfield (2008), while market

imperfections (externalities, information asymmetries

and compromised competition) partly explain the

need for CSR, they are also the source of competitive

advantage. On the one hand, in the face of market

failures, society finds need for CSR. On the other

hand, under Resourced-based View, CSR practices

may be used as a differentiation strategy (Branco and

Rodrigues, 2006), if and only if firms can prevent

competitors from imitating their strategy (Reinghardt,

1998). Moreover, CSR activities closely linked to

innovation strategies might be more profitable than

those oriented toward public relation, marketing, etc.

(Maxfield, 2008).

Henderson (2007) affirms that the particularities

of tourism add an extra dimension to CSR: society is

part of the product and firms should be thorough and

responsible with the places they are located in. In this

way, Porter and Kramer (2006) suggest that engaging

socially responsibility as part of organizational

strategy offers the host companies competitive


41

advantage within the market place, as environment

and society in destinations are in close relationship

with their products. The general conclusions from the

literature review is that CSR has received increased

attention over the past decade by hospitality and

tourism association and firms, and these practices are

strongly related to the broader corporate socially

responsible initiatives occurring worldwide

(Henderson, 2007). According to Nicolau (2008), the

analysis of CSR in tourism is particularly interesting

because these activities might contribute to its social

force by means of both non-economic and economic

mechanisms. Besides economic value, tourism offers

social, cultural and environmental benefits

contributing to development, because tourism is a

social-economic phenomenon that acts as an engine of

social force an economic progress

(Higgins-Desbiolles, 2006).

There are several studies which analyse the CSR

reporting activities (Esrock and Leichty, 1998; Lewis,

2003; Philip, 2003; Jenkins and Yakovelva, 2005,

Brammer and Pavelin, 2006; Holcomb et al., 2007;

Nicolau, 2008). Although most of them do not verify

those activities that might have existed but for some

reason were not publicly reported, it is supposed that

the great majority of firms report their CSR efforts

with the intention of improving their image. So,

nowadays the biggest companies tend to report their

CSR activities through internet (Line et al, 2002).

There is little research relating CSR practices in the

hospitality and tourism industry and, as Holcomb et al.

(2007) have pointed out, in their paper about top hotel

companies, this industry has to go so far in order to

catch up other industries in the reporting of CSR

activities. Nicolau (2008) states that people tend to

put their trust in responsible firms and in tourism trust

is essential. What is more, tourism firms, with the aim

of making their clients aware that uncertainty does no

exist in their service provision, may seek for CSR

practices as a robust public relations strategy,

particularly in the current market environment in

which stakeholders may have strong social concerns.

In this sense, this author points out that the most

important managerial implication of his study is that

acting as a responsible citizen in not incompatible

with obtaining economic profits.

2. Methodology

Case studies provides a methodological tool for

generating and testing theory in the strategic

management field (Eisengardt and Graebner, 2007;

Siggelkow, 2007, Weick, 2007, Gibbert et al., 2008).

In particular, case studies are ideal to create

managerial relevant knowledge (Amabile et al. 2001),

above all in early phases of a new theory, when key

variables are being explored (Yin, 1994). An

important difference with other research methods is

that case studies try to study phenomena in their

context (VanWynsberghe and Khan, 2007) in which

the aims, strategies, data analysis and validity are

woven together in the process of the study (Maxwell,

1996; Lloyd-Jones, 2003).

The purpose of this study is to provide two case

studies in the Spanish hospitality industry, Sol Meliá

and NH, which are the only top hotel companies that

offer information about their CSR practices in their

web sites and Annual Reports. Table 1 shows the

ranking of the main Spanish hotel companies.

Table 1. Ranking of the Spanish hotel companies 2007

Cadena N. hoteles est. Total unid.

HOTEL COMPANY NUMBER OF HOTELS NUMBER OF ROOMS

SOL MELIA HOTELS & RESORTS 143 33.051

NH HOTELES 123 13.936

BARCELO HOTELS & RESORTS 46 11.210

RIU HOTELS 37 10.985

H10 HOTELS 30 8.375

HUSA HOTELES 77 7.624

BEST HOTELS 24 7.495

AC HOTELS 74 7.392

FIESTA HOTEL GROUP 27 6.944

IBEROSTAR HOTELS & RESORTS 19 6.274

Source: Hostelmarket

A socially responsible company must conduct

itself in an appropriate manner within its various

spheres of action (Henderson, 2007). This fact means

that different companies often may label similar

responsible conduct in a different way, so this paper

selects the five categories that better fit the activities

that hotel companies are used to report (Holcomb et

al., 2007): community, environment, market place,

vision and values, and workforce. In Table 2, some

keywords by categories are collected in order to

explain the contents of each category.


42

Table 2. CSR Categories reported by hotel companies

CSR CATEGORY KEYWORDS

Community A. Communities and charities

B. Jobs for handicapped

C. Aids policy

D. Employee volunteer

Environment E. Environment

F. Architectural integration

G. Guidelines for sustainability development

Market place H. Suppliers diversity

I. Responsible gaming

Vision and values J. Vision/ mission statement

K. Code of conduct

L. Board conducted CSR review

M. Independent verification

Workforce N. Employee diversity

O. Family services/employee welfare programs

P. Child care

Source: Based in Holcomb et al. 2007

In order to measure these companies´ CSR reporting,

an analysis of web sites, annual reports and CSR

reports available on their web sites were carried out.

3. Study

Table 3 shows the areas that were found to be reported

by the hotel companies in their Annual Reports. As it

can be observed the analysed firms provides detailed

information regarding CSR practices. Sol Meliá offers

a 132 page CSR report and NH a 173 page CSR

report, both downloadable in PDF format, as a link in

their web sites. On the one hand, Sol Meliá Report

contains areas such as economic, management, brand,

commercial, human, and social and environment

values. On the other hand, NH Report includes areas

of responsibility with environment, society, suppliers,

shareholders, clients and employees.

Table 3. CSR Categories reported by Spanish hotel companies

CSR CATHEGORY KEYWORDS SOL MELIÁ NH

Community A. Communities and charities

B. Jobs for handicapped

C. Aids policy

D. Employee volunteer

X

X

X

X

X

X

Environment E. Environment

F. Architectural integration

G. Guidelines for sustainability development

X

X

X

X

X

Market place H. Suppliers diversity

I. Responsible gaming

X

X

X

X

Vision and values J. Vision/ mission statement

K. Code of conduct

L. Board conducted CSR review

M. Independent verification

X

X

X

X

X

X

X

X

Workforce N. Employee diversity

O. Family services/employee welfare programs

P. Child care

X X

X

2.1. Community

At Sol Meliá, Community Involvement became part

of company strategy in 2001 and the firm received the

―Business and Society Award‖ in recognition of its

Community Involvement projects in 2004. Sol Meliá

focuses its projects in the communities in which it

operates, attending to the needs of the most

disadvantaged members of the community and also

hotel staff. Amongst the groups that receive greatest

support are children, the disabled, women victims of

domestic violence, and staff members affected by


43

natural disasters. These projects form part of two

different areas: ―Top-Down‖ projects which originate

in corporate offices and ―Bottom-Up‖ projects which

are created in hotels and reported to corporate offices.

In 2007 the company achieve an investment of

€1638 thousand, €230 more than in 2006.

For NH Hotels, the company must be an active

agent in the fair development of society, creating

wealth through their activity in the community in

which they operate and sharing part of the profits

obtained with society. To this end, the Corporate

Responsibility Department of NH has designed its

own ―Solidarity Index‖ to evaluate all projects that

are presented by NGOs, foundations and institutions,

analysing them under the same criteria and selecting

those that are most in line with the Company's

strategy. NH Hotels collaborated in a total of 224

actions in 2007, up 59 on the previous year. There was

also a considerable increase of investment, which

totalled €638,317 as against €537,048 in 2006.

2.2. Environment Responsibility to the environment at Sol Meliá is

replicated both in the daily activity in hotels and in

the actions promoted by corporate offices. 2007 may

be considered the year of the definitive consolidation

of environmental activities in the company, collecting

all of the individual activities together and learning

from the experience already acquired, and becoming

one of the key strategic areas of company activity.

The major areas of activity are as follows:

Mitigate the effects of climate change,

mainly through energy savings and greater energy

efficiency.

Minimization of the environmental impact

generated, by reducing the generation of waste

products and the consumption of water and other

resources.

Protection and conservation of habitats with

high ecological value to help preserve their

biodiversity.

Compliance with environmental regulations.

In 2007 the company had 22 hotels with a total

of 28 environmental management certifications based

on ISO 14001: 2004 rules, the European EMAS

regulations or the Green Globe XXI and Biosphere

Hotel Standards, which do no only include

environmental requirements but also requirements on

sustainability.

Relating to NH, in 2007 the environmental

policy has been endorsed by the Chairman and the

board of the Company as a strategic line to define the

―working principles‖ at NH Hotels:

1. To ensure that all activities satisfy current

environmental legislation, as well as our policy and

other environmentally friendly commitments acquired

by NH Hotels.

2. To set up a Waste Management Plan to minimise

waste production. To foster selective refuge collection

as well as the three R‘s rule (Reduce, Reuse and

Recycle).

3. To promote the conservation of natural resources

through reduction in consumption of water, energy

and gas using the best clean technologies possible.

4. To promote training, raising of awareness and

information with all NH Hotels staff.

5. To inform our clients of our environmental

undertakings and try to raise their awareness of what

we do so that they can provide valuable collaboration.

6. To periodically review the environmental policy

and its aims so that we can continually improve our

environmental conduct.

7. The Sustainable Construction Criteria on the basis

of which we build and remodel our hotels.

The certifications NH holds are: 4 hotels with

ISO 14001, 15 with Green Key certification, 3 hotels

with Single Environmental License in Mexico, and 17

hotels with Catalonia Environmental Licence.

2.3. Marketplace

The mission of the Sol Meliá Purchasing Department

is ―to apply supplier management criteria that meet

the needs of hotels and corporate offices in a balanced

and sustainable way‖. The following criteria, however,

are also taken into account:

• The geographical limits of the supplier

• Type of industry: manufacturer, importer, exporter,

distributor, installer and/or maintenance supplier

• Quality certification

• Environmental certification

• Health and safety certification

• Special Employment Centre certification

• Economic conditions

During the registration process, suppliers must

fill in a form related to human rights. The department

is very strict in this respect and if any suppliers do not

respect human rights their contracts are cancelled

immediately.

NH corporate purchasing policy stems from the

premise of ensuring that the highest standards of

quality and service along with commercial ethics are

put into practice. With this aim the Purchasing

Department of NH Hotels lays down and updates the

standards and tries to ensure these are always above

the rest of the market. The standards are subject to

ongoing assessment to ensure compliance of the

following principles:

• Equal opportunities for all offers.

• Transparency and documentation of all contracts

awarded.

• Stability in our commercial dealings.

• Cordial and polite treatment, avoiding unnecessary

upsets, to improve the fluidity of our dealings.

• Promotion of responsible practices.


44

Bearing in mind the relevant role of NH Hotels in

driving responsibility, in 2007 NH compiled a

Supplier Ethics Code which ensures that their

suppliers respect human rights, good labour practices,

environmental practices and the international

anticorruption fight.

2.4. Vision and values

The mission at Sol Meliá is ―to add value for all of

our stakeholders through hotel brands and residential

tourism positioned as reference points for responsible

tourism in their different market segments, satisfying

our guest experience needs and developing our human

capital‖.

Its vision is ―to be a leader and point of

reference for responsible tourism, employability

profitability, increasing the value of our brands and

using the hotel business to promote the growth of

associated businesses such as residential tourism or

the vacation club‖.

Values at Sol Meliá are the following:

• First generation values: For 52 years, Sol Meliá

based its development on solid corporate values such

as austerity, hard work, simplicity and ethics, leading

by

example, encouraging responsibility and constant

self-improvement as well as

delegation, personalised service, value for money and

control.

• Second generation values: The company today

maintaining this basic ―cultural‖ tradition, adds new

21st. century values to its philosophy and values such

as globalisation, diversity, equality and no

discrimination, conciliation of work and family life,

dialogue with shareholders, loyalty to the company,

proximity and, in particular, sustainability.

The full modernisation and consolidation of the

new Sol Meliá brand values will be tackled during the

course of the current Strategic Plan 2008-2010.

The regulation of corporate governance of Sol

Meliá is contained in Company Bylaws, in the

Regulations of the Board of Directors and in the Rules

on Internal Conduct in latter related to the stock

market, and to the Regulations of the Shareholders‘

Meeting. All of the mentioned documents are

available for shareholders and investors in company

headquarters and in at the website in the Corporate

Governance section.

The vision at NH Hotels can be summarised as

―offering hotel services that cater to the current and

future needs of our internal and external stakeholders

(employees, clients, shareholders, suppliers, etc.), the

communities in which we operate and future

generations, whilst always paying the utmost attention

to detail and providing efficient and sustainable

solutions‖.

This vision is reflected in the values that

characterise the culture of NH Hotels and the firm‘s

activities as a highly responsible Company:

• Reliability

• Business sense

• Enjoyment

• People focus

• Innovation

The Investor Relations Department adopts a

constantly proactive policy when communicating with

investors, and provides them with the Company‘s

quarterly results and any other relevant information

that may arise. To illustrate its commitment to

communicating transparently as part of our strategy of

responsibility with shareholders and investors, the

company elaborated a Corporate Governance Code in

2006, but in 2007 the firm decided to revise and

update it with a view to increasing its rigor and

raising its standards to meet the recommendations of

the Unified Code of Good Governance.

2.5. Workforce

In the opinion of Sol Meliá, one of the basic

requirements for guest satisfaction is the satisfaction

of their employees. For that reason, every year the

company applies a specific internal quality and

workplace programme and action plan to improve the

working environment of all workers. In this line,

every year, hotels conduct workplace surveys to

provide a global and objective vision of the state of

each of the dimensions of the company and areas for

improvement (teamwork, pride in belonging,

leadership, clarity, work conditions, recognition,

training and development, promotion expectations,

communications and self improvement). So these

surveys highlight, on the one hand, employee

requirements and expectations, and on the other hand,

the quality of the service provided by corporate

departments in terms of humanity, speed of the

response, ease of contact, capacity to find solutions

and flexibility.

The importance of human resources at Sol Meliá

is shown in the fact that one of the five firm key

strategic areas is Talent Management and

Empowerment. The different stages of talent

management, identification, recruitment, development

and promotion, allow the company to employ a highly

qualified human team and to improve service levels

on a daily basis, as service and staff skills are the

aspects most appreciated by guests in the external

quality audits carried out in hotels.

Employees at NH are one of the key players

when it comes to corporate responsibility. As is

quoted in the CSR Report, ―one of our priorities is to

increase their levels of motivation and satisfaction, as

it is through them that we manage to improve the

quality of our service and enhance the way we

manage our relationships with all other public


45

stakeholders‖.

The Code of Conduct at NH seeks to integrate,

bringing the Company‘s inspiring principles to all

employees in their daily tasks, promoting

communication. Therefore, internal communication is

a priority in the relationship with employees and,

during 2007 the firm has reinforced its internal

channels of communication with the aim of spreading

corporate values and collecting employee initiatives.

At NH Hotels the Satisfaction Surveys of its

employees, which are carried out every two years, are

considered as a key tool to enable them to

communicate their level of involvement, motivation,

as well as make suggestions for improvements.

Moreover, these surveys also allow the company to

detect areas for improvement where it is necessary to

establish Action Plans to be implemented at each

hotel, Business Unit or corporate level with the

supervision of the Human Resources department.

3. Conclusions

The study illustrates that only the two top Spanish

hotel companies, Sol Meliá and NH, reported social

responsible activities through CSR Reports,

downloadable in PDF format, as a link in their web

sites. This differs from the study conducted by

Holcomb et al. (2007) where the ten US large hotel

companies reported CSR activities to some extent.

Nonetheless, in our case a clear commitment to CSR

issues is observed, above the hotels analysed by

Holcomb et al. (2007), given that environmental

category, vision, value statements and stated code of

ethics were not heavily reported in the reviewed

media by these authors.

In closing with other studies, this paper shows

how far the hospitality industry is from other

industries in relation to CSR coverage. However,

reporting efforts of CSR activities are progressive in

the analysed firms, as in the last two years they have

included separate CSR reports. In this sense, as web

sites are continuously evolving, it is expected that the

rest of companies could start to report CSR practices

in order to improve their image in a

consumer-orientated industry such as tourism.

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http://www.accountability.org.uk/


47

NEW ZEALAND CEO COMPENSATION FACTORS

Sam Hurst, Ed Vos*

Abstract This paper analyses a combination of factors to try and determine whether they explain CEO compensation, and in turn help determine what makes the board of directors more effective. Factors include busy boards, local or international board members, dependent and not independent board members, director’s pay and tenure variables. Of the new and old factors considered in this approach and using a sample size of 31 NZ firms over the 2006/2007 years, a correlation existed between firm size/firm performance and CEO compensation. Further distinctions in regards to busy boards showed no significant relationship to CEO compensation, differing from previous studies, and casting doubt on whether it matters how busy the board is. Also the locality of the board was not a determining factor in CEO compensation. Keywords: CEO, compensation, board of directors *Correspondence to: Ed Vos, Professor, Department of Finance, Waikato Management School, University of Waikato

Private Bag 3105, Hamilton, New Zealand

Email: [email protected]

Introduction

It is well documented that CEO compensation is

notably high and rarely significantly related to firm

performance or factors that it should be tied to

(Anderson, Cavanagh, Collins, and Pizzigati, 2007).

Some say that CEOs get paid too much (Moriaty,

2005). The trend is increasing, and one of the most

important reasons relate to the board of directors

(CEO pay: sky high gets even higher, 2005). It seems

no matter what laws are put in place, CEO

compensation continues to have an unrelenting

upward trend that seems destined to never end. More

recent studies have been conducted to do with a

variety of explanations and relations, including

managers being awarded in up markets but not for

penalised for bad runs in the market (Garvey &

Milbourn, 2006). Hartzell and Starks (2003) agree

with many other researchers that higher institutional

ownership has a degree of bearing towards impacting

and controlling a CEO‘s compensation. Many of these

studies are also based on the large firms in the US

market, whereas this study focuses on the unique

situation of New Zealand with many smaller firms

and a much smaller market in which to compete.

This paper sets out to try and examine the more

behavioural implications behind each board member

and to see more clearly if any of them relate to CEO

compensation and therefore impact on their

effectiveness. These factors include the relative

importance of whether a busier board is less

concerned with making accurate decisions in regards

to fair compensation. The findings in this paper

suggest that there is little difference between a busy

boards CEO pay package and a non busy board. Also

analysed is the locality of the board members, which

involves identifying whether the board members are

in fact local to the business and/or the country, and

this reveals no significant relationship, suggesting it

does not matter whether the directors are local or

foreign. Further examined is whether the CEO sits on

the board, the percentage of inside/outside directors,

the directors pay, the tenures on the CEO and board

members, firm performance and firm size, with the

last two being the only significant variables that help

determine the level of CEO compensation.

The next section conducts a literature review,

with sections three, four, and five covering the sample,

method, and results respectively.

2. Literature Review

The Board of Directors

The best place to analyse implications behind CEO

pay is to look at where and who makes the decisions.

The board of directors have come under increasing

scrutiny (CEO pay: sky high gets even higher, 2005)

for the level of pay CEO‘s are currently getting for

failing companies. This paper attempts to justify what

is a suitable board of directors set up in regards to the

following factors, all of which have had their own

relevant attention in the prior literature. With regards

with past research covering many elements, Cahan,

Chua and Nyamori (2005) analyse board structure

traits such as board size, whether the CEO is on the



48

board, busy and independent directors. They find that

board structure is important even only when focusing

on CEO pay decisions. Ghosh and Sirmans (2004)

also find that board structure variables should be

included in a CEO package, as well as economic

factors. There is no doubt that board structures are

important and related to CEO compensation, and the

rest of the literature review is broken down into the

major specific factors to be analysed further.

Busy boards

The founding papers studying busy boards includes

Fama and Jensen (1983) and Fama (1980), who argue

that having a market for outside directors makes them

strive for maintaining a good reputation as monitoring

members of a board. Core, Holthausen, and Larcker,

(1999), along with Fich and Shivdasani (2006)

studied the effectiveness of the busy directors and

found that boards that had members who sat on 3 or

more boards on average were linked to weaker

corporate governance. Petra and Dorata (2008) also

discover that firms should restrict the amount of

boards their directors sit on in order to reduce CEO

compensation. This contrasts to Ferris, Jagannathan,

and Adam Pritchard (2003) who found no evidence

for limiting the amount of boards one person can sit

on. Currently there is no definitive method for

identifying correctly what a busy board is, so two

methods are followed in this paper to help see

whether the differing determinants contribute to

further significance. An important note also is the

level of compliance regulations required by a typical

NZ director. It is found that there are over 40 acts of

parliament that they need to recognise or at least be

aware of (Healy, 2002). So experience or busyness

could be a positive as well, with busy directors having

a greater awareness of the rules, or could possibly

know how to in fact bend them further than a less

busy director.

Locality of the board

Much of the previous research has failed to recognise

locality of the directors as an important factor due to

the more intensive research needed to obtain this

information. This can be analysed for New Zealand

companies as they go to great lengths to talk about

their directors and their histories in their annual

reports. A possible hypothesis of this factor is that the

more local the board, in terms of nationality and years

with the business, the more incentive they will have

for the business to succeed, and will therefore be

more in line with maximising shareholder wealth, not

CEO wealth. Contrary to this however, it could imply

that they will let the CEO do what they want as they

would be long-term friends and will not want to go

against their wishes. Therefore this is a justifiable

factor as it could potentially have a negative or a

positive relation in the context of CEO compensation,

and if a relation is found then there could be further

implications for current NZ business laws in which

some industries require three or more directors to be

of local residence (Air NZ, 2007).

Dependent/independent board

There has been much attention given to dependent

and independent boards over the years. The evidence

suggests that there is an inverse relation between CEO

compensation and the level of control the board of

directors has. That is, the less control a board has, the

higher the pay for the CEO. The value of independent

directors has long been stressed (Felton, Hudnut, Witt,

& Valda, 1995). Wright, Kroll, and Elenkov (2002)

found that having directors that are independent with

no ties to the business resulted in better board

effectiveness and improved firm performance. More

recently Petra (2005) finds that having independent

directors does appear to strengthen corporate boards.

Also Choi, Park, and Too (2007) find in Korea that

the effects of independent directors on firm

performance are strongly related. Contrary to these

findings however are Kumar and Sivaramakrishnan

(2008) who find that more independent boards

actually perform worse, which is attributed from their

monitoring efficiency decreasing as they improve the

incentive efficiency of executive compensation

contracts. These results indicate that the benefits of

having independent directors may somewhat be

construed. In terms of New Zealand NZX, at least one

third of directors must be independent of the firm

(Corporate Governance in New Zealand, n.d.).

Board Size, board composition, firm size and performance

Directly relating to NZ firms, Chin, Vos, and Casey

(2004) had a sample of 426 annual observations and

found board size and composition factors did not

relate to firm performance. Conversly Petra and

Dorata (2008) find that firms wishing to keep the

CEO‘s pay lower will opt for a board with nine or less

members on it. With regards to firm size, it has long

been considered the best explanatory variable in terms

of CEO compensation (Tosi et aL, 2000), (Lau & Vos,

2004).

Based on the literature review, these hypotheses

are created and will be tested further: the more local

the board, the greater impact (negative relation) it will

have on CEO compensation in regards to a more

justified amount. Agreeing with much of the literature,

there is predicted to be a negative relation between

independent directors and CEO compensation. That is,

the more independent directors there are, the lower

the level of CEO pay. A positive relation is predicted


49

to be seen between CEO compensation and board

busyness, similar to Fich and Shivdasani (2006)

findings. A final test will show whether these

variables gain or lose explanatory power controlling

for size. Other predictions also considered are a

relationship between directors pay, CEO tenure,

director‘s tenure, firm size, and firm performance

with regards to CEO compensation.

3. Data

The data set contains the majority of the largest public

firms that are listed on the NZX stock exchange.

These were preferred in the study as it was more

likely they would have a more detailed description of

each board of director member, which is not

mandatory in their annual reports. Similar to Fich &

Shivdasani (2006), utility and financial companies are

ignored due to possible further regulations they have

on their board of directors. Companies were excluded

if the relevant details could not be found in their

proxy statements gathered from DATEX.

Performance and size criteria were retrieved from

Datastream and Thompson Financial respectively.

The total size of the data set is 31 companies over the

periods 2006-2007. Where the level of CEO pay

could not be found, it was assumed that the highest

paid employee was the CEO. Firms also must have

had the appropriate data across the two years. The

variables used are further explained in Table 1, which

shows the summary statistics. Where tenure data

could not be found, a Google search was done to

retrieve the information from news reports.

Methodology

In contrast to Fich & Shivdasani (2006) the relative

busyness of the board was determined by having 50%

or over of board members has 3 or more directorships.

Busy board (2) takes into account Fich & Shivdasanis

(2006) method of totalling the amount of directorships

then averaging this amount. This change in method

changes the average of total busy firms from 58% to

68%. In regards to the level of directorships, this

study also takes into consideration directors who are

CEO‘s, and committee members in other firms.

However, being on a committee is given less value

compared with directorships, and this was taken into

account when it came to extracting the data from the

annual reports.

In terms of locality, this was determined by the

description provided in the annual reports, where

most go into detail about their nationality and career

paths leading up to their respective positions. Each

board member was determined to be either a local of

the business and country, otherwise they were

considered of foreign descent. In assessing the

locality factor, the threshold for a board to be

determined local is 70%. 50% or more was not used

as there are contributing factors that require some

firms to have local board members, and also there was

a relative small amount of foreign directors in regards

to local directors. This percentage gives a greater

chance for the foreign board factor to be seen.

The return on assets was used as a proxy for firm

performance, and the market value of equity was used

for the company‘s size.

The first step is to provide descriptive statistics

on each variable considered, and these are shown in

Table 1. The total average pay for a CEO in this

sample was $919,050, with the lowest payout being

$105,980. Inside directors get paid on average

$20,464.88 more than independent directors. Outside

directors averaged out to be 61% of each board, with

the highest percentage of not independent directors at

71%. The average directors pay stands at $104,030,

which is relatively high, however this figure involves

the chairman, but never the CEO‘s pay unless directly

stated that they get directors fees. The average board

size in this sample is 6.8, with the maximum being 11

directors on one board. The total number of directors

analysed in this study is 211, which is a relatively

representative figure based on the limited size of New

Zealand and the public companies. Comparing with

Fich & Shivdasani (2006), New Zealand directors are

much busier; with US directors in their study only

21% of the boards are considered busy, compared

with 68% and 58% of boards in this sample being

busy.

The second step in this empirical analysis

involved a pair-wise regression which was estimated

between the 11 dependent variables to ascertain any

connections with one another. As table 2 indicates, a

negative correlation can be seen between the locality

of the directors and whether or not the CEO sits on

the board, showing that when the CEO is on the board

less of the directors are local. Also in regards to

locality, the director‘s tenure has a positive relation

indicating that boards are more likely to be local if the

majority of directors have not been rotated. The

larger firms are more likely to possess outside

directors, and have a higher firm performance.

Also of important note from Table 2 is the fact

that the number of directors is positively related to a

busy board, indicating that the larger boards have the

busiest directors. When the CEO sits on the board

there is a negative correlation with busy boards,

suggesting that boards are less busy when the CEO is

on the board. This can also be explained in that the

CEO‘s rarely have other responsibilities in terms of

directorships and committees. Also the directors last

on the board longer when the CEO is on the board,

indicative that perhaps CEO‘s have more power and

influence when they sit on the board. With regards to

outside directors, there is a positive relation with

director tenure and firm size, implying that outside


50

directors have a longer stay in the board, and are higher in percentage in larger firms.

Table 1. Descriptive statistics – Data based on 31 NZX listed companies over the periods 2006/2007. CEO pay is

the dependent variables and all the others are explanatory variables. See notes further below for further details on

each variable

Variables average Standard deviation median minimum Maximum

CEO Pay – Dependent

Variable

919.05 728.84 786 105.980 5125

Busy Board .68 .475 .60 0 1

Busy Board (2) .58 .501 1 0 1

Outside Directors .61 .19 .38 0 .71

Inside Directors .39 .19 .63 .29 1

Local Directors .81 .166 .83 .43 1

Directors Pay 104.03 119.907 61.391 0 975

Firm Size 12.6 18.07 5.85 .2479 96.94

Firm Performance 9.676 9.0485 7.022 -65.616 45.164

CEO Tenure 9.48 8.25 6 1 29

Tenure of Directors 8.56 8.14 5 1 46

Board Size 6.806 1.424 7 3 11

CEO on Board .838 .373 0 0 1

Notes:

CEO pay – total pay for given year, as stated in there respective annual reports. Where the figure could not be

found, it was assumed that the highest paid employee was the CEO

Busy Board(1) – Board defined as busy if the majority (50% or over) of board members have 3 or more

involvements in directorships, CEO‘s, and committees. The parameters used include: 1=busy 0=not busy

Busy Board (2) – Board is defined as busy by adding up total directorships and dividing by number of board

members for each company. The parameters used include: 1=busy 0=not busy

Inside directors – As defined in there annual reports, inside directors are classified as not independent

Outside directors – As defined in there annual reports, inside directors are classified as independent of the firms

operations.

Local board – Deemed local if over 70% of the board members are local as determined in the descriptions offered

in there annual reports. The parameters used include: 1=busy 0=not busy.

Directors pay – total pay given to each director, then averaged per board for that respective year.

Firm size – Identified by the market value of equity at the end of each year

Firm performance – given by the ROA: return on assets

CEO tenure – time spent as CEO of current company

Director‘s tenure – time spent as director of current company

Board size – the amount of directors on the given company board

CEO on board – Whether or not the CEO sits on the board. The parameters used include: 1=busy 0=not busy.

Table 2. Pair wise regression between each variable. Description of each variable is shown below table 1

Locality

of

directors

Outside

directors

Firm

perfor-ma

nce

Firm size Busy

board

Director

s pay

Director‘s

tenure

CEO‘s

tenure

Number

of

directors

CEO on

board

Locality of directors 1

Outside directors .13376 1

Firm performance .9895 .24054 1

Firm size .09166 .0402** .0320** 1

Busy board .6354 .94747 .2833 .76019 1

Directors pay .7815 .12507 .43499 0.07166 .729 1

Director‘s tenure .00029** .0149** .0282** .2622 .223 .329 1

CEO‘s tenure .5361 .0934 .7448 .6900 .2813 .9379 .0542 1

Number of directors .4403 .5219 .31962 .2801 .0050** .4215 .465 .8838 1

CEO on board .00307* .49069 .50716 .9729 .0329** .68229 .0033** .114 .0329** 1

Busy Board (2) .1454 .7425 .9742 .3808 .0216** .8369 .5191 .9877 .0807 .0097**

** - indicates significance at the 5% level of significance. *- indicates significance at the 10% level of significance


51

To ascertain which if any factors explain the

level of CEO pay the following OLS regression is

calculated:

CEO pay j =

1(Busy board)

j +

2(Busy board(2))

j

+3(inside directors)

j +

4(outside directors)

j+

5(local

directors)j+

6(directors pay)

j+

7 (firm size)

j+

8(firm

performance)j+

9(CEO tenure)

j+

10 (Directors

tenure)j+

11(Number of directors)

j+

12 (CEO on

board)j

The results of this regression are shown in Table

3. Similar to previous CEO compensation studies

such as Core et al (1999) and Cahan, Chua and

Nyamori (2005), the adjusted R squared is .597,

which indicates that this model explains 59.7% of the

cross-sectional variation in this sample involving 31

NZ firms.

Table 3. Regression of CEO compensation and variables. CEO compensation is the dependent variable

Variable Co efficient t-value significance

Locality of Directors -5.788 -.315 .754

Outside Directors -8.345 -.550 .585

Firm Performance 1.043 1.755 .085*

Firm Size .0297 7.256 .000**

Busy Board -10.02 -.493 .624

Busy Board (2) -30.73 -1.608 .113

Directors Pay -8.15(E-05) -.836 .407

Director‘s Tenure -1.279 -.64412 .522

CEO‘s Tenure -.346 -.38641 .701

Number of Directors 2.306 .456 .651

CEO on Board -5.992 -.254 .801

* - denotes significance at 10% confidence level

** - denotes significance at 5% confidence level

4. Results

The results of the regression, as shown in Table 3 are

similar to many previous studies, with only

performance and size being able to explain CEO

compensation. Once again size was the largest

explanatory factor with a positive relation and

significance at the 95% confidence level. Firm

performance only became significant at the 10%

confidence level, and was also a positive relation to

CEO compensation, indicating that CEO‘s do

somewhat get paid for better performance. Finding no

significance in the locality and busyness of the board

indicates that these factors are not important in

regards to offering a stronger board in terms of

corporate governance, for this sample. These results

go against previous findings such as Fich and

Shivdasani (2006) who do find a link between busy

directors and weaker corporate governance.

The sample shows that inside directors hold on

average 3.29 other directorships, which is only

slightly less than the outside directors who averaged

3.84. This suggests that in this sample, the outside

directors are not much busier than the inside directors.

In the previous section as identified, a busy board was

classified as busy when the majority of directors had 3

or more directorships. To come in to line with Fich

and Shivdasani (2006), they totalled the number of

directorships of all the directors and then divided this

by the amount of the board members. Following this

method, the results remain insignificant, however

much lower with a significance of .113 compared

with .624 as above. When regressing on firm

performance, it also offers insignificant figures,

agreeing with Ferris, Jagannathan, and Pritchard

(2003), who found no relation between firm

performances and how busy the directors were.

Further tests

One further test involves sorting the firms out in terms

of size, to see whether any factors gain explanatory

power in terms of CEO compensation. Table 4 shows

the results. Once again size and performance are

significant but only for the larger firms, not for the

smaller firms, where none of the identified factors are

significant. At the 10% the busy boards (2) factor has

negative significance in the large firms, suggesting

that as the board gets busier, CEO compensation

decreases.


52

Table 4. The firms are sorted into the largest 31 in terms of market value of equity, and smallest. Then two OLS

regressions are done with CEO compensation as the dependent variable and the same independent variables as

above are considered. The large group is the bolded figure while the figure below in brackets is from the small

group regression

Variable Co efficient t-value significance

Board Size

0.2775

(3.4803)

0.0183

(.7682)

0.9855

(.4518)

Tenure of Directors

-5.170

(.7215)

-1.356

(.3433)

0.1912

(.7351)

Directors Average Pay

-5E-05

(-.0001)

-0.2031

(-.8248)

0.8412

(.4197)

Size

0.0169

(0.0107)

2.1604

(.2604)

0.0437**

(.7973)

Firm Performance

4.1723

(.1913)

2.6902

(.4092)

0.0145**

(.6454)

CEO Tenure

-0.5274

(.1868)

-0.355

(.2028)

0.7267

(.8414)

Ceo on Board

52.306

(-10.424)

1.072

(-.4000)

0.2971

(.6936)

Outside Directors

3.5703

(-14.26)

0.075

(-1.270)

0.9407

(.2195)

Local (0 if no, 1 if yes)

3.003

(-15.97)

0.0833

(-.8992)

0.9345

(.3798)

Busy Board

-6.436

(-6.962)

-0.218

(-.5614)

0.8295

(.5811)

Busy board(2)

-57.25

(-.7458)

-2.018

(-.0638)

0.0579*

(.9498)

* - denotes significance at the 10% confidence level

* - denotes significance at the 5% level

One more test involved separating out the two years;

however this provided similar results as above, with

firm size being the only significant variable to CEO

pay. Interestingly firm performance lost its

explanatory power suggesting that a larger sample is

needed to identify this as a factor.

5. Conclusions

The board of directors has a difficult task in that they

must obtain a good leader in a CEO, however they

risk coming under high scrutiny if their compensation

package over extends there efforts, especially when

the company is not performing. This paper has

demonstrated that locality and the independency of

the board have no relation to the level of CEO pay,

suggesting that perhaps board structure in regards to

these two factors play a marginal role. When sorting

for size busy boards do gain some explanatory power,

however interestingly enough it is reverse of what

was hypothesised, suggesting that busy boards is

negatively related to CEO compensation. This could

be due to, as mentioned above, the experience factor

playing a role and the fact that busier board members

are more knowledgeable and aware of a fair

compensation package for the CEO.

Limitations of this study include the relatively small

sample size and the restrictiveness of relative data

needed, and the time required to analyse the

qualitative information. However with 62 annual

observations it is close to the sample size of a similar

study done (80) on CEO compensation factors, who

did find significance in board structure as a relation to

CEO compensation (Cahan, Chua and Nyamori,

2005).

This paper offers further direction in terms of

requiring greater and more determinants of factors

such as busy boards and locality of board members, as

an increasing amount of qualitative data is more

publicly available. It provides some insight into

smaller companies that have boards. Contrary to other

findings, none the factors used in this study explain

CEO compensation for these firms, suggesting that

further research is needed in this field.

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54

OWNERSHIP AND CONTROL IN GERMANY: DO CROSS-SHAREHOLDINGS REFLECT BANK CONTROL ON LARGE

COMPANIES?

Alberto Onetti*, Alessia Pisoni**

Abstract This paper aims to analyse the relationships (equity and non-equity) between German banks and German firms, which are the peculiarities of the German institutional system of corporate governance. Scholars agree on the fact that cross shareholdings among banks, insurance companies and institutional firms (Charkham 1994, Baums 1993), combined with long term shareholdings (Gerschenkron 1989), and close relationships and interlocking between board members of different companies (Tilly 1969, Hopt and Prigge 1998), are the main features of bank-firms relationships in Germany. Specifically the main purpose of the paper is to demonstrate, for the panel of German companies investigated, that bank-firm relationship relies not only on patrimonial linkages but also on personal relationships. In the light of the sweeping changes that this model has undergone since the late 1990s, an empirical study has been carried out regarding relationships (patrimonial and personal) among the first 100 German companies with the highest turnover and the 6 main German financial institutions, showing the evolving trend along a period of 8 years and comparing the collected data with previous research. Therefore, in order to try to measure the extent of the banks role in Corporate Governance and to evaluate in a deeper sense the effective influence they have on the industry management, we carried out two different analyses. The first, takes into consideration the equity relationships between banks/insurances and the German industrial firms, the second analyses the number of seats held by the same banks in the correspondent supervisory board. In particular, in our opinion, the analysis of the composition of the supervisory boards can help to outline the personal relationships above mentioned. Therefore is understood, that we consider the presence of bank’s representatives in others than banks’ supervisory boards as signal of banks’ opportunity to exert power and influence. Keywords: corporate governance, interlocking, cross-shareholdings () Associate Professor of Strategic Management – Faculty of Economics – Insubria University – Via Monte Generoso 71 – 21100 Varese – Italy. e-mail: [email protected] () Lecturer – Faculty of Economics – Insubria University – Via Monte Generoso 71 – 21100 Varese – Italy. e-mail:

[email protected]

1. The German “financial capitalism”: traditional features and evolving trends

The system of relationships between banks and

companies is traditionally considered as one of the

main success factors of German industrialisation and

the distinguishing aspects of the national capitalism

model (Gerschenkron 1968). The Hilferding‘s

expression ―financial capitalism‖ is still used to

characterize a national system where banks play a

central role in dealing with industrial companies. The

specificity of the German model derives from a

combination of different factors as described below.

1) Universal banks. The German law, contrary

to other systems based on a pure banking model,

allows banks to hold relevant equity shares in

industrial companies (Großl 1989). Holding equity

shares enables banks to influence the management

board and therefore the company‘s decisions. The

greater the equity share is, the stronger the influence

the bank may exert (Porter 1992, defines this situation

as ―shareholder direction‖). Although, according to

the German law there are long-term banking

institutions62

, the universal banks are the most

common. At the end of 2005, universal banks made

up 80% of the total number of financial institutions

and accounted for 79% of total banking revenues

(Table 1).

62 Among these specialist banks there are mortgage banks

(Hypothekenbank) and building and loan associations

(Bausparkassen) (Banfi, Locatelli, Schena 1991).



55

Table 1. German banks (Deutsche Bundesbank: 2002-2005)

CategoryNr. of

banks

Tunover

(mio €)

Nr. of

branches

in

Germany

Nr. of

banks

Tunover

(mio €)

Nr. of

branches

in

Germany

Commercial banks: 354 2306208 5122 357 2592895 14044

Big banks 4 1497060 2256 5 1859720 11446

Regional banks and other commercial banks 245 700590 2849 217 629831 9059

Branches of foreign banks 105 108558 17 135 103344 72

Landesbanken 13 553 12 580

Saving banks 519 15628 463 13950

Regional institutions of credit cooperatives 2 12 2 11

Credit cooperatives 1490 13889 1293 12722

Mortgage banks 25 880899 117 24 890447 56

Special purpose banks 15 510366 19 18 701627 31

Building and loan associations: 28 164503 2843 26 2682

private 17 2027 15 1951

pubblic 11 816 11 731

Banks out of monthly statistics 145 18 148 24

Total banks 2963 7276506 7794375

Deutsche Postbank AG1)

1

Total 2964 2726

2005

2581304

834801

2002

2642446

772084

Notes: 1) in 2005 Deutsche Postbank figures has been included by Deutsche Bundesbank among the category

―Big banks‖.

Source: Deutsche Bundesbank (August 2003), pp. 104-107 and Deutsche Bundesbank (July 2007), pp. 104-107,

and own calculations.

2) The high level of industry concentration.

Within the German banking sector four institutes play

a dominant role: we refer to the traditional top three

commercial banks (Deutsche Bank, Dresdner Bank,

and Commerzbank), founded at the beginning of the

Eighteenth Century in the period of the first German

industrialization, and to Bayerische Hypo- und

Vereinsbank63

, which was added to the ―Großbanken‖

category in January 1999 by Bundesbank. These

banks account for 20% of the whole banking revenues

(Table 1). The remaining banks are the other minor

commercial banks, savings banks, and cooperative

banks. The latter two are organized according to a

three-tier system (local branches, regional and central

institutes64

).

3) Hausbank. The bank-firm relationship in

Germany is long-term oriented and very concentrated

(Charkham 1989). This doesn‘t mean that the German

companies work exclusively with one bank, but one

bank in particular plays a more prevalent role than the

others. In other words, one bank provides the larger

share of debt and manages the most relevant financial

operations in the medium-long term. Providing both

debt and equity, enhances the bank-company

relationships allowing the bank to participate in and

influence the company‘s management decisions

(Gerschenkron 1968). Generally big commercial

63 Bayerische Hypo- und Vereinsbank comes from the

merger between Bayerische Hypobank and Bayerische

Vereinsbank occurred in 1998. 64 Respectively, Deutsche Girozentrale for saving banks

and Deutsche Genossenschaftsbank for cooperative banks.

banks manage the whole range of financial products

and can support customers also in capital market

operations. As a consequence they are in the best

position to play the ―Hausbank‖ role when dealing

with the financed firms (Limentani 2003).

4) Proxy votes (Depotstimmrechte). German

banks add proxy votes to the votes related to direct

equity shares, i.e. they can exercise the voting rights

for the shares that retail customers deposit with them.

This enhances their influence on companies in which

they hold equity shares, especially in public

companies. Empirical researches (Baums and Fraune

1994 and Gottschalk 1988)65

show that banks, taken

as a whole, can exercise, through proxy votes, the

60% of the voting rights in addition to about the 25%

arising from direct and indirect equity shares. As a

result in Germany the banking system generally has a

strong power over the industrial companies gathering

in some cases the 90% of the voting rights (i.e. Basf

and Bayer) and sometimes more than 95% (Siemens,

Hoechst and Mannesmann). Some authors (Jensen

and Meckling 1979, Merkt 2002) highlight the risk of

a conflict of interest associated with the dominating

65 The only researches available regarding proxy votes are

the ones published by Baums and Fraune (1994) and

Gottschalk (1988). The data they analysed had been

provided by the Monopolkommission, which at that time

investigated on the influence the banks were able to exert on

German non-financial companies. The most difficult data to

obtain are those concerning bank control of equity voting

rights, because banks are not obliged to declare them. For

further details see note 22.


56

position banks have in the companies. Banks play

many roles at the same time: they simultaneously act

as creditors, shareholders, proxy-agents and even

consultants, with the risk of giving priority to one or

some of these. In this situation they might not

represent all of the interests related to the different

roles equally. For instance, a bank having an

important financial exposure in a company may prefer

low-risk investment policies, maybe compromising

the interest of the stockholders they are also supposed

to represent (Baums and Schmitz 1998).

5) The minor role played by the stock market in

the governance of German companies. The German

financial system is bank-oriented (de Jong 1997). The

size of debt and equity markets is not as important as

it is in anglosaxon systems. We can refer to the

capitalization data as a percentage of the GDP. The

average German capitalization is 38% in the period

1990-2005 (table 2), while the US and UK data are

respectively 113% and 132%. It is as nearly the same

as Italy‘s average capitalization (33.1%).

Table 2. Domestic market capitalization on GDP (average 1990-2005) Paese Indici di borsa Capitalizzazione di mercato sul Pil media

%

America

Stati Uniti 112.5%

NYSE 89.3%

Nasdaq 22.0%

Amex 1.2%

Bermuda Bermuda N.A.

Argentina Buenos aires 16.6%

Perù Lima 18.2%

Messico Mexican Exchange 28.6%

Cile Santiago 89.4%

Brasile Sao Paulo 27.6%

Canada TSX Group 81.2%

Europa - Africa - Medio Oriente

Grecia Athens Exchange 37.0%

Italia Borsa Italiana 33.1%

Ungheria Budapest 23.8%

Danimarca, Finlandia, Svezia OMX 95.9%

Germania Deutsche Borse 37.6%

Francia, Paesi Bassi, Belgio, Portogallo Euronext 72.9%

Irlanda Irish 61.0%

Turchia Istanbul 25.0%

Sud Africa JSE 145.0%

Slovenia Ljubljana 13.7%

Regno Unito London 132.3%

Lussemburgo Luxemburg 136.8%

Malta Malta 35.2%

Norvegia Oslo 35.0%

Spagna BME Spanish Exchanges 52.9%

Svizzera Swiss Exchange 181.8%

Iran Tehran 10.9%

Israele Tel-Aviv 47.2%

Polonia Warsaw 11.7%

Austria Wiener borse 18.0%

Asia - Pacifico

Australia Australian 80.6%

Sri Lanka Colombo 15.2%

Cina, P.R.: Hong Kong Hong kong 297.3%

Cina, P.R.: Mainland 26.0%

Shangai 18.0%

Shenzhen 8.0%

Indonesia Jakarta 20.5%

Giappone Tokyo 72.6%

Corea Korea 41.6%

Malesia Bursa Malasya 171.5%

India 97.7%

Bombay 50.9%

National Stock Exchange India 46.8%

Nuova Zelanda New Zeland 42.2%

Filippine Philippine 46.0%

Singapore Singapore 158.9%

Taiwan Prov. Cina Taiwan 93.8%

Thailandia Thailand 53.1% Notes: N.A.: Not Available.

Source: IMF World Economic Outlook (2007) and World Federation of Exchange (2007), own calculations.

This difference indicates the minor role of the

German capital market in corporate funding. In fact

German non-financial companies are mainly financed

indirectly, by banks. The data in Table 3 shows how

banks are the prevalent source of funding of the

German industrial companies (the banking loans


57

amount on average to 36% of the overall companies

liabilities in the period 1993-2000).

Table 3. Financing of non-financial German companies from 1993 to 2000 1993 1994 1995 1996 1997 1998 1999 2000 average

Total (DM billion) 463,3 483,8 491,5 528,9 498,2 690,8 780,5 935,4 609,05

Internal financing rate 59,1% 60,2% 72,4% 68,6% 71,6% 54,7% 44,2% 36,2% 58,4%

External financing rate 48,2% 42,6% 32,7% 32,8% 31,0% 46,4% 49,4% 64,6% 43,5%

of external financing:

Banks 32,1% 16,3% 55,6% 57,6% 55,3% 40,7% 32,1% 13,5% 37,9%

- domestic 32,5% 17,9% 52,8% 56,5% 51,3% 39,2% 22,8% 15,1% 36,0%

- foreign -0,4% -1,7% 2,8% 1,1% 4,0% 1,5% 9,3% -1,6% 1,9%

Other investors 10,6% 16,3% 19,6% 14,8% 22,7% 21,9% 44,3% 45,1% 24,4%

- domestic 6,8% 6,4% 5,9% -3,5% 1,9% 5,5% 11,6% 1,0% 4,5%

- foreign 3,8% 9,9% 13,8% 18,2% 20,7% 16,4% 32,8% 44,1% 20,0%

Equity investment 12,4% 18,3% 20,1% 28,6% 21,2% 36,9% 20,6% 37,2% 24,4%

- domestic 13,8% 16,2% 17,1% 29,5% 16,1% 35,2% 10,2% 5,2% 17,9%

- foreign -1,5% 2,2% 3,1% -0,9% 5,1% 1,7% 10,4% 32,0% 6,5%

Other 44,8% 49,1% 4,7% -0,9% 0,8% 0,5% 3,0% 4,3% 13,3% Source: Jürgens and Rupp (2002), pp. 8-9.

6) Cross-shareholdings. German companies,

both industrial and financial, hold long term

shareholdings in other companies. Equity linkages are

often reciprocated, creating a cross shares system

(―Ringverflechtungen‖) between companies and other

companies and between companies and banks. The

cross equity shareholdings, which sometimes find

expression in Konzern66

, give stability (Gerschenkron

1968) to the corporate relationships and lead to the

development of mutually defined strategies.

7) Interlocking directorate. To the opposite of

most western economies, German companies have a

two-tier board: in German companies there is an

additional board (called the supervisory board) which

nominates the members of the board of directors and

approves its most important decisions. Other than by

the workers67

, the supervisory board members are

appointed by the shareholders. The system of

cross-shareholdings leads to a system of interlocking

at level of supervisory boards of many companies and

banks, often involving the same people. Interlocks are

66 The general characteristic of a Konzern is that at least

one legally indipendent company is under centralized

control exerted by the parent company (§ 18 AktG). 67 The system of co-determination of the employees

(Mitbestimmung) also contributes to the unique nature of

the German system of corporate governance (Figge 1992,

Hohmann-Dennhardt 1980, Müller 1986). The

co-determination of employees is twofold: via supervisory

boards and via works councils. Various laws determine the

proportion of employee representation on the supervisory

board, and distinguish three regimes of co-determination

(full-parity, quasi-parity and one third regimes), depending

on the size of the firms, the total number of employees and

the sector in which the firm works. More broadly, the

co-determination system means that workers‘

representatives have information, consultation and veto

rights on certain issues. Therefore German workers have,

besides external mechanisms of representation, as trade

unions, also direct mechanisms of influence and control

inside the firm.

characterized by extremely close relationships and

interdependencies between board members of

different companies and therefore lead to stable

intercompany relationships and mutual strategies

(Tilly 1969, Hopt and Prigge 1998). The fact that

companies nominate their own members in the other

companies‘ supervisory boards, without having

significant ownership stake, is a widespread

phenomenon in Germany. The presence of bank‘s

representatives in the supervisory boards of industrial

companies, also without being a shareholder, is a

strong signal of the influence the overall financial

sector can exert on the management of the industry.

8) Stable ownership. Cross shareholdings

among banks, insurance companies and industrial

firms combined with long term shareholdings lead to

ownership stability and continuity, protecting the

companies from hostile takeovers (Porter 1992

describes the German model using terms as

―permanent owner‖ and ―dedicated capital‖ to

distinguish it from the anglosaxon one described as

―fluid‖ and ―transient‖). This is proven by the fact that

from the end of the second world war until the famous

Mannesmann-Vodafone case (occurred in 1999/2000)

(Höpner and Jackson 2001), only three relevant public

takeovers occurred and only one was successful. In

1989 Veba AG made a take over attempt on Feldmule

AG (Franks and Meyer 1990, Nolte and Leber 1998)

and in 1990/91 Continental AG resisted the take over

attempt by Pirelli (Baums 1993, Droste 1995). The

third case, this one successful, refers to the Hoesch

AG take over by Krupp AG (Baestlein 1997, Schmidt

et al. 1997, Franks and Meyer 1998). The stable

ownership protects management from hostile

takeovers attempts and allows them to make long

term oriented decisions.

The aspects described above contribute jointly to

explain the main characteristic of German

bank-industry relationships: to be precise, the


58

presence of strong and stable ties among companies

(both financial and industrial) which leads to widely

shared strategies.

This aspect has been discussed by many authors

and defined in different ways. To mention a few,

Porter (1992) refers to a ―relation oriented‖ model,

indicating how investment decisions are long term

oriented and not only aimed at capital gain. Shonfield

(1965) uses the term ―collective management‖ in

order to highlight the widespread agreements among

companies often leading to cartels creation. Albert

(1991) with the term ―dialogue sociale‖ describes the

widespread practice in German society in looking for

consent involving all the stakeholders in decision

making.

In our opinion the specific feature of bank-firm

relationships depends on the characteristics of the

German institutional system of governance68

. Taking

mutual decisions as well as looking for broad consent

characterize not only bank-firm relationships, but also

the whole German system, at all levels and for both

private companies and public offices. In our opinion

the widespread use of this modus operandi can be

explained only referring to institutional variables.

Business behaviour is embedded in the institutional

model and becomes routine (de Jong 1997, Guatri and

Vicari 1994, Kirat and Lung 1999, Porter and Sölvell

1999, Warglien 1997). The German institutional and

constitutional framework (and in particular

subsidiarity) plays a key role in this process of

―contextualization‖69

(Onetti 2001).

At the moment the German system is quickly

evolving as a consequence of a variety of factors. In

the following points, without aiming to cover all the

sweeping changes, that, since the late 1990s, have

undergone this model, we will discuss those as

considered with the most relevance.

68 The term governance refers to different concepts. In this

paper we use it referring to its broader meaning,

highlighting the influence that the institutional environment

exerts on stakeholder behaviour. Therefore, quoting

Warglien (1997), for governance model we intend (p. 1):

―institutional arrangements within and between firms, as

well as (…) the institutional environment within which such

arrangements emerge‖. In this way is possible to show up

both the regulatory and institutional aspects (―formal

regulation‖, de Jong 1997, p. 5) and the informal one

(―social factors and processes‖, Warglien 1997, p. 1;

―informal customs‖, de Jong 1997, p. 5). In general ―a

system of corporate governance is defined as a more or less

country specific framework‖ (Weimer and Pape 1999, p.

152), even if the recent debate regarding economic

geography (Zucchella and Maccarini 1999) leads to the

definition of the new concept of economic regions, where

the national border are loosing importance. 69 Boschma (2005) refers to (p. 63) ―institutional

proximity‖ pointing out as ―interactions between players are

influenced, shaped and constrained by the institutional

environment‖.

1) The growing internationalization of German

companies. The German companies have been

increasing their international presence since the

beginning of the nineties. This happened both through

the listing of many important German companies on

foreign stock exchanges (i.e. Daimler and SAP on

NYSE) and through the acquisition of foreign

companies70

: two prime examples are the acquisition

of Morgan Grenfell and Bankers Trust by Deutsche

Bank and of Kleinwort Benson by Dresdner Bank.

2) The growth of foreign direct investments in

German companies. A prime example is the takeover

of Mannesmann by Vodafone Air Touch71

. Given that

it involved a leading German company and large

capital, it has often been cited by many authors

(Jürgens et al. 2000) as a turning point in the

transformation of the German system of corporate

governance.

3) Banks‘ growing attention towards economic

performance. The internationalization of financial

markets puts the banks in competition with one

another to raise capital. As a consequence banks have

to meet investors‘ expectations in terms of value

creation also in the short term (as regards the growing

attention paid by banks to the shareholder value, see

Jürgens and Rupp 2002). This reduces the possibility

for banks to manage their investment portfolio

exclusively on a long term basis72

.

4) The increase of German companies‘

bankruptcy. As shown in Figure 1, the number of

companies that faced bankruptcy in the decade

1995-2004 almost doubled.

70 This phenomenon regarding the growing

internationalization of German companies is in particular so

much related to the USA to lead some authors

(Meyer-Larsen 1999) to define it as ―Germany Inc.‖. 71 Initially this takeover attempt was hosted by the

supervisory board of Mannesmann, then after months of

negotiations the two involved parts reach an agreement and

Vodafone could acquire the second German operator of

mobile telephony. The Vodafone-Mannesmann takeover

leads the German legislator to promulgate in December

2001, the Takeover Act (Wertpapierwerbs- und

Übernahmegesetz – WpÜG), in order to regulate all the

tender offer, which take place on the German financial

market or any other tender offer, which regards a German

company. 72 Porter (1992) describes the German traditional approach

pointing out (p. 70) as ―owners are virtually permanent, they

seek long term appreciation of their shares, which they hold

in perpetuity‖.


59

Figure 1. Firm‘s bankruptcy in Germany (1995-2004)

Source: Creditreform (2004)

In 2002 this phenomenon became evident

because it involved some leading companies such as

Herlitz, Fairchild Dornier, Kirch Media and Philipp

Holzmann. The latter was the most relevant one

because it involved a well established century old

company and showed for the first time how German

banks changed their traditional lending policies.

Holzmann went into a deep financial crisis in 1990 as

the recession hit the construction industry. The main

German banks provided a 2.2 billions euro rescue

plan to which the government added an additional 120

millions euro. In 2001, Holzmann accumulated losses

of 463 mln. euro and debt for 1,5 bln. Euro; on these

grounds Dresdner Bank, Commerzbank and

Bayerische Hypo- und Vereinsbank refused to take

part to the new rescue plan proposed by Deutsche

Bank, the most exposed bank. This fact can be

interpreted in two ways: on one hand, it signals the

change in the traditional bank lending policies aimed

at guaranteeing corporate continuity (i.e. bank receive

company equity shares in exchange for providing new

loans); on the other hand, as a symptom of the

difficulties German banks are facing: as bankruptcies

increase, they have to accumulate more for credit

default, reducing their profit margins.

5) Banks‘ reduction of corporate equity

shareholdings. Banks and insurance companies are

progressively restricting the cross shares network they

belong to. On one hand, this phenomenon is related to

the strategic repositioning of the main commercial

banks towards investment banking and asset

management. On the other, it is pushed by the recent

tax reform, approved by the Schröder government in

2000 and become effective in 2002, lowering the

fiscal burdens on shares transfer73

. Moreover the

reform should stimulate the market for corporate

control, making the German capital markets more

interesting for domestic and foreign investors.

6) The increased role of financial markets. The

stock market bubble burst at the beginning of 2000 –

which led to the closure of Neuer Markt – has

undervalued the growing role financial markets have

acquired in Germany and the rest of Europe in the last

decade (Jürgens and Rupp 2002). The development of

capital markets increases the range of financing

options available to the companies - mainly to the

largest ones -, improving their bargaining power with

banks and reducing their dependence to banking

loans74

.

7) Recent evolution in the German law. An

important development is the Law on corporate

control and transparency (Gesetz zur Kontrolle und

Transparenz im Unternehmensbereich – KonTraG),

which, approved in May 1998, aims at improving the

investor‘s position by forcing companies to provide

them more information. In particular, the law

73 The key point of this tax reform are:

- Reduction of the tax rate to 25% for both retained

profits (from 40%) and distributed profits (from

30%);

- Capital gains tax for equity participation of

corporations in other domestic incorporated

companies will be abolished. 74 The traditional role of German banks is changing in

particular in relation to the larger German non-financial

companies, to whom banks are becoming financial services

providers (Jürgens and Rupp 2002). As regards the so called

Mittelstand (small-medium sized firms), instead, the

traditional role of universal banks remains unchanged.


60

proposes to limit the ―Depotstimmrecht effect‖ by

obliging the banks, owning more than 5% of voting

rights of listed companies or participating in the

syndicate for public offering of their shares, to inform

their customers how the bank will exert the voting

rights75

. To the same purpose is the modification of

the Article 135, par. 3 of Act on stock corporation

(AktienGesetz – AktG). According to this, banks are

not allowed to exert voting rights on behalf of their

depositing customers when they own more than 5% of

the company equity shares, unless they received

specific voting instructions from their customers or

give up their own voting rights76

. As a consequence of

the above mentioned measures, the banks‘ discretional

power in exerting proxy voting rights has been

strongly restricted (Martin 2004). Moreover the

German corporate governance code (Deutscher

Corporate Governance Codex – DCGC), become

effective in February 2002, limits the banks‘ practice

of nominating their own representatives in the

supervisory boards of companies, in which they hold

equity shares (Hopt 2003). According to the new code,

the number of external supervisory board positions

that the same person may hold in listed companies is

limited to five77

.

8) The current law harmonisation process in

the EU and the international self-regulation process.

The process of law harmonization, at EU level, is

going to reduce the law specificity of the German

system. To mention the most relevant cases, we have:

the German securities trading Act78

adopted in 1995

(implementing the European Union‘s Large Holdings

Directive 88/627/EEC), which deals with the

disclosure of information on the company‘s

shareholder structure and with insider trading

regulation; other measures aiming at standardizing the

different types of companies (the Regulation on the

statute for a European company in 2000, the Directive

2002/14/CE regarding worker‘s information and

participation rights in 2002). At the same time we can

see the diffusion of international agreements, as for

example the Basel one, regarding the banks‘

patrimonial requirements, which is going to have

effects on the behaviour of financial institutions.

The recent changes in the German model above

75 To the same information duties are also subjected banks,

whose officials are members of the supervisory board or of

the board of management of the company at issue. 76 Moreover, banks are forced to disclose, in their annual

reports, all the mandates in other supervisory or

management boards accumulated by their officials. 77 Before the DCGC this limit was fixed in 10 mandates. 78 The German securities trading Act

(Wertpapierhandelsgesetz – WpHG) states that stakes above

thresholds of 5% of the voting rights need to be disclosed to

the Financial Supervisory Authority (BaFin), which makes

than this information public. Prior to 1995, shareholders

only had to report their stakes if they exceeded the threshold

of 25%.

described indicate a certain trend towards a

market-oriented system. Although there has been

some degree of convergence, in particular to the

anglo-saxon model, the fundamental differences with

respect to a market-based system are still significant79

.

Therefore, despite the importance of the evolutionary

trends above described, is our opinion that the

peculiar features of the German bank-industry

relationship won‘t change, at least in the short time,

because they are expression of the culture of

co-decision and co-responsibility (the so called

Mitbestimmung) deeply rooted in the German system

(Shonfield 1965, Albert 1991, de Jong 1997, Warglien

1997 and Hacketal et al. 2003). Only considering all

these aspects, we can explain the stability

characterizing the bank-firm relationship, stability

which presumes a widespread participation and

sharing in decisions. Stability, which comes out not

only from reciprocated equity linkages

(cross-shareholdings), which rarely are substantial

enough to assert effective control, but rather from

strategic co-decision, deeply embedded in the

institutional model. Talking about strategic

co-decision we refer to the common participation of

the different subject involved in the decision making

process, whose behaviour and answers, at strategic

and organizational level are expression of this culture.

Is therefore our opinion that the evolutionary aspects

of the German model can be interpreted and faced,

only taking into consideration this point of view.

What said above finds confirmation so far, in the

empirical research we carried out on the German

bank-industry relationship. If, on one hand, we find

out that the patrimonial ties among financial and

industrial sector are rarefying, on the other hand, we

observe how the personal linkages among supervisory

boards remained unaltered. These findings seem to

validate the thesis regarding the existence and the

importance of the culture of strategic co-decision. As

this modus operandi is deeply rooted in the German

system, unlikely will be modified by the recent

changes above described. On the opposite this culture

will probably help to direct the evolutionary process,

characterizing it with the specificities of which the

German model is traditionally bearer.

2. Research hypothesis, data and methodology

This paper aims at analysing the characteristics of the

bank-industry relationship in Germany, showing the

ties among financial and industrial companies, both in

terms of cross-equity-shareholdings and interlocking

directorates for the 1998, 2001 and 2005. The

79 As regards the persistence of the fundamental

peculiarities of the German corporate governance system,

see also: Baliga and Polak (2004), Mayer and Whittington

(2004) and Goergen, Manjon and Rennenboog (2004).


61

relationships among the German financial and

industrial sector create a close and complex network

of companies. The analysis of equity shareholdings

can explain the ties among the companies, but is our

opinion that does not provide a complete and

exhaustive picture of the network. Around the

patrimonial linkages develop wider relationships,

which often are personal, that are of crucial

importance to explain the behaviour, the strategic

choices, in other terms the governance of the involved

companies.

Sample

The sample investigated is made of:

on the industrial side: the 100 largest

German non-financial companies for turnover at the

end of 2005 (chosen from the ―top 500 deutsche

Unternehmen‖ – WELT ONLINE ranking);

on the financial side: the 4 Großbanken

(Deutsche Bank, Dresdner Bank, Commerzbank and

Bayerische Hypo- und Vereinsbank) and the 2 main

German insurance companies (Allianz and Münchener

Rückversicherungsgesellschaft).

As regards the time period, it has been decided

to consider the sample over 8 years, from 1998 to

2005. The year 1998 was chosen because only after

the issue of the KonTraG (Gesetz zur Kontrolle und

Transparenz im Unternehmensbereich) in 1998, banks

have been forced by law to publish in their annual

reports all the mandates that their collaborators have

on the supervisory and management board of large

companies, and all the stakes above thresholds of 5%

of the voting rights they held in the same companies80

.

Data collection

The data on shareholdings has been collected

analysing the annual reports of all the 106 companies

of the sample for the time period considered, and

through a database (―Wer Gehört zu wem?‖,

Commerzbank) that every year gathers the data

regarding the major shareholders (if existing) of about

12,000 German companies. The data on the

composition of the supervisory boards has been

collected only through annual reports because they are

the only official documents that display such

information. The information of the mandates that

each bank/insurance‘s employee detects in the

supervisory board of other German companies was

first gathered from the annual reports of the 6

80 Before the KonTraG states this principle, the WpHG

(Wertpapierhandelsgesetz – Security Trading Act) requires

that stakes above thresholds of 5% of the voting rights need

to be disclosed to the Financial Supervisory Authority

(BaFin), which then makes this information public. Prior to

1995, shareholders only had to report their stakes if they

exceeded the threshold of 25%.

financial institutions, then, this data has been

cross-checked with the information published in the

annual reports of the 100 companies in the sample.

Methodology

In order to investigate the relationship between

German banks and German firms (equity and

non-equity) two different empirical analysis have

been carried out:

First, the analysis of the equity linkages

among banks/insurance companies and the 100 largest

German non-financial firms;

The second analysis has been carried out on

personal linkages among the 6 financial institutions

and the 100 largest German non-financial firms to

evaluate in a deeper sense the role that banks and

insurances have in German corporate governance and

to provide evidences of the effective influence they are

able to exert in corporate management. The object of

the study has been the composition of the supervisory

board of all the 100 largest German non-financial firms

and all the mandates detained by all the employees

(managers, collaborators, supervisors, and so on) of the

6 financial institutions in these companies identifying

the number and type of seats (if chairman or not) held

by the same financial institutions in the supervisory

board of the firms. Such a methodological choice, i.e.,

to consider the presence of banks‘ representatives in

other than banks‘ supervisory boards as a signal of

banks‘ opportunity to exert power and influence and as

a proxy of banks‘ influence in the system of corporate

governance is strongly supported in the literature (see

among the others, Pfannschmidt 1993, Windolf and

Beyer 1995, Leimkühler 1996, Hopt and Prigge 1998).

Specifically the main purpose of the analysis is to

demonstrate, for the panel of German companies

investigated, that bank-firm relationship relies not

only on patrimonial linkages but also on personal

relationships. To provide evidence of this fact, we

statistically test how the stock participations held by

the six financial institutions considered are not able to

completely explain the considerable number of seats

they have in the supervisory boards of the firms we

chose for the panel.

Variables and research hypotheses

The variables analysed are two:

Shareholders‘ structure: in this framework,

what should be pointed out, is that the analysis of the

banks/insurances shareholdings in the German

industry along with the analysis of the shareholders‘

structure of the 100 German firms in the sample, will

be the basis for providing a map showing the wide

relationship network, which directly or indirectly joins

a high number of firms and financial institutions.


62

Composition of the supervisory board: the

study of this variable is on the basis of the second

analysis previously described. Studying the presence

of banks/insurances‘ members seated on the

supervisory boards of non-financial firms is important

in understanding the governance mechanisms used by

banks to exert their influence in the firms‘ management

(see among the others, Pfannschmidt 1993, Windolf

and Beyer 1995, Leimkühler 1996, Hopt and Prigge

1998). It has been decided to focus on the composition

of this board because it is the one that appointed the

members of the other one (the board of managing

directors), and because of its, at least theoretically,

correspondence to the shareholdings (Windolf and

Beyer 1995, Gorton and Schmid 1996).

The hypotheses developed are concentrated

mainly on the relationship between corporate

ownership and interlock ties:

Hp. 1: On the supervisory boards of sample

companies there are only members of financial

institutions participating in the company‘s equity.

Support for this research hypothesis can be found in

various studies carried out on the German corporate

governance model. As the supervisory board‘s

members are nominated at the annual general meeting

of shareholders, except for the seats reserved for the

workers‘ representatives, it is expected to find,

theoretically, a certain correspondence between the

representatives of shareholders in the Aufsichtsrat and

the stock held by the same shareholders (Gorton and

Schmid, 1996; Böhm, 1992; Edwards and Fischer,

1994; Seger, 1997).

Hp. 2: Most of the personal linkages through banks‘

representatives are among the first 10/50 German

companies.

The main studies carried out on the composition

of supervisory boards outlined that the banks‘

members are mainly represented on the boards of the

largest German companies and in particular the DAX

ones (see among the others André 1996, Seger 1997,

Hansen 1994).

3. Bank-firm relationship and cross-shareholdings

The German system of relationships between banks

and companies is traditionally considered as one of

the main features of the German model of corporate

governance (Gerschenkron 1968, Charkham 1989,

Baums 1993). The issue related to the dominant role

that banks play in German corporate governance,

based on direct share ownership and on a system of

proxy voting, under which they cast votes for other

shareholders, has been under debate from the early

seventies. Several studies (Gessler 1979, Gottschalk

1988, Baums and Fraune 1994) have been carried out

with the purpose of measuring the extent of banks‘

influence and control they exert in corporate

governance.

The most quoted researches carried out on this

issue are the Gottschalk one (1988) and the study of

Baums and Fraune (1994). Gottschalk‘s study took

into consideration 33 among the 100 major German

enterprises listed in 1986 (column a, Table 4), while

Baums and Fraune the 24 biggest German companies

listed in 1992 (column b, Table 4).

In Table 481

we put together the data related to

the 16 German firms considered by both authors in

their researches. We can observe that the data

collected in 1986 are not far from the data of Baums

and Fraune of 1992: this fact can be interpreted as a

signal of relative stability of the phenomenon under

examination. Analysing the data in Table 4, comes out

how the German bank system, considered as a

whole82

holds the majority of exerted voting rights in

almost all cases (15 enterprises in 1986 and 13 in

1992). Moreover we can observe how the majority of

exerted voting rights is often (6 companies in 1988

and 3 in 1992) concentrated in the hands of the 3

Großbanken, which anyhow exceed the 20% of

exerted voting rights in 14 cases in 1986 and 11 cases

in 1992.

As a consequence, from the analysed data comes

out how the banks, as a whole, could appoint the

majority of the members which represent the

shareholders in the supervisory boards, of almost the

considered companies. Moreover, the voting rights

appear to be, on average, concentrated in the hands of

the 3 Großbanken, confirming the role of guide they

traditionally have in the German system.

81 In both studies the role of banks has been quantified in

terms of voting rights presented by German banks in the

AGMs of the analysed firms as a percentage of all voting

rights presented in each AGM. Both studies considered,

besides the voting rights related to direct shares held by

banks, also the votes casted on the basis of proxy voting as

well as the votes casted by the subsidiaries and the

management companies possessed by the respective bank. 82 As sum of the voting rights exerted by the 3 big

commercial banks (Großbanken), by the regional banks

(Regionalbanken), by the saving banks (Sparkassen), by the

credit cooperatives (Kreditgenossenschaften) and by other

banks.


63

Table 4. Voting rights of banks at the AGMs of some German companies (two empirical researches in

comparison)

Enterprise

a b a b a b

BASF 55,40 50,39 51,68 40,35 96,64 94,71

Bayer 53,18 50,21 54,50 41,66 95,78 91,32

Degussa 70,94 73,26 41,79 33,86 67,09 60,65

Deutsche Babcock 67,13 37,30 22,54 31,38 97,01 90,58

Hoechst 57,73 71,39 63,48 69,49 98,34 98,46

KHD 72,40 69,60 49,54 73,97 85,29 97,96

Linde 52,99 60,03 59,87 57,93 90,37 99,07

MAN 64,10 72,09 30,17 18,89 52,85 48,20

Mannesmann 50,63 37,20 50,53 38,76 95,40 98,11

Preussag 69,58 69,00 19,34 18,10 99,68 99,46

Schering 46,60 37,42 51,50 40,69 99,08 94,50

Siemens 60,64 52,66 32,52 34,57 79,83 95,48

Strabag 83,02 67,10 27,32 9,80 95,24 99,28

Thyssen 68,48 67,66 32,62 19,13 58,11 45,37

VEBA 50,24 53,40 47,92 41,98 98,18 90,85

Volkswagen 50,13 38,27 7,98 15,07 19,53 44,05

Media 60,82 56,69 40,21 36,60 83,03 84,25

Voting rights

presented at the AGMVoting rights presented

% of voting rights at the AGM

3 big banks1

Total big banks

Notes: a: Data from Gottschalk 1988

b: Data from Baums and Fraune 1992

1: Großbanken: Deutsche Bank, Dresdner Bank and Commerzbank

Source: Data from Gottschalk (1988) and Baums and Fraune (1994) and own calculations.

What above described confirms the considerable

influence and control that banks, as a whole, may

exert on corporate governance. To remark is the

control exerted by banks, taken as a whole: what we

have to point out is the network of relationships rather

than single positions of one financial institution. The

German bank-firm relationship is based on a network

of tightly joined financial institutions (in which the

Großbanken play a dominant role), which together

exert a considerable influence on industrial

companies. Using the term ―Hausbank‖, we refer to

the financial institution within this group which has

the implicit or explicit mandate, to carry out the

―relationship‖, although this term is often, in our

opinion improperly, used to indicate the existence of

an exclusive relationship between a bank and a firm.

In order to evaluate if the situation described for the

past is still actual83

, also keeping into consideration

83 The different sources of the data (Gottschalk 1988,

Baums and Fraune 1994 and the ones we collected in

2001/02) causes some problems of comparison of them,

therefore we think that there are some points to make clear.

As already outlined in note 19, the empirical researches

carried out by Gottschalk and Baums and Fraune, consider,

besides the voting rights related to direct shares held by

banks, also the votes casted on the basis of proxy voting

(the so called Depotstimmrechte) as well as the votes casted

by the subsidiaries and the management companies

possessed by the respective bank. The studies analysed the

data collected by the Monopolkommission in government

inquiries carried out in order to evaluate the extent of the

the evolutionary trends previously mentioned, we

provide a descriptive analysis of the results obtained

with the analysis carried out on shareholdings.

banks‘ role in the industrial sector (Nardozzi 1983).

The analysis we carried out differs from the others two

mainly in three aspects:

- Firstly our research considers only the direct

shareholdings of the examined financial institutions

and not the proxy votes. Banks do not have to report

their delegated voting rights (Becht and Boehmer

2003) as, according to § 135 V and § 128 II, the bank

have to consult shareholders when casting votes on

their behalf and has to follow their instructions.

Therefore it has not been possible analyse them

because banks regard them as confidential;

- Secondly our study has enlarged the sample analysed

out of the banking sector, including the two biggest

German insurance companies (Allianz and Münchener

Rück). This choice is justified, on one hand, by the

entity of the stocks holds in the financial and

non-financial sector, and on the other, considering the

recent trends that have led to the ever-growing

integration between banking and insurance sector

(Schüler 2004 and Börner 2000).

- At the end, the appearance, among the 3 big

commercial banks, of Bayerische Hypo-und

Vereinsbank, the entity resulting from the merger

between Bayerische Vereinsbank and Bayerische

Hypobank occurred in 1998.


64

As regards the financial sector, we take into

consideration the six financial institutions (4

Großbanken and 2 insurance companies) previously

mentioned. This choice, on one hand, limits the range

of our research in comparison with the ones carried

out by Gottschalk and Baums and Fraune, which

considered the banking sector as a whole; on the other

hand we include also the two main German insurance

company, whose consideration (also by the light of

what said in note 22) cannot, in our opinion, be set

aside. As regards the industrial sector, we chose the

100 largest German non-financial companies for

turnover at the end of 2005 (chosen from the ―top 500

deutsche Unternehmen‖ – WELT ONLINE ranking)84

.

The importance of cross-shareholdings both among

non-financial enterprises and between financial

institutions and industrial firms is a principal feature

of German corporate governance aimed at cementing

long-term relationships between companies.

Moreover, in our opinion, the tight network of

linkages cannot be neutral as regards the strategies

definition of the involved enterprises. The existence

of reciprocated equity linkages leads to common or, at

least, widely shared strategies. Under this point of

view, an analysis limited to equity shareholdings does

not provide a complete and exhaustive picture of the

strategic linkages within the network, which often are

based on informal aspects, like the existence of close

relationships and interdependencies between board

members of different companies (Windolf and Beyer

1995)85

.

84 The choice we made in integrating the analysis of equity

shareholdings with the analysis of the composition of the

supervisory boards answer to the purpose of making up for

two structural limits that our study meet. On one hand,

German banks are forced by German law to disclose all the

directly held participation of more than 5%. Therefore, in

our research we could not consider the shareholdings under

that threshold, unless they are voluntarily disclosed (as for

example the case of Allianz). On the other hand, we could

not analyse the proxy votes exerted by banks, because they

are not disclosed (see note 22). The data collected through

the lists of mandates included in the annual report of every

German company and the study of the composition of the

supervisory boards we carried out, enables us to compare

the number of seats that banks representatives effectively

hold in the boards of other companies and the number of

seats that the same representatives should hold theoretically

on basis of the declared shareholdings. Moreover this study

enables us to make up the limits that structurally a research

based on annual reports has to face. 85 It has been noted, for example that: ―The members of the

supervisory board have to control company management

and to prevent the misuse of power. At the same time, they

are part of an encompassing network which functions as a

means of social integration and cohesion among the

business elites and to which they owe the position they

have‖ (Windolf and Beyer 1995).

An example of this can be found analysing the

linkages of three of the DAX 30 companies: RWE

(multi-utility of energy generation and sales and

water), E.ON. (multi-utility of energy sector) and

Thyssenkrupp (steel producer). The relationship

among these three companies, as it is indirect and not

immediately noticeable (these companies control

RAG, a firm of the energy sector, with shareholdings

of 20-30% each one), risks of not being completely

estimated by only considering the equity linkages.

Therefore, the opportunity of integrating the analysis

of equity relationships with the analysis of the

composition of the supervisory boards is particularly

important because it can help to outline in a deeper

sense the linkages existing among the considered

companies. In fact, taking into consideration the

above mentioned example again, we can notice how

the supervisory boards of each company seat

members of the boards of the other two firms,

pointing out, therefore, the existence of a strong

interrelation and interdependency between the

corporate organs of these companies.

The total number of shareholdings, held by the 6

financial institutions in the 100 largest German

non-financial companies, more or less halved in 2005

when compared to the total numbers obtained from

2001 and 1998. This is mainly ascribable as an effect

of the tax reform, approved by the Schröder‘s

government in 2000 and it became effective in 2002,

lowering the fiscal burdens on the transfer of shares.

Such a reform, as already explained in note 12,

reducing taxation on capital gains, allowed the banks

to sell the shareholdings they held in their portfolio

that they considered no more to be core. Looking at

the column total numbers, it is worth noting that the

banks/insurances‘ shareholdings are mainly

concentrated in the top 10 firms and more in the first

50 companies than in the firms ranked between 51

and 100. Such an evidence shows that the interest of

the 6 leading German financial institutions is mainly

focused in the biggest German companies. An

explanation is needed as regards the positions

between 31 to 40, that shows quite a huge number of

banks/insurances‘ shareholdings. Within this ranking

there are historical German firms such as MAN,

Karstadt Quelle and Deutsche Lufthansa that in the

past joined higher positioning. The interest that the 6

financial institutions have in such firms is mainly

ascribable to historical reasons because they are firms

with more or less a century of history. Such an interest

will be better explained in the next pages when

talking about interlocking directorates.


65

Table 5. Number of shareholdings held by the 6 financial institutions in the 100 largest German non-financial

firms

Nr of shareholdings held by

Firms ranked between the

positions

1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005

0-10 6 8 4 1 0 1 1 1 1 3 1 1 1 1 1 13 11 7

11-20 2 2 2 2 2 4 2 4

21-30 1 1 1 1 0

31-40 2 4 1 1 2 1 1 2 1 1 1 1 7 8 3

41-50 1 2 1 1 1 1 3 4 0

51-60

61-70 1 1 1 1 1 1 1 1 1 3 3 3

71-80 3 2 2 1 1 2 3 7 1

81-90 1 1 1 1 1 1 2 2

91-100

Total 12 20 8 6 6 4 6 7 3 7 2 3 3 3 2 1 0 0 35 38 20

TotalAllianz Dresdner Bank Deutsche Bank Munchener Ruck CommerzbankBayerische Hypo-

und Vereinsbank

Source: Own calculations.

Taking into consideration the amount of equity

controlled by each one of the 6 financial institutions,

the control exerted by them, taken as a whole, is to be

emphasised. Under this point of view, it is worth

noting that the network of relationship rather than

single positions of one financial institution is to be

pointed out. The German bank-firm relationship is

based on a network of tightly joined financial

institutions, which together exert a considerable

influence on industrial companies. In fact, as table 6

shows, a single financial institution rarely is in the

position to exert a dominant role of control86

on a

86 Legal definition of control in Germany:

- As to Commercial Code (HGB), §290: Firms within a

group are controlled by a parent, if they are led by the

same parent company and the parent has a long term

stake in these firms (exceeding 20%). A parent always

controls a subsidiary, if it controls the majority of

votes, if it has the right to appoint the majority of

management or supervisory board members and

control votes, and if it exerts controlling influence via

contractual agreements or company statutes;

- As to Corporate code (AktG), §15, 16, 17, 18:

Affiliated firms are stand-alone entities: if a firm is

majority-controlled, if the parent owns a majority of

the capital or the majority of the votes; if a firm is

dependent on a parent, if the latter can directly or

indirectly exert controlling influence or has majority

control; if firms form a group (Konzern), if firms are

under a common leadership; if firms are mutually

involved in each other, if each owns at least 25% of

the capital or the votes of the other;

- Law for unlimited-liability firms (PublizitätsG), § 11:

Firms within a group are controlled by a parent if they

are led by the same parent company;

- Law for trading of securities (WpHG), § 22: Voting

rights are attributed to an entity, if (excerpt): they are

owned by a third party acting in the interest of the

entity or of a company controlled by the entity; they

are owned by a company controlled by the entity; they

company. As regards the panel of firms, only in two

cases in 1998 and in 2001, and in only one case in

2005, a single financial institution owns a stock

proportion higher than 20% and we haven‘t found

shareholdings over 30% (table 6). What we notice

instead, is that often a plurality of financial

institutions, each holding stock participations between

0 and 15%, exerts jointly a considerable role in the

governance of the controlled firms. In fact, in each of

the 3 years shown, more or less in 90% of the cases,

the stock owned by banks/insurances (on the total

amount of the shareholdings they have in the 100

largest German firms) is concentrated between 0 and

15%.

are owned by a third party but a contractual voting

agreement exists with the entity; the entity can

purchase them by exercising an option; they are

deposited and can be voted in the entity‘s interest

unless specific instructions are given;

- Law on takeovers and antitrust issues (GWB), §23:

Extends § 17 and 18 AktG to all firms and further

states that if several firms jointly control another

company, each of them is considered a controlling

firm;

- Banking code (KWG), § 1: Refer to § 290 HGB but

extends the definition to all legal forms; A major stake

exists, if a company owns directly or indirectly at least

10% of the capital or of the voting rights, or if it holds

any stake and can exert material control over

management. And § 10: A financial group exists, if a

bank owns at least 40% of a company that operates a

banking related business.


66

Table 6. Number of firms of which the financial institutions hold equity shareholdings, considered under the

point of view of the % of stock owned

nr of firms of which financial institutions hold equity shareholdings

Proportion of stock owned %

1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005

0-5 5 7 7 1 2 2 1 5 1 3 1 1 10 12 14

5-10 1 7 4 2 1 3 1 1 2 1 2 1 12 12 2

10-15 5 4 1 1 3 4 1 1 1 1 1 10 10 3

15-20 1 1 1 1 2 0

20-25 1 1 1 1 0

>25 1 1 1 1 1 1

Total 12 20 8 6 6 4 6 7 3 7 2 3 3 3 2 1 0 0 35 38 20

Allianz Dresdner Bank Deutsche Bank Munchener Ruck CommerzbankBayerische Hypo-

und VereinsbankTotal


Such data, will be deeply explained in the next

paragraph when considered in relationship to the data

related to the composition of supervisory boards.

4. Do cross-shareholdings reflect bank control on German companies? An analysis of the composition of the supervisory boards

As already said, the relationships among the German

financial and industrial sector create a close and

complex network of companies. The analysis of

equity shareholdings can explain the ties among the

companies, but is our opinion that does not provide a

complete and exhaustive picture of the network.

Around the patrimonial linkages develop wider

relationships, which often are personal, that are of

crucial importance to explain the behaviour, the

strategic choices, in other terms the governance of the

involved companies. The study of these personal

linkages can help to understand the behaviour and the

strategic choices of the involved firms (see Windolf

and Beyer 199587

).

In order to try to measure the extent of the

banks/insurances‘ role in Corporate Governance and

to evaluate in a deeper sense the effective influence

they have in corporate management, we integrated the

analysis of equity cross-shareholdings with a study of

the composition of the supervisory boards of the 100

largest German firms of the panel. In particular, we

collected for the years 1998-2005, from the lists of

mandates in the annual reports of the six financial

institutions considered, the number of mandates that

banks/insurances‘ representatives hold on the

supervisory boards of the industrial firms in the panel.

At the same time, we cross-checked the information

in the annual reports of the financial institutions with

the information provided by the 100 firms in their

reports.

87 Windolf and Beyer (1995) carried out an empirical

research on basis of a panel of 623 German firms. They

assert that in order to completely understand the linkages

among German firms, the analysis of equity shareholdings

should be integrated with the analysis of personal linkages.

Analysing the data collected, one can notice, by

looking at table 7, that the financial institutions

holding mandates on the supervisory boards of the

100 largest German non-financial companies can be

listed in order of importance in such a way:

For the year 1998: Dresdner Bank (31

mandates), Commerzbank (30 mandates), Münchener

Rück (24), Allianz (19), Deutsche Bank (12) and

Bayerische Hypo- und Vereinsbank (2);

For the year 2001: Allianz (45 mandates),

Commerzbank (41) and Dresdner Bank (37),

Deutsche Bank (31), Münchener Rück (29) and

Bayerische Hypo- und Vereinsbank (6);

For the year 2005: Allianz (38 mandates),

Commerzbank (33), Deutsche Bank (27), Münchener

Rück (17), Dresdner Bank (10) and Bayerische Hypo-

und Vereinsbank (5).

Observing this data, one can also notice that in 2005,

in comparison to 2001, there was a decrease in the

number of members appointed by the 6 financial

institutions, that is mainly ascribable to the retirement

of some important directors (each holding more than

2/3 mandates on the supervisory boards of German

firms) of the 4 banks and the 2 insurance companies

considered. Nevertheless, it is worth noting that the

presence of banks/insurances‘ members on the

supervisory boards of large German firms is a steady

phenomenon, but also a little bit increasing from 1998

to 2005.


67

Table 7. Mandates of the banks insurances in the 100 largest German firms

Nr of members appointed by the 6 financial institutions on the supervisory boards of the 100 firms

Firms ranked between

the positions

1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005 1998 2001 2005

0-10 12(P) 16(2P) 13(P) 14 13 5 8(3P) 16(4P) 11(3P) 11(P) 11 7(P) 4(P) 5(P) 4(2P) 2 2(P) 5

11-20 1(P) 3(P) 5(2P) 4(P) 2(P) 5(P) 5 1 4(2P) 2(P) 3(P) 3(P) 2

21-30 3 3(2P) 2 1(P) 2(2P) 2(2P) 1(P) 4 5 5

31-40 3(P) 9(P) 6(P) 6 7 1 3(2P) 4(P) 5(P) 4 6 3 7(P) 7(P) 7(2P) 2

41-50 1 4 2 3 3(P) 1(P) 1(P) 2(P) 3(P) 1 2 2 7(P) 9(2P) 5(2P) 1

51-60 1 1 1 1 1 2 2 1(P)

61-70 2(P) 3(2P) 3(2P) 1 1 1 2 2 1 1 3 4 3

71-80 3 2 2 3 1 1 1 1 2 1(P) 2(P)

81-90 2 1 2 2(P) 1 1 1(P) 1

91-100 2 3 2(P) 1 1 4 3

Total 19(4P) 45(6P) 38(8P) 31 37(5P) 10(2P) 12(6P) 31(7P) 27(5P) 24(3P) 29(4P) 17(3P) 30(5P) 41(6P) 33(7P) 2 6(2P) 5

of which members 19 45 38 31 37 10 12 31 27 24 29 17 30 41 33 2 6 5

of which Presidents 4 6 8 5 2 6 7 5 3 4 3 5 6 7 2

Allianz Dresdner Bank Deutsche Bank Munchener Ruck CommerzbankBayerische Hypo-

und Vereinsbank


Moreover, the figures in table 8 show that the

mandates held by banks/insurances‘ members are

mainly concentrated in the first 50 largest German

companies and mainly in the top 10. Such evidence

confirms the hypothesis nr. 2 by which we assert that

most of the personal linkages through bankers were

among the first 10/50 German companies.

To be more precise:

In 1998, nearly 85% of mandates held by

banks/insurances‘ members are seated on the

supervisory boards of the first 50 largest German

companies; specifically 43% of such members are

seated on the Aufsichtsräte of the top 10 German

largest firms;




companies; specifically 33% of such members are

seated on the Aufsichtsräte of the top 10 German

largest firms;




companies; specifically more or less 35% of such

members are seated on the Aufsichtsräte of the top 10

German largest firms.

Moreover, the presidents of the firms‘

supervisory boards appointed by banks/insurances are

mainly concentrated in the top 10 German largest

companies.

Table 8. Mandates of bankers in the 100 largest German firms (% for 1998, 2001 and 2005)

Firms ranked between the

positions

Membersof which

PresidentsMembers

of which

PresidentsMembers

of which

Presidents

0-10 43.2% 33.3% 33.3% 26.7% 34.6% 28.0%

11-20 4.2% 11.1% 10.1% 20.0% 12.3% 16.0%

21-30 6.8% 11.1% 5.8% 10.0% 6.9% 12.0%

31-40 19.5% 22.2% 18.5% 10.0% 16.9% 16.0%

41-50 11.0% 11.1% 11.1% 13.3% 10.0% 16.0%

51-60 2.5% 0.0% 2.6% 3.3% 1.5% 0.0%

61-70 5.9% 5.6% 5.8% 6.7% 6.9% 8.0%

71-80 2.5% 0.0% 4.8% 3.3% 5.4% 4.0%

81-90 3.4% 5.6% 2.6% 3.3% 0.8% 0.0%

91-100 0.8% 0.0% 4.8% 3.3% 4.6% 0.0%

Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Total nr of banks/insurances' members

1998 2001 2005


Such an evidence needs to be better explained.

Looking at figure 2, showing the equity and

personal linkages among the 6 financial institutions

and the 10 largest German companies in 2005, one

can immediately notice that the huge presence of

banks/insurances‘ members seated on the firms‘

supervisory boards is not supported by a

corresponding huge amount of capital controlled by

the same financial institutions.


68

Figure 2. Network of cross shareholdings and mandates among the top 10 German firms (2005)

DEUTSCHE BANK

MÜNCHENER RÜCKBAYERISCHE

HYPO- UND VEREINSBANK

COMMERZ-BANK

ALLIANZ

DRESDNERBANK

Siemens AG

DaimlerChrysler AG

Volkswagen AG

BMW AG

E.ON. AG Thyssen-Krupp AG

Deutsche Telekom AG

DeutschePost AG

Metro AGBASF AG

UNICREDITGROUP

4,9%93,81%

100%

4,99%

<5%

9,8%

3,2%

4,82%

10,4%

2,5%

1,2%

3,2%

2,6%

4,1%

0,4%

Source: own calculations.

Once we settle this, we try to demonstrate, for

the panel of German companies investigated, that

bank-firm relationship relies not only on patrimonial

linkages but also on personal relationships. Therefore

is understood, that we consider the presence of own

representatives in the supervisory boards of other

companies as signal of the opportunity to exert power

and influence. As the supervisory board‘s members

are, except the seats reserved to the worker‘s

representative88

(normally the half of the whole

board), nominated at the annual general meeting of

shareholders, we expect, theoretically a certain

correspondence between the representatives of

shareholders in the Aufsichtsrat and the stock hold by

the same shareholders (Gorton and Schmid 1996,

Böhm 1992, Edwards and Fischer 1994, Seger 1997).

In other words, if a company holds a stock proportion

of 10% of another company, we theoretically expect

to find in the supervisory board (composed of e.g. 20

members) of the second one, one member of the

above mention shareholder‘s company (corresponding

to the 10% of the member of the board which are

representative of the shareholders)89

.

Specifically, what we are going to test is the

88 The total number of the member of supervisory board

varies from a minimum of 3 to a maximum of 21,

depending on the extent of share capital. Various laws

determine the proportion of employee representation on the

supervisory board, and distinguish three regimes of

co-determination (see note 6). 89 Shareholders can appoint the half of the supervisory

board as the other half is by law reserved to worker‘s

representatives (e.g. in a board of 21 members they appoint

10 members).

research hypothesis nr.1 we set, under which we

assert that bank-firm relationship relies not only on

patrimonial linkages, but also on personal

relationships. In other words, we implicitly are going

to test that shareholdings cannot, at least completely,

explain the considerable number of seats hold by

financial institutions in the supervisory boards of

firms. In order to do that, we carry out the following

study on the data collected.

For each year (1998, 2001 and 2005), we

express the relation between y and x with the

following equation:

yi = α + βxi

with:

yi : being the % of mandates of shareholder

financial institutions on the total number of member

of the Aufsichtsrat which are representatives of

shareholders, for firm i(i=1…31)

xi : being the proportion of stock owned by

financial institutions for firm i(i=1…31)

Therefore if we theoretically expect a certain

correspondence between the representatives of

shareholders in the Aufsichtsrat and the stock hold by

the same shareholders, the situation should be

represented by the following graph and the indicated

equation:


69

y = x

R2

= 1

0

20

40

60

80

100

0 20 40 60 80 100

Proportion of stock owned by financial institutions (%)

shareholdings and mandates

Lineare (shareholdings and mandates)

Man

da

tes

of

sha

reh

old

ers

fin

an

cia

l in

stit

uti

on

s

as

% o

f th

e t

ota

l m

emb

ers

of

the

Au

fsic

hts

ra

t

wh

ich

are

rep

rese

nta

tiv

es o

f sh

are

ho

lder

s

where: α = 0

β = 1

Therefore to check the research hypothesis by which

the bank-firm relationship relies, for the panel of

German companies investigated, not only on

patrimonial linkages we have to test that:

α ≠ 0 or

β ≠ 1

What we obtain analysing the data collected for the

panel of firms investigated, is:

For the year 1998:

for the year 2001:

and for the year 2005:


70

For the 3 considered years, α ≠ 0 and β ≠ 1;

moreover R2

is closer to 0 than 1 showing how the

points (expression of a couple of observations:

shareholdings and mandates) are not flatten on the

straight line interpolating our observations; this means

that y do not follows the x when it varies. In other

words the proportion of stock owned by financial

institutions can explain only partially the percentage

of mandates of shareholders financial institutions on

the total number of members of the Aufsichtsrat

which are representatives of shareholders.

Moreover, what comes out from our research is

that, if shareholdings of financial institutions could

only partially explain the seats that shareholders

financial institutions hold in the supervisory board,

how could they explain the mandates that

non-shareholder financial institutions hold in the

supervisory boards of the firms investigated.

In fact, in the analysed panel we find:

- companies which, although are only

marginally participated by financial institutions, show

in their supervisory boards, a considerable presence of

banks‘ representatives;

- companies in whose supervisory boards seat

members of non-shareholders financial institutions;

- companies in whose supervisory boards seat

more members of non-shareholders financial

institutions than members of shareholders financial

institutions.

Some examples can help to clarify what above

outlined.

In 2001, on the supervisory board of BASF,

there were two members appointed by Allianz, which

held the 10.9% of the share capital, and two members,

one of which was also chairman, of Deutsche Bank,

which was not a BASF shareholder. In 2002, although

the Allianz shareholding came down to 6.1%, its two

members have been confirmed; Deutsche Bank‘s

representatives came down to one, the chairman

became a member expressed by Commerzbank, which

held no direct stocks participation in BASF. Moreover

there was another member appointed by Bayerische

Hypo-und Vereinsbank, which had no patrimonial

linkages with the company in question. Therefore as

regards 2002, we noticed that non-shareholdings‘

financial institutions, control 19.5% of BASF‘s

supervisory board, to which another 9.5% controlled

by Allianz is to be added. As a consequence the main

financial institutions, with a stock participation of

6.5% (which theoretically do not give the right to

appoint any member), consisted of five (including

also the chairman) out of the ten members

representatives of the shareholders.

In 2001, Bayer had Allianz among its

shareholders, which held a stock participation of 5.8%.

In its Aufsichtsrat, as regards 2001, there wasn‘t any

member of Allianz, while there were four (including

the chairman) which were representing other

non-shareholders‘ financial institutions

(Commerzbank, Deutsche Bank, Münchener Rück).

Nevertheless these financial institutions were equity

linked90

with Allianz directly (Deutsche Bank and

Münchener Rück) and indirectly (Commerzbank had

among its shareholders Münchener Rück, which was

directly linked with Allianz by a considerable

cross-shareholding).

BMW‘s share capital, in 2001, was participated

by Allianz (6.5%) and by Dresdner Bank (5%): the

percentage of members of these two institutions

among the shareholders‘ representatives of

Aufsichtsrat, was 10%, lined up with the proportion

of stock owned. What it has to be noticed is that the

percentage of mandates representatives of

non-shareholders‘ financial institutions was higher

(19.5%) than the percentage of members of

shareholders financial institutions. In 2002, Dresdner

Bank sold the stock participation owned and Allianz

shareholding decreased to 5.2%. As in 2002, Allianz

had totally acquired Dresdner Bank, we considered

90 Analysing the data collected from the annual reports

2001 of the financial institutions considered came out that:

Allianz owned a direct shareholding of 4.5% in Deutsche

Bank, a 78.5% in Dresdner Bank, a 25% in Münchener

Rück. On the other hand, Allianz had among its

shareholders: Deutsche Bank (7.4%), Dresdner Bank (9.2%)

and Münchener Rück (25%). Moreover it was indirectly

linked with Commerzbank through the shareholding of

10.4% that Münchener Rück held in this bank.


71

the Dresdner‘s representatives as members appointed

by Allianz. For 2002, the position of the members of

Allianz on the supervisory board was unchanged. At

the same time, the position of non-shareholders‘

financial institutions appeared to be reinforced

(raising up to 23.5%). Analysing the situation from

the point of view of the shareholdings, the control

exertable by financial institutions appears as not

particularly remarkable (11.5% in 2001 and 5.2% in

2002); while taking into consideration the control they

are able to exert on corporate governance through the

control of the supervisory board, their position

appears to be noticeable (28.5% in 2001 and 35% in

2002).

Moreover, what is to be pointed out from the

three examples above described, is that the chairmen

of the Aufsichtsrat have been appointed by the

financial institutions, which are not shareholders of

the three companies.

These three examples are emblematic of the

widespread phenomenon in the German system by

which the main financial institutions are able to exert

influence and control on the main German industrial

firms. In fact, analysing91

the aggregated data of the

panel under evaluation, we notice that:

- as regards 1998, the six financial institutions,

holding directly on average the 2.7% of the share

capital (altogether considered) of the industrial

companies of the panel, appointed the 3.3% of the

part of the Aufsichtsrat reserved to the shareholders‘

representatives. To this percentage we can add another

6.5% of members that represent non-shareholders‘

financial institutions. Summarizing, the main financial

institutions owing on average a 2.7% stock proportion

of the industrial firms considered, express the 9.8% of

the seats reserved to the shareholders‘ representatives

on the supervisory boards (in other words nearly the

20% of the total number of members of the

Aufsichtsrat). Therefore, they are able to exert a

considerable influence and control on the boards of

these firms.

- as regards 2001, the six financial institutions,

holding directly on average the 3.2% of the share

capital (altogether considered) of the industrial

companies of the panel, appointed the 5.1% of the

part of the Aufsichtsrat reserved to the shareholders‘

representatives. To this percentage we can add another

10% of members that are representatives of

91 To analyse aggregated data of the panel, we calculate the

percentage of share capital owned by financial institutions

as a mean of all shareholdings they owned in the firms of

the panel. The percentage referred to the proportion of seats

of representatives of the financial institutions on supervisory

boards has been calculated as a mean of the number of seats

they hold (taking into consideration the double vote that the

chairman can exert, as though there was an additional

member on the board) on the total amount of member

representatives of shareholders of different boards.

non-shareholders‘ financial institutions. To summarize,

the main financial institutions owing on average a

3.2% stock proportion of the industrial firms

considered, express the 15.1% of the seats reserved to

the shareholders‘ representatives on the supervisory

boards (in other words nearly the 30% of the total

number of members of the Aufsichtsrat). Therefore

they are able to exert a considerable influence and

control on the boards of these firms.

- repeating the same calculations for 2005, we

noticed that: the six financial institutions, holding

altogether the 1.1% of the share capital of all

industrial firms, express the 12.4% of the members on

the supervisory board which are shareholders‘

representatives (of which 2.6% are representatives of

shareholders‘ financial institutions and 9.8% of

non-shareholder financial institutions). In other words

they can express nearly the 25% of the total members

of the Aufischtsrat92

.

To summarize, for the 3 considered years, the

proportion of voting rights, which the six financial

institutions can exert in the supervisory boards of the

industrial firms considered, is clearly higher (with a

multiplier set between 4 and 5)93

than the proportion

of stocks they directly own. Therefore, also

considering the results of the statistic test above

carried out, does not seem to be the shareholdings to

determine the proportion of voting rights that the

financial institutions are able to express in the

supervisory boards of the industrial firms considered.

The evidence resulting from the test and from

these last calculations showing a weak

correspondence between shareholdings and mandates,

require an explanation. In particular, we try to verify

if these results are to be attributed to proxy voting‘s

phenomenon, that we could not analyse, or to other

factors, that are peculiar of the German institutional

model (see note 22).

The fact that financial institutions can express a

higher proportion of members in the supervisory

boards than the one they are expected to control

according to their shareholdings, can be justify by the

exercise of proxy voting. As already said our study

could not quantify this aspect because banks are not

obliged to disclose the votes casted on behalf of their

92 Our results are lined up to what was obtained by

Charkham (1995) and Andreani (2003), who assert that

analysis carried out on different samples and in different

years show as a result that banks‘ representatives seated on

the supervisory boards of industrial firms are about 20% of

all seats of the Aufsichtsrat. 93 This multiplier has been calculated as a ratio between the

proportion of stock owned by the financial institutions and

the proportion of voting rights they can express (through

their representatives) on the part of the Aufsichtsrat which is

expression of shareholders‘ representatives (instead,

considering the last proportion on the total number of the

members of the supervisory board, the same multiplier will

be set from 4 and 5).


72

clients94

.

Nevertheless we assert that this aspect, by its

own, cannot explain the founded out misalignments.

This on basis of two considerations:

- On the one hand, a study carried out by

Edwards and Nibler (2000) of the University of

Cambridge, on the German model of corporate

governance and specifically on the aspect of

ownership concentration, provides empirical evidence

of the poor relevance of the phenomenon of proxy

voting. Their research takes into consideration 156

companies among the main German industrial firms

for turnover of 1992, aiming at finding any

correspondence between proxy voting and the

considerable presence of banks‘ representatives on the

supervisory boards of German firms. The regression

analysis they carried out explains this relation only

partially: they conclude that noticeable presence of

banks representatives cannot be interpreted

exclusively as a reflection of the control that financial

institutions exert on voting rights at annual general

meetings. Moreover, as other authors point out

(Westermann 1996), the practice of delegating voting

rights to banks without specific instructions is bound

to reappraise (Martin 2004), also considering the

recent law disposals (KonTraG and AktG reform). As

a consequence, as regards the years 1998-2005,

Depotstimmrechte should be of less importance in

comparison to what can be noticed in a study carried

out at the beginning of the nineties.

- On the other hand, the weak correspondence

we noticed between mandates and shareholdings

regards not only banks but also insurance companies.

For example, considering the composition of the

supervisory boards of Metro, Thyssen-Krupp and

Volkswagen, we noticed how in their boards seat

representatives of Allianz and Münchener Rück,

which do not hold any stock proportion in these firms.

As Allianz and Münchener Rück are insurance

companies, the presence of their representatives on

these supervisory boards cannot be explained by

proxy votes, because only banks can be delegated by

their client to exert these rights on their behalf.

Taking into consideration what has been said

above, we assert that the explanation of the

considerable presence of representatives of financial

institutions on the supervisory boards of other

companies is not to be found in proxy voting, but

elsewhere.

In our opinion, the strong and stable ties, both

patrimonial and personal, which traditionally

characterize the relationships among the six main

German financial institutions, have a dominant role in

94 Banks do not have to report their delegated voting rights

as, according to § 135 V and § 128 II, the banks have to

consult shareholders when casting votes on their behalf and

have to follow their instructions. Therefore, theoretically,

banks cannot exert them on discretionary basis.

explaining the composition of the supervisory boards

of industrial firms. This network of relationships

among financial institutions is reflected on the

industrial sector, showing the considerable influence

the financial sector is able to exert on the latter. These

assertions need to be clarified.

On the one hand, it‘s necessary to specify that,

when we talk about linkages, we do not refer

exclusively to the equity ones, and in particular to the

cross-shareholdings which traditionally and still

characterize the German system. Obviously the

cross-shareholdings help to explain the phenomenon

described (considerable presence of banks‘

representatives on the supervisory boards of other

companies), but under this point of view we noticed

how the presence of representatives of

non-shareholders‘ companies could be explained by

other equity linkages they have with other

shareholders of the company in question.

Moreover, we have to point out the considerable

role that personal relationships have among members

of the supervisory board of these institutions. The

habit of sharing the seats on the boards of other

companies with representatives of other financial

institutions, and of keeping at the top organs of the

company members, who have participated in the

company management for a long time95

(Hopt and

Prigge 1998), has led to the establishment of

significant personal relationships among managers

which are part of a close network (Pfannschmidt 1993,

Leimkühuler 1996). These linkages persist with time,

independently of the existence of a cross-shareholding.

For example, companies such as Volkswagen,

Daimler Chrysler and Thyssenkrupp, maintain the

composition of their supervisory board unaltered,

having banks‘ representatives seated on them, also

after the shareholders‘ financial institutions have sold

their equity participations.

On the other hand, to emphasise the control

exerted by the main financial institutions, taken as a

whole; the network of relationships rather than single

positions of one financial institution is to be pointed

out. The German bank-firm relationship is based on a

network of tightly joined financial institutions, which

together exert a considerable influence on industrial

companies. In fact, as table 6 shows, a single financial

institution rarely is in the position to exert a dominant

role of control on a company.

The fact that this potential exertable influence

will become effective depends on the eventuality that

these financial institutes express a common position.

In our opinion the presence on the supervisory boards

95 This fact is confirmed also in a study carried out by

Korn-Ferry International (1996), which states that, in almost

43% of the companies, at least one member of the board of

management (normally the managing director), after retiring

from the role filled on that board, became a member (often

the chairman) of the supervisory board.


73

of most of the analysed firms of representatives of

these non-shareholders‘ institutions, which are

indirectly linked to shareholders‘ institutions, seems

to be a sign that this common position has been found

in reality.

The fact that the main financial institutions

express a common position of considerable

importance does not mean that they necessarily exert

control on industrial firms. What we would like to

point out is that the German banking system,

according to the German culture marked by

co-decision and consensus-research (Albert 1991,

Onetti 2001), represents, as a whole, an important

interlocutor for German firms. Nevertheless German

companies, also taking into consideration the

positions expressed by these stakeholders, make their

strategic and management decisions essentially in

autonomy.

5. Conclusion

One of the main traditional features that the

researchers generally attribute to the German national

capitalism model is the system of relationships

between financial institutions and between these and

the main industrial companies.

This system has supported and led the German

industrialization, contributing to create and maintain a

stable industrial basis (Velo 1996). The system of

cross-shareholdings, guaranteed to firms stable

ownership and continuity in corporate management.

At the same time, it allowed financial institutions to

gain a substantial control‘s power on industrial

companies and led to the creation of a network of

personal relationships, not always clear, among a

restricted number of managers of different companies.

Moreover cross-holdings served as restraints of

competition in the market for corporate control.

The recent changes, we noticed occurred in the

German model, indicate a certain trend towards a

market-oriented system.

In particular, some important functions of banks

in the corporate governance of firms are changing.

The main traditional mean of control they have on

industrial system (through shareholdings) is loosing

its importance. German banks, in order to face global

competition in a financial market becoming more and

more wide, integrated and competitive, are selling

their shareholdings in the industry. Nevertheless, the

process of reduction of their equity portfolio does not

seem to be stood by a reappraisal of the control they

are able to exert through their representatives in the

supervisory board of the German industrial companies

analysed, which is in our opinion still relevant.

The study carried out prove that bank-firm

relationship do not only rely, for the panel of firms

investigated, on patrimonial linkages. In other words

the proportion of stock owned by financial institutions

(2.7% in 1998 and 1.1% in 2005) can explain only

partially the considerable and slightly increasing

percentage of bankers seated on the supervisory

boards of the firms in the panel (20% in 1998 and

25% in 2005). Moreover, it has been shown that

bankers are mostly represented on the supervisory

boards of the top 10 German firms, showing the

important role that banks and insurance companies

maintains in the corporate governance of such firms.

Limits of our empirical research are various. To

mention someone:

- The fact that we could not take into

consideration the proxy votes, as already said, which

could help to explain the non correspondence between

the proportions of stocks owned by financial

institutions and the percentage of members they can

appoint on the supervisory boards of the firms

analysed;

- The sample analysed refers to big German

companies, the Mittelstand has not been taken into

consideration in the present study, but conscious of

the importance to add such a comparison to the

analysed data to provide a much more complete

picture of German corporate governance, we can say

that this will be one of our future research interests.

Concluding, is our opinion that the explanation of the

considerable presence of banks representatives in the

supervisory boards of other companies, is to be found

in the personal linkages that are the peculiar feature of

the German bank-industry relationship. This type of

relationship, despite many regulatory and structural

changes occurred in the German model, won‘t change,

at least in the short time, because it is expression of

the culture of co-decision and co-responsibility deeply

rooted in the German insitutional system of

governance (Shonfield 1965, Albert 1991, de Jong

1997, Warglien 1997, Hacketal et al. 2003).

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78

THE IMPACT OF PROBLEM LOAN, OWNERSHIP STRUCTURE, AND MARKET STRUCTURE UPON THE BANK PERFORMANCE

Andy Chein*

Abstract

Some research on the causes of bank failure finds that failing institutions had large proportions of problem loans prior to failure, and that the extra costs of administering these loans reduced the bank performance. At this moment, if bank management goes after maximizing one’s utility, not the bank performance, in addition confronting from rising competitive environment, it would be quite dangerous. So, this article studies the impact of problem loan, ownership structure, and market structure upon the bank performance with the basis of cost efficiency. Empirical results show that problem loan, ownership structure, and market structure have a significant effect upon the bank performance.

Keywords: problem loan, ownership structure, market structure National Kaohsiung First University of Science and Technology, Kaohsiung, Taiwan Email: [email protected]

Tel: 886-7-6011000#3111; Fax: 886-7-6011039

1.Introduction

For the dramatic changes of financial environment,

rising competition in the banking services has been

spurred on by deregulation. After the government

agency opening new bank chartering in 1991, the

intensity of competition has grown to make banks

face a far heavier burden. Hence, how to improve

ones‘ operating efficiency to confront big challenge in

the future should be the most important and urgent

mission for the banks. But, the relevant literatures

often put the direction of main research in the

measurement of the bank performance, but

infrequently focus upon the factor influencing

performance. So, this paper tries to fill up the above

deficiency through the determinants of banks

performance.

The quality of making loans in recent years was

confronting some deterioration, and the adverse

situation may make the bank management expend

more cost to deal with. Hence, how the problem loan

affect bank performance will be an important issue to

explore. Because the studies about the ownership

structure influencing bank performance are diverse, so

this paper attempts to comprehend the possibility that

the CEO can reconcile the benefit between principal

and agent. The traditional literature point out the bank

with high market concentration, its profit could be

relatively high. But, some articles cast doubt on this

argument and develop a contrary opinion. When the

trend of consolidation is growing, this study seeks to

find out the impact that the banks may suffer due to

the rising market concentration.

This article modifies the stochastic frontier

production model of Schmidt and Sickles (1984) and

Cornwell et al. (1990), and transforms it into a

stochastic frontier dual cost model. Thus, the model is

mainly expressed as the function of problem loan,

ownership structure, and market structure.

2.Literature

Quite a lot of studies probe into the performance of

the bank. Farrell (1957) pioneers the frontier concept

into the production function. Farrell defines the

efficient production function (or frontier) and

recognizes the output that a perfectly efficient firm

could obtain from any given combination of inputs.

That means if a perfectly efficient firm uses the same

input proportion, it can achieve the maximum output

in its production frontier and takes the value of 100

per cent. But, the efficiency will become indefinitely

small if the amounts of input per unit output become

indefinitely large. Forsund et al. (1980) divide the

frontier studies into the four empirical models:

deterministic nonparametric frontier approach,

deterministic parametric frontier approach,

deterministic statistical frontier approach, and

stochastic frontier approach.

The representative method of deterministic

nonparametric frontier approach is data envelopment

analysis (DEA). The merit of DEA is no need to

specify the form of the production function. However,

a crucial weakness of DEA is that it neglects the

influence of random error. The deterministic

parametric frontier approach estimates the parameters


79

through the specification of the production function,

but it does not make special statistical assumption to

the random error. The deterministic statistical frontier

approach makes assumption to the random error in

order to get a statistical property of estimates, but may

result in some bias if the assumption is wrong. The

stochastic frontier approach specifies a functional

form but with an error term including random error

and inefficiency.

Schmidt and Sickles (1984) use fixed effect and

random effect model to estimate a stochastic frontier

production function with panel data in an attempt to

solve three serious difficulties that stochastic frontier

approach may suffer. Cornwell et al. (1990) revise

slightly to the above way. And, their approach can

estimate time-varying efficiency levels for individual

firms without invoking strong distributional

assumptions for technical inefficiency or random

noise. Because the stochastic frontier approaches of

Schmidt and Sickles (1984) and Cornwell et al.

(1990) are better than the other efficiency

measurement ways, this paper uses them as the basis

of the empirical model. Considering the multi-product

characteristics of banks, so the paper modifies the

stochastic frontier production function with panel data

to the stochastic frontier dual cost function with panel

data. The dual cost function adopts a transcendental

logarithmic (translog) model to allow the substitution

elasticity of input factor being flexible.

Mester (1993) applies the logit regression

method to investigate efficiency in mutual stock and

stock S&Ls using 1991 data on U.S. S&Ls. But, the

result shows that the problem loans do not have

significant influence on the cost efficiency. Berger

and DeYoung (1997) employ Granger-causality

techniques to test hypotheses regarding the

relationships among loan quality, cost efficiency, and

bank capital. The data suggest that problem loans

precede reductions in measured cost efficiency.

Besides, a number of researchers find that failing

banks tend to have large proportions of problem loans.

So this study tries to examine the relationship

between problem loans and bank performance.

Pi and Timme (1993) utilize the ordinary least

squares to find an inconsistent relationship between

cost efficiency and CEO ownership for the bank

holding companies from 1987-1990. Berger and

Hannan (1998) utilize ordinary least squares and two

stage least squares methods to probe into the impact

of board ownership on cost efficiency for the bank

holding companies from 1980-1989. But, there is no

obvious relation to exist between both of board

ownership and cost efficiency. Because the result of

academic topic on the ownership structure and bank

cost efficiency is diverse, so this paper tries to explore

linearity and nonlinearity among the ownership

structure and cost efficiency. Besides, this study takes

CEO ownership, board of directors ownership, and

major shareholders equity as the proxy variables of

ownership structure.

According to the analysis of the traditional

structure-conduct-performance(SCP) such as

Heggestad (1977), Short (1979) and Hannan (1991),

the banks with higher market concentration obtain

more profit. Berger and Humphrey (1997) give

explanation that it may be due to market-power

explanations in which banks in concentrated markets

exercise market power in pricing and earn

supernormal profits. However, Berger and Hannan

(1998) find the banks with higher market

concentration, their cost efficiency is lower instead.

This phenomenon can be explained by the quote from

Hicks (1935): the best of all monopoly profits is a

quiet life. It means that the banks with higher market

concentration may prefer to pursue a ―quiet life‖ than

to maximize operating efficiency within a less

competitive pressure. So, this paper seeks to study the

relationship between the market structure and cost

efficiency of banks. In addition, this article takes

market concentration and market share, as the proxy

variables of market structure.

3.Methodology 3.1.Hypothesis

Hypothesis 1: The problem loan has a negative

relationship with bank performance.

According to Berger and DeYoung (1997), after

the loans becoming past due or nonaccruing, the bank

begins to expend extra costs to deal these problem

loans. Under this circumstance, one can expect

increases in nonperforming loans to cause decreases

in measured cost efficiency.

Hypothesis 2-1: The CEO ownership structure has a

nonlinear relationship with banks performance.

Hypothesis 2-2: The board of directors ownership

structure has a nonlinear relationship with banks

performance.

The convergence-of-interests hypothesis

suggests a uniformly positive relationship between

management ownership and firm value, but the

entrenchment hypothesis suggests that market

valuation can be adversely affected for some range of

high ownership stakes. Thus, Stulz (1988) predict a

nonlinear relationship between management

ownership and market valuation of the firm‘s assets.

And, Morck et al. (1988) support the above

prediction.

Hypothesis 2-3: The major shareholders equity has a

positive relationship with banks performance.

According to the viewpoint of Berle and Mean

(1932) and Jensen and Meckling (1976), there may

exist a positive relationship between main

shareholders ownership concentration and cost

efficiency. Since the agency cost will decline as major

shareholders equity increases.


80

Hypothesis 3: The market structure has a negative

relationship with banks performance.

Berger and Hannan (1998) apply the easy life

theory to explain the cost efficiency for banks with

relatively monopolized market structure will be lower.

As the management prefers to enjoy an easy life due

to lower competitive pressure, as well not making

efforts to go after the maximization of cost efficiency.

3.2.Variables and sources In total cost, mainly includes labor cost, fund cost and

capital equipment cost.

In price of input, mainly includes price of labor,

price of fund, and price of capital equipment.

In output, as considering the bank can offer

multi-product, mainly includes short-term net

investments and net amounts of loans and

discounting.

In problem loan, the proxy variable is

nonperforming loan divided by the total loans.

The CEO ownership is measured by the

shareholding ratio of general manager.

The board of directors ownership is measured by

the shareholding ratio of board of directors.

The major shareholders equity is measured by

the shareholding ratio of top 4 shareholders.

The proxy variable of market structure is

Herfindahl index of market concentration to measure.

The other variables include market share, size,

and age, which are measured by market share of sales,

total asset, and time period to establish, respectively.

The sources are mainly from TEJ database.

3.3.Specification of empirical model The stochastic frontier dual cost function is specified

as follows:

it

2

tt

m

it

l

it

2

1l

2

1mlm

j

it

3

1jjt

l

it

j

it

3

1j

2

1ljl

k

it

j

it

3

1j

3

1kjkt

l

it

2

1ll

j

it

3

1jjiit

νtβ2

1

YlnYlnβ2

1twlnβYlnwlnβ

wlnwlnβ2

1tβYlnβwlnβαCln

(1)

where C is total cost, jw and kw is price of input

factor, j(k)=1, 2, 3, represents labor, fund, and capital

equipment, lY ( mY ) is output level, l(m)=1, 2,

represents short-term net investments and net amounts

of loans and discounting, i represents bank i, t

represent period t.

Let 2

ittiit t2

1tu

, then the cost

efficiency of bank i will equal to exp(min( itu

)- itu

).

The next step is to express cost efficiency as the

function of problem loan, ownership structure, market

structure and other relevant factors.

3.4.Econometric method This study combines cross section and time series

data to run the pooled regression. Before estimating,

one should determine the type of intercept: the

ordinary least squares method assumes that intercept

is the same within all samples; the fixed effect model

assumes that there are different intercepts in the cross

section sample; the random effect model assumes that

intercept is a random variable. Whether the fixed

effect model superior to the ordinary least squares,

one can use F statistic to test. Whether the random

effect model superior to the ordinary least squares,

one can use LM statistic to test. Whether the random

effect model superior to the fixed effect model, one

can use Hausman statistic to test.

3.5.Samples The samples include 34 banks listed on the TWSE

(Taiwan Stock Exchange) and OTC

(Over-the-Counter), where there are 18 older bank

and 16 newer banks. The former established before

1991, and the latter established after 1991.

4. Empirical results

The tests of bank performance pooling regression are

shown in table 1. The results demonstrate the fixed

effect model is superior to the ordinary least squares,

the random effect model is superior to the ordinary

least squares method, and the fixed effect model is

superior to the random effect model again.

Table 1. The tests of bank performance pooling regression

Model Ｈ0: OLS

Ｈ1: Fixed Effect Model

Ｈ0: OLS

Ｈ1: Random Effect Model



Statistics F-value= 9.9144 LM = 258.7363 χ2 = 127.9726

（p=0.0000）（p=0.0000） (p=0.0000)

Results Reject Ｈ0 RejectＨ0 Reject Ｈ0

Subsequently, table2 measures bank performance by the fixed effect model. From table 2, one can see


81

the cost efficiency of bank at any time during the

entire sample period. In the meantime, the trend of

bank performance is decline.96

If one distinguishes

the whole banks into older banks and newer banks,

their average cost efficiency would be 30.74% and

42.32%. The average cost efficiency of older banks is

significantly less than the average cost efficiency of

newer banks.97

The reason may be that older banks

most are public banks, which less concerned about the

efficiency. In contrast, all newer banks are private

banks, which pay more attention to the efficiency.

The tests of bank performance determinants

pooling regression are shown in table 3. The results

illustrate the fixed effect model is superior to the

ordinary least squares, the random effect model is

superior to the ordinary least squares method, and the

fixed effect model is superior to the random effect

model.

So, table 4 is the pooling regression for bank

performance determinants by fixed effect model.

The empirical results show that the problem loan

is negatively related with the cost efficiency of bank.

The CEO ownership is negatively related with the

cost efficiency of bank, and CEO ownership‘s square

is positively related with the cost efficiency of bank,

implying a non-linear relationship between CEO

ownership and cost efficiency of bank. The board of

directors ownership is positively related with the cost

efficiency of bank, and board of directors ownership‘s

square is negatively related with the cost efficiency of

bank, implying a non-linear relationship between

board of directors ownership and cost efficiency of

bank. The major shareholders equity has no effect on

cost efficiency of bank. The market concentration is

positively related with the cost efficiency of bank. But,

the market share and size have no effect on cost

efficiency of bank. The age is negatively related with

the cost efficiency of bank.

5.Conclusions

Generally, most study for banks focus on the issue

concerning the measurement of bank performance,

seldom examines the topic about the factors

influencing the bank performance. So this paper

investigates the problem loan, ownership, and market

structure how to influence the bank performance from

the view of the determinants of bank performance.

Because the problem loan is negatively related with

the bank performance, how to lower credit risk and to

enhance management quality will be an urgent

response mechanism for the bank management. Since

there is a non-linear U-shaped relationship between

CEO ownership and cost efficiency of bank, thus the

96 The average cost efficiency from 1995 to 1999 is 75.22%,

52.86%, 31.13%, 15.37%, and 6.36%, respectively. 97 The test statistic of two sample t test for equal means is

-2.81, its p value is 0.0057.

lower or higher CEO ownership seems to help

improving the bank performance. While there is a

non-linear inverse relationship between board of

directors ownership and cost efficiency of bank, thus

the moderate board of directors ownership appears to

facilitate the bank performance in progress. As the

market concentration is positively related with the

cost efficiency of bank, meaning that higher market

concentration helps to get the bank performance well,

excluding the preference for easy life owing to the

monopolistic market structure.

Table 2. The cost efficiency of bank- fixed effect

model

Bank 1995 1996 1997 1998 1999

Bank1 42.24% 29.68% 17.48% 8.63% 3.57%

Bank2 40.35% 28.35% 16.70% 8.25% 3.41%

Bank3 40.56% 28.50% 16.79% 8.29% 3.43%

Bank4 59.37% 41.72% 24.57% 12.13% 5.02%

Bank5 65.48% 46.01% 27.10% 13.38% 5.54%

Bank6 70.61% 49.61% 29.22% 14.43% 5.97%

Bank7 73.84% 51.89% 30.56% 15.09% 6.24%

Bank8 68.56% 48.17% 28.37% 14.01% 5.80%

Bank9 78.85% 55.41% 32.63% 16.11% 6.67%

Bank10 68.25% 47.95% 28.24% 13.95% 5.77%

Bank11 57.36% 40.30% 23.74% 11.72% 4.85%

Bank12 64.13% 45.06% 26.54% 13.10% 5.42%

Bank13 100.00% 70.27% 41.39% 20.43% 8.46%

Bank14 58.51% 41.11% 24.21% 11.96% 4.95%

Bank15 92.48% 64.99% 38.28% 18.90% 7.82%

Bank16 92.33% 64.88% 38.21% 18.87% 7.81%

Bank17 56.21% 39.49% 23.26% 11.48% 4.75%

Bank18 91.41% 64.23% 37.83% 18.68% 7.73%

Bank19 46.17% 32.44% 19.11% 9.43% 3.90%

Bank20 87.19% 61.27% 36.09% 17.82% 7.37%

Bank21 82.95% 58.28% 34.33% 16.95% 7.01%

Bank22 87.20% 61.27% 36.09% 17.82% 7.37%

Bank23 82.78% 58.16% 34.26% 16.91% 7.00%

Bank24 85.81% 60.29% 35.51% 17.53% 7.26%

Bank25 83.27% 58.51% 34.46% 17.01% 7.04%

Bank26 86.14% 60.52% 35.65% 17.60% 7.28%

Bank27 83.43% 58.62% 34.53% 17.05% 7.06%

Bank28 92.62% 65.08% 38.33% 18.93% 7.83%

Bank29 88.14% 61.93% 36.48% 18.01% 7.45%

Bank30 89.75% 63.07% 37.15% 18.34% 7.59%

Bank31 90.75% 63.77% 37.56% 18.54% 7.67%

Bank32 92.72% 65.15% 38.37% 18.95% 7.84%

Bank33 85.64% 60.18% 35.44% 17.50% 7.24%

Bank34 72.53% 50.96% 30.02% 14.82% 6.13%


82

Table 3. The test of bank performance determinants

Model Ｈ0: OLS


Ｈ0: OLS




Statistics F-value= 7.0974 LM = 28.5222 χ2 = 77.3220

（p=0.0000）（p=0.0000） (p=0.0000)

Results Reject Ｈ0 RejectＨ0 Reject Ｈ0

Table 4. The regression of bank performance determinants- fixed effect model

Explainable variables Coefficient estimates t-statistics p value

Problem loan -0.4701* -1.6931 0.0920

CEO ownership -0.6442*** -4.4672 0.0000

CEO ownership‘s square 1.2433*** 4.7209 0.0000

Board of directors ownership 0.8711** 2.5954 0.0102

Board of directors ownership‘s square -0.9836*** -2.7621 0.0063

Major shareholders equity -0.2953 -1.5947 0.1124

Market concentration 65.8730*** 3.4852 0.0000

Market share -0.2278 -0.1382 0.8902

Size -0.0779 -1.2294 0.2204

Age -0.2980*** -6.0724 0.0000

R-squared 0.9785 Adjusted R-squared 0.9711

*** denotes signification at the 1%; ** at 5%; and * at 10% level

References

1. Berger, A., and R. DeYoung, (1997), ―Problem Loan

and Cost Efficiency in Commercial Banks,‖ Journal of

Banking and Finance 21, 849-870.

2. Berger, A., and T. Hannan, (1998), ―The Efficiency

Cost of Market Power in the Banking Industry: A Test

of the ―Quiet Life‖ and Related Hypotheses,‖ Review

of Economics and Statistics 3, 454-465.

3. Berger, A., and D. Humphrey, (1997), ―Efficiency of

Financial Institutions: International Survey and

Directions for Future Research,‖ European Journal of

Operational Research 98,175-212.

4. Berle, A., and G. Means, (1932), The Modern

Corporate and Private Property, New York:

MaCmillan.

5. Cornwell, C., P. Schmidt, and R. Sickles, (1990),

―Production Frontiers with Cross Sectional and Time

Series Variation in Efficiency Levels,‖ Journal of

Econometrics 46, 185-200.

6. Farrell, M., (1957), ―The Measurement of Productive

Efficiency,‖ Journal of the Royal Statistical Society A,

general 120, 3, 253-281.

7. Forsund, F., C. Lovell, and P. Schmidt, (1980), ―A

Survey of Frontier Production Functions and Their

Relationship to Efficiency Measurement,‖ Journal of

Econometrics 13, 5-25.

8. Hannan, T., (1991), ―Bank Commercial Loan Markets

and the Role of Market Structure: Evidence from

Surveys of Commercial Lending,‖ Journal of Banking

and Finance 15, 133-149.

9. Heggestad, A., (1977), ―Market Structure, Risk, and

Profitability in Commercial Banking,‖ Journal of

Finance 32, 1207-1216.

10. Jensen, M., and W. Meckling, (1976), ―Theory of the

Firm: Managerial Behavior, Agency Costs, and

Capital Structure,‖ Journal of Finance Economics 3,

305-360.

11. Mester, L., (1993), ―Efficiency in the Saving and Loan

Industry,‖ Journal of Banking and Finance 17,

267-286.

12. Morck, R., A. Shliefer, and R. Vishny, (1988),

―Management Ownership and Markets Valuation: An

Empirical Analysis,‖ Journal of Financial Economics

20, 293-315.

13. Pi, L., and S. G. Timme, (1993), ―Corporate Control

and Bank Efficiency,‖ Journal of Banking and finance

17, 515-530.

14. Schmidt, P., and R. Sickles, (1984), ―Production

frontier and Panel Data,‖ Journal of Business and

Economic Statistics 2, 367-374.

15. Short, B., (1979), ―The Relation between Commercial

Bank Profits Rates and Banking Concentration in

Canada, Western Europe, and Japan,‖ Journal of

Banking and Finance 3, 209-219.

16. Stulz, R., (1988), ―Managerial Control of Voting

Rights: Financing Policies and the Market for

Corporate Control,‖ Journal of Financial Economics

20, 25-54.


83

INFORMATION SHARES: EMPIRICAL EVIDENCE FROM THE FTSE CHINA A50 INDEX AND THE ISHARES FTSE A50 CHINA TRACKER

Yih-Wenn Laih*, Chun-An Li**

Abstract We study the price discovery process and common factor weights of SS50 (the FTSE China A50 Index traded in Mainland China) and A50 (the iShares FTSE A50 China Tracker traded in Hong Kong) using daily open-to-open price pairs and close-to-close price pairs. Due to Qualified Domestic Institutional Investor (QDII) scheme (13 April 2006) and US subprime mortgage crisis (middle 2007), our sample, which covers from November 18, 2004 to October 31, 2008, is divided into three periods. We find A50 has a much larger common factor weight than SS50, and A50 dominants for both open and close prices during all periods. The QDII enlarges the contribution of SS50, but financial crisis reduces it. Keywords: corporate governance, stock market, China

* Corresponding author

1 Ling Tung Road, 40852 Taichung Taiwan R.O.C.

phone: +886+968064403, fax: +886+4+27056896

e-mail: [email protected]

**Dept. of Finance, National Yunlin University of Science and Technology

1. Introduction

Price discovery is a dynamic process of finding

equilibrium price. In a perfectly integrated system, all

markets impound information simultaneously, such

that prices adjust to a new equilibrium with no lag. In

fact, different market structures uniquely affect

processing of incoming information, each security

design distinguished from others by the speed at

which it digests new information. Consequently, one

security may be more capable of registering impact of

new information than another, although both are

based on the same underlying asset. Once venue or

security design is known to dominate the price

discovery process, it is possible to infer that who are

the most informed traders and what is the nature and

source of their informational advantage.

This article examines price discovery and

common factor weights of the FTSE China A50 Index

(traded in Mainland China‘s stock market; hereafter

SS50) and the iShares FTSE A50 China Tracker

(traded in Hong Kong‘s stock market; hereafter A50)

using daily open-to-open price pairs and

close-to-close price pairs. SS50 is designed to

represent performance of the largest firms in China‘s

stock markets and consists of 50 of the largest liquid

Chinese companies. Securities in the Index are

weighted by total market value of their shares, so

those with higher total market value generally have

higher representation in the Index, all of whose

securities are traded on Shanghai and Shenzhen Stock

Exchanges. A50, a sub-fund of iShares Asia Trust, is

an exchange traded fund (ETF) established in Hong

Kong; its objective is to track performance of SS50.

The fund does not directly hold A-shares but rather

Chinese A-shares Access Products (CAAPs) issued by

a Qualified Foreign Institutional Investor (QFII). The

QFII is a scheme which allows qualified foreign

financial institutions to trade Chinese A shares via

special accounts opened at designated custodian bank.

On November 5, 2002, the China Securities

Regulatory Commission and the People‘s Bank of

China introduced the QFII program to provide a

means for foreign capital to access China‘s financial

markets. A CAAP is a security (such as a warrant,

note or participation certificate) linked to an A-share,

which synthetically replicates the economic benefit of

the relevant A-share that is traded on the Shanghai or

Shenzhen stock exchange. Each CAAP constitutes a

direct, general and unsecured contractual obligation of

the CAAP issuer, and subject to counterparty risk.

China‘s stock exchanges are relatively new

players among the world‘s financial markets. Official

Shanghai Stock Exchange (SHSE) and Shenzhen

Stock Exchange were established in December 1990

and July 1991, respectively. Since that time, they have

expanded rapidly in terms of capitalization, turnover,

and number of firms listed. The market capitalization

of the SHSE was 10,093.5 billion RMB (about

US$1,477.8 billion) in November 2008, 81.6% of

total market capitalization in all Chinese stock

markets. It is obvious that the SHSE plays a dominant


84

role in Chinese stock market, which is also the reason

why the FTSE China A50 Index is selected for this

study.

The SHSE and Hong Kong Stock Exchange

(HKSE) are order-driven markets using electronic

trading without market makers. Both markets have a

lunch break at midday, between the morning and

afternoon trading sessions, which are thoroughly

continuous from opening to close of trading. Morning

session of SHSE is from 9:30 to 11:30, its afternoon

session from 13:00 to 15:00. HKSE trades

10:00-12:30 and 14:30-16:00. There are some

differences in trading rules, such as price limit, tick

size and short-selling restriction. Finally, like many

other emerging markets, SHSE has a relatively

immature infrastructure: e.g., inadequate disclosure,

opaque legal and governance framework,

inexperienced regulator. Co-existence of the latter

with a limited number of informed investors with

financial strength, plus enormous member of

uninformed and unprotected investors with budget

constraint, gives informed investors an opportunity to

manipulate stock prices to earn a profit at the expense

of uninformed investors (Lu and Lee, 2004).

As one of the most successful financial

innovations in the past two decades, ETFs are popular

and growing rapidly in global markets. ETFs have

characteristics of both closed-end funds and open-end

funds. They offer possible tax benefits compared to

open-end mutual funds. Since ETFs are not actively

managed and managers do not need to sell some of

the underlying securities when demand for ETFs

decreases, they rarely have capital gains distributed to

investors. Hence they provide a tax advantage over

mutual funds with lower trading costs. Furthermore,

introduction of ETFs also improves the price

formation efficiency of underlying securities. Chu et

al. (1999) employ Gonzalo and Granger (1995)

common factor weight model to investigate the price

discovery function of S&P 500 index markets and

propose four hypotheses to explain why index

products should contribute to the price discovery

process based on market microstructure information

models. The main idea is that prices reflect new

information through the trading of informed traders; a

particular market that informed traders prefer should

lead other markets. Four hypotheses are: (1) leverage

hypothesis, which predicts that informed traders tend

to trade in higher leveraged markets to generate

higher returns than lower leveraged markets with the

same amount of capital; (2) trading cost hypothesis,

which states that informed traders are more likely to

trade in a market with lower transaction costs; (3)

trading restriction hypothesis, which predicts that

informed traders prefer a market with fewer

restrictions; and (4) market information hypothesis,

which states that informed traders tend to trade

baskets of securities in order to avoid adverse

selection risk (Subrahmanyam, 1991). Thus, index

funds should dominate price discovery relative to

individual component stocks.

Here we use SS50 as a proxy for Chinese

domestic investors‘ assessment, A50 as a proxy for

foreign investors‘ assessment, and employ Gonzalo

and Granger‘s (1995) common factor weight model to

compute information dominant between SS50 and

A50 to find price discovery contribution. We divide

our study into periods: [I] A50 was listed on the

HKSE to enforce Qualified Domestic Institutional

Investor (QDII) scheme (from November 18, 2004 to

April 12, 2006); [II] after QDII but before US

subprime mortgage crisis (from April 13, 2006 to June

30, 2007); and [III] after the subprime mortgage crisis

(from July 1, 2007 to October 31, 2008). The QDII is

a capital market scheme allowing financial

institutions in Mainland China to invest in offshore

markets such as securities and bonds in Hong Kong.

One goal is to probe common factor weights between

assessments of domestic and foreign investors, using

matched daily open-to-open price pairs and

close-to-close price pairs. A second is to observe the

difference of common factor weights during these

three periods.

The rest of the paper is organized as follows.

Section 2 introduces and discusses empirical models.

Section 3 describes data. Section 4 reports and

analyses empirical results. Section 5 offers some

conclusions.

2. Methodology

We utilize formal econometric models regarding price

discovery and common factor weights for a relation

between SS50 and A50. First, we specify empirical

vector error-correction model (VECM). Next, we use

the common factor weight model of Gonzalo and

Granger (1995) to estimate common factor weights of

variables.

2.1. Vector error-correction model We formulate the long-term equilibrium relationship

between variables:

p

i

p

i

titiititt ASZS1 1

111111

p

i

p

i

titiititt ASZA1 1

222122

where tS and tA indicate changes in natural

logs of SS50 and A50, respectively. Optimal

lag-length of VECM is determined using the modified

Schwartz Information Criteria (MSIC). We use

Johansen‘s (1991, 1995) methodology to test how

many co-integration vectors span cointegration space.

1tZ is the lagged log-level of each variable in the

cointegrating equation estimated by Johansen‘s


85

methodology.

2.2. Common factor weight model Based on VECM, Gonzalo and Granger (1995)

proposed a decomposition model for the common

factor in the cointegration system. As suggested by

Stock and Watson (1988), I(1) cointegrated series can

be portrayed by a common factor model:

Yt = θft + tY~

,

where Yt is the vector of variables considered: i.e., Yt

=(SS50t, A50t)‘; θ is a loading matrix; ft is a vector of

I(1) common stochastic trends; and tY~

is a vector of

I(0) transitory components. Following Johansen‘s

framework, Gonzalo and Granger showed the

common factor given by

ft ='

Yt,

where α⊥ is a matrix of full rank orthogonal to the

error correction matrix α. Let matrix X

=1

uuX uvX 1

vvX vuX , where X is a

variance-covariance matrix for residual vectors from

ordinary least squares regression; and subscripts u and

v denote the level and first-difference regression,

respectively. By solving eigenvalues 1̂ > 2̂ > …

> n̂ and corresponding eigenvectors 1m̂ , 2m̂ ,

…, nm̂ of matrix X, satisfying M̂ ‘X M̂ = I where

M̂ = ( 1m̂ , 2m̂ , …, nm̂ ), we find maximum

likelihood estimator for the long-run common factor

is now α⊥ = ( 1ˆ

rm , …, nm̂ ), where r is the number of

cointegration relations in the system, as found in the

Johansen approach. Specifically, ft ='

Yt indicates

common factor as linear combination of all

cointegrated variables, where coefficients of α⊥

determine the weights of variables. A variable with

greater weight contributes more to a common factor

and moves more closely with common long-run

stochastic trend. Gonzalo and Granger developed a χ2

distributed test statistic for examining whether any

individual series represents a common stochastic

trend. If χ2 test shows the variable having greatest

weight is weighted more significantly than the other

variables, this variable can be viewed as dominant.

3. Data Description and Sample Description 3.1. Data description Interday data used in this study come from two

sources. Daily quote data for SS50 is from the Taiwan

Economic Journal (TEJ) China stock markets

database, A50 from Datastream Hong Kong stock

market files. This study covers from November 18,

2004 to October 31, 2008. On April 13, 2006, the

Beijing government announced the QDII scheme,

letting Chinese institutions and residents entrust

Chinese commercial banks to invest in financial

products overseas, limited to fixed-income and money

market products. In mid-2007, both markets suffered

from the US subprime mortgage crisis. We divide our

sample as: [I] from November 18, 2004 to April 12,

2006; [II] from April 13, 2006 to June 30, 2007; and

[III] from July 1, 2007 to October 31, 2008.

Opening hours and trading mechanisms differ

between SHSE and HKSE. Both conduct trading from

Monday to Friday except for public holidays, which

could differ for two regions. Therefore, our sample

eliminates days when only one market data is

available, since our cointegration and price discovery

analysis requires the interaction between two markets.

Besides, SS50 is traded in Chinese Yuan and A50 is

traded in Hong Kong dollars, we use corresponding

days‘ exchange rates between Yuan and Hong Kong

dollars to transfer A50 price to comparable Chinese

Yuan to make prices consistent in terms of

denomination and magnitude. We obtain everyday

exchange rate between Chinese Yuan and Hong Kong

dollars from the Datastream database.

To acquire synchronous assessment from

investors, we form matched pair data sets that

minimize span (i.e., observation interval) between

SS50 and A50. Morning session of SHSE starts at 9:30

versus HKSE‘s 10:00; afternoon sessions end at 15:00,

and 16:00 respectively, so two price pairs constructed

by daily open-to-open prices and daily close-to-close

prices are examined.

3.2. Sample description Some sample statistics and correlation coefficients

among variables appear in Table 1. Period III

averages a larger standard deviation than Periods I

and II. Besides, daily close prices have larger standard

deviation than open prices, except for Period I.

4. Empirical Results

In this section, we test price discovery between SS50

and A50 for open and close prices at Periods I, II, and

III. To avoid scalar problem, we transfer involved

variables into natural log forms during our study

period. First we assess whether all variables are

non-stationary, then long-term contemporaneous

relation between variables. Lastly, we estimate

common factor weights reflecting which has

dominant information.


86

Table 1. Summary statistics for open and close prices of SS50 and A50.

Panel A: Descriptive statistics of open prices

Period I Period II Period III

SS50 A50 SS50 A50 SS50 A50

Mean 813.957 4.636 1652.527 9.194 3128.439 17.414

Median 818.189 4.505 1292.509 7.482 3065.509 16.975

Max 912.680 5.935 3133.307 17.088 4726.083 26.906

Min 699.266 3.755 908.253 5.628 1274.795 6.172

Std. Dev. 48.846 0.467 690.154 3.358 940.524 5.278

Skewness -0.073 0.972 0.704 0.681 -0.171 -0.154

Kurtosis 1.981 3.097 2.043 2.181 1.805 1.933

Jarque-Bera 14.448 51.578 34.181 29.814 20.329 16.222

Probability 0.001 0.000 0.000 0.000 0.000 0.000

Observations 327 327 283 283 316 316

Panel B: Descriptive statistics of close prices


SS50 A50 SS50 A50 SS50 A50

Mean 813.884 4.626 1667.554 9.259 3124.750 17.367

Median 817.497 4.500 1341.731 7.697 3024.481 16.826

Max 912.391 5.899 3133.531 17.228 4731.826 26.710

Min 700.434 3.754 892.133 5.594 1305.705 6.066

Std. Dev. 48.394 0.461 697.507 3.400 942.924 5.286

Skewness -0.052 0.984 0.674 0.669 -0.162 -0.150

Kurtosis 2.024 3.133 2.000 2.178 1.795 1.922

Jarque-Bera 13.565 54.757 34.537 30.193 21.267 17.108

Probability 0.001 0.000 0.000 0.000 0.000 0.000

Observations 338 338 294 294 328 328

4.1. Unit root tests and cointegration

Augmented Dickey-Fuller (1981) test and

Phillips-Perron test (1988) are used to check for

presence of unit root. For each variable series, we

consider three regression equations: the first has a

drift term, the second a linear time-trend, and the third

both of these. We use MSIC to determine number of

leads and lags in the model. In general, our unit root

estimations confirm both SS50 and A50 are

non-stationary or containing unit root I(1).

Subsequently, test for cointegration relation of these

two non-stationary variables. Prior to testing for

cointegration of SS50 and A50, we use Granger

causality to check order between SS50 and A50.

Results hint Granger causality unidrectional from A50

to SS50. We ascertain order of integration and optimal

lag length for VECM, then test for cointegration and

number of cointegrating vectors. The statistic λtrace(r)

tests the null hypothesis that number of distinct

cointegrating vectors is less than or equal to r against

a general alternative. The statistic λmax(r, r+1) tests a

null hypothesis that number of cointegrating vectors is

r against the alternative of r+1 cointegrating vectors.

Both λtrace and λmax follow nonstandard distribution.

Results of both tests indicate one cointegrating vector

significant at a 5% level (to save space, the results are

not reported in detail here but available upon request).

4.2. Common factor weights and price discovery We use Gonzalo and Granger‘s (1995) model to

decompose common factors in the cointegration

system, and to examine whether any one series

signifies a common factor. Price discovery results are

plotted in Table 2. Panel A shows common factor

weight of SS50 at Periods I, II, and III as 0.134, 0.199,

and 0.104; that of A50 at Periods I, II, and III as 0.866,

0.801, and 0.896, respectively. A50 has much larger

common factor weights than SS50 during all three

periods. For each time frame, the χ2 test that single

series is not included in the common factor ft, with

significant level 10%, is rejected for A50 but not for

SS50. This implies that A50 is the dominant for open

price during all periods. At Period II, QDII scheme

increases (decreases) common factor weight of SS50

(A50) from 0.134 to 0.199 (from 0.866 to 0.801). Yet

at Period III, financial crisis decreases (increases) the

common factor weight of SS50 (A50) from 0.199 to

0.104 (from 0.801 to 0.896). Results suggest that

QDII scheme, the deregulation of investment between

Mainland China and Hong Kong, enlarges

contribution of SS50, but financial crisis reduces it.

The close price case reported in Panel B is similar to

the open price case.


87

Table 2. Price discovery results for open and close prices of SS50 and A50


SS50 A50 SS50 A50 SS50 A50

Panel A. Open price case

Common factor ft 0.134 0.866 0.199 0.801 0.104 0.896

H0: single series is not included in ft a 0.001** 0.034 0.013*** 0.029 0.001** 0.092

P-value 0.982 0.853 0.909 0.864 0.971 0.761

Panel B. Close price case

Common factor ft 0.128 0.872 0.188 0.812 0.097 0.903

H0: single series is not included in ft a 0.000* 0.040 0.014*** 0.027 0.001** 0.051

P-value 0.993 0.841 0.907 0.870 0.975 0.822 a Test statistic is distributed as χ

2 (1)

*, **, and *** mean significant at 1%, 5%, and 10% levels, respectively.

5. Conclusion

This study uses SS50 (FTSE China A50 Index) as a

proxy for Chinese investors‘ assessment and A50

(iShares FTSE A50 China Tracker) for foreigners‘

assessment to examine the price discovery and

common factor weights of SS50 and A50 based on

daily data from November 18, 2004 to October 31,

2008. Due to the QDII scheme and subprime

mortgage crisis, we divide sample periods: [I]

November 18, 2004 to April 12, 2006; [II] April 13,

2006 to June 30, 2007; [III] July 1, 2007 to October

31, 2008.

To make the prices consistent in terms of

denomination and magnitude, price of A50 is

transferred to comparable Chinese Yuan by

multiplying corresponding days‘ exchange rates

between Yuan and Hong Kong dollars. Unit root tests

conform both open and close prices of SS50 and A50

are non-stationary. Analyzing the daily pairs of

open-to-open and close-to-close prices, we find that

both kinds of pairs in SS50 and A50 cointegrated with

one cointegrating vector.

Estimates of the Gonzalo and Granger (1995)

common factor weights show the following: First,

A50 plays a key role in price discovery, while close

price contributes more than open price, probably

because SHSE ends at 15:00 but HKSE at 16:00.

Second, A50 contributes over 85% on the price

discovery process on a daily basis except for Period II.

Because index ETFs have characterize on high

leverage, low cost and less restriction, which are most

likely to bulk large in the price discovery process.

Chinese stock markets exhibit government

intervention, frequent regulatory change, poor

shareholder protection, information transparency, and

abundant speculative trading among retail investors.

For example, price limits, in general, many studies

find ineffective because they delay price discovery

process, interfere with trading, and also increase

volatility. Third, contribution of A50 is reduced during

Period II, but increased during Period III. It seems

that QDII scheme, deregulation of investment

between Mainland China and Hong Kong, enlarges

the contribution of SS50 during period II. However,

financial crisis destroys this.

References

1. Chu, Q. C., Hsieh, W. G. and Tse, Y. (1999), ―Price

discovery on the S&P500 index markets: an analysis

of spot index, index futures, and SPDRS‖,

International Review of Financial Analysis, Vol. 8 No.

1, pp. 21-34.

2. Dickey, D. A. and Fuller, W. A. (1981), ―Likelihood

ratio statistic for autoregressive time series with a

unit root‖, Econometrica, Vol. 49, pp. 143-159.

3. Gonzalo, J. and Granger, C. (1995), ―Estimation of

common long-memory components in cointegrated

systems‖, Journal of Business and Economic

Statistics, Vol. 13, pp. 27-35.

4. Johansen, S. (1991), ―Estimation and hypothesis testing

of cointegration vectors in Gaussian vector

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4, pp. 17-51.


88

РАЗДЕЛ 2 СТРУКТУРА

СОБСТВЕННОСТИ SECTION 2 OWNERSHIP STRUCTURE

MANAGEMENT OWNERSHIP AND FIRM PERFORMANCE: EVIDENCE FROM AN EMERGING ECONOMY

Talat Afza*, Choudhary Slahudin**

Abstract Due to the separation of ownership and control in modern corporation, the form of relationship between firm performance and insider ownership has been the subject of empirical investigation for last many decades. It is argued, that as managers' equity ownership increases, their interests coincide more closely with those of outside shareholders, and hence, the conflicts between managers and shareholders are likely to be resolved. Thus, management's equity ownership helps resolve the agency problem and improve the firm's performance (Jensen and Meckling, 1976; Agrawal and Knoeber, 1996; Chen et al., 2003). However, several studies suggest that management's ownership does not always have a positive effect on corporate performance (Demsetz and Villalonga, 2000; Cheung and Wei, 2006). Most of the empirical studies on this issue have focused on the developed economies and there is little empirical evidence on the emerging economies in general and almost no work has been done on emerging economy of Pakistan in particular. Therefore, present study is an effort to analyze the relationship between insider ownership and firm performance in emerging market of Pakistan while taking a sample of 100 firms listed on Karachi Stock Exchange. In spite of entirely different characteristics of data, it has been observed that there is strong positive relationship between insider ownership and firm performance in Pakistan and the results of cross-sectional regression are consistent with theory of “convergence of interest” of relationship between insider ownership and firm performance. Although these results did not conform with the theory “ownership entrenchment” that have proved true in many developed economies yet the empirical results have provided the Pakistani corporate sector positive indications to solve the agency problem through stock options for their employees. Keywords: Insider Ownership, Firm Performance, Convergence of interest theory, Pakistan

* Corresponding author: Dean, Faculty of Business Administration, COMSATS Institute of Information Technology, Defence

Road off Rawind Road, Lahore, Pakistan:

Ph: ++92-42-5321092, Fax: ++92-42-9203100, e-mail: [email protected], [email protected]

**Department of Finance and Economics, University of Management and Technology

1. Introduction

The role of ownership structure in solving the agency

problem and improving the firm performance has

been the subject of an important and ongoing debate

in the corporate finance literature for last few decades.

This debate rooted back to the thesis (Berle and

Means, 1932), which proved an inverse relationship

between the diffusion of shareholders and firm

performance. It is believed that the classical problem

of corporate governance lies within the separation of

ownership and control, i.e. the agency cost resulting




89

from a divergence of interest between the owners and

the managers of the firm (Jensen and Meckling, 1976).

However, it may become convergent either when a

large fraction of shares are held by few owners or the

owners are performing as managers in the firm.

Researchers have extensively studied the conflict

between managers and owners and its influence on

firm‘s performance, yet, the research on

understanding the differences in behavior of different

shareholder identities is limited. On the one hand, a

rich empirical literature has investigated the efficacy

of alternative mechanisms in terms of the relationship

between takeovers, performance, managerial pay

structure and performance of the firm and on the other

hand, the separation of ownership and control, and

form of the relationship between the performance of

firms and insider ownership has been the subject of

empirical investigation for last many decades. It is

argued, that as managers' equity ownership increases,

their interests coincide more closely with those of

outside shareholders, and hence the conflicts between

managers and shareholders are likely to be resolved.

Thus, management's equity ownership helps resolve

the agency problems and improve the firm's

performance (Jensen and Meckling, 1976; Agrawal

and Knoeber, 1996; Chen et al., 2003).

However, several studies suggest that

management's ownership does not always has a

positive effect on corporate performance. (Fama and

Jensen, 1983) demonstrate various possibilities that

managers who own enough stock to dominate the

board of directors could expropriate corporate wealth.

A large-block shareholder could, for example, pay

himself an excessive salary, negotiate 'sweetheart'

deals with other companies he controls, or invest in

negative-net-present-value projects. (Stulz, 1988)

explains how owning large blocks makes it easier for

managers to be entrenched. Thus, greater stock

ownership by managers increases the power of the

internal constituency, but decreases the power of the

external constituency in influencing corporate

performance.

The existing empirical studies focusing on the

relationship between insider ownership and firm

performance have provided contradictory evidence in

developed as well as developing economies.

Moreover, most of the empirical studies on this topic

have covered the developed economies and there is

little work done on the emerging economies in general

and economy of Pakistan in particular. In case of

Pakistan, it is a fact that during the period under study

(2002-05), the low interest rate environment and

investor friendly policies of the Government of

Pakistan coupled with positive geopolitical

developments have paved the way for the

macroeconomic conditions conducive for the

development of the equity and money markets of the

country. The increased investor‘s confidence along

with the improvements in the corporate earnings has

contributed to the impressive performance of the

equity markets as compared to the other South East

Asian economies. Therefore, it is imperative to study

the corporate governance characteristics of this

growing market to achieve a consistent positive

performance of the equity market. Therefore, the

present study is an effort to provide empirical

evidence on the insider ownership and its impact on

firm performance from emerging economy of

Pakistan. It is expected that the outcome of research

may provide an insight into this important issue which

will be useful for both the investors and regulators of

the emerging economies.

2. Literature Review

Existing literature on the relationship between insider

ownership and corporate performance has reported

three different dimensions of this relationship. It can

take the form of convergence of interest (Linear

positive) or entrenchment behavior (Non-linear) or

ownership structure as indigenous outcome (No

relationship). As firm size increases, diffuseness of

ownership renders owners of shares powerless to

constrain professional management that owns a small

portion of shares. The separation of ownership and

control creates conflict of interest between owners

(principals) and managers (agents). When the interests

of managers do not naturally coincide with that of the

owners of the firm, this would seem to imply that

corporate resources are not used efficiently to pursue

the goals of shareholders. Therefore, managers are

inclined to use the resources of the firm for their own

benefits. In this scenario, owners may offer stock

option for managers to reduce the agency cost and

create the convergence in the interest of both parties.

Jensen and Meckling (1976) investigated this

issue first time and showed empirically how the

allocation of shares among management and owner

can influence the firm performance. The stockholders

were divided into two groups: insider shareholders

who manage the firm and have exclusive voting rights

and outside shareholders who have no voting rights

but, both groups were entitled for the same dividends

per share. However, the insider shareholders were

able to augment this stream of cash flow by

consuming additional non-marketable perquisites. In

this situation, there was an incentive for the mangers

to adopt investment and financing policies that benefit

them, but reduce the payoff to outside stockholders.

Thus, the value of the firm depends on the amount of

shares owned by the insiders. The greater the

proportion of shares owned by the insiders, the greater

would be the value of the firm.

Later, (Agrawal and Knoeber, 1996) selected the

Forbes 800 firms to study the firm performance and

mechanism to control the agency cost. The findings of


90

cross-sectional OLS regression reported a positive

relationship between insider shareholding and Tobin‘s

Q of largest firms of the world. Furthermore, (Sarkar

and Sarkar, 2000) provided the evidence on the role of

insider shareholders in monitoring the firm value with

respect to a developing and emerging economy of

India. A sample of 1567 manufacturing Indian firms

listed at Bombay Stock Exchange during the period of

1995-96 was selected. The results of piece-wise linear

regression reported a positive relationship between

insider holding and firm value which is consistent

with ―convergence of interest‖ hypothesis.

Ang et. al. (2000) postulated the following

hypotheses derived from agency theory when

compared to the base case: (i) agency costs are higher

at firms whose managers own none of the firm‘s

equity, (ii) agency cost is an inverse function of the

managers‘ ownership stake, and (iii) agency costs are

an increasing function of the number of non-manager

shareholders. They utilized a sample of 1,708 small

corporations from the FRB/NSSBF database of

private US firms and found that agency costs (i) are

significantly higher when an outsider rather than an

insider manages the firm; (ii) are inversely related to

the manager‘s ownership share; (iii) increase with the

number of non-manager shareholders, and (iv) to a

lesser extent, are lower with greater monitoring by

banks. The relationship between insider ownership

and firm performance in Asian markets was studied

by (Mitton, 2002) who took a sample of 398 firms

from Indonesia, Korea, Malaysia, Philippines, and

Thailand, to study the firm-level differences in

variables related to corporate governance and their

impact on firm performance during the East Asian

financial crisis of 1997–1998. The regression results

of crisis-period stock returns and ownership structure

variables are consistent with the idea that if

shareholders are involved in management they could

have more opportunity and power to enhance

efficiency of the firm. Therefore, relationship between

insider holding and firm performance is positive for

the selected Asian economies during the study period.

Recently, (Chen et al., 2003) studied the

relationship between insider ownership and Tobin‘s Q

for 123 Japanese firms from 1987 to 1995. Managers

in Japanese firms own a smaller stake in their firms

relative to their US counterparts. The initial analyses

using an Ordinary Least Squares (OLS) regression

model showed a negative relation between Tobin‘s Q

and managerial ownership at low levels of ownership

and vice-versa at higher level. However, when the

fixed effects of the firm were controlled, as suggested

by the literature, a different conclusion was reported.

Specifically, results indicated that Tobin‘s Q increases

monotonically with managerial ownership. Therefore,

the findings suggested that as ownership increases,

there is a greater alignment of managerial interests

with those of stockholders. Furthermore, (Lemmon

and Lins, 2003) investigated the effect of managerial

shareholding on firm valuation by taking the sample

of 800 firms from eight East Asian economies during

the financial crises of 1997-98. They reported a

positive and linear relationship between managerial

ownership and firm value.

On the other hand, most of the researchers

recognized that when a manager owns a stake in the

firm‘s shares, it would motivate him to work for the

value maximization of their shares. In contrast, the

managers who control a substantial fraction of the

firm may have enough voting power to guarantee

their employment with the firm at an attractive salary.

With effective control, the managers may indulge

themselves in non-value maximizing behavior. This

entrenchment theory predicts that corporate assets can

be less valuable when the stake of managers increase

from a certain level in firm‘s equity. Therefore, the

relationship between the insider ownership and firm

performance will be non-linear.

In the same context, (Morck et al., 1988)

validated the relationship of insider ownership and

firm performance on a sample of 371 Fortune-500

firms in 1980. Their reasoning was based on the

argument that there are two forces that shape the

behavior of managers, first is the tendency to use

corporate sources for their own best interest and

second for the value maximization of shareholders.

The managers‘ response to these opposing forces and

the relationship between ownership & performance

depends upon the force that dominates the other over

any particular range of insider ownership. It is a

natural tendency that managers prefer to allocate

corporate resources in their own best interests, which

may conflict with the interests of owners. As insider

ownership increases, their interests are likely to

coincide more closely with those of shareholders. The

first of these forces has a negative effect on the firm

performance, whereas the second has a positive effect.

Based on this reasoning, their tests reported that the

Tobin‘s Q rises as the board ownership increases from

0% to 5%, falls form 5% to 25%, and then rises

slowly. The entrenchment effect dominates the

convergence of interest effect in the range between

5% to 25% insider ownership.

Stulz (1988) focused on the importance of the

takeovers for disciplining corporate managers. The

mathematical models proved that the premium that a

hostile bidder must pay to gain control of target firm

increases as the insider ownership increases, but the

probability that the takeover will succeed decreases.

When insiders own a small fraction of the shares, it is

more likely that a hostile takeover will succeed at a

relative lower premium. As insider ownership

increases, the probability of a successful hostile

takeover, for a given premium will decline. At 50 %

insider ownership, the probability of a hostile

takeover is zero. This reasoning leads to a curvilinear


91

relation between insider ownership and firm

performance. In this relation, firm performance first

increase then decrease as insider ownership increases.

In the end, the firm‘s value reaches at minimum when

insider ownership reaches to 50%.

Later, (McConnell and Servaes, 1990)

investigated the relationship between Tobin's Q and

the structure of equity ownership for a sample of

1,173 firms for 1976 and 1,093 firms for 1986. A

significant curvilinear relation between Tobin‘s Q and

the fraction of common stock owned by corporate

insider was reported. The curve slopes upward until

insider ownership reaches approximately 40% to 50%

and then slopes downward, which is consistent with

the hypothesis of entrenchment. Furthermore, (Han

and Suk, 1998) examined the non-linear relationship

between insider ownership of 301 firms and average

stock returns during 1988 to 1992. To capture the

potential of the non-linear relationship, the insider

ownership and insider ownership squared variables

are used. The insider ownership consists of not only

the board members, but also the officers, beneficial

owners and principal stock holders owning ten

percent or more of the firm‘s stock. The results show

that the insider ownership is positively related to the

stock returns whereas the insider ownership square is

negatively related. The results concluded that as

insider ownership increases, stock returns also

increase however, excessive insider ownership rather

hurts corporate performance.

To study the same issue in a different market,

(Short and Keasey, 1999) have chosen a sample 225

UK based firms quoted on the official list of the

London Stock Exchange for the period 1988-99. The

empirical results of the regression, confirm that UK

management becomes entrenched at higher levels of

ownership than their US counterparts. Moreover, the

results from extending the analysis to consider

different measures of firm performance and a more

generalized form of the relationship confirm the

general finding of the US literature of a non-linear

relationship between firm performance and

managerial ownership.

Recently, (Beiner et al., 2006) examined the

relationship between insider ownership and firm value

with cross-sectional data of 109 Swiss firms in 2002.

The results of OLS and 3SLS regression revealed a

curvilinear relationship between shareholdings of

officers & directors and firm valuation, i.e., higher

managerial shareholdings are associated with higher

firm valuation up to some point (even in the presence

of alternative corporate governance mechanisms). The

negative effect on firm value for levels of insider

shareholding beyond this point might be explained by

managerial entrenchment (for example, managers

controlling a substantial fraction of the firm‘s equity

may have enough voting power and/or influence to

guarantee their employment and attractive salaries).

However, the same issue was taken up by

(Cheung and Wei, 2006) who examined the

relationship between insider ownership and corporate

performance by using the data of 1430 US firms for

the period of 1991-2000. The regression results of the

study are consistent with many earlier studies that

there is no relationship between insider holding and

firm performance.

3. Research Design

A large number of studies in literature have analyzed

the relationship between insider ownership and firm

performance from different angles. However, the most

recent dimension is non-linear relationship between

the insider ownership and firm performance (Beiner et

al., 2006; Short and Keasy, 1999). In the light of the

existing literature, the present study attempts to

explore the nature of relationship (linear or nonlinear)

between the insider ownership and firm performance

and provides the empirical support to ―convergence of

interest‖ or ―ownership entrenchment‖ theory(ies)

from an emerging economy of Pakistan. To validate

the non-linear relationship between ownership

structure and firm performance in the context of

Pakistan, current study has adopted the (Short and

Keasy‘s, 1999) cubic form model given below:

Performance = a +1 O w n + 2 O w n 2

+ 3 O w n 3 + Control Variables (3.1)

The variables of Own2 and Own

3 are defined as

the square and the cube, respectively, of the

percentage of shares held by the respective group, are

used to capture this non-liner relationship. To be

consistent with the non-linear relationship estimated

by the previous studies, such as (Short and Keasy,

1999), the estimated coefficients for the Own and

Own3 variables should be positive, and that of the

Own2 variable should be negative.

On the basis of above model and objectives of

present study the following two types of the equations

have been formulated to test the non-linear as well as

linear relationship between insider ownership

structure and firm performance. Two control variables,

firm size and debt have also been used to validate the

results in their presence besides the variables of

insider ownership and performance.

Non-linear relationship between insider

ownership and Firm Performance for company i and

year t can be expressed as:

(a) ROA = 0 + 1 Insider i,t + 2 Insider2 it + 3

Insider3 it + 4 Debt it + 5 Size it +it (3.2)

(b)Tobin’s Q = 0+1Insider i,t +2 Insider2 it

+3 Insider3 it + 4 Debt it + 5 Size it +it (3.3)

Linear relationship between insider ownership

and Firm Performance for company i and year t can

be expressed as:

(a) ROA = 0 + 1 Insider it + 2 Debt it +

3 Size it +it (3.4)


92

(b) Tobin’s Q = 0 + 1 Insider it + 2 Debt

it + 3 Size it +it (3.5)

Where,

0 = Intercept

Insider i,t = Fraction of shares owned by Board of Directors

(BOD) and employees of company i for year t

Insider2 i t = Square of fraction of shares owned by BOD

and employees of company i for year t

Insider3 i t = Cube of fraction of shares owned by BOD and

employees of company i for year t

DEBT i,t =Ratio of total liabilities to total assets in

company i for year t

SIZEi,t = Log of total assets held by company i for year t

it = Error term

The most frequently used performance variables

in literature are Return on Assets (ROA) and Tobin‘s

Q. Although (Demsetz and Lehn, 1985) study used

accounting profit rate to measure firm performance

whereas most of the empirical studies used the

Tobin‘s Q. These two performance variables differ on

two important aspects. On the one hand, is the time

perspective, where accounting profits are taken as

backward looking whereas the Tobin‘s Q is assumed

to be forward-looking. In an attempt to assess the

effect of ownership structure on firm performance, is

it more sensible to look at an estimate of what

management has accomplished or at an estimate of

what management will accomplish? On the other hand,

second difference is, in measuring performance. For

the accounting profit rate, this is the accountant

constrained by standards set by the professional

body(ies). Whereas, for Tobin‘s Q, this is primarily

the community of investors constrained by their

acumen, optimism, or pessimism. The proclivity of

economists, most of whom have a better

understanding of market constraints than of

accounting constraints, favor Q. Accounting profit

rate is not affected by the psychology of investors,

and it only partially involves estimates of future

events, mainly in the valuations of goodwill and

depreciation. Tobin‘s Q, however, is buffeted by

investor psychology pertaining to forecasts of a

multitude of world events that include the outcomes

of present business strategies. Since, both of the

performance variables carry their own bag of

advantages and disadvantages, therefore, both the

variables have been used in this study. The

institutional shareholding will be measured by the

fraction of total shares owned by the financial

institutions at the end of the respective accounting

year.

3.1 Sample Description The following criteria have been used while selecting

the firms for study during the period 2002-05.

1. Firm should be in profit for the whole window

period

2. Listed at Karachi Stock exchange (KSE) for the

whole window period.

3. It should not be a SOE (State Owned

Enterprises).

As per the above criteria only 310 firms

qualified as the population of the study out of 736

listed companies at Karachi Stock exchange and a

sample of 100 firms has been taken through

systematic random sampling method. The insider

ownership is the shareholding of board of directors &

their spouses, company executives & their spouses

and employees. The descriptive statistics of insider

ownership in selected sample across different

industrial sectors has been reported in Table 3.1. The

maximum holding of insider is in Auto and Allied

Engineering sector which is 93.22 percent for the year

2005, whereas, the minimum holding is in

Non-Banking Financial Institutions (NBFIs) which is

very low of just 0.02 percent. On the average, there is

53.44 percent insider ownership in selected sample

for the year 2005. However, the lowest mean insider

holding of 44.80 percent is for NBFIs and highest is

for the Pharmaceutical industry with 68.92 percent.

For the rest of the sectors, five sectors have mean

insider ownership above the sample mean and six

below the sample mean. Which shows a good spread

in the data to produce more reliable results for

statistical estimation from regression analysis.

The descriptive statistics of Table 1 reflect that

in case of Pakistan majority of the shareholdings are

with board of directors, company executives and their

spouses. Most of the businesses are owned by few big

business families. Family firms are a fundamental and

intrinsic feature of the Pakistani economy.

Approximately 80% of all listed companies on the

Karachi Stock Exchange have family involvement or

are indirectly affiliated to a large business family

(Zaidi, 2005). These family firms were established

traders in different parts of united India, and it was a

historical accident that gave them the opportunity to

establish themselves in new land of Pakistan. Post

privatization era in Pakistan also brought a new class

of industrial and family businesses.

Pre-nationalization ( pre 1973) business families like

Adamjees, Habibs or Valikas were so adversely

affected that they never really invested in businesses

in Pakistan. At the same time privatization and

liberalization of the economy during the last 20 years

have mostly helped textile tycoons to venture into

other sectors which include Dewans, Mansha,

Sherazis, Elahis, Munoos etc. (Slahudin, 2007). Due

to this fact, there is a lot of cross ownership in family

firms and it has increased the ratio of insider

ownership across the whole economy of Pakistan.


93

Table 1. Pattern of Insider Ownership in Different Industries of Pakistan for the Year 2005

Name of Industry Mean Maximum Holding Minimum Holding

Auto and Allied Engineering 57.75 93.22 3.25

Banking Institutions 48.82 65.80 10.50

Cement 46.50 85.12 22.04

Chemical and Allied 57.82 76.45 48.86

Food and Allied 49.111 82.53 11.01

Non-Banking Financial Institutions 44.80 70.10 0.02

Oil and Energy 62.98 69.41 61.30

Pharmaceutical 68.92 79.21 40.53

Sugar 46.87 66.34 32.03

Textiles 56.70 75.72 27.41

Miscellaneous 47.56 71.30 23.44

Total 53.44 93.22 0.02

4. Statistical Analysis

As per the empirical literature there can be three types

of relations between insider ownership and firm

performance. The first one can be the ―convergence of

interest‖ that is formed when agency problem is

resolved by convergence of agents as a principal of

the organization in the form of stock ownership. It

mostly results in positive relationship between insider

ownership and firm performance (Jensen and

Meckling, 1976; Chen et al., 2003; Lemmon and Lins,

2003). The second type can be the ―entrenchment‖

which may produce positive as well as negative


performance. It may be positive in the beginning

when insiders have a lower level of ownership so they

will work hard with other shareholders to maximize

the shareholder‘s wealth. However, when they will

have controlling shares in any firm that may result in

negative relationship with firm performance. In this

situation, they feel no check and balance on them and

they may work for their own interests instead of firm

interest. Both of these relationships have been

discussed by (Morck et al., 1988), (McConnell and

Servaes, 1990) and (Beiner et al., 2006) while

predicting a positive or negative relationship between

firm value and size of insider holdings, depending on

the ownership range. Managerial stock ownership can

be the basis of a convergence-of-interests with a

positive effect on firm value, although large

managerial ownership can provide necessary control

to the manager to carry on the non-value maximizing

behavior.

However, many researchers do not agree with

the notion that the ownership structure has a

relationship with firm performance. According to

(Demsetz, 1983), there is no cross-sectional

relationship between firm value and concentration of

insider or external ownership, since the ownership

structure that ―emerges is an endogenous outcome of

competitive selection in which various cost

advantages and disadvantages are balanced to arrive

at an equilibrium of the firm.‖ Consequently,

shareholder wealth maximization may require a

diffused external ownership structure in one case,

while a large outside equity block is optimal in the

case of another firm. Similarly, one cannot infer

differences in share values from differences in sizes of

insider stakes across firms. Supporting this view,

(Demsetz and Lehn, 1985) and (Demsetz and

Villalonga, 2001) find no relationship between the

accounting profit rate and different measures of

ownership concentration for a sample of U.S. firms.

The present study has used different

combinations of models of existing literature to

validate the nature of relationship between

performance variables and insider ownership

variables. Insider ownership in Pakistan is higher than

average insider ownership of all board members in

other countries such as Malaysia, USA and UK.

Average insider ownership in Pakistan is 53.22

percent while it is 32.70 percent in Malaysia. (Davies

et al., 2005) and (Short and Keasey, 1999) report a

value of around 13% for the UK. (Morck et al., 1988)

and (McConnell and Servaes, 1990) report slightly

lower levels of insider ownership for US firms

compared to UK levels. Average Tobin‘s Q in

Pakistan is lower compared to the values reported for

the USA and the UK. In Pakistan, mean Tobin‘s Q of

1.53 is lower than 1.96 reported by (Davies et al.,

2005) for UK. As expected the mean market

capitalization of companies in Pakistan is much

smaller than that of the US and UK companies.

The results of regression analysis based on

equations 3.2 and 3.3 to validate the non-linear


performance are reported in Table 2. As per the results

in the table, all three variables of insider ownership

could not establish any statistically significant

relationship with both the performance variables of

ROA and Tobin‘s Q. To establish the non-linear

relationship, equation 3.2 and 3.3 should have

produced positive signs for the estimated coefficients

of INSIDER and INSIDER3, whereas estimated

parameter of INSIDER2 should have a negative sign.

To the extent of signs, the insider ownership

variables and performance variable of Tobin‘s Q have

the signs as expected but with performance variable


94

of ROA, these signs were not as expected. Moreover,

none of the estimated parameter was statistical

significance which did not confirm the entrenchment

theory of (Morck et al., 1988), (McConnell and

Servaes 1990), and (Beiner et al., 2006). Therefore,

the notion of non-linear relationship between insider

ownership and firm performance does not seem valid

in case of Pakistan. As far as the control variables are

concerned the negative impact of debt on firm

performance is statistically significant similar to

earlier studies but size as a variable could not show

any significant relationship with performance.

Table 2. Relationship between Insider Ownership and Firm Performance (For Non-linear Equation)

Variable ROA Tobin‘s q

t-Statistics Sig. t-Statistics Sig.

INTERCEPT INSIDER INSIDER2 INSIDER3 DEBT SIZE ADJ-R-SQUAR N D/W

4.185* -.241 .073 .198

-7.555* .719 .410 97

1.803

.000

.810

.942

.843

.000

.474

2.524* 1.142 -1.236 1.348

-2.494** .510 .130 97

1.934

.013

.256

.220

.181

.010

.612

Table 3. Relationship between Insider Ownership and Firm Performance (For Linear Equation)

Variable ROA Tobin‘s q

t-Statistics Sig. t-Statistics Sig.

INTERCEPT INSIDER DEBT SIZE ADJ-R-SQUAR N D/W

4.836* 1.691** -7.879*

.851

.407 97

1.726

.000

.093

.000

.397

3.999* 1.072** -1.753**

.622

.206 97

1.907

.000

.104

.083

.536

*significant at level of 1% ** significant at level of 10%

Equations 3.4 and 3.5 are estimated to assess the

linear relationship between variable of insider

ownership and performance variables of ROA and

Tobin‘s Q with two control variables of Debt and size.

The cross-sectional regression results of these

equations are reported in Table 4.2. As per these

results, there is a statistically significant relationship

between insider ownership variable and performance

variables of ROA and Tobin‘s Q at 10 % level. These

results have supported the notion that a positive

relationship exists between insider ownership and

firm performance in emerging economy of Pakistan.

In line with the previous empirical investigations, the

debt has a significant negative relationship with

performance whereas, the relationship between size

and performance variable of ROA and Tobin‘s Q is

positive but not statistically significant.

The results of Table 4.1 and 4.2 are consistent

with (Jensen and Meckling 1976), (Chen et al., 2003)

and (Davies et al., 2005) that the insider ownership

and corporate performance are co-deterministic.

However, these findings are in contrast to (Demsetz

and Lehn, 1985), and (Demsetz and Villalonga, 2000)

who find no relationship between insider ownership

and firm performance. In summary, the above results

have supported the view point of ―convergence of

interest‖ that there is a strong positive linear


performance in the emerging economy of Pakistan.

5. Conclusion

The motivation of the current study stemmed from

lack of empirical and theoretical investigations

regarding the impact of insider ownership on firm

performance for an emerging economy of Pakistan. It

examined whether the variation in ownership

structure across firms results in systematic variations

in the performance of these firms listed at Karachi

Stock Exchange. The cross sectional regression has

been applied to find the impact of ownership structure

on the performance of selected 97 Pakistani firms.

The results of the empirical analysis, indicated a

statistically significant positive and linear relationship

between insider ownership and firm performance

which supports the ―converge of interest‖ theory of

insider ownership and firm performance. These

results are consistent with those of (Chen et al., 2003)

and (Davies et al., 2005), who found that insider

ownership and corporate performance are

co-deterministic. However, the estimated result did

not match with the ―entrenchment theory‖ by (Morck

et al., 1988), (McConnell and Servaes, 1990), and

(Beiner et al., 2006). Moreover, these findings are in

contrast with (Demsetz and Lehn, 1985), and

(Demsetz and Villalonga, 2001) who found no


95


performance. In summary, the above results have

validated that there is a strong positive linear


performance in the context of the emerging economy

of Pakistan. Moreover, debt appeared to have a

negative and linear relationship with firm

performance, consistent to most of the previous

studies, indicating that higher level of debt increases

interest and financial charges which leads to lower

earnings or retunes. However, the firm‘s size variable

has a positive but statically insignificant relationship

between the firm‘s size and performance indicating

that large size firms may perform better than smaller

size firms. The above results indicates that in case of

the emerging economy of Pakistan, the relationship

between the insider ownership and firm performance

is consistent with the theory ―convergence of interest‖

rather than the theory ―ownership entrenchment‖ that

have proved true in many developed economies. In

spite of entirely different characteristics of data,

estimated result have supported a strong positive


performance. As shown in table 3.1, that most of the

Pakistani firms have is also shown concentrated

ownership, which means they are efficiently managed

and may perform better in future. The policy

implication is that the agency problems in Pakistan

can be solved by offering the stock options to the

employees as there are many successful examples of

good governance/ management by employees in post

privatization era of many state owned enterprises in

Pakistan, for examples, Allied Bank Limited and

Engro Chemicals Limited.

References

1. Agrawal, A. and C. Knoeber (1996), ―Firm

Performance and Mechanisms to Control Agency

Problems between Managers and shareholders‖

Journal of Financial and Quantitative Analysis 31: PP

377-397.

2. Ang, S. J., Rebel A. Cole, and James Wuh L. (2000),

―Agency Costs and Ownership Structure‖ The Journal

of Finance 1: PP 81-106.

3. Beiner, S., Drobetz, W., Schmid, M. M. and

Zimmermann, H. (2006), ―An Integrated Framework

of Corporate Governance and Firm Valuation:

Evidence from Switzerland‖, European Financial

Management Journal 12: PP 137-285.

4. Berle, A. and Means, G. (1932), the Modern

Corporation and Private Property, MacMillan, New

York.

5. Chen, C. R., Guo,W. (2003), ―Managerial Ownership

and Firm Valuation: Evidence from Japanese Firms‖,

Pacific-Basin Finance Journal 11: PP 267–283.

6. Cheunga W.K. and K.C. Wei (2006), ―Insider

Ownership and Corporate Performance: Evidence

from the Adjustment Cost Approach‖ Journal of

Corporate Finance 12: PP 906–925.

7. Davies, Hillier, and McColgan (2005), ―Ownership

Structure, Managerial Behavior and Corporate Value‖,

Journal of Corporate Finance 11: PP 645-660.

8. Demsetz, H. (1983). ―The Structure of Ownership and

the Theory of the Firm‖, Journal of Law and

Economics 26: PP 375-90.

9. Demsetz, H. and Lehn, K. (1985), ―The Structure of

Corporate Ownership: Cause and Consequences‖

Journal of Political Economy 93: PP 1155-1177.

10. Demsetz, Harold, and Villalonga, B. (2000),

―Ownership Structure and Corporate Performance‖,

Journal of Corporate Finance 7: PP 209-233.

11. Fama, E. F. and Jensen, M. C. (1983), ―Separation of

Ownership and Control‖, Journal of Law &

Economics XXVI: PP 301-325.

12. Han, C. K. and Suk, D. Y. (1998), ―The Effect of

Ownership Structure on Firm Performance: Additional

Evidence‖, Review of Financial Economics 7.

13. Jensen, M. C. and Meckling, W. H. (1976), ―Theory

of the Firm: Managerial Behavior, Agency Cost, and

Ownership Structure‖ Journal of Financial

Economics 3: PP 305-360.

14. Lemmon, M. L., and Lins, K. V. (2003), ―Ownership

Structure, Corporate Governance and Firm Value:

Evidence from East Asian Financial Crisis‖, Journal

of Finance 58: PP 1445-1468.

15. McConnell, J. and Servaes, H. (1995), ―Equity

ownership and the two faces of debt‖, Journal of

Financial 39: PP 131–57.

16. Mitton, T. (2002), ―A Cross-Firm Analysis of the

Impact of Corporate Governance on the East Asian

Financial Crisis‖, Journal of Financial Economics 64.

17. Morck, R., Shleifer, A. and Vishny, R. (1988),

―Management Ownership and Market Valuation: An

Empirical Analysis‖, Journal of Financial Economics

20: PP 293-315.

18. Sarkar, J. and S. Sarkar (2000), ―Large Shareholder

Activism in Corporate Governance in Developing

Countries: Evidence from India‖ International Review

of Finance 1: PP 161–194.

19. Scott R.W. (1998), Financial Accounting Theory,

Prentice Hall, New Jersey.

20. Short, H. and K. Keasey (1999), ―Managerial

Ownership and the Performance of Firm: Evidence

from the UK.‖ Journal of Corporate Finance 5.

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Sustaining Entrepreneurial Spirit in Their Firms‖

Proceedings of 9th South Asian Management Forum,

Bangladesh, (February 24-25 2007).

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Rights: Financing Policies and the Market for

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http://ideas.repec.org/a/eee/corfin/v11y2005i4p645-660.html




96

OWNERSHIP STRUCTURE, CORPORATE PERFORMANCE AND FAILURE: EVIDENCE FROM PANEL DATA OF EMERGING MARKET

THE CASE OF JORDAN

Rami Zeitun*

Abstract

This study investigates the impact of ownership structure (mix and concentrate) on a company’s performance and failure in a panel estimation using 167 Jordanian companies during 1989-2006. The empirical evidence in this paper shows that ownership structure and ownership concentration play an important role in the performance and value of Jordanian firms. It shows that inefficiency is related to ownership concentration and to institutional ownership. A negative correlation between ownership concentration and firm’s performance both, ROA and Tobin’s Q, is found, while there is a positive impact on firm performance MBVR. The research also found that there is a significant negative relationship between government ownership and a firm’s accounting performance, while the other ownership structure mixes have significant coefficients only in Tobin’s Q using the matched sample. Firm’s profitability ROA was negatively and significantly correlated with the fraction of institutional ownership, and positively and significantly related to the market performance measure, MBVR. The result is robust when indicators of both concentration and ownership mix are included in the regressions. The results of this study are, to some extent, inconsistent with previous findings. This paper also used ownership structure to predict the corporate failure. The results suggest that government ownership is negatively related to the likelihood of default. Government ownership decreases the likelihood of default, but has a negative impact on a firm’s performance. The results suggest that, in order to increase a firm’s performance and decrease the likelihood of default, it is reasonable to reduce government ownership to some extent. Furthermore, a certain degree of ownership concentration is needed to increase the firm’s performance and to decrease the firm’s chance of default. Keywords: Ownership Structure, Ownership Concentration, Corporate Performance, Failure, Jordan

* Assistant professor of finance in the Finance Discipline, Department of Finance and Economic, College of Business and

economic, Qatar University. Emails: [email protected] and [email protected]. I would like to thank Gary Tian,

Steve Keen, Don Ross, Yanrui Wu and Subba Reddy Yarram for their very helpful comments on the earlier draft of this paper.

The author remains responsible for all errors.

1. Introduction

The literature includes the hypotheses that ownership

concentration may improve performance by

decreasing monitoring costs (Shleifer and Vishny,

1986). The financial literature assumes that managers

are imperfect agents for investors, as managers may

attempt to pursue their own goals rather than

shareholders‘ wealth maximisation. Also, it has been

stated that there may be a conflict of interest between

shareholders and managers, as managers may have

incentives which serve their own benefit rather than

maximising shareholders wealth (Jensen and

Meckling, 1976). One approach that may control this

conflict, suggested by Jensen and Meckling (1976), is

to increase the equity ownership of managers in the

firms, therefore encouraging managers to work more

efficiently to maximise shareholders‘ wealth and carry

out less activities of self-interest (see Jensen and

Meckling (1976); Fama and Jensen (1983); Shleifer

and Vishny, (1986)). However, it may also work in the

opposite direction, as large shareholders may use their

control rights to achieve private benefits.

The corporate governance mechanisms vary

around the world which could affect the relationship

between ownership structure and corporate

performance (Shleifer and Vishny, 1997). For

example, in Europe and Japan, there is less reliance

on elaborate legal protection, and more reliance on

large investors while, in the US, firms rely on legal

protection. So, due to the differences between US

corporate governance and other systems, a different

relationship between ownership and firm value could

be expected. Also, recent studies of corporate

governance suggest that geographical position, the tax

system, industrial development, and cultural


97

characteristics, along with other factors, affect

ownership structure which in turn impacts on a firm‘s

performance and its failure (Pedersen and Thompson,

1997). Therefore, this study is important as it provides

evidence from the emerging markets and, more

specifically, from Middle Eastern countries using

Jordan as a case study98

.

Privatisation of publicly held shares is an

ongoing program in Jordan. Managing state holdings

in Jordanian listed companies has become a top

government priority, with the government supporting

the private sector to takeover and participate more in

economic growth99

. So, it could be anticipated that

privatisation in Jordan would affect a firm‘s

performance and failure as it changed the ownership

structure of firms. One of the main reasons for low

performance and distress or bankruptcy might be bad

management, which drives the firm out of the market

as a consequence of unsolved problems in corporate

governance. The inefficiency that might lead firms to

default is as a result of the agency problem that could

arise from a conflict of interest between managers and

shareholders (see, for example, Jensen and Meckling

(1976); Shleifer and Vishny (1997)).

This paper investigates the effect of ownership

structure on a firm‘s performance and its failure in

Jordan. In this paper I argue that if ownership

structure variables are relevant to corporate

performance, then they will have a significant effect

in determining and predicting corporate failure.

Therefore, they could be used to determine and

predict corporate failure. To the best of the author‘s

knowledge, this is the first study that utilises real

figures about ownership structure (mix and

concentration) to investigate the effect of ownership

structure on corporate performance for Jordanian

companies. Furthermore, it could be considered as the

first effort to utilise ownership structure variables

(mix and concentration) to determine corporate failure

as there is a lack of empirical evidence about the

effect of ownership structure on corporate failure.

It is worth noting that collecting the data on

ownership structure (mix and concentration) for each

firm and for each year over the period 1989-2006

constituted a large part of the research for this paper

as the data were collected manually. This vast effort

made this research possible.

The remainder of this paper is organized as

follows. Section 2 provides a descriptive discussion

about ownership concentration and ownership mix for

98 For more details about the effect of corporate governance

on the incentives for the private sector to invest, see Stone,

Hurly and Khumani (1998). 99 Privatisation is part of the overall economic package that

the government has adopted since the economic adjustment

program of the early nineties, and self-reliance in the

aftermath of the economic crisis in 1989 that befell the

country.

the Jordanian companies used in the study. Section 3

introduces the estimation method. Section 4 introduces

the empirical results and the hypotheses test. Section 5

concludes the paper.

2. Ownership Structure and Firm Performance: a Descriptive Discussion 2.1 Ownership Structure (Mix) and Firm Performance

Since the establishment of the ASE in the 1970s, the

number of listed companies, trading volume, and total

market capitalisation have increased drastically. Table

1 reports the ownership structure of listed companies

by sectors100

. Despite its privatisation program, the

government still holds a large stake in Media, Utility

and Energy, and Steel, Mining and Heavy Engineering

companies (43.20%, 33.70 %, and 22.04 %,

respectively) because they are considered strategic

industries. Institutional ownership is very high in

transportation, real estate, and trade and commercial

services and rental, and communication (44.80%,

44.00%, and 36.89%, respectively). Individual

citizens as a group are the largest shareholder of

Educational Services, Medical Pharmacies, Textiles

and Clothing, and Construction and Engineering. The

largest foreign ownership stakes are in Steel, Mining

and Heavy Engineering, followed by Tobacco

(16.05% and 13.41%, respectively); foreign

ownership is also high in the Insurance sector.

Table 2 presents the basic statistics of the

ownership structure for defaulted and non-defaulted

firms. The individual (citizen) owns an average of

51.42 percent of defaulted firms, a figure which is

larger than 45.36 percent in non-defaulted firms. The

fractions of government and foreigner ownership have

their lowest median in the defaulted firms, 0.58 and

1.21 percent respectively, compared with 2.37 and

4.20 percent in non-defaulted firms for government

and foreigner respectively.

There are several notable differences. First of all,

defaulted firms have a lower median of government

ownership. Also, the median of institutional

ownership is lower, as is the median of foreigner

ownership. Table 2 suggests that Jordanian firms with

government, institutional, and foreign ownership have

a lower risk of failure (default) (in this analysis, we

will concentrate on the joint factor of Arab and

foreign ownership rather than taking each one

separately as both of them are considered foreign

owners). The next section discusses the characteristics

of defaulted firms in terms of ownership

concentration.

100 The classification of these sectors is based on the

Amman Stock Exchange (ASE) classification for firms

based on their activities. The author got this classification

from the ASE management.


98

Table 1. Ownership Structure by Sector*

Sector No. of Firms Government Companies

Citizen

(Individual) Foreign

Foods

19

10.67

(21.25)

29.08

(19.91)

47.83

(26.50)

8.79

(16.76)

Paper, Glass, and Packaging

12

7.58

(13.15)

23.72

(12.29)

54.80

(19.92)

11.22

(10.03)

Steel, Mining and Heavy Engineering

20

21.04

(25.15)

20.10

(17.98)

36.42

(26.25)

16.05

(17.11)

Medical Pharmacy

11

7.45

(14.89)

16.07

(12.56)

65.27

(19.01)

11.36

(14.60)

Chemical and Petroleum

11

2.78

(3.76)

25.22

(13.09)

51.63

(16.06)

12.06

(21.27)

Textiles and Clothing

8

14.95

(12.81)

19.37

(14.93)

59.31

(21.54)

3.17

(4.24)

Utilities and Energy

11

33.70

(39.33)

18.60

(19.53)

34.11

(31.45)

7.40

(13.42)

Tobacco

3

7.21

(10.67)

23.28

(14.64)

53.24

(17.44)

13.41

(26.89)

Construction and Engineering

10

8.06

(12.61)

23.82

(10.14)

56.83

(19.45)

10.20

(9.43)

Hotels and Tourism

11

18.02

(28.36)

32.87

(22.65)

34.71

(24.41)

10.89

(17.54)

Transportation

10

15.96

(21.24)

44.80

(17.17)

30.85

(22.11)

6.43

(12.45)

Real Estate

10

2.57

(4.36)

44.00

(20.50)

39.44

(21.03)

7.01

(5.55)

Media

5

43.20

(20.22)

18.62

(13.19)

33.21

(14.40)

0.60

(0.74)

Medical Services

5

0.00

(0.00)

21.39

(33.25)

56.19

(37.24)

12.58

(19.59)

Trade and Commercial Services and Rental,

Communication

15

8.73

(17.94)

36.89

(26.03)

45.83

(27.41)

7.46

(10.89)

Educational Services

3

1.36

(1.77)

9.40

(7.32)

81.30

(10.58)

5.09

(3.40)

*Firms averages with standard deviations in parentheses. Calculated from ASE Annual Reports

Table 2. Ownership Concentration for Defaulted and Non-Defaulted Firms

Non-Defaulted Firms (120) Defaulted Firms (47)

Mean Median Std.Dev Maximum Minimum Mean Median Std.Dev Maximum Minimum

Government 13.88 2.37 22.84 100 0 10.17 0.58 19.18 96.48 0

Companies 26.23 23.44 18.72 84.264 0 26.42 17.79 24.67 99 0

Individual

(Citizen) 45.36 46.73 25.59 98.776 0 51.42 53.94 27.05 99.87 0

Foreign 9.93 4.20 14.04 99.017 0 7.54 1.21 14.62 81.02 0

2.2 Ownership Concentration

It was established in that the ownership structure in

the ASE is highly concentrated (the median largest

shareholder in Jordan is large by Anglo-American

standards but within the range of those in France and

Spain, 20 and 34 percent respectively (see e.g. Becht

and RÖell, 1999)101

. Table 3 sheds more light on the

ownership concentration for Jordanian companies by

101 For more detail about the ownership concentration in the

ASE, see Zeitun (2006).


99

sectors using five measures of ownership

concentration across all firm-years102

. The largest

shareholder (C1) owns the highest percentage in the

Hotel and Tourism sector and Media sector (35.32

percent and 35.50 percent respectively). The largest

shareholder C1 owns the lowest percentage in the

Educational sector (7.86 percent). The data also

reveals that there is a substantial variation across

firms and sectors in ownership concentration.

Given that the holding of the largest shareholder

(C1) is so large, the other shareholders are small. As

shown in Table 3, the cumulative percentage of

ownership tapers rapidly103

, and there is little

difference between C3 and C5 in all sectors. The

average of C3 is highest in the Media sector followed

by the Transportation sector with 49.53 percent and

45.94 percent in each sector respectively.

The Educational, Medical Pharmacy, Tobacco,

and Paper, Glass, and Packaging sectors have the

lowest ownership concentration in terms of the largest

five shareholders (C5), compared with highest stake

in Transportation, Media, and Trade, Commercial

Services, Rental and Communication. The variation

could relate to the capital required in these sectors,

and also the importance of the sector; often there is

high state ownership in sectors regarded as strategic.

Table 4 presents the basic statistics of ownership

concentration for defaulted and non-defaulted firms.

Considering the median, the largest shareholder (C1)

owns 20 percent in the defaulted firms, a figure which

is larger than the 18.86 percent in the non-defaulted

firms. The largest two shareholders (C2) own 29.09

percent in the defaulted firms, a figure which is only

marginally larger than 28.60 percent in the

non-defaulted firms. The other measures of

concentration C3, C5, and HERF are all larger in

defaulted than non-defaulted firms. The data also

reveals that there is a substantial variation across

firms in ownership concentration: despite the high

average, the largest owner‘s value varies between 0

and 100 percent. In this study, we used C5 and HERF

indexes as indictors of ownership concentration to

investigate whether ownership concentration

increased the firm's performance and contributed to

the firm's default.

3. Estimation Method 3.1 Data

The data used in this study is derived from publicly

102 The results provided are for 167 firms and over the

period of 1989 to 2006. These ownership concentration

statistics were collected and computed by the author. 103 The second largest shareholder (C2) does, in fact, tend

to have a substantially smaller stake, although the largest

(C1) still quite large compared with the second largest

shareholder.

traded companies quoted on the Amman Stock

Exchange (ASE), over the period 1989-2006. The

data set contains detailed information about each

enterprise. The major items of interest are: balance

sheets, income statements, ownership structure, and

the percentage holdings of all direct shareholders104

.

The full balance sheets and income statements are

usually available from firms as the law requires

disclosure.

The ownership data was collected manually, as it

is not available for all firms and for all years from the

Amman Stock Exchange (ASE) reports. Collecting

this data on ownership structure and concentration for

each firm and for each year constituted a large part of

the research for this thesis. This vast effort made this

research possible, since the analysis uses real figures

rather than dummy variables for ownership structure.

Furthermore, the changes in real figures over years

are more valuable, as they shed light on the effect of

changes in ownership structure on both the firm‘s

health and failure. It is worth noting that the

unavailability of data for the managerial ownership

and ownership held by outside block holders

prevented the researcher from further investigation for

the effect of these variables.

104 The ownership concentration is defined as any owner

possessing more than 5% and 10% of the company's shares.


100

Table 3. Ownership Concentration by Sector*: Cumulative percentage of shares controlled by different types of

shareholders

Sector Definition C1 C2 C3 C5 HERF

Sector1

Foods

27.77

(1359.69)

38.06

(535.21)

40.41

(559.61)

41.91

(819.71)

13.28

(1599.66)

sector2

Paper, Glass, and Packaging

18.53

(14.53)

25.38

(20.35)

27.09

(21.36)

28.24

(22.55)

7.11

(11.03)

Sector3

Steel, Mining and Heavy Engineering

28.05

(18.72)

37.43

(24.90)

41.95

(27.95)

44.57

(29.85)

14.09

(12.95)

Sector4

Medical Pharmacy

11.08

(11.18)

14.74

(14.56)

15.64

(15.47)

15.90

(15.89)

3.01

(4.01)

Sector5

Chemical and Petroleum

17.97

(15.02)

25.91

(17.39)

28.96

(20.14)

29.48

(20.54)

6.91

(11.76)

Sector6

Textiles and Clothing

15.83

(10.05)

24.38

(14.27)

29.89

(17.96)

32.08

(20.35)

5.39

(4.91)

Sector7

Utilities and Energy

34.22

(31.53)

41.89

(37.34)

43.21

(37.06)

43.49

(37.36)

23.22

(31.01)

Sector8

Tobacco

12.41

(6.15)

18.06

(10.15)

20.39

(13.39)

21.44

(15.72)

2.92

(2.27)

Sector9

Construction and Engineering

16.93

(12.60)

24.90

(16.41)

28.95

(17.90)

31.48

(20.64)

6.14

(7.50)

Sector10

Hotels and Tourism

35.32

(24.47)

40.91

(25.98)

43.11

(26.38)

45.24

(27.09)

19.66

(22.79)

Sector11

Transportation

24.01

(16.18)

37.20

(19.95)

45.94

(22.58)

53.59

(26.24)

12.49

(13.79)

Sector12

Real Estate

30.94

(21.47)

38.92

(20.36)

42.71

(20.45)

45.98

(19.84)

15.68

(19.66)

Sector13

Media

35.50

(13.57)

44.87

(16.29)

49.53

(19.73)

50.61

(20.91)

15.50

(8.72)

Sector14

Medical Services

21.18

(30.85)

23.20

(30.55)

23.57

(30.59)

23.57

(30.59)

13.89

(32.93)

Sector15

Trade and Commercial Services

and Rental, Communication

31.04

(21.05)

40.21

(24.54)

42.37

(25.56)

44.72

(26.13)

16.25

(16.83)

Sector16

Educational Services

7.86

(9.45)

11.28

(13.60)

11.71

(14.49)

11.71

(14.49)

1.93

(2.90)

Notes: *Firms averages with standard deviations in parentheses. Calculated from ASX Annual Reports; C1- percentage

holding of largest shareholders, C2- combined percentage holdings of 2 largest shareholders, C3- combined percentage

holdings of 3 largest shareholders, C5- combined percentage holdings of 5 largest shareholders, and HERF-Herfindahl index

of ownership concentration, the sum of squared percentage of shares controlled by the largest 5 shareholders.

Table 4. Ownership Concentration for Defaulted and Non-Defaulted Firms

Non-Defaulted Firms (120) Defaulted Firms (47)

Mean Median Std.Dev Maximum Minimum Mean Median Std.Dev Maximum Minimum

C1 24.03 18.86 19.73 100 0 25.94 20.00 21.92 99 0

C2 32.17 28.60 24.21 100 0 33.84 29.09 23.33 99 0

C3 35.23 33.38 25.76 100 0 36.99 36.00 24.72 99 0

C5 37.55 35.70 27.53 100 0 37.67 36.00 25.31 99 0

HERF 11.62 5.46 16.18 100 0 13.10 6.56 19.04 98.01 0

Notes: C1- percentage holding of largest shareholders, C2- combined percentage holdings of 2 largest shareholders, C3- combined percentage

holdings of 3 largest shareholders, C5- combined percentage holdings of 5 largest shareholders, and HERF- Herfindahl index of ownership

concentration

For data analysis, a clear and consistent

definition of failure or default is required. While

default is usually defined as a corporation not being

able to meet its obligations on a due date, different

researchers have used different criteria to define

default. For example, Beaver (1968) used a wider


101

definition of default, which includes default on a loan,

an overdrawn bank account, and non-payment of a

preferred stock dividend. Alternatively, default may

be defined in a stricter legal sense as in Deakin (1972),

who defined default to include only those firms which

experienced bankruptcy or liquidation and faced legal

action. In the case of Jordan, we define default as a

firm that had a receiver or liquidator appointed, was

delisted from the Amman Stock Exchange (ASE) in

the period 1989 to 2006105

, or that stopped issuing

financial statements for two years or more, since firms

are obliged by law to submit their annual financial

statements. The date of failure is the date the

liquidator was appointed, or the date of delisting from

the formal market106

, or the date of the first failure to

submit returns.

The first sample includes pooled cross-sectional

and time-series data for 167 firms (47 defaulted and

120 non-defaulted) over the period 1989-2006. These

firms ranged from old to newly established ones. The

second sample is a matched sample which reduces the

number of defaulted firms to 29 (from the 47) that

meet our definition and requirement. Therefore, the

initial sample in this study consisted of 59 industrial

and services firms with 29 failed and 30 non-failed

firms. The non-failed sample was matched to the

failed sample from the same industry and the same

year of data collection. No financial companies such

as banks or insurance firms are included, since the

characteristics of these firms are substantially

different to manufacturing and service firms.

3.2 Variables Selection

Four ratios to measure firms‘ performance were

calculated for both the panel data sample and matched

sample, namely return on equity (ROE), return on

assets (ROA), Tobin‘s Q, and MBVR. Tobin‘s Q and

MBVR are used to measure the market performance

of firms, while the ROE and ROA are employed as

measures representing accounting performance

measures. The explanatory variables are ownership

fractions, concentration ratios, and other control

variables.

The measures of concentration are the

cumulative percentage of shares held by the largest

five shareholders (C5), and the Herfindahl index of

ownership concentration (the sum of squared

percentage of shares controlled by each top 5

shareholders). The ownership fraction (mix) is

divided into the fraction owned by government

(GOV), the fraction owned by the foreigner (FORG),

105 This definition is very similar to the one used by Izan

(1984). 106 According to Ohlson (1980), the timing issue is a crucial

problem in data collection. It arises as firms‘ financial

statements are not always released to the public on a timely

basis.

the fraction owned by companies (INSTIT), and the

fraction owned by individuals (CITIZEN). By

controlling for both ownership concentration and mix,

we hope to be able to distinguish which factors are

more significant in poorly performing enterprises.

Factors other than ownership structure may also

affect a firm‘s performance and health. To take them

into account, we introduce a set of control variables.

Dummy variables for industries are used to control

the difference between sectors, DUMi, i= 1, 2,...,5, for

Manufacturing, Trade, Steel and Mining, Utility, and

Real Estate in the matched sample, and 16 industrial

dummy variables in the panel data regressions (see

Table 3 for sector definitions). Also, firm size

(SIZE)107

, firm‘s age (AGE), capital structure variable

(DEBT), which is defined as total debt to total assets

(TDTA) or total debt to total equity (TDTE),

long-term debt to total assets (LTDTA). Growth

opportunity (GROW) is defined as growth in sales

(GROW1), or net income to capitalisation (NICAP)

108.

3.3 Empirical Model and Proxies Variables 3.3.1 Ownership Structure and Firm Performance

Let Y and CR represent performance and

concentration ratio variables respectively. If

ownership structure does not affect firm‘s

performance, it would be found that there is no

correlation between Y and CR. Thus, the first

hypothesis can be stated as follow:

1H : Ownership concentration does not affect a

firm‟s performance.

Equation (1) is estimated to test the first

hypothesis using panel data and a random effects

model109

:

107 In the previous work, the value of total assets is used to

control size effect (see e.g. Morck et al., 1988 and

McConnell and Servaes, 1990). Other studies used sales to

control for size (see e.g. Xu and Wang, 1997). The

logarithm of total sales is used in this research. It has lower

explanatory power than assets, and its inclusion in

regressions of ROA and ROE makes the results not

significant. 108 The growth in total assets and the book value of total

assets minus book value of equity plus market value of

equity divided by book value of total assets are used in this

study. However, while all the measures of growth are found

to have a similar result, the growth in sales and NICAP are

provide the best results regarding the model explanatory

power. 109 The random effect model is preferred more than the

fixed effect model in this estimation as a dummy variable

for industrial sectors is included in the analysis to control

for the effect of the industrial sectors on corporate

performance.


102

0 1 2 3 4it it it it it itY SIZE DEBT GROW CR (1)

After testing the hypothesis of the irrelevance

ownership concentration on firm performance, this

study further addresses the effect of ownership

structure on a firm‘s performance by studying the

effects of ownership mix on a firm's performance. If

ownership mix is irrelevant, there will be no

correlation between firm performance and firm value

and ownership mix. Thus, to test the irrelevance of

ownership mix on firm performance, the second

hypothesis is stated as:

2H : Ownership mix does not affect firm

performance.

If this hypothesis is rejected, the government

ownership, GOV, is hypothesised to be negatively

related to a firm‘s performance as its main focus is

social benefit rather than profit. It is hypothesised that

firms with both foreign (FORG) and institutional

(INSTIT) ownership will have a higher performance.

Equation (2) is estimated to test the second

hypothesis using the panel data model:

0 1 2 3 4it it it it it itY SIZE DEBT GROW F (2)

If ownership mix and concentration are relevant

to firm performance, this study will investigate

whether there is any effect of ownership concentration

on the significance of ownership mix. This study

explores the effect of both ownership concentration

and mix on firm performance by estimating the

following equation:

0 1 2 3 4 5it it it it it it itY SIZE DEBT GROW CR F (3)

Finally the matched sample110

is used to test the

irrelevance of ownership structure by estimating the

following equation:

0 1 2 3 4

5 6 7

Y SIZE AGE DEBT LTDTA

GROW CR F

(4)

where Y is alternatively ROA, ROE, Tobin‘s Q,

and MBVR for firm i as a measure of performance.

The independent variables are represented by

concentration ratio (CR), ownership fraction (F),

SIZE, AGE, DEBT (TDTA111

or TDTE), LTDTA112

,

110 The purpose of including the matched sample model

estimation is to provide evidence of how ownership

structure could have an impact on defaulted and

non-defaulted firms from the same industry and having the

same year of data. Furthermore, the pooled data model is

used in this study and is found to give better results than the

panel data model. An example of this is the result from the

matched sample. 111 It is worth noting that I re-estimated these equations by

introducing instrumental variables in order to investigate the

endogeneity problem; however, the results remain almost

the same without changing the estimated parameters

and GROW. Only C5 and the HERF are used as

concentration ratios113

in the estimation to investigate

the effect ownership concentrations on a firm‘s

performance. F is alternately GOV, FORG, INSTIT,

and CITIZEN. is a error term. The government

ownership, GOV, is hypothesised to be negatively

related to a firm‘s performance, while both foreign

(FORG) and institutional (INSTIT) ownership are

hypothesised to have a positive impact on corporate

performance. The next section will introduce the

empirical model that investigates the impact of

ownership structure on a firm‘s likelihood of default.

3.3.2 Ownership Structure and Corporate Failure

To further examine the issue of ownership structure

and its effect on a firm‘s likelihood of default, a test

estimating the likelihood of default was conducted

using both mix and concentration ownership structure

variables. Many studies used Logit models, such as

Martin (1977), Ohlson (1980), Zavgren (1985),

Johnsen and Melicher (1994), Lennox (1999),

Westgaard and Wijst (2001), and Ginoglou, Agorastos

and Hatzigagios (2002), among others. The Logit

model is formulated for Jordanian companies‘

conditions, and contains two state dependent

variables: state 1 for default firms, otherwise 0 for

non-default.

To investigate whether ownership concentration

and mix contributes to a firm‘s default, two

hypotheses are developed. If ownership structure (mix

and concentration) is irrelevant to default probability,

the ownership concentration and fraction will produce

an insignificant correlation between ownership

structure and corporate failure. Thus, the two

hypotheses can be stated as follows:

3H : Ownership concentration does not affect a

firm‟s default.

4H : Ownership mix does not affect firm

default.

The basic estimating equation for the matched

sample is as follows:

0 1 2 3 4 5 6*iY SIZE AGE TDTA NICAP CR F

(5)

significantly. In order to save space, these results are not

reported in this research. 112 The purpose of including the LTDTA and the DEBT

ratios in the matched sample is to control for the effect of

debt structure as this sample focused more on the defaulted

and the non-defaulted firms, and as DEBT is defined in the

matched sample as TDTE. 113 It is worth noting that the ownership concentration C1,

C2, and C3 are tried in this study, but C5 is found to have

more predictive power.


103

Equation (6) is estimated to test hypotheses three

and four ( 3H and 4H ) using panel data and the

random effects model:

0 1 2 3 4 5 6*it it it it it it it itY SIZE AGE TDTA NICAP CR F

(6)

where Y* represents the firm‘s status with

Yit

=1 if firm i defaults at period t and it

y =0

otherwise, CR represents ownership concentration

ratios, C5 and HERF. F represents ownership

fractions, GOV, FORG, and INSTIT. is the

stochastic disturbance term corresponding to the ith

(estimated error).

Government ownership, GOV, is hypothesised to

be negatively related to a firm‘s default, as their main

focus is social benefit rather than profit. Priorities of

government do not necessarily coincide with a firm's

performance maximisation. For instance, the

government may care more about unemployment or

control over certain strategic industries than the value

of state assets. So, the government will support

distressed firms even until they default. Therefore,

government ownership could affect a firm's

performance negatively and, at the same time,

decrease the likelihood of default. Institutional

shareholders (INSTIT) are more profit-oriented and

may have more incentive to monitor the firm. It is

hypothesised that firms with institutional ownership,

INSTIT, will have a lower risk of failure as they

monitor the firm more closely and their goal is profit

maximisation.

Foreign shareholders (FORG) are also more

profit-oriented than government and may have more

incentive to monitor the firm. It is hypothesised that

firms with foreign ownership, FORG, will have a

lower risk of default (failure). Furthermore,

ownership concentration, C5, is expected to have a

negative effect on the likelihood of default. Four

control variables are used in this study: the firm‘s size,

the firm‘s age, TDTA114

, and the growth ratio NICAP.

These variables are expected to contribute to a firm‘s

default. It is expected that firms with high debt ratio

will have a high corporate failure and firms with a

high profit ratio will have a lower corporate failure.

Furthermore, it is argued that larger and older firms

will have a lower corporate failure.

4. Empirical Results

The analysis of the results is presented here in

separate subsections. It begins with an analysis of the

114 I re-estimated these equations by introducing

instrumental variables in order to investigate the

endogeneity problem; however, the results remain almost

the same without changing the estimated parameters

significantly. In order to save space, these results are not

reported in this research.

effect of ownership structure on corporate

performance, where ownership concentration and mix

are used in the analysis. The analysis then moves to

examining the effect of ownership structure (mix and

concentration) on corporate failure. This includes an

analysis of the statistical significance of each variable.

The random-effects model is used to examine the

effect of ownership structure and control for the effect

of industrial sectors on corporate performance.

4.1 Ownership Structure and Corporate Performance

In order to explore the appropriateness of a

random-effects model, a Breusch-Pagan Lagrange

Multiplier test is conducted to determine the overall

significance of these effects. According to the

Breusch-Pagan test the null hypothesis is that random

components are equal to zero. This test also provided

support for the Generalized Least Squares (GLS) over

a pooled Ordinary Least Squares (OLS) regression. In

all models, the Breusch-Pagan Lagrange Multiplier

test supported the use of the random-effects model.

Also, the Hausman test failed to reject the null

hypothesis of no difference between the coefficients

of the random- and the fixed-effects models. For

example, the 2Chi (4) = 0.36, P=0.98 and

2Chi

(4) = 3.4, P=0.49 for Tobin‘s Q and MBVR,

respectively. Our model also contains time-invariant

variables which cannot be estimated using the

fixed-effects model.

The overall goodness of fit (2R ) for the

random-effects model, using both ownership mix and

concentration and industrial sector variables, is

greater than the goodness of fit for the random-effects

model using only ownership concentration. A general

test for serial autocorrelation in panel data has been

conducted using the test developed by Wooldridge

(2002) (see Drukker, 2003). The null hypothesis is

that there is no serial autocorrelation for the data

examined. The hypothesis is strongly accepted as ((F1,

134) =0.847, P=0.3591). Therefore, our models do not

have a serial autocorrelation. The overall significance

of the models was tested using the Wald test, which

has a Chi-square (2 ) distribution under the null

hypothesis that all the exogenous variables are equal

to zero. For all models, the value of the 2 statistic

is significant at least at the 1 % level of significance

using ROA.

The estimation results of Equation (1) are

presented in Table 5 and Table 6 using the

random-effects model. Table 7 and Table 8 report the

results for the estimation of Equation 2. To examine

the robustness of our results, the model included

dummy variables to control for industry effects, and

the results are reported in Appendix 1. Appendix 2

and Appendix 3 report the result of the cross-sectional

analysis for the matched sample to provide more


104

evidence on the effect of ownership structure on

corporate performance. The regression model using

price per share to earnings per share, ROE115

, is not

significant and, hence, is not reported using the panel

data analysis.

4.1.1 Ownership Concentration Results

From Hypothesis 1, the variables representing

ownership concentration are expected not to have any

significant impact on corporate performance. Two

variables are used, C5 and HERF. From the regression

results in Table 5, the variable C5 was found to have a

negative and significant impact on ROA at the 10%

level of significance, while it has a positive and

significant impact on MBVR. The estimated

coefficient of the HERF indicates that it does not have

a significant impact on any measure of firm

performance or value. Neither the HERF nor the C5

have any significant impact on Tobin‘s Q (although

the sign of the coefficient was positive in both

equations). The result for Tobin‘s Q and MBVR are

more robust as proved by the R-square and Waled test.

Hypothesis 1 is thus rejected as C5 is significantly

different from zero in regressions of ROA and MBVR.

As concentration is immensely different from industry

to industry, this gives rise to the potential for industry

effects of ownership concentration on a firm‘s value

(see Table 4). It can be argued that the effect of

ownership concentration may be different from one

industry to another (see Wei, Xie and Zhang, 2005).

To control for potential industry effects, 15

industrial dummy variables116

were taken and

Equation (1) was re-estimated. The results, reported in

Table 6, almost changed the significance of C5. The

largest five shareholders, C5, became insignificant in

ROA, while the significance of C5 increased in

MBVR. Furthermore, of the 15 industrial dummy

variables, only that for sector 8 was found to have a

positive impact on a firm‘s performance ROA. Also,

all the coefficients of the industrial variables were

found to have a negative and significant impact on a

firm‘s value measured by Tobin‘s Q. It should be

noted that the significance of these industrial sectors

may imply presence of industry sector.

The significant impact of concentration ratios on

MBVR supports the Shleifer and Vishny hypothesis

(1986) that large shareholders may reduce the

problem of small investors and, hence, increase the

firm‘s performance. The finding of a positive and

significant relationship between ownership

concentration and corporate performance is consistent

with prior research based on advanced capital markets

including Hill and Snell (1988, 1989), Kaplan and

115 The only variable that is found to be significant is

DEBT. 116 The analysis included 16 dummy variables but one

dummy variable (sector 16) is dropped due to collinearity.

Minton (1994), and Morck, Nakamura and Shivdasani

(2000), among others.

However, this finding is inconsistent with the

result of Wu and Cui (2002) that there is a positive

relationship between ownership concentration and

accounting profits (indicated by ROA), but consistent

with the result of Leech and Leahy (1991) and

Mudambi and Nicosia (1998). The insignificant

results for concentration variables in the Tobin‘s Q

equation could suggest that the Jordanian equity

market is inefficient (or there could be other factors

that affect the market performance measure, which

were missed in our models). These results are

consistent with Abdel Shahid (2003), that ROA is the

most important factor used by investors rather than

the market measure of performance.

4.1.2 Ownership Mix and Corporate Performance

This section presents the results of ownership mix.

The hypothesis is that if ownership mix is irrelevant

to firm performance (Hypothesis 2), then the

ownership fractions will be expected to be

insignificant in Equation 2. Hypothesis 2 is rejected

decisively as GOV, INSTIT and CITIZEN are

significantly different from zero in regressions of

ROA and Tobin‘s Q. The results of the panel

regression are reported in Table 7. The results in Table

7 indicate that the fraction of equity owned by

government, GOV, has a positive coefficient in ROA

performance equations, and it is statistically

significant at the 10% level. However, GOV is found

to have a negative but insignificant impact on both

Tobin‘s Q and MBVR. The fraction owned by

institutions, INSIT, has a negative coefficient on both

ROA and Tobin‘s Q measure of performance, and

these coefficients are highly significant. The fraction

of equity owned by foreign shareholders, FORG, does

not seem to have any significant impact on the

profitability of firms as measured by ROA, Tobin‘s Q,

and MBR.


105

Table 5. Ownership Concentration and Firm‘s Performance

SIZE DEBT GROW1 C5 HERF Constant

Adj. 2R Wald test

Breusch and

Pagan

ROA

0.0595

(6.10)***

-0.1606

(-10.87)***

0.0007

(2.39)**

-0.0310

(-1.91)*

-0.3418

(-5.10)*** 0.1978

152.85

(0.00)***

337.65

(0.00)***

ROA

0.0557

(5.70)***

-0.1600

(-10.84)***

0.0007

(2.40)**

0.0151

(0.58)

-0.3292

(-4.89)*** 0.1944

149.89

(0.00)***

333.57

(0.00)***

Tobin‘s Q

-0.6661

(-0.5)

-2.1318

(-0.95)

-0.00992

(-0.18)

-2.92159

(-1.13)

8.633798

(0.93)

0.0036

2.82

(0.7280)

28.22

(0.00)

Tobin‘s Q

-0.756

(-0.56)

-2.0572

(-0.92)

-0.01016

(-0.19)

-2.0744

(-0.48)

8.358025

(0.9)

0.0024

1.63

(0.8026)

28.08

(0.00)

MBVR

0.3688

(2.49)***

-0.3089

(-1.18)

-0.00708

(-0.38)

0.41736

(1.64)*

-1.06873

(-1.05)

0.0266

26.20

(0.00)

324.75

(0.00)

MBVR

0.3872

(2.62)***

-0.3284

(-1.25)

-0.00817

(-0.44)

0.39192

(0.90)

-1.07434

(-1.06)

0.0156

9.06

(0.06)

314.63

(0.00)

Note: ***, **, * indicate significant at a 1%, 5%, and 10% level, respectively. t statistics are in parentheses.

Table 6. Ownership Concentration and Firm‘s Performance Including Industrial Dummy Variables

ROA ROA Tobin‘s Q Tobin‘s Q MBVR MBVR

Constant

-0.4095

(-4.72)***

-0.3874

(-4.47)***

87.2243

(9.9)***

87.4586

(9.89)***

-2.0809

(-1.52)

-2.1917

(-1.59)

SIZE

0.0606

(5.6)***

0.0564

(5.23)***

-0.5307

(-0.52)

-0.5939

(-0.58)

0.4176

(2.53)**

0.4469

(2.72)***

DEBT

-0.1615

(-10.61)***

-0.1609

(-10.58)***

-0.6956

(-0.38)

-0.7273

(-0.39)

-0.3586

(-1.35)

-0.3685

(-1.38)

GROW1

0.0007

(2.43)**

0.0008

(2.46)**

-0.0476

(-0.93)

-0.0476

(-0.93)

-0.0016

(-0.08)

-0.0027

(-0.15)

C5

-0.0271

(-1.62)

-0.8105

(-0.39)

0.4740

(1.78)*

HERF

0.0299

(1.1)

0.2707

(0.08)

0.4401

(0.98)

No. of Observation 1265 1265 1163 1163 1113 1113

Wald test

166.21

(0.00)***

164.99

(0.00)***

229.39

(0.00)***

228.98

(0.00)***

33.09

(0.0234)**

30.93

(0.0411)**

R-square 0.2184 0.2155 0.1876 0.1876 0.0952 0.0936

Breusch and Pagan test

238.16

(0.00)***

238.27

(0.00)***

16.97

(0.00)***

17.03

(0.00)***

128.17

(0.00)***

126.14

(0.00)***

Note: ***, **, * indicate significant at a 1%, 5%, and 10% level, respectively. t statistics are in parentheses. Statistical

significance t-statistics are determined with White (1980) standard errors to correct for heteroskedasticity. Industrial dummy

variables are included in the regression.

Table 7. Ownership Structure and Firm‘s Performance

SIZE DEBT GROW1 GOV INSTIT CITIZEN FORG Constant Wal test Adju 2R

ROA

0.0541

(5.53)***

-0.1622

(-10.9)***

0.0007

(2.4)**

0.0410

(1.66)*

-0.3211

(-4.75)***

150.84

(0.00)*** 0.19

ROA

0.0619

(6.3)***

-0.1675

(-11.14)**

*

0.0007

(2.38)**

-0.0447

(-2.04)**

-0.3557

(-5.22)***

158.7

(0.00)*** 0.20


106

Table 7 continued

ROA

0.0612

(6.19)***

-0.1594

(-10.81)**

*

0.0007

(2.41)*

*

0.0379

(1.84)*

-0.3830

(-5.34)***

153.93

(0.00)*** 0.20

ROA

0.0554

(5.7)***

-0.1591

(-10.75)**

*

0.0007

(2.42)*

*

0.0320

(1.1)

-0.3289

(-4.89)***

149.35

(0.00)***

0.19

Tobin‘s Q

-0.7927

(-0.58)

-2.0466

(-0.9)

-0.0104

(-0.19)

-0.6047

(-0.17)

8.4473

(0.89)

1.42

(0.84) 0.002

Tobin‘s Q

-1.0316

(-0.75)

-2.8212

(-1.24)

-0.0145

(-0.27)

-10.012

(-2.95)***

13.0078

(1.35)

10.11

(0.034)* 0.0052

Tobin‘s Q

-2.4531

(-1.75)*

-2.6991

(-1.2)

-0.0070

(-0.13)

-12.7624

(-4.14)***

26.0185

(2.54)**

18.51

(0.00)*** 0.0107

Tobin‘s Q

-0.6041

(-0.44)

-2.2295

(-0.99)

-0.0112

(-0.21)

-4.8781

(-1.06)

7.6135

(0.81)

2.52

(0.6410) 0.0025

MBVR

0.4026

(2.7)***

-0.3236

(-1.23)

-0.0090

(-0.49)

-0.0164

(-0.04)

-1.1322

(-1.11)

8.34

(0.08)* 0.0135

MBVR

0.3603

(2.38)**

-0.3161

(-1.21)

-0.0088

(-0.48)

-0.2877

(-0.92)

-0.7090

(-0.65)

9.06

(0.06)* 0.0166

MBVR

0.3728

(2.48)**

-0.2427

(-0.91)

-0.0070

(-0.38)

0.5036

(1.51)

-1.0919

(-1.05)

9.23

(0.06)* 0.0184

MBVR

0.4189

(2.8)***

-0.3343

(-1.27)

-0.0101

(-0.55)

-0.3280

(-0.75)

-1.2091

(-1.18)

8.89

(0.06)*

0.0157

Note: ***, **, * indicate significant at a 1%, 5%, and 10% level, respectively. Statistical significance t-statistics

is determined with White (1980) standard errors to correct for heteroskedasticity.

However, the significance of the ownership

structure (Mix) variables changed as 15 industrial

dummy variables were included in the model to

control for potential industry effects (see Table 8).

The significance of both government ownership

(GOV) and institutional ownership (INSTIT)

increased, while individual citizen ownership

(CITIZEN) becomes insignificant. Also, foreign

ownership, FORG, becomes significantly negatively

related to firm value, as proxied by Tobin‘s Q. This

finding is inconsistent with the previous finding of

Wei, Xie, and Zhang (2005). This result indicates that

foreign investors negatively influence management of

the firm. The sign of the institutional ownership in

MBVR is changed and becomes significant. The

changes indicate that the effect of the same proportion

of state, institutional, or foreign ownership could be

different in one industry from others.

The estimation of Equation (3) that investigates

the effects of both ownership concentration and mix

on corporate performance and value is reported in

Appendix 1. The indicator of concentration C5 is

included and it shows a negative and significant effect

on ROA, and Tobin‘s Q, while it has a positive effect

on MBVR. The impact of ownership mix did not go

away. Instead, the government (GOV), institutional

(INSTIT), and foreign (FORG) ownership become

stronger in ROA regression. The fraction of

government ownership shares (GOV) has a positive

coefficient in the two regressions, ROA and Tobin‘s Q,

but has a significant impact in all ROA regressions.

The fraction of institutional shares (INSTIT) is found

to have a negative and significant impact on both

ROA and Tobin‘s Q, while institutional ownership is

found to have a positive and significant impact on

MBVR regressions. The fraction owned by the

foreigners (FORG) is found to have a negative and

significant impact in all Tobin‘s Q regressions, while

it has a positive, but insignificant, impact in all ROA

regressions.

We further investigate the effect of ownership

structure on corporate performance using a

cross-sectional analysis for a matched sample of

defaulted and non-defaulted firms. The results of

pooled regressions for the matched sample of

defaulted and non-defaulted firms (Equation 4) are

reported in Appendix 2 and Appendix 3. The results

show that ownership concentration has a positive and

significant impact on both ROE and ROA, but neither

the HERF nor the C5 have any explanatory power for

both Tobin‘s Q and MBVR (although the sign of the

coefficient was positive in both equations). The

fraction of equity owned by government, GOV, has a

negative coefficient in ROE performance equations,

and it is statistically significant at the 10% level. The

FORG also has a negative coefficient in both ROE

and ROA measure of performance, but none of these

coefficients are significant.

Table 8. Ownership Structure and Firm‘s Performance Including Industrial Dummy Variables


107

ROA

Constant

-0.3854

(-4.45)***

-0.4447

(-5.11)***

-0.4364

(-4.84)***

-0.3950

(-4.56)***

SIZE

0.0562

(5.25)***

0.0665

(6.09)

0.0618

(5.63)***

0.0564

(5.24)

DEBT

-0.1633

(-10.71)***

-0.1692

-(10.98)***

-0.1607

(-10.57)***

-0.1605

(-10.54)***

GROW1

0.0007

(2.45)**

0.0007

(2.42)**

0.0007

(2.44)**

0.0008

(2.47)**

GOV

0.0552

(2.14)**

INSTIT

-0.0470

(-2.07)**

CITIZEN

0.0313

(1.46)

FORG

0.0343

(1.16)

No. of Observation 1263 1263 1263 1263

Wald test

168.40

(0.00)***

177.02

(0.00)***

166.83

(0.00)***

164.46

(0.00)***

R-square 0.2134 0.23 0.22 0.21

Breusch and Pagan

test

241.33

(0.00)***

224.57

(0.00)***

241.83

0.00)***

223.05

(0.00)***

Tobin‘s Q MBVR

Constant

87.6015

(9.68)***

88.2722

(9.65)***

95.9267

(9.95) ***

85.9313

(9.79)***

-2.34069

(-1.7)*

-2.0455

(-1.49)

-1.7423

(-1.24)

-2.3026

(-1.67)*

SIZE

-0.6523

(-0.61)

-0.6286

(-0.58)

-1.6544

(-1.47)

-0.1285

(-0.12)

0.4706

(2.85)***

0.4076

(2.45)**

0.3985

(2.38)**

0.4754

(2.87)***

DEBT

-0.7732

(-0.41)

-0.9421

(-0.5)

-1.2407

(-0.66)

-0.8736

(-0.47)

-0.3354

(-1.25)

-0.2728

(-1.01)

-0.3568

(-1.35)

-0.3609

(-1.35)

GROW1

-0.0469

(-0.91)

-0.0511

(-0.99)

-0.0394

(-0.77)

-0.0488

(-0.95)

-0.0037

(-0.2)

-0.0006

(-0.030)

-0.0028

(-0.15)

-0.0046

(-0.24)

GOV

0.6459

(0.24)

-0.2098

(-0.53)

INSTIT

-4.6848

(-1.65)*

0.7090

(2.05)**

CITIZEN

-6.9564

(-2.79)***

-0.3898

(-1.2)

FORG

-7.3521

(-2.03)**

-0.2539

(-0.57)

No. of Observation 1163 1163 1163 1163 1113 1113 1113 1113

Wald test

223.69

(0.00)***

225.31

(0.00)***

222.99

(0.00)***

235.87

(0.00)***

30.25

(0.05)**

33.55

(0.02)**

33.06

(0.02)**

30.28

(0.04)**

R-square 0.19 0.19 0.1917 0.19 0.0906 0.1035 0.0987 0.0929

Breusch and Pagan

test

16.97

(0.00)***

15.61

(0.00)***

14.60

(0.00)***

16.67

(0.00)***

126.73

(0.00)***

117.55

(0.00)***

121.68

(0.00)***

125.51

(0.00)***

Note: ***, **, * indicate significant at a 1%, 5%, and 10% level, respectively. Statistical significance t-statistics

is determined with White (1980) standard errors to correct for heteroskedasticity. Industrial dummy variables are

included in the regression.

The fraction of equity owned by institution

shareholders (INSTIT) does not seem to have any

significant impact on the profitability of firms as

measured by ROE, ROA, Tobin‘s Q, and MBVR.

However, we would argue that the explanatory power

for both ROE and ROA regressions is fairly high with

the adjusted R-squared value ranging from 50 to 73

percent, while the adjusted R-squared is merely 5 to

15 percent for both MBVR and Tobin‘s Q equations.

Furthermore, the F statistics are significant and very


108

high for the two measures of performance, ROE and

ROA, but very low though still significant for Tobin‘s

Q. In all of the regression, five industrial dummy

variables were included as control variables and their

coefficients were not significant at any level of

significance. The results from the cross-sectional

regression confirm our finding that ownership

structure (mix and concentration) has a significant

effect on corporate performance.

In all regressions, the controlling variable firm‘s

size (SIZE) has a positive impact on the firm‘s

performance measures, ROA and MBVR, and they

are significant, at least at a 1% and 5% level, in both

ROA and MBVR, respectively. The controlling

variable growth, GROW, has a positive and

significant impact on firm performance measure ROA

only. The controlling variable for capital structure,

DEBT, is found to have a negative and significant

impact on ROA and ROE, while DEBT does not have

any significant impact on Tobin‘s Q and MBVR.

There are some conflicting results regarding the

coefficient‘s sign between ROA, Tobin‘s Q and

MBVR equations indicating that ownership structure

(mix and concentration) affects corporate

performance measures differently.

The findings of a significant impact of

ownership structure (mix) on corporate performance

and value are consistent with prior research including

Agrawal and Mandelker (1990), Xu and Wang (1997),

Miguel and Pindado (2001), Lizal (2002), Abed

Shahid (2003), Wei, Xie, and Zhang (2005), among

others. Therefore, the results provide support for

Shleifer and Vishny (1986) and for the agency theory

(Jensen and Meckling, 1976).

4.2 Ownership Structure and Corporate Failure

The estimation results of Equation (5) for the matched

sample of defaulted and non defaulted firms using

Logit estimation are presented in Table 9. The fraction

of equity owned by government, GOV, is found to

have a negative coefficient on the likelihood of

default, and it is statistically significant at a 5% level

of significance in Table 9 panel A. The variable GOV

is found to have a negative but statistically

insignificant coefficient using the panel data

(Equation 6) in Table 9 panel B. This indicates that

government ownership decreases the likelihood of

default as the government has objectives other than

profit. This result is consistent with other studies, such

as Lizal (2002), who finds that government ownership

reduces corporate failure. The fraction of foreign

owned equity, FORG, has a positive but insignificant

coefficient. The fraction of equity owned by

institution shareholders, INSTIT, does not seem to

have any significant impact on the likelihood of

default, while the coefficient of the institutional

ownership is negative.

From the results of the estimation in Table 9

panel A, we find that the ownership concentration

measure C5 has a positive and significant impact on

the likelihood of default, and the effect is statistically

significant at the 5% level in Models 1 and 3. In

Model 2, we find that the ownership concentration C5

is not significant in combination with the fraction of

foreign owners, but it still has a negative effect on

corporate failure. Our finding also supports the

findings in the previous section that ownership

concentration affects corporate performance and

participates in corporate failure. This finding can be

explained by the fact that only a few firms are

family-controlled in Jordan as supported by

Al-Malkawi (2005). Therefore, the managers

(insiders) may have incentives to pursue activities for

their own benefits. The agency conflict between

insiders (mangers) and outsiders (shareholders) results

in the managers‘ tendency to appropriate perquisites

out of the firm‘s resources for their own benefit which

leads to corporate failure.

The estimated coefficient of the HERF is not

significant using the matched sample data. However,

HERF is found to have a positive and significant

impact on Jordanian corporate failure using the

pooled cross-sectional and time-series data. The

impact of ownership mix with ownership

concentration measure HERF does not affect the

significance of government ownership GOV.

Government ownership is still significant at the 5%

level in the matched sample. Neither FORG nor

INSTIT has any significant impact on the likelihood

of default in both panels. Controlling variables such

as the firm‘s size, SIZE, and the firm‘s age, AGE, do

not have any explanatory power in predicting the

corporate failure in panel A, while both SIZE and

AGE are found to decrease the likelihood of default

for Jordanian companies. The firm‘s growth, NICAP,

has a significant effect on the likelihood of default in

both estimations. This result is consistent with the

theory that firms with high growth rates have a low

risk of default. The results also provide support for

agency theory.

For the Logit models, the Pseudo 2R ranges

from 47 to 60 percent, while the LR ranges from 38 to

49 percent, and is statistically highly significant in the

corresponding asymptotic Chi-squared distribution for

the cross-sectional data in panel A. For the

cross-sectional and time-series data, the Pseudo 2R

ranges from 18 to 19 percent, while the Wald test

ranges from 62.85 to 63.30 and is statistically

significant at the 1% level. To sum up, results from

cross-sectional and panel data analysis provide

evidence of the effect of ownership structure on

corporate failure. The result shows that ownership

concentration affects corporate performance

negatively and participates in corporate failure. The


109

results also, show that government ownership decreases a firm‘s likelihood of default.

Table 9. Ownerships Concentration and Mix and Firm‘s Likelihood of Default using The Logit Model

Note: a, b, c: indicate significant at a 1%, 5%, and 10% level, respectively. Statistical significance t-statistics is

determined with White (1980) standard errors to correct for heteroskedasticity. Industrial dummy variables are


To the best of the author‘s knowledge, this paper

provides the first attempt to document that ownership

concentration is positively related to corporate failure

as shown by the positive and significant coefficient of

C5 in most regressions in panel B, and in Model 1 and

Model 3 in panel A. In other words, when a firm has a

high concentration in its ownership structure it will

have a higher risk of failure, no matter what the

ownership mix (GOV or FORG or INSTIT) is.

5 Conclusion

The possible impact of ownership structure on a

firm‘s performance has been central to research on

corporate governance, but evidence on the nature of

this relationship has been decidedly mixed. While

some theories and empirical investigations suggest

that ownership structure affects firm performance,

others suggest the irrelevance of the relationship

between ownership structure and firm performance.

Furthermore, most of the studies are conducted in

developed countries and in some Asian countries

where the characteristics of ownership structure are

different from Middle Eastern countries. So,

implications from the theory may not be applicable to

other countries. This study provides evidence from

Middle Eastern countries and expands the previous

studies by investigating the effect of ownership

structure on the firm‘s failure.

The empirical evidence in this chapter shows

that ownership structure and ownership concentration

play an important role in the performance and value

of Jordanian firms. It shows that inefficiency is

related to ownership concentration and to institutional


110

ownership. A negative correlation between ownership

concentration C5 and firm‘s performance both, ROA

and Tobin‘s Q, is found, while there is a positive

impact on firm performance MBVR. The HERF is not

significant at any level of significance in any measure

of performance. The insignificance of the HERF

shows that there could be a non-linear relationship

between ownership concentration and a firm‘s

performance.

The research also found that there is a significant

negative relationship between government ownership

and a firm‘s accounting performance, while the other

ownership structure mixes have significant

coefficients only in Tobin‘s Q using the matched

sample. However, government ownership had a

positive impact on the firms performance measure

ROA only. Firm‘s profitability ROA was negatively

and significantly correlated with the fraction of

institutional ownership, and positively and

significantly related to the market performance

measure, MBVR. The result is robust when indicators

of both concentration and ownership mix are included

in the regressions. The results of this study are, to

some extent, inconsistent with previous findings.

This paper also used ownership structure to

predict the corporate failure. The results suggest that

government ownership is negatively related to the

likelihood of default. Government ownership

decreases the likelihood of default, but has a negative

impact on a firm‘s performance. The results suggest

that, in order to increase a firm‘s performance and

decrease the likelihood of default, it is reasonable to

reduce government ownership to some extent.

Individual share holders have no apparent capability

to monitor and influence the behaviour of

management. Furthermore, a certain degree of

ownership concentration is needed to increase the

firm‘s performance and to decrease the firm‘s chance

of default. This paper also provides evidence that the

performance of the firms is a non-linear function of

ownership structure.

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Appendix 1. Ownership Mix and Concentration and Firm‘s Performance Including Industrial Dummy Variables

ROA ROA

Constant

-0.3998

(-4.6)***

-0.3823

(-4.4)***

-0.4357

(-4.98)***

-0.4378

(-4.85)***

-0.3875

(-4.44)***

-0.4511

(-5.15)***

-0.4323

(-4.77)***

-0.4099

(-4.7)***

SIZE

0.0594

(5.48)***

0.0557

(5.16)***

0.0649

(5.9)***

0.0608

(5.53)***

0.0554

(5.1)***

0.0679

(6.16)***

0.0625

(5.66)***

0.0591

(5.42)***

DEBT

-0.1644

(-10.78)***

-0.1631

(-10.69)***

-0.1692

(-10.97)***

-0.1603

(-10.55)***

-0.1603

(-10.52)***

-0.1692

-(10.95)***

-0.1612

(-10.58)***

-0.1609

(-10.55)***

GROW1

0.0007

(2.43)**

0.0007

(2.45)**

0.0007

(2.43)**

0.0008

(2.47)**

0.0008

(2.47)**

0.00073

(2.41)**

0.0007

(2.43)**

0.0008

(2.46)**

C5

-0.0343

(-2.02)**

0.0122

(0.42)

0.0341

(1.24)

0.0498

(1.72)*

HERF

0.0238

(0.85)

-0.0184484

(-1.09)

-0.0204

(-1.11)

-0.0339

(-1.96)**

GOV

0.0646

(2.46)**

0.0514

(1.88)*

INSTIT

-0.0441

(-1.93)*

-0.0456

(-2.00)**

CITIZEN

0.0451

(1.97)**

0.0206

(0.87)

FORG

0.0282

(0.92)

0.0491

(1.61)

No. of

observation 1265 1265 1265 1265 1265 1265 1265 1265

Wald test

172.32

(0.00)***

168.39

(0.00)***

177.91

(0.00)***

169.42

(0.00)***

164.54

(0.00)***

177.27

(0.00)***

167.18

(0.00)***

167.44

(0.00)***

http://www.ssrn.com/



112

R-square 0.2178 0.2124 0.2234 0.22 0.2115 0.2272 0.2192 0.2107

Breusch

and Pagan

test

241.55

(0.00)***

240.09

(0.00)***

224.26

(0.00)***

243.94

(0.00)***

223.22

(0.00)***

223.25

(0.00)***

240.05

(0.00)***

224.32

(0.00)***

Tobin’s Q MBVR

Constant

87.6192

(9.63)***

88.0990

(9.57)***

98.3229

(10.04) ***

85.9391

(9.75)***

-2.1715

(-1.57)

-1.9225

(-1.39)

-1.8485

(-1.31)

-2.0974

(-1.52)

SIZE

-0.6317

(-0.59)

-0.5919

(-0.54)

-1.7731

(-1.56)

-0.1367

(-0.13)

0.4287

(2.58)***

0.3761

(2.24)**

0.3924

(2.34)**

0.4371

(2.62)***

DEBT

-0.8027

(-0.43)

-0.9463

(-0.5)

-1.3224

(-0.7)

-0.8784

(-0.48)

-0.3237

(-1.2)

-0.2836

(-1.05)

-0.3559

(-1.34)

-0.3708

(-1.39)

GROW1

-0.0463

(-0.9)

-0.0509

(-0.99)

-0.0355

(-0.69)

-0.0487

(-0.95)

-0.0017

(-0.09)

0.0011

(0.06)

-0.0017

(-0.09)

-0.0032

(-0.17)

C5

-1.2306

(-0.53)

-0.7316

(-0.34)

-5.0872

(-2.04)**

0.1900

(0.09)

0.5293

(1.94)*

0.4366

(1.63)

0.4152

(1.41)

0.5497

(1.99)**

GOV

1.2714

(0.43)

-0.3794

(-0.94)

INSTIT

-4.7444

(-1.65)*

0.6944

(2.00)**

CITIZEN

-9.9565

(-3.46)***

-0.1738

(-0.48)

FORG

-7.4381

(-1.99)**

-0.4865

(-1.06)

No. of

observation 1163 1163 1163 1163 1113 1113 1113 1113

Wald test

221.95

(0.00)***

223.49

(0.00)***

223.57

(0.00)***

234.45

(0.00)***

33.75

(0.03)**

36.14

(0.01)***

34.89

(0.021)**

34.05

(0.03)**

R-square 0.1877 0.19 0.194 0.1904 0.0950 0.1074 0.0981 0.0980

Breusch

and Pagan

test

16.92

(0.00)***

15.61

(0.00)***

13.82

(0.00)***

16.72

(0.00)***

127.61

(0.00)***

114.27

(0.00)***

121.47

(0.00)***

124.31

(0.00)***

Note: ***, **, * indicate significant at a 1%, 5%, and 10% level, respectively. t statistics in parentheses are



Appendix 1 (Continued). Ownership Mix and Concentration and Firm‘s Performance Including Industrial

Dummy Variables

Tobin’s Q MBVR

Constant

87.5196

(9.62)***

88.2157

(9.55)***

96.8305

(9.96)***

86.2923

(9.76)***

-2.2760

(-1.64)*

-1.9844

(-1.44)

-1.7547

(-1.26)

-2.2087

(-1.6)

SIZE

-0.6567

(-0.61)

-0.6390

(-0.59)

-1.7125

(-1.52)

-0.1818

(-0.17)

0.4581

(2.77)***

0.3950

(2.36)**

0.3964

(2.39)**

0.4653

(2.8)***

DEBT

-0.7722

(-0.41)

-0.9542

(-0.5)

-1.1220

(-0.59)

-0.9881

(-0.53)

-0.3370

(-1.25)

-0.2933

(-1.08)

-0.3626

(-1.37)

-0.3817

(-1.43)

GROW1

-0.0467

(-0.91)

-0.0509

(-0.99)

-0.0377

(-0.74)

-0.0485

(-0.95)

-0.0028

(-0.15)

0.0005

(0.03)

-0.0026

(-0.14)

-0.0042

(-0.22)

HERF

-0.1120

(-0.03)

0.1367

(0.04)

-5.7080

(-1.39)

2.1186

(0.58)

0.5869

(1.22)

0.5245

(1.15)

0.2727

(0.56)

0.5619

(1.19)

GOV

0.6834

(0.23)

-0.3830

(-0.92)

INSTIT

-4.7419

(-1.66)*

0.7550

(2.16)**

CITIZEN

-8.8551

(-3.14)***

-0.3230

(-0.92)

FORG

-7.8955

(-2.11)**

-0.4144

(-0.89)


113

No. of Observation 1163 1163 1163 1163 1113 1113 1113 1113

Wald test

221.39

(0.00)***

222.72

(0.00)***

222.37

(0.00)***

234.64

(0.00)***

31.61

(0.048)**

34.64

(0.022)**

34.13

(0.025)**

31.52

(0.049)**

R-square 0.1876 0.1889 0.1928 0.1906 0.0926 0.1063 0.0988 0.0961

Breusch and Pagan

test

16.97

(0.00)***

15.63

(0.00)***

14.16

(0.00)***

16.70

(0.00)***

125.62

(0.00)***

115.46

(0.00)***

121.77

(0.00)***

122.01

(0.00)***

Note: ***, **, * indicate significant at a 1%, 5%, and 10% level, respectively. t statistics in parentheses are



Appendix 2. Ownerships Concentration (C5) and Mix and Firm‘s Performance

Note: a, b, c: indicate significant at 1%, 5%, and 10% level, respectively. t statistics in parentheses are determined

with White (1980) standard errors to correct for heteroskedasticity. Industrial dummy variables are included in the

regression. (1) Q refers to Tobin's' Q.


114

Appendix 3. Ownerships Concentration (HERF) and Mix and Firm‘s Performance

Note: a, b, c: indicate significant at 1%, 5%, and 10% level, respectively. t statistics in parentheses are determined

with White (1980) standard errors to correct for heteroskedasticity. Industrial dummy variables are included in the

regression. (1) Q refers to Tobin's' Q.


115

THE IMPACTS OF MANAGERIAL AND INSTITUTIONAL OWNERSHIP ON FIRM PERFORMANCE: THE ROLE OF STOCK PRICE INFORMATIVENESS AND CORPORATE GOVERNANCE

William Cheung, Scott Fung, Shih-Chuan Tsai*

Abstract This paper provides new evidence on the relations between managerial and institutional ownerships and firm performance. These relations are found to be affected by firm’s stock price informativeness and corporate governance. Based on a sample of US firms from NYSE, AMEX, and NASDAQ between 1989 and 2006, we document three important findings. First, managerial ownership and firm future performance are non-linearly related; the positive relation is stronger for firms with less informative prices or more agency problems. This finding suggests that poor governance and uninformative price increase the importance of managerial value creation for their firms by improving internal governance. Second, institutional ownership has a significant positive impact on firm future performance, with larger impact for firms with less informative prices or good governance. However, institutional ownership, which reflects external monitoring, has a weaker positive effect compared to managerial ownership, which controls for internal governance. Third, the interaction between managerial ownership and institutional ownership has a significant positive impact on firm future performance, suggesting that there are synergistic effects of internal and external corporate governance mechanisms in improving firm value. Keywords: Managerial Ownership; Institutional Ownership; Corporate Governance; Stock Price Informativeness * William Cheung is at University of Macau. Scott Fung is at California State University, East Bay, and Shih-Chuan Tsai is at Ling Tung University in Taiwan. Cheung would like to acknowledge the financial supports from Research Grant Committee of University of Macau. Fung would like to acknowledge the financial supports from Faculty Research Grant from College of Business and Economics, California State University East Bay, July 2008. Tsai would like to acknowledge the financial support from National Science Council of Taiwan (grant #NSC97-2410-H-275-005). Address correspondence to Shih-Chuan Tsai, 11F-2, No. 18, Sec. 2, Jin-Shan South Road, Taipei, Taiwan; e-mail: [email protected].

1. Introduction

The economic relation between ownership structure

and firm performance has long been a key issue in

corporate finance and governance. Morck, Shleifer

and Vishny (1988) document a non-linear relation

between ownership and firm performance. They

conjecture that the non-linear relation between

managerial ownership and firm performance is due to

the balance of alignment of interest and entrenchment

between shareholders and managers. Shleifer and

Vishny (1986) model the large shareholders, including

banks, insurance companies and funds, find that they

have enough incentives to monitor the management,

initiate takeover if necessary and thereby improve

firm value. Voluminous researchers study the

ownership-performance relation under various

paradigms [Demsetz (1983), Demsetz and Lehn

(1985) Holderness and Sheehan (1988), Himmelberg,

Hubbard and Palia (1999), Demsetz and Villalonga

(2001), Claessens, Djankov, Fan and Lang (2002),

Anderson and Reeb (2003), Cronqvist and Nilsson

(2003), and Lins (2003)].117

Whilst firm performance

is related to ownership structure, Faure-Grimuad and

Gromb (2004) show that public trading (smaller

shareholder activities) affects large shareholder‘s

private incentives to engage in value-increasing

activities and increases firm value. They suggest that

ownership concentration and stock price

informativeness ―are likely not to be independent‖.

Wurgler (2000) and Durnev, Morck and Yeung (2003)

117 Holderness and Sheehan (1988) find that family firms

have a lower Tobin‘s q than non-family firms while

Anderson and Reeb (2003) find that opposite. Demsetz

(1983) argues that ownership concentration is the

endogenous outcome of profit-maximizing decisions by

current and potential shareholders and should have no effect

on firm value. Demsetz and Lehn (1985), Himmelberg,

Hubbard and Palia (1999), and Demsetz and Villalonga

(2001) provide supporting evidences of Demsetz (1983).

Claessens et al. (2002) and Lins (2003) evident that in East

Asian economies, ownership concentration improve firm

values. Cronqvist and Nilsson (2003) further find that in

Sweden, the cash flow ownership has a negative impact on

firm value. Excellent literature survey are in Villalonga and

Amit (2006) and Cheung and Wei (2006).



116

provide direct evidences of informative prices

enhance firm value.

In essence, there are two important dimensions –

stock price informativeness and corporate governance

(control rights) – that can affect a firm‘s

ownership-performance relation. Aforementioned

studies find that ownership structure and firm value

are both related to insiders‘ incentives. More recent

studies provide evidence that insider incentives to

create firm value are determine by stock price

informativeness and corporate governance (control

rights). An informative price is vital for manager

incentives to have positive effects on the performance

of a firm. Faure-Grimaud and Gromb (2004) suggest

that an informative stock price increases the manager

incentives to engage in value-increasing activities

because of his activities can be publicly observed

through the informative price. Hence, when

mitigating owner-manager agency conflicts,

managerial incentives and ownership are positively

aligned with the stock price informativeness.

Similar to stock price informativeness, corporate

governance and agency cost can also affect the

impacts of manager ownership on performance.

Classic corporate finance problem of owner-manager

conflicts [e.g. Berle and Means (1932) and Jensen and

Meckling (1976)] can be mitigated by giving large

shareholders enough equity stakes as incentives to

monitor the manager. As such, firm value may

increase as the advisory and monitoring benefit excess

the private benefit of expropriating minority

shareholders. Villalonga and Amit (2006) suggest that

the classic owner-manager conflict in non-family

firms is more costly than the conflict between family

and nonfamily shareholders in founder-CEO firms.

Claessens et al. (2002) and Lins (2003) find support

of excess large shareholders voting right over cash

flow rights may reduces firm values but not enough to

tradeoff the benefits from ownership concentration.

Cronqvist and Nilsson (2003) find evidence in

Sweden that cash flow ownership, rather than the

excess voting rights, has a negative impact on firm

value. However, the effectiveness of the corporate

ownerships and their impacts on firm performance

remain important research questions.

Moreover, managerial ownership is not the only

type of corporate ownerships that determine firm

performance. Existing literature shows that

institutional ownership can affect stock market

valuation of the firm. Davis and Steil (2001) discuss

the corporate governance role of institutional

investors. Gompers and Metrick (2001) support the

impacts of institutional ownership on stock returns.

Woidtke (2002) examines valuation effects with

respect to public and private pension funds in a firm.

Recent studies suggest that institutional investors can

have direct impact on firm value (in additional to

valuation effect). Hartzell and Starks (2003) show that

institutional investors serve as monitor and affect

executive compensation. Cornett, Marcus, Saunders,

and Tehranian (2007) find a significant relation

between institutional ownership and firm‘s operating

performance – especially for institutional investors

with potential business relations with the firm in

which their investment are considered as monitoring.

Chen, Harford, and Li (2007) show that independent

institutions with long-term investments will specialize

in monitoring during takeover.

Similar to managerial ownership, the impact of

institutional investors on firm value can also depend

on the availability of firm-specific information and

corporate governance practices. Informed institutional

investors with sufficient ownerships can perform

governance and monitoring on the management

(external governance), replace the incumbents and

initiate takeover if necessary [Jensen and Meckling

(1976), Shleifer and Vishny (1986), Admati,

Pfleiderer and Zechner (1994)]. Recent studies,

including Kahn and Winton (1998) and Noe (2002),

suggest that instead of exerting external governance,

institutional investors may choose to benefit from the

information asymmetry from outsiders and avoid the

cost of activism. Nonetheless, empirical evidences of

the impact of institutional investors on firm value are

far from conclusive.

Given the motivations above, this study sets out

to examine the relationship between managerial

ownerships and firm performance, and the variations

of such relationship with respect to stock price

informativeness and corporate governance. Equally

important, we provide parallel examinations of the

relationship between institutional ownerships and firm

performance, and how the relationship varies with

stock price informativeness and corporate governance.

By examining the ownership-performance relations

above, we are able to gain insightful comparison

between internal governance (incentives) provided by

managerial ownerships, and external governance

(monitoring) provided by institutional investors.

Further, this study considers the joint impacts of

managerial and institutional ownerships provide

important insights into the effectiveness of different

corporate ownership and control mechanisms. It is not

uncommon to have both manager and institutional

investors to own significant proportion of a public

firm. Manager‘s ownership can provide internal

corporate governance such as incentives and control,

while institutional ownership can provide external

governance, such as monitoring and control.

Based on a sample of US firms from NYSE,

AMEX, and NASDAQ between 1989 and 2006, we

document three sets of new empirical findings.

First, consistent with Morck, Shleifer and

Vishny (1988), managerial ownership and firm future

performance are non-linearly related. Interestingly,

this relation is stronger for firms with less informative

prices or more agency problems. This finding

suggests that managers improve firm value by (i)

reducing costs of agency problem with better internal

governance and (ii) lowering monitoring costs with

more informative prices. We find that with sufficient

equity stake, managers create more value for firms


117

with poor governance or less informative stock prices,

i.e. where information transparency is low and agency

cost is high. The reason is that poor governance and

uninformative price increase the importance of

managerial value creation for their firms by

improving internal governance. This creates

additional incentives for managers with sufficient

equity stake.

Second, institutional ownership can predict firm

future performance, with larger impact for firms with

less informative prices or better corporate governance.

Institutional investors, contrast to traditional view of

advisory and monitoring roles, improve firm value by

producing information but not by providing external

monitoring. However, the institutional ownership,

which reflects external monitoring, has weaker effect

compared to managerial ownership, which controls

for internal governance.

Third, the interaction between managerial

ownership and institutional ownership has a

significant positive impact on firm future performance.

This result suggests that internal governance (by

manager) and external monitoring (institutional

investors) have complementary economic impacts on

firm performance. In addition, institutional investors

create more value for a firm, by providing monitoring

service, when managers have more incentives to

co-operate results from their holdings of the firm. Our

overall results are consistent with Shleifer and Vishny

(1986) that large minority shareholders, such as the

institution investors, mitigate free rider problem of

managerial performance monitoring. This value

creation by large minority shareholders is more

profound when the stock price of a firm is less

informative or better corporate governance. Finally

the external monitoring role of institutional investors

enhances firm value only when both institutional

investors and managers have enough equity stakes to

create the synergistic effects on improving corporate

governance.

Overall, our results suggest that both manager

and institutional investors has an informational role in

creating firm value. However, the institutional

investors cannot resolve the governance problem on

their own when agency is high but can mitigate the

agency problem with collective effort from them and

a firm‘s management with incentives aligns with firm

performance.

In terms of contributions, our study presents new

empirical evidence on how institutional investors,

managers and their interactions can enhance firm

value, and how these impacts are dependent upon

firms‘ corporate governance and information

environments. Our findings provide the following

contributions. First, for the ownership-performance

relation, we identify two important firm

characteristics which affect this relation, namely

corporate governance and price informativeness. Our

findings enrich the theory on manager ownership and

its relation with firm performance [Morck, Shleifer

and Vishny (1988) among others] by looking into

what price informative or governance condition will

managerial ownership matter for firm value; our

findings are also consistent with Ferreira and Laux

(2007) that better corporate governance firms has also

more informative prices. Second, our overall findings

add to the existing literature by demonstrating that

internal governance (incentives) provided by

managerial ownerships have largest positive impacts

on firm value for firms with less informative stock

prices and higher agency problems; in contrast,

external governance (monitoring) provided by

institutional investors can increase firm value when

firms are subject to less informative stock prices, but

it cannot mitigate agency problems. Our findings

suggest that role of institutional investors is

informational, while the role of manager

ownership/incentives are both informational and

governance (e.g. monitoring, incentives, control).

Third, managerial ownerships can complement

institutional ownerships in improving firm value

when firms are subject to less informative stock prices

and higher agency problems. Our study is among the

first to document that that managerial incentives and

institutional influences are complement, rather than

substitute, governance mechanisms.

The remainder of the paper is organized as

follows. Section 2 provides a description of the

empirical framework and the methodology and data

adopted for this study. Section 3 presents the

descriptive statistics and the empirical findings on the

relationships between managerial and institutional

ownerships and firm performance. Further evidence

on joint impacts of managerial and institutional

ownerships is provided in Section 4, followed by the

conclusions drawn from this study in Section 5.

2. Framework and testable hypotheses

Our paper focuses on the net effect of managerial and

institutional ownership on firm value in separate

framework and in joint consideration under various

governance level and price informativeness. In this

section, we develop testable hypotheses on both types

of ownership with respect to the existing evidences.

Our test not only identifies different roles of managers

and institutional investors but also constructs the

environment of governance and price informativeness.

Ferreira and Laux (2007) suggest that better

governance firms are associated with more

informative prices. Our tests enable us to identify this

unobservable relation of corporate governance and

stock price informativeness, by looking at their

impact on the each type of ownership-performance

relations.

2.1 Managerial ownership on firm value

Jin and Myers (2006) model how control rights and

information affect the division of risk-bearing

between insiders and outside investors, predict that

less transparent stocks are more likely to crash. Their


118

model suggests that firm value is related to (i) control

rights and (ii) firm-specific information content in

stock prices. Faure-Grimuad and Gromb (2004) show

that public trading (smaller shareholder activities) can

affect large shareholder‘s private incentives to engage

in value-increasing activities and thus increase firm

value. An insider may have to sell part of his stake

such that his value-increase activities can be observed

by the general public through trading activities. A

more informative price rewards his activities and

increases his incentive to do so. Their model predicts

that insider ownership has stronger relation with firm

performance when stock prices are more informative.

Durnev, Morck and Yeung (2004) and Ferreira and

Laux (2007) suggest that firms with better corporate

governance is associated more informative stock

prices. Based on the theories, we develop the

following hypothesis.

H1: Manager of firms with more informative

prices (less stock price synchronicity) or better

corporate governance (less agency problem) has

stronger impact on firm‘s performance when his

ownership increase because stock price increases the

manager incentives to engage in value-increasing

activities because of his activities can be publicly

observed through the informative price

[Faure-Grimaud and Gromb (2004)].

On the other hand, for firms with less

informative prices and poorer governance, the

marginal productivity is the higher than those firms

which are of more informative stock prices and good

governance. As such, we have the following

alternative hypothesis.

H2: Manager of firms with less informative prices

(more stock price synchronicity) or poorer

governance (more agency problem) has stronger

impact on firm‘s performance when his ownership

increase, because managerial incentive can mitigate

agency problem when information transparency is

low and agency cost is high. In Faure-Grimaud and

Gromb (2004)‘s model, there is no agency problem.

2.2 Institutional investors on firm value

In the presence of owner-manager conflict, informed

institutional investors with sufficient ownership can

exert external governance, replace the incumbent

management and initiate takeover if necessary [Jensen

and Meckling (1976), Shleifer and Vishny (1986),

Admati, Pfleiderer and Zechner (1994)]. These studies

implicitly assume some degree of information

efficiency. However, Kahn and Winton (1998) and

Noe (2002) suggest that instead of exerting external

governance, institutional investors may choose to

benefit from the information asymmetry from

outsiders and avoid the cost of activism. These studies

collectively suggest that the impact of institutional

investors on firm value depends on the availability of

firm-specific information and corporate governance

practices. Therefore, stock price synchronicity or

corporate governance can affect the impact of

institutional investors on firm performance in two

possible ways.

H3: Institutional investors of less informative

price or poorer governance firm has stronger impact

on firm performance when his ownership increase as

they have better opportunity to improve the firm‘s

operations through their advisory and monitoring

ability (Shleifer and Vishny, 1986).

H4: Institutional investors of more informative

price or good governance firm has stronger impact on

firm performance when his ownership increase as the

informative price (or good governance) lowers their

monitoring costs (Holmstrom and Tirole, 1993), make

them less costly to provide their expertise.

3. Data collection and variable definitions

3.1. Managerial and Institutional Ownerships and Performance

This study analyzes a sample of 49,907 firms,

excluding finance and utilities from NYSE, AMEX,

and NASDAQ over the 1989 to 2006 period. We

construct the sample from different databases

including CRSP, Compustat and Thomson Ownership

Data. Annual financial data (including managerial

ownerships) are obtained from the CRSP and

Compustat database, and the percentage equity stake

data, as of June-end of every year of different

institutional investors, comes from the Thomson

Ownership Data. Thomson reports the security

holdings of institutional investors with greater than

$100 million of securities under discretionary

management. Institutional ownership data are then

matched to the following fiscal year financial

statement data from Compustat.

Similar to other studies that examine the relation

between ownerships and the firm performance [e.g.

Morck, Shleifer and Vishny (1988)], we use Tobin‘s Q

as a measure of firm value, which is computed as the

market value of equity plus the book value of assets

minus the book value of equity, scaled by book assets.

We lag the explanatory variables so that ownership

available in the beginning of the year can predict

performance (Q) in the following year. Our regression

of Tobin‘s Q includes different cohorts of explanatory

variables that are useful to predict firm performances.

These control variables have been used by Chung and

Jo (1996), and Gompers and Metrick (2001), plus

additional control variables as follows: (i)

Log(Number of Shareholders); (ii) Beta (estimated

using OLS, from a standard CAPM model on

value-weighted market returns over a rolling 5-year

period); (iii) Residual variance (estimated using OLS,

from a standard CAPM model on value-weighted

market returns over a rolling 5-year period); (iv)

Log(firm age); (v) Firm size proxy by log(total

assets); (vi) Indicator of NYSE firms; and (vii)

Log(shares turnover).


119

3.2. Stock Price Informativeness

We measure the stock price informativeness (the

amount of private information of stock) by the stock

return synchronicity, first suggested by Roll (1988),

developed by Morck, Yeung and Yu (2004), Durnev et

al. (2003, 2004) and Chen, Goldstein and Jiang

(2007).118

The stock return synchronicity is measured

by the correlation between the stock returns and the

returns of corresponding industry and the market. The

idea is that if the price of a firm‘s stock is informative

in the sense that firm-specific information is always

reflected by informed trading, the firm-specific

variation in stock price should dominate the variation

driven by a common set of information in the industry

or market. Thus, more informative stock price should

result in lower stock synchronicity, and vice versa.

Wurgler (2000), Durnev, Morck, Yeung and

Zarowin (2003), Durnev, Morck, and Yeung (2004)

support this general argument. Moreover, if

synchronicity can reflect firm transparency and

information cost, lower synchronicity (lower

information costs) can facilitate efficient allocation of

capital and reduce cost of external capital by reducing

hazard and adverse selection problems. Durnev, Morck

and Yeung (2004) document a negative relation across

industries between synchronicity and the efficiency of

external financing and capital budgeting. Chen,

Goldstein, and Jiang (2007) show the amount of

private information in stock price — inverse measure

of price synchronicity — has a strong positive effect on

the sensitivity of corporate investment to stock price.

Veldkamp (2006) shows that in an information market,

if investors price an asset with a common subset of

information because of high fixed costs of information

production, the information of one asset affects the

pricing of other assets and as such, asset prices

co-move even if the asset fundamentals are

uncorrelated.

Following Durnev et al. (2004) and Chen et al.

(2007), we estimate the stock return synchronicity by

the R2 of the following model. For each firm-month

observation, we regress the daily returns of a firm on

the corresponding industry returns and the market

returns over the 12 months immediately before the

month in question:

where Ri, Rj and Rm are return for stock i, industry

j, and the market, in trading day t. We use industry

returns in addition to market returns to control for

publicly available information that cannot be reflected

by the market returns. The industry return is the

value-weighted average of individual firms‘ returns for

118 See Chen et al. (2007) for detailed review of

development of the stock return synchronicity, as a measure

of amount of private information in the stock price.

all firms with the same two-digit SIC code as the firm

in concern. The market is the value-weighted average

of daily returns of all stocks in CRSP. We exclude the

firm in question from the calculation of industry return

to eliminate the spurious correlations between firm and

industry returns with only a few firms.119

In addition,

we include lag period industry and market returns to

control for potential autocorrelation problems due to

sparse trading. We use a logistic transformation to

circumvent the bounded nature of 2R and to yield a

dependent variable more conforming to the normal

distribution, that gives,

.

3.2. Probability of Informed Trading As an alternative measure of the stock price

informativeness (the amount of private information in

stock prices), we use the probability of informed

trading, PIN, developed by Easley, Hvidkjaer and

O‘Hara (2002). Recent studies such as Brown et al.

(2004) and Vega (2005) use PIN to investigate issues

in corporate finance like post-earnings-

announcement-drift. PIN is derived from the market

microstructure model in Easley and O‘Hara (1992)

which is unobservable. The PIN value we use in this

paper is used in Easley, Hvidkjaer and O‘Hara (2002)

and is available from the website of Soeren

Hvidkjaer.120

The idea of PIN is to measure the

information asymmetry between informed and

uninformed trades in a market by constructing a ratio

of informed trades over total trades,

SB

PIN

,

where is the probability of an information

event occurs, is the daily arrival rate of informed

traders, B is the daily arrival rate of uninformed

buy orders and S is the daily arrival rate of

uninformed sell orders. All of these structural

parameters are estimated using numerical

maximization of a likelihood function containing

these parameters. The interpretation of PIN is that the

higher PIN implies higher probability of informed

trading, and hence more informative stock prices.

Since PIN covers only NYSE firms, we use this

measure as robustness and alternative measure of

stock price informativeness. Our results are similar

and the same conclusion remains for both the

synchronicity and PIN (see section 4 below).

119See Durnev et al. (2004) for detailed discussion. 120 See

http://www.insead.edu/facultyresearch/faculty/profiles/shvid

kjaer/.

http://www.insead.edu/facultyresearch/faculty/profiles/shvidkjaer/

http://www.insead.edu/facultyresearch/faculty/profiles/shvidkjaer/


120

4. Main findings and interpretation

In this section, we examine: (i) the relationship

between managerial ownerships and firm

performance; (ii) the relationship between

institutional ownerships and firm performance; and

(iii) the relationship between interaction effect of the

two types of ownership and firm performance. The

variations of these relationships are examined with

respect to stock price informativeness and corporate

governance. Based on a sample of US firms from

NYSE, AMEX, and NASDAQ between 1989 and

2006, this study provides the following sets of new

findings that may help to shed new light on the

impacts of managerial and institutional ownerships on

firm performance, as well as the ways in which stock

price informativeness and corporate governance can

influence the effectiveness of managerial and

institutional ownerships.

Table 1 presents the relationship between

managerial ownerships and firm future performance

(Tobin‘s Q). We examine this relationship across

different firm characteristics including stock price

informativeness, corporate governance, and

information asymmetry. First, Table 1 shows that

managerial ownership is higher for low stock price

synchronicity or high PIN (more informative stock

prices); this finding supports the theory by

Faure-Grimaud and Gromb (2004). Institutional

ownership is higher for firms with higher stock price

synchronicity (lower stock price informativeness),

suggesting that when price is not informative, external

agency can provide not only monitoring but also

increase information.

4.1. Managerial ownerships and firm future performance

Table 2 presents the relationship between managerial

ownerships and future firm value (Tobin‘s Q), for

different firms grouped by (i) stock price

informativeness (synchronicity), (ii) probability of

informed trading, PIN, and (iii) corporate governance

level (G-index), according to the following regression

equation (1):

NYSEDshrtosizeagesigmabetasharemgrmgrQ 9876543

2

210 )log()log()log(

Table 2 shows that managerial ownership has

impact on firm value, and that managerial ownership

is non-linearly related to firm performance. The

impact of managerial ownership is significant and

positive, while the impact of the quadratic term of

managerial ownership is significant and negative.

Moreover, we examine this relationship across

different firm characteristics including stock price

informativeness, information asymmetry and

corporate governance. We first examine the impact of

managerial ownership for firms with high vis-à-vis

low stock price informativeness. Hypothesis H1 posits

that managerial ownership of firms with more

informative prices (lower synchronicity) has stronger

impact on firm‘s performance - suggesting that their

impacts on firm value are the most important when

firms are opaque or low price informativeness. The

managerial ownerships have larger positive linear

impact on firm‘s performance for firms with high

price synchronicity (less informative prices) than

firms with low price synchronicity (more informative

prices).

Furthermore, we examine the impact of

managerial ownership for firms with high vis-à-vis

low Governance-Index, we find that the managerial

ownerships have larger positive linearly impact on

firm‘s performance for firms with high

Governance-Index where firms are subject to poorer

governance. This result is consistent with the theory

that managerial ownership (private incentives)

becomes more effective governance mechanism in

improving firm value when firms are subject to poorer

governance. Further examination (results not

reported here) shows that managerial ownerships have

larger positive linearly impact on firm‘s performance

for firms that have analyst coverage (less information

asymmetry). Overall our findings here support the

hypotheses H2, as managerial ownership has stronger

impact on firm value when price is less informative or

governance is poorer.

4.2 Institutional ownership and firm value

Table 3 presents the relationship between institutional

ownership and firm value (Tobin‘s Q), for different

firms grouped by (i) stock price informativeness

(Synchronicity), (ii) probability of informed trading,

PIN, and (iii) corporate governance problem

(G-index) according to the following regression

equation (2):

NYSEDshrtosizeagesigmabetashioioQ 9876543

2

210 )log()log(log_

In Table 3, Panel A reports the results for all

firms while Panels B, C and D report subsamples

results for firms with different price synchronicity,

probability of informed trading and governance index.

Panel A of Table 3 shows that institutional ownership

is non-linearly related to firm performance. The

impact of institutional ownership is significant and

positive, while the impact of the quadratic term of

institutional ownership is significant and negative.

Panels B and C of Table 3 examine the impact of

institutional ownership for firms with high vis-à-vis

low stock price informativeness. We find that the

institutional ownerships have larger positive linearly

impact on firm‘s performance for high pricing

synchronicity or low PIN, both indicating the firms in

questions are having less informative stock price (or

when firms contain more common information and

institutional investors are more effective when firms

are subject to higher information asymmetry). Our

results in Panel B on informativeness subsamples and

Panel C on PIN subsamples support partially the


121

hypothesis H3 that institutional investors have

stronger positive impact on firm value for firms with

less informative stock prices.

Moreover, we examine the impact of

institutional ownership for firms with high vis-à-vis

low Governance-Index. Panel D of Table 3 reports the

regression results of governance subsamples, and

provides partial support for hypothesis H4.

Institutional ownership has larger impact on firm

value for low G-index (good corporate governance)

firms. We find that the institutional ownerships have

larger positive linearly impact on firm‘s performance

for firms with low G-index where firms are subject to

better governance. This result is different from the

result of managerial ownership; institutional investors

become more effective governance mechanism in

improving firm value when firms are subject to better

governance. This further suggests that managerial

ownership (internal governance) could be more

important for firms that are subject to poor

governance. Further examination (results not reported

here) shows that institutional ownerships have larger

positive linearly impact on firm‘s performance for

firms that have analyst coverage (less information

asymmetry). Finally, these mixed results are

interesting, because institutional investors may be

valuable with monitors in traditional agency problem

setting while their ability of producing information

has not been explored fully, also the interacting effect

with various corporate governance levels which we

report in Table 4.

4.3 Interaction effects of managerial and institutional ownership on firm value

To further explore how institutional investors create

value for firms with different information content of

stock prices and governance (in the presence of

managerial ownership), we modify equation (2) to

include the interaction of institutional ownership and

managerial ownership as equation (3) as follows:

)log(log_* 76543

2

210 agesigmabetashmgrioioioQ

NYSEDshrtosize 1098 )log( .

Table 4 presents the interaction between

managerial (internal governance) and institutional

investors (external governance). This enables us to

distinguish if the two types of ownership are

substitutes as suggested in the literature or

complement. This separation is important for a firm‘s

policy making and value enhancement.

Panel A of Table 4 reports the results of the full

sample. All variables are significant to explain the

firm future performance with expected signs.

Institutional ownership and performance is

non-linearly related with the manager-institutional

ownership interaction significantly positive,

suggesting there exists potential synergistic effect of

manager and institutional investors.

Panel B reports the results of the price

synchronicity subsamples. The interactions of

manager-institutional ownership are significantly

positive and it is stronger for firms with less

informative stock prices (high synchronicity) while

the individual coefficients of institutional ownership

and its quadratic term result insignificantly. Panel C

reports the results of the PIN subsamples. Consistent

with Panel B, the interactions of manager-institutional

ownership are significantly positive in both

subsamples. This interaction effect is stronger for

firms with less informative stock prices (low PIN).

The individual coefficients of institutional ownership

and its quadratic term are all insignificant. Our

conjecture is that there is an informational role of

institutional investors, i.e. the institutional investors

are better off from a more informative price results

from public trading. However for the institutional

investors to increase firm value via increasing the

information content of stock prices, the manager of

the firm need to have enough private incentives to put

effort together with the institutional investors such

that the indirect benefit of informative stock prices

from active public trading (Faure-Grimuad and

Gromb, 2004) can be realized.

Panel D reports subsample results of firm with

good governance (low G-index) or poor governance

(high G-index). The interaction effect between

managerial and institutional ownership has significant

and positive impacts on firm performance for both

low and high G-index firms, with larger impact for

firms with good governance (low G-index). As in

Panel D of Table 3, the impact of institutional

investors on firm value is significant only for firms

with good governance. The signs are in opposite

directions with respect to Panel D of Table 4 when we

include the interaction of manager-institutional

ownership. The result in Panel D of Table 4 suggests

that if managerial ownership is zero (non-zero), an

increase in institutional ownership lowers (improves)

firm value. This is striking as it is a shape contrast to

the previous studies that institutional investors

monitor the manager and create value by improving a

firm‘s operation strategy. While potential

multicollinearity problem maybe of concerns, we

offer an explanation on our results. For a firm which

its manager have no equity stake (or other forms of

compensation align with firm performance), a monitor

can only replace the incumbent management.

Therefore increase in ownership of the institutional

investors in such a firm is more probable to destroy

firm value when the costs of expropriation of small

shareholders by the large shareholders exceed the

benefit of advisory and monitoring by the large

shareholders [Villalonga and Amit (2006)].

Overall, our results suggest that both manager

and institutional investors has an informational role in

creating firm value. In summary, our study contains

three sets of findings and contributions. First, Tables 1

and 2 present managerial ownership and firm value

with respect to price informativeness and governance.


122

The overall findings support agency theory and

corporate transparency. Second, Tables 1 and 2

present institutional ownership and firm value with

respect to price informativeness and governance. The

findings support external governance and institutional

monitoring. Third, Table 4 presents the interactions of

managerial and institutional ownerships on firm value.

The findings support that institutional ownership and

managers ownerships are complement but not

substitute; in contrast with the view that manager‘s

monitoring make institutional investors redundant as

monitors. However, the institutional investors cannot

resolve the governance problem on their own when

agency is high but can mitigate the agency problem

with collective effort from them and a firm‘s

management with incentives aligns with firm

performance.

5. Conclusion

This study is among the first to identify two important

dimensions that can influence a firm‘s ownership and

performance relation, namely corporate governance

and stock price informativeness. In this respect, we

examine managerial ownership, institutional

ownership, and the interactions of the two. This study

provides new empirical evidence that can enrich the

theory of corporate ownership and its relation to firm

performance [Morck, Shleifer and Vishny (1988)

among others]. We find that, with sufficient equity

stake, managers can create more value for firms with

poor governance or firms with less informative stock

prices, i.e. where information transparency is low and

agency cost is high. Poor corporate governance and

uninformative prices seem to make managerial

ownerships matter more and create additional

incentives for managers with sufficient equity stake to

improve firm value. On the other hand, institutional

investors increase more value for firms with low price

informativeness and good governance. This suggests

that institutional investors can create more value by

producing firm specific information; however,

external governance and monitoring performed by

institutional investors alone cannot resolve the

governance problem when agency conflicts are severe.

Furthermore, institutional ownerships can interact

with managerial ownerships in improving firm value

when firms are subject to less stock price

informativeness and higher agency problems.

Managerial incentives and institutional influences are

complement, rather than substitute, in providing

corporate governance and improving firm value. The

crux for enhancing corporate governance is to search

for the collective efforts from institutional investors

and managers who have incentives aligned with firm

performance.

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Table 1. Summary Statistics

This table reports the summary statistics of 49,907 firms, excluding finance and utilities from NYSE, AMEX, and NASDAQ over the

1989 to 2006 period. Tobin‘s Q is the market value of equity plus the book value of assets minus the book value of equity, scaled by

book assets computed. Percentage equity stake data, as of June-end of every year of different institutional investors, comes from the

Thomson Ownership Data. Thomson reports the security holdings of institutional investors with greater than $100 million of

securities under discretionary management. Institutional ownership data are then matched to the following fiscal year financial

statement data from Compustat. Monthly price synchronicity, SYNCH, is measured by the R-square from the market model of

regressing the individual stock returns on market index daily over the 12 months immediately before the month in question.

Corporate governance index, G-INDEX, is from the Gompers, Ishii and Metrick (2003). The probability of informed trading, PIN, is

from Easley, Hvidkjaer and O‘Hara (2002). Beta is estimated using OLS, from a standard CAPM model on value-weighted market

returns over a rolling 5-year period. Residual variance is estimated using OLS, from a standard CAPM model on value-weighted

market returns over a rolling 5-year period. N represents number of observations used in computing the relevant statistics. Panel A

reports the summary statistics for full sample. Panel B reports the summary statistics based on subsamples of cross-sectional median

of firm‘s synchronicity. Panel C reports the summary statistics based on subsamples of cross-sectional median of firm‘s probability of

informed trading. Panel D reports the summary statistics of subsamples split in cross-sectional median of firm‘s corporate governance

index.


124

Panel A: Full sample

Panel B Stock Price Synchronicity

LOW HIGH

N

Mean

(Median)

Standard

Deviation N

Mean

(Median)

Standard

Deviation N

Mean

(Median)

Standard

Deviation

Tobin‘s Q

One Year Ahead 62,100 0.4304 0.5705 29,973 0.3179 0.5353 30,139 0.5353 0.5758

(0.3259) (0.2156) (0.4308)

Institutional Ownership 70,545 0.2497 0.2807 33,842 0.1894 0.2339 33,842 0.3237 0.3085

(0.1339) (0.0854) (0.2729)

Managerial Ownership in % 21,960 0.2371 0.4009 12,452 0.2658 0.4937 8,942 0.1950 0.2190

(0.1615) (0.1978) (0.1152)

Share outstanding 62,988 0.3253 1.6672 30,768 0.0518 1.4535 29,938 0.6783 1.7890

(0.2414) (0.0065) (0.6302)

Beta 59,306 1.0067 0.6670 29,750 0.8521 0.6270 29,227 1.1659 0.6694

(0.9318) (0.7767) (1.0847)

Sigma 59,306 0.1281 0.0443 29,750 0.1317 0.0419 29,227 0.1241 0.04630

(0.1265) (0.1313) (0.1202)

Firm Age 70,209 2.0466 1.0200 33,763 2.0287 0.9610 33,785 2.1543 1.0043

(2.1972) (2.0794) (2.1972)

Size / Total Asset 70,545 5.3767 1.9822 33,842 4.6651 1.6994 33,842 6.1556 1.9590

(5.1480) (4.4761) (6.0162)

Share Turnover 57,917 0.7284 0.5353 29,025 0.6035 0.5704 28,843 0.8544 0.5185

(0.6143) (0.4909) (0.7613)

Table 1 (Continued). Summary Statistics

This table reports the summary statistics of 49,907 firms, excluding finance and utilities from NYSE, AMEX, and NASDAQ over the

1989 to 2006 period. Tobin‘s Q is the market value of equity plus the book value of assets minus the book value of equity, scaled by

book assets computed. Percentage equity stake data, as of June-end of every year of different institutional investors, comes from the

Thomson Ownership Data. Thomson reports the security holdings of institutional investors with greater than $100 million of

securities under discretionary management. Institutional ownership data are then matched to the following fiscal year financial

statement data from Compustat. Monthly price synchronicity, SYNCH, is measured by the R-square from the market model of

regressing the individual stock returns on market index daily over the 12 months immediately before the month in question.

Corporate governance index, G-INDEX, is from the Gompers, Ishii and Metrick (2003). The probability of informed trading, PIN, is

from Easley, Hvidkjaer and O‘Hara (2002). Beta is estimated using OLS, from a standard CAPM model on value-weighted market

returns over a rolling 5-year period. Residual variance is estimated using OLS, from a standard CAPM model on value-weighted

market returns over a rolling 5-year period. N represents number of observations used in computing the relevant statistics. Panel C

reports the summary statistics based on subsamples of cross-sectional median of firm‘s probability of informed trading. Panel D

reports the summary statistics based on subsamples of cross-sectional median of firm‘s corporate governance index.

Panel C Probability of Informed Trading, PIN Panel D Corporate Governance Index, G-INDEX

LOW HIGH LOW HIGH

N

Mean

(Median

)

Standard

Deviation N

Mean

(Median

)

Standard

Deviation N

Mean

(Median

)

Standard

Deviation N

Mean

(Median

)

Standard

Deviatio

n

Tobin‘s Q

One Year Ahead 8,555

0.4632(

0.3810) 0.4646 8,475

0.2521(

0.1734) 0.4445 3,487

0.1545

(0.4127) 0.5417 3,438

0.4516

(0.3739) 0.4477

Institutional

Ownership 9,042

0.4299

(0.5094) 0.3001 9,042

0.2670

(0.2162) 0.2484 3,645

0.4302

(0.4784) 0.3098 3,590

0.4979

(0.5798) 0.2910

Managerial

Ownership in % 3,603

0.1277

(0.0409) 0.1874 4,950

0.2280

(0.1491) 0.2344 1,055

0.1781

(0.0903) 0.2106 1,281

0.0925

(0.0337) 0.1399

Share

outstanding 8,593

1.7118

(1.7829) 1.5929 8,791

0.3462

(0.3750) 1.3215 3,516

0.8876

(0.8040) 1.5747 3,464

1.8273

(1.8152) 1.4275

Beta 8,758 0.9912

(0.9685) 0.4629 8,537

0.9154

(0.8966) 0.5363 3,601

1.1526

(1.0792) 0.6448 3,536

0.9797

(0.9388) 0.5160


125

Sigma 8,758 0.0948

(0.0891) 0.0358 8,537

0.1134

(0.1097) 0.0366 3,601

0.1189

(0.1144) 0.0425 3,536

0.0978

(0.0910) 0.0365

Firm Age 9,040 2.6790

(3.0910) 0.8656 9,027

2.4168

(2.7726) 0.9367 3,645

2.4283

(2.4849) 0.7387 3,590

2.8729

(3.1355) 0.7233

Size / Total Asset 9,042 7.2648

(7.2777) 1.5762 9,042

5.2191

(5.2441) 1.4249 3,645

6.6759

(6.4978) 1.3833 3,590

7.2550

(7.1341) 1.4104

Share Turnover 8,589 0.6518

(0.6060) 0.3221 8,371

0.4377

(0.3666) 0.3145 3,545

0.8911

(0.8010) 0.5165 3,480

0.7796

(0.6996) 0.3968

Table 2. Impact of Managerial Ownership on Firm Value

This table reports the results of the impact of managerial ownership on firm value, measured by 1-year ahead Tobin‘s q, includes

18,110 firm-year observations from 1989 to 2006,

NYSEDshrtosizeagesigmabetasharemgrmgrQ 9876543

2

210 )log()log()log(

where Q is one year ahead Tobin‘s q of the firm in question. Tobin‘s Q is computed as the market value of equity plus the book value

of assets minus the book value of equity, scaled by book assets. Independent variables include the followings: (i) managerial

ownership in percentage of total shares. (ii) square percentage of managerial ownership, (iii) share outstanding, (iv) beta computed by

CAPM model on value-weighted market returns over a rolling 5-year period, (v) Residual variance, Sigma, is estimated using OLS,

from a standard CAPM model on value-weighted market returns over a rolling 5-year period, (vi) firm size computed by market

capitalization over total asset. (vii) share turnover, and (viii) indicator variable of NYSE listed firms. Partitioning variables include

the followings: (i) Monthly price synchronicity, SYNCH, is measured by the R-square from the market model of regressing the

individual stock returns on market index daily over the 12 months immediately before the month in question, (ii) Corporate

governance index, G-INDEX, is from the Gompers, Ishii and Metrick (2003), and (iii) probability of informed trading, PIN, is from

Easley, Hvidkjaer and O‘Hara (2002). Panel A reports the regression results for full sample. Panel B reports the regression results

based on subsamples of cross-sectional median of firm‘s synchronicity. Panel C reports the regression results of subsamples based on

subsamples of cross-sectional median of firm‘s probability of informed trading. Panel D reports the regression results based on

subsamples of cross-sectional median of firm‘s corporate governance index. t-statistics are reported in parentheses. *, ** and *** are

ten, five and one percent significance respectively.

Panel A: FULL SAMPLE Panel B: SYNCH Panel C: PIN Panel D: G-INDEX

LOW HIGH LOW HIGH LOW HIGH

Managerial

ownership 0.1791*** 0.1458*** 0.2781*** 0.2137 0.0694 0.3906* 0.4956**

(6.55) (4.89) (2.65) (1.28) (0.63) (1.83) (2.44)

(Managerial

ownership)2 -0.0033*** -0.0026*** -0.0229 -0.1406 0.0298 -0.2267 -0.4777**

(-5.87) (-4.28) (-0.18) (-0.68) (0.22) (-0.86) (-1.97)

log(share

outstanding) 0.0441*** 0.0310*** 0.0558*** 0.0634*** 0.0210** 0.0644*** 0.0682***

(7.84) (5.11) (7.02) (5.24) (2.26) (3.79) (4.21)

Beta 0.0579*** 0.0446*** 0.0455*** 0.0119 0.0211 0.0348 0.0233

(6.33) (4.35) (3.32) (0.48) (1.07) (0.94) (0.67)

Sigma -3.2231*** -2.2750*** -4.6163*** -5.6633*** -2.8761*** -6.4732*** -5.2656***

(-15.90) (-11.12) (-14.38) (-10.85) (-8.91) (-8.90) (-7.72)

log(firm age) -0.0485*** -0.0417*** -0.0558*** -0.648*** -0.0660*** -0.0747*** -0.03577

(-5.97) (-4.69) (-4.95) (-3.40) (-4.81) (-2.74) (-1.13)

Firm size -0.0556*** -0.0554*** -0.0868*** -0.0928*** -0.0644*** -0.0892*** -0.0904***

(-9.21) (-8.22) (-10.04) (-6.83) (-6.22) (-4.37) (-5.64)

log(share turnover) 0.4933*** 0.4585*** 0.4848*** 0.2677*** 0.4518*** 0.4395*** 0.3425***

(30.23) (25.19) (21.84) (4.99) (10.73) (8.09) (5.71)

NYSE indicator 0.1109*** 0.1107*** 0.0917*** 0.0998** 0.0892*** -0.0116 -0.0576

(6.61) (6.14) (3.94) (2.00) (3.23) (-0.26) (-0.92)

R square 0.2859 0.2750 0.2872 0.2166 0.2081 0.2800 0.2640

F Statistics 1,660.48*** 1,819.23*** 59.69*** 18.24*** 20.53*** 13.75*** 15.66***

N 18,110 10,521 7,581 3,255 4,491 1,003 1,205


126

Table 3. Institutional Ownership on Firm Value

This table reports the results of the impact of institutional ownership on firm value, measured by 1-year ahead Tobin‘s q, includes


NYSEDshrtosizeagesigmabetashioioQ 9876543

2

210 )log()log(log_


of assets minus the book value of equity, scaled by book assets. Independent variables include the followings: (i) institutional

ownership in percentage of total shares. (ii) square percentage of institutional ownership, (iii) share outstanding, (iv) beta computed

by CAPM model on value-weighted market returns over a rolling 5-year period, (v) Residual variance, Sigma, is estimated using

OLS, from a standard CAPM model on value-weighted market returns over a rolling 5-year period, (vi) firm size computed by market

capitalization over total asset, (vii) share turnover, and (viii) indicator variable of NYSE listed firms. Partitioning variables include





based on subsamples of median of firm‘s synchronicity. Panel C reports the regression results based on subsamples of cross-sectional

median of firm‘s probability of informed trading. Panel D reports the regression results based on subsamples of cross-sectional

median of firm‘s corporate governance index. t-statistics are reported in parentheses. *, ** and *** are ten, five and one percent

significance respectively.



Institutional ownership 0.4339*** 0.2522*** 0.5227*** 0.2635** 0.1727** 0.3723*** 0.1619

(9.19) (4.68) (8.78) (2.56) (1.97) (2.94) (1.23)

(Institutional ownership)2 -0.2968*** -0.0664 -0.4391*** -0.1153 -0.0564 -0.2421 -0.1057

(-4.84) (-0.93) (-5.82) (-0.88) (-0.47) (-1.58) (-0.68)

log(share outstanding) 0.0311*** 0.0179*** 0.0362*** 0.0544*** 0.0191*** 0.0345*** 0.0669***

(9.14) (4.74) (8.65) (6.83) (2.68) (4.11) (6.61)

Beta 0.0506*** 0.0434*** 0.0299*** 0.0314* 0.0118 0.0059 0.0333

(8.07) (5.80) (3.57) (1.77) (0.79) (0.31) (1.61)

Sigma -2.3799*** -1.6169*** -3.2918*** -4.1312*** -1.9714*** -4.3572*** -4.6375***

(-17.35) (-10.95) (-17.68) (-12.02) (-7.74) (-9.93) (-11.50)

log(firm age) -0.0471*** -0.0453*** -0.0466*** -0.0424*** -0.0659*** -0.0603*** -0.0175

(-8.34) (-7.22) (-6.37) (-3.33) (-6.17) (-3.32) (-1.05)

Firm size -0.0452*** -0.0465*** -0.0610*** -0.0784*** -0.0623*** -0.0682*** -0.0699***

(-11.09) (-10.40) (-11.23) (-8.44) (-7.59) (-5.24) (-5.82)


(41.47) (31.72) (32.59) (5.51) (12.32) (13.70) (7.33)

NYSE indicator 0.0620*** 0.0874*** 0.0208 0.0954** 0.1055*** 0.0047 -0.1599***

(4.64) (6.41) (1.20) (2.36) (4.74) (0.14) (-4.11)

R square 0.2788 0.2644 0.2667 0.2120 0.2213 0.2661 0.2604

F Statistics 194.02*** 116.82*** 112.58*** 26.36*** 29.02*** 30.05*** 25.27***

N 49,907 25,116 24,751 7,914 7,850 3,331 3,275


127

Table 4. Interaction between Managerial and Institutional Ownership

This table reports the results of the impact of managerial ownership on firm value, measured by 1-year ahead Tobin‘s q, includes


NYSEDshrtosizeagesigmabetashmgrioioioQ 109876543

2

210 )log()log(log_*


of assets minus the book value of equity, scaled by book assets. Independent variables include the followings: (i) managerial

ownership in percentage of total shares. (ii) square percentage of managerial ownership, (iii) share outstanding, (iv) beta computed by

CAPM model on value-weighted market returns over a rolling 5-year period, (v) Residual variance, Sigma, is estimated using OLS,

from a standard CAPM model on value-weighted market returns over a rolling 5-year period, (vi) firm size computed by market

capitalization over total asset, (vii) share turnover, and (viii) indicator variable of NYSE listed firms. Partitioning variables include





based on subsamples of cross-sectional median of firm‘s synchronicity. Panel C reports the regression results of subsamples based on

subsamples of cross-sectional median of firm‘s probability of informed trading. Panel D reports the regression results based on

subsamples of firm‘s corporate governance index. t-statistics are reported in parentheses. *, ** and *** are ten, five and one percent

significance respectively.



Institutional ownership 0.0892*** 0.1305 -0.080 0.2088 -0.0641 -0.6174** -0.5075

(2.57) (1.22) (-0.63) (0.79) (0.35) (-1.77) (-0.81)

(Institutional ownership)2 -0.0032*** -0.0523 0.1305 -0.1306 0.1383 0.8807** 0.5683

(-5.64) (-0.43) (0.85) (0.5) (0.7) (2.41) (0.99)

Institutional ownership x

Managerial ownership 0.4020***

0.1777*** 0.6727*** 0.5112*** 0.2841**

0.9171*** 0.5466***

(4.01) (2.58) (5.69) (3.44) (2.15) (3.66) (2.81)

log(share outstanding) 0.0467*** 0.3123*** 0.0582*** 0.0691*** 0.0217** 0.0748*** 0.0739***

(8.26) (5.15) (7.29) (5.4) (2.3) (4.22) (4.37)

Beta 0.0551*** 0.0391*** 0.0396*** 0.0065 0.017384 0.0317 0.0198

(6.05) (3.84) (2.86) (0.27) (0.89) (0.86) (0.60)

Sigma -3.1094*** -2.0239*** -4.2790*** -5.287*** -2.7017*** -5.8295*** -5.1370***

(-15.47) (-9.53) (-13.07) (9.75) (7.74) (-7.84) (-6.71)

log(firm age) -0.0471*** -0.0486*** -0.0582*** 0.0624*** -0.0675*** -0.0611** -0.0334

(-5.79) (-5.61) (-5.11) (3.28) (4.96) (-2.28) (-1.10)

Firm size -0.0589*** -0.0639*** -0.0906*** -0.0989*** -0.0672*** -0.0996*** -0.0988***

(-9.69) (-9.02) (-10.37) (7.12) (6.43) (-4.81) (-5.82)


(29.16) (22.51) (19.15) (4.25) (9.96) (6.53) (5.51)

NYSE indicator 0.1063*** 0.1037*** 0.0785*** 0.0799 0.0811*** -0.0379 -0.0674

(6.32) (5.67) (3.31) (1.57) (2.7) (-0.81) (-1.05)

R square 0.2878 0.2740 0.2882 0.2233 0.2087 0.2954 0.2671

F Statistics 1,422.10*** 75.49*** 57.05*** 17.70*** 19.22 13.69*** 14.86***

N 18,110 10521 7,581 3,255 4.491 1,003 1,205


128

OWNERSHIP STRUCTURE AND CORPORATE VOLUNTARY DISCLOSURE-EVIDENCE FROM TAIWAN

Grace M. Liao*, Chilin Lu**

Abstract

Compared to western markets, listed firms in East Asia typically have low levels of information transparency and do not motivate to disclose proprietary information to the public. One of the most frequently cited reasons for the low level of transparency and disclosure quality is poor corporate governance structures in this region. In this study, we explore the association between ownership structure and voluntary information disclosure in Taiwan. Annual report index data from Information Disclosure and Transparence Ranking System (IDTRS) are used as the proxy of the firm’s voluntary information. The empirical results indicate that the level of information disclosure is likely to be less in “insider” or family-controlled companies. Keywords: voluntary disclosure; family firms, Taiwan * Lecturer/Ph D Candidate, Chung Jung Christian University, e-mail: [email protected]

**Associate Professor, National Formosa University, e-mail: [email protected]

1. Introduction

Corporate disclosure has been the focus of an

increasing research subject in recent years. Since

Enron, corporate American has come under even

greater scrutiny and increased regulation. E.g.,

Sarbanes Oxley is, at least in part, intended to

enhance the role of corporate governance in safe

guarding the quality of reported earnings and overall

corporate disclosure.

With growing interests in the topic, recently

researchers have attempted to examine directly

whether and how corporate governance affects

corporate disclosure quality in US, UK and

Continental European countries (Meek et al., 1995;

Turpin & DeZoort, 1998; Ball et al., 2003; Bushman

et al., 2004; Khanna et al., 2004). In contrast, very

few studies have been examined with the nature and

extent of corporate disclosure in Asian countries.

Accordingly, this study aims to examine the corporate

disclosure in Taiwan listed companies.

Corporate disclosure deserves special attention

in the Asian context because firms in these countries

have less incentives for transparent disclosure than

US and UK markets (Ball et al., 2003). Taiwan capital

market plays an important role in Asian emerging

stock market. Research made in Taiwan provides us

with an opportunity to examine empirically the firm

characteristics affecting corporate information

disclosure in emerging economies. Further, the

disclosure orientation in Asian market is also greatly

influenced by the form of their ownership and

management structure (Lam et al., 1994; Mok et al.,

1992). In Asian market, especially in Chinese society,

listed companies are usually controlled by a family

group who staff many of the senior positions and also

own a large proportion of the shares. As Taiwan

become one of the major international capital market,

there is an increase demand from market users for

more corporate disclosure for proper evaluation of

firm‘s performance.

This study examines whether ownership

structure is associated with the corporate disclosure of

listed companies in Taiwan. It is also investigates

whether family ownership and control of firms has an

impact on the level of disclosure.

The rest of the paper is organized as follows.

Section 2 discusses our hypotheses. Section 3

discusses the sample and research method. Section 4

presents the results. Section 5 concludes the paper.

2. Hypotheses development 2.1 Ownership structure and disclosure

Voluntary disclosure is greatly influenced by the form

of the ownership and management structure (Chau &

Gray, 2002; Gelb, 2000; Ho & Wong, 2001). Jensen

and Meckling (1976) assert that when ownership and

control are separated, the potential for agency costs

arises because of conflicts of interests between the

contracting parities (manager and shareholders). As a

result, information disclosure is likely to be greater in

widely held firms so that principals can effectively

monitor that their economic interests are optimized



129

and agents can signal that they act in the best interests

of the owners. There is limited researches in Asian

market. Hossain et al. (1994) found that ownership

structure is statistically related to the level of

information voluntarily disclosed by listed Malaysian

companies. Thus, the analysis leads to the following

hypothesis:

H1: There is a positive association between

wider ownership and the extent of

voluntary disclosure.

2.2 Family ownership and voluntary disclosures

In Asian market, it seems that family-owned and

–controlled companies are more in evidence than in

western developed stock markets and that ―insiders‖

control a significant proportion of listed companies

(Claessens et al., 1999).

Chau and Gray (2002) argue when the

ownership structure is concentrated, large institutional

investors may be less concerned with voluntary

disclosure, given that they have access to the

information from inside. Chau and Gray have

examined this relationship on Hong-Kong and

Singapore firms, and found the predominance of

insiders and family-controlled firms is associated with

low levels of disclosures. Insiders and

family-controlled firms have little motivation to

disclose information in excess of mandatory

requirements since the demand for public information

disclosure is relatively weak in comparison with that

of firms with wider share ownership. This leads to the

following hypothesis:

H1: There is a negative association between

family or concentrated ownership and of

voluntary disclosure.

3. Research methods 3.1 Sample and data selection

Our sample encompassed all industrial listed firms

included in the Taiwan Economic Journal (TEJ)

database. All the 45 banking and insurance firms were

excluded because they are subject to specific

disclosure requirements. The final sample included

1,219 firms. The sample period was from 2005 to

2007. We selected to work on this sample period since

voluntary disclosures have greatly increased in

Taiwan during this time. Table 1 presents sample

composition.

Table 1. Sample composition by industry (N=1,219)

Industry Numbers

Cement 7

Food 22

Plastic 27

Textiles 56

Electric 60

Cable 30

Chemistry & Biotechnology 77

Glass 6

Paper 7

Steel 38

Rubber 11

Car 5

Electronic 711

Construction 53

Container 21

Tourism 11

Retail 18

Fuel 12

Others 64

3.2 Disclosure index

The voluntary disclosure checklist was based on the

one developed by Taiwan Securities and Futures

Exchange Commission (TSFEC). TSFEC developed

Information Disclosure and Transparence Ranking

System (IDTRS) in 2003. The items on the checklist

were checked to the sample companies. (see

Appendix A). Annual report index data from IDTRS

were used as the proxy of the firm‘s voluntary

information. The items on the checklist were

categorized into three information types: (a) Finance

and Operation Transparence; (b) Board and

Ownership Structure; (c) Mandatory or Voluntary.

The voluntary index was unweighted scoring of

the disclosure items. An information disclosed will

get 1 point, and 0 otherwise or not applicable (N/A)

when the particular item is not included in the annual

report. The voluntary disclosure index for each

company is calculated as TD/MD-the number of total

disclosures (TD) as a proportion of the maximum

disclosure (MD). Table 2 presents index data from

2005 to 2007.

Table 2. Annual reports by disclosure index

Index 2005 2006 2007

Total disclosures 48 54 61

Finance and operation

transparence

31 36 39

Board and ownership structure 17 19 21

Mandatory 32 32 34

Voluntary 16 17 19


130

3.3 Voluntary disclosure and ownership structure

Voluntary disclosure is greatly influenced by the form

of the ownership and management structure (Chau &

Gray, 2002; Gelb, 2000; Ho & Wong, 2001). The

family firm versus the non-family firm distinction is

employed to identify firms facing differing unresolved

agency problems (Jensen and Meckling, 1976). Chau

and Gray have examined this relationship on

Hong-Kong and Singapore firms, and found that

family-controlled firms have little motivate to

disclose information in excess of mandatory

requirements.

For Taiwan listed companies, there is

information about the proportion of shares owned by

directors and dominant shareholders, as this is a

required disclosure by Taiwan Stock Exchange

(TWSE). The ownership variable in this study was

calculated by adding together the proportions of

equity belonging to directors and to dominant

shareholders to arrive at the proportion of a firm‘s

equity owned by insiders.

Furthermore, Chen and Jaggi (2000) show that

the larger the proportion of outsiders, the more

effective will be the monitoring of voluntary financial

disclosures.

3.4 Regression model Prior studies have identified various attributes, such

as size and performance, that affect firms‘ disclosures

and thus, the results presented in the previous section

may be influenced by these attributes. Accordingly,

we estimate a multivariate OLS regression equation to

examine how the level of control party affects a firm‘s

disclosures. The analysis of voluntary disclosure was

based on the following multiple regression model:

0 1 2 3 4 5DQ t SIZE LEV AUD OOWN EPS

Where,

DQt=extent of voluntary disclosure scores.

β0=intercept.

SIZE=firm size.

LEV=leverage.

AUD=opinions of auditors.

OOWN=ownership structure.

EPS=earnings per share

4. Results and discussion 4.1 Descriptive statistics Table 3 presents information about the sample

companies in terms of the independent and control

variables. The proportion of equity owned by the

external compared with the insiders (directors and

dominant shareholders) was 0.609, 0.610 and 0.588

from 2005 to 2007 respectively. A further analysis of

the biographical details of the directors of sample

companies indicated that the family relationships

were among the directors and senior management

staff. Based on the family relationships, a further

analysis of the shareholdings among the family

members revealed that more than half of the listed

companies were subject to family control (i.e., one

family group of shareholders own 50% or more of the

issued share capital).

Table 3. Sample Characteristics

Size1 LEV2 AUD3

Oown4

(outsider) EPS5

Year Mean S.D. Mean S.D. Mean S.D. Mean S.D. Mean S.D.

2005 6.630 0.386 4.227 0.456 -1 0 0.609 0.133 3.136 0.345

2006 6.830 0.391 4.439 0.418 -1 0 0.610 0.143 1.940 0.104

2007 6.584 0.389 4.369 0.389 -1 0 0.588 0.110 1.030 0.162

2005-2007 6.681 0.389 4.345 0.421 -1 0 0.534 0.129 2.035 0.204

Notes: 1Natural logarithm of total assets.

2Total liabilities over total assets

3Auditor opinion, 2 for adverse opinion; 1 for qualified opinion; 0 for disclaimer opinion and -1 for

unqualified opinion. 4Ratio of a firm‘s equity owned by outsiders to all equity of the firms.

5Net profit after tax and preferred stock dividend over weighted average published shares

Table 4 reports the descriptive statistics of

sample companies in terms of the disclosure scores

from 2005 to 2007. The voluntary mean disclosure in

2005-2007 varied from 0.58 in the case of finance and

operation transparence; 0.535 for board and

ownership structure; 0.819 for mandatory information

and 0.05 for voluntary information. The overall mean

disclosure in 2005-2007 was at 0.567.


131

Table 4. Disclosure scores

Year Mean S.D. Minimum Maximum

Finance and operation 2005 0.510 0.062 0.377 0.631

2006 0.601 0.115 0.355 0.680

2007 0.629 0.145 0.407 0.760

2005-2007 0.580 0.107 0.355 0.760

Board and ownership structure 2005 0.592 0.130 0.357 0.846

2006 0.525 0.143 0.231 0.889

2007 0.487 0.138 0.185 0.821

2005-2007 0.535 0.133 0.185 0.889

Mandatory 2005 0.802 0.072 0.623 0.918

2006 0.816 0.070 0.566 0.903

2007 0.838 0.076 0.520 0.911

2005-2007 0.819 0.075 0.520 0.918

Voluntary 2005 0.047 0.075 0 0.357

2006 0.053 0.060 0 0.300

2007 0.049 0.075 0 0.500

2005-2007 0.050 0.078 0 0.500

Total disclosures 2005 0.552 0.058 0.419 0.682

2006 0.483 0.040 0.401 0.702

2007 0.667 0.094 0.322 0.886

2005-2007 0.567 0.083 0.322 0.886

Source: TSFEC

4.2 Multivariate results Table 5 indicates that the level of overall disclosure is

significant at the 0.01 level, the F value of 27.484.

The adjusted coefficient of determination (R2) for the

level of overall disclosure is 50.9%. Thus, these

multiple regression models are highly significant and

have an explanatory power similar to those reported

in earlier studies (Cook, 1991). The amount of

explained variation in disclosure range from 65.3%

for finance and operation transparence; 7.9% for

board and ownership structure; 16.6% for mandatory

information; 2.2% for voluntary information. The use

of this statistical tool is based on the assumptions of

no significant multicollinearity between the

explanatory variables, and conditions of linearity and

normality. Multicollinearity does not appear to be

affecting the reported results. Hair et al. (1995)

indicate that very large VIF values indicate high

collinearity and a common cutoff threshold is VIF

values above 10. The variance inflation factor (VIF)

in all the regression tests is lower than 10 for any of

the independent variables. As shown in Table 5, the

coefficients for ownership structure of Taiwan listed

companies are significant (p<.01) for total

information and board & ownership structure. The

coefficients are also significant (p<.05) for all other

subgroup information. These findings are consistent

with Hypothesis 1 that there is a positive association

between wider ownership and the extent of voluntary

disclosure. The coefficient for EPS is significant

(p<.1) for board & ownership structure which reveals

that earning voluntary disclosures is associated with

ownership structure. This finding is consistent with

Chen and Jaggi‘s (2000). Further analysis of the

shareholdings among the family members of the

sample companies from 2005-2007 reveals that more

one third of the listed companies are subject to family

control. In order to analyze the impact of family

control on voluntary disclosures, another regression

model was run with the same variables as in Table 5,

but with an added indictor variable for family control

as shown in Table 6. As shown in Table 6, the

coefficient on OOWN remains significantly positive,

and the coefficient on the proportion owned by family

members is negative and statistically significant

(p<.01) for mandatory, voluntary and total

information disclosures. This indicates that while

concentrated ownership in general reduces disclosure

that effect is particularly pronounced when the firm is

family-controlled. Gray‘s (1988) secrecy hypoethesis

also argues that where a firm‘s shares are held by

family-control, there is a preference for

confidentiality and restriction of disclosure of

information about the business only to those who are

closely involved with its management and financing.

Thus, the findings of this study support Hypothesis 2

that there is a negative association between family

ownership and voluntary disclosures.


132

Table 5. Regression results Independen

t variablesa


transparence

Board and ownership

structure

Mandatory

information

Voluntary

information

Total disclosures

coefficien

t

t-statisc

(p-value)

coefficien

t

t-statisc

(p-value)

coefficien

t

t-statisc

(p-value)

coefficien

t

t-statisc

(p-value

)

coefficien

t

t-statisc

(p-value)

Intercept 0.595 7.965

(0.000)**

*

0.275 1.565

(0.120)

0.761 7.271

(0.000)**

*

0.048 1.113

(0.268)

0.526 6.186

(0.000)**

*

SIZE1 0.1875 3.1028

(0.002)**

0.043 1.594

(0.113)

0.0003 0.017

(0.986)

-0.0006 -0.098

(0.922)

0.1288 1.9995

(0.0459)*

LEV2 0.034 1.025

(0.307)

-0.103 -1.563

(0.120)

-0.012 -0.309

(0.758)

0.013

0.686

(0.493)

-0.004 -0.131

(0.896)

AUD3 -0.009 -0.675

(0.501)

-0.070 -2.587

(0.011)**

-0.042 -1.808

(0.072)*

0.005 0.675

(0.501)

-0.026 -1.656

(0.100)*

OOWN4 0.209 2.060

(0.004)**

0.041 3.511

(0.001)**

*

0.027 2.203

(0.045)**

-0.022 -1.974

(0.050)*

*

0.036 2.831

(0.005)**

*

EPS5 0.046 0.917

(0.359)

0.128 1.999

(0.045)*

0.015 1.076

(0.283)

-0.004 -0.391

(0.696)

0.012 1.012

(0.313)

Adjusted R2 0.653 0.079 0.166 0.022 0.509

F-statistic 49.198**

*

3.187*** 6.106 1.574 27.484**

*

Notes: aThe estimated coefficients and two-tailed p-values (in parentheses). 1Natural logarithm of total assets. 2Total liabilities over total assets 3Auditor opinion, 2 for adverse opinion; 1 for qualified opinion; 0 for disclaimer opinion and -1 for unqualified opinion. 4Ratio of a firm‘s equity owned by outsiders to all equity of the firms. 5Earnings per share.

*Significant at 0.1

**Significant at 0.05

***Significant at 0.01 Table 6. Regression results-family control

Independen

t variablesa


transparence

Board and ownership

structure

Mandatory

information

Voluntary information Total disclosures

Coefficien

t

t-statisc

(p-value)

coefficien

t

t-statisc

(p-value

)

coefficien

t

t-statisc

(p-value)

coefficien

t

t-statisc

(p-value)

coefficien

t

t-statisc

(p-value)

Intercept 0.498 4.929

(0.000)**

*

0.177 0.778

(0.438)

0.692 5.355

(0.000)**

*

0.207 16.327

(0.000)

0.463 4.331

(0.000)**

*

OOWN 0.603 8.157

(0.000)**

*

0.341 1.980

(0.049)*

*

0.798 7.849

(0.000)**

-0.022 -1.974

)0.050)**

0.550 6.564

(0.000)**

*

Family

control

-0.006 -1.930

(0.055)*

-0.015 -1.913

(0.058)*

-0.011 -3.009

(0.003)**

*

-0.067 -3.319

(0.001)**

*

-0.009 -2.908

(0.004)**

*

Adjusted R2 0.665 0.099 0.214 0.068 0.538

F-statistic 33.234*** 2.789** 5.440*** 2.858** 19.952**

*

Notes: aThe estimated coefficients and two-tailed p-values (in parentheses).

*Significant at 0.1, **Significant at 0.05, ***Significant at 0.01

5. Conclusion

As the features of the emerging capitalism in East

Asia is becoming more distinct, it is clear that

controlling shareholders will play a key role in

corporate structure and governance for the foreseeable

future.

Family firms have incentive to reduce the

transparency of corporate governance practices to

facilitate getting family members on boards without

interference from non-family shareholders. Consistent

with this argument, we find that family firms tend to

disclose less information than those wide shareholder

firms.

The empirical findings highlight the importance

of the contextual characteristics of Taiwan. The strong

prevalence of ―insider‖ and family-controlled

companies is likely to be associated with lower levels

of disclosure. Insider and family-controlled

companies have little motivation to disclose

information in excess of mandatory requirements

because the demand for public information disclosure

is relatively weak in comparison with that of

companies with wider share ownership. These

findings have important implications for national

regulatory process that regulators should consider

differences of control party settings in ownership

structure prior to establishing rules for corporate

disclosures.


133

Appendix A. Disclosure checklist

A. Finance and operation transparence

1. Does annual report reveal important accounting policy?

2. Does annual report apply GAAP aligned with local GAAP?

3. Does annual report provide accounts in alternate internationally recognized accounting method?

4. Does annual report reveal assets impairment?

5. Does annual report reveal depression method of fixed assets?

6. Does annual report reveal methods for assets valuation?

7. Does annual report reveal related information for long-term and shot-term investment transactions?

8. Does annual report reveal analysis information for individual department?

9. Does annual report reveal information of auditing firm and auditors‘ report?

10. Does annual report reveal any non-audit fees paid to auditor or any other affiliated companies by auditing

company?

11. Does annual report reveal chart and ownership structure of affiliated companies?

12. Does annual report reveal endorsement of affiliated companies, loan to others and investment in derivate financial

goods?

13. Does annual report reveal transactions of related party?

14. Does annual report reveal information of operation?

15. Does annual report reveal trends and environment of industry from perspective of macro economy?

16. Does annual report reveal business development from long- and short-term perspective?

17. Does annual report reveal details of its R&D investment plans?

18. Does annual report reveal details of its future investment plans and R&D expenditure?

19. Does annual report reveal R&D investment plans and milestone?

20. Does annual report reveal details of products and service?

21. Does annual report reveal sales and production volume and products combination?

22. Does annual report reveal any industry-specific ratios?

23. Does annual report reveal any industry-specific Key Performance Indicator (KPI)?

24. Does annual report reveal historical performance indicator (ROI, ROA, ROE, etc.)?

25. Does annual report reveal policy of risk management?

26. Does annual report reveal organization of risk management?

27. Does annual report reveal its accounting target and method of hedge?

28. Does annual report reveal employee productivity?

29. Does annual report reveal employee training?

30. Does annual report reveal employees disclosing transparency of financial information, who got related certificate

from authority?

31. Does annual report reveal employees‘ behavior or ethics regulation?

32. Does annual report reveal protection of working environment and employee safety?

33. Does annual report reveal to implement social responsibility?

B. Board of directors and ownership structure

1. Does annual report reveal member of board directors, experience, shares holding and when joined the board?

2. Does annual report reveal board information upon independence?

3. Does annual report real board information upon taking a job in a company?

4. Does annual report reveal board information upon taking part-time job in other companies?

5. Does annual report reveal compensation details of board directors and board supervisors?

6. Does annual report reveal remuneration of board directors and board supervisors?

7. Does annual report reveal related compensation information of individual director and supervisor?

8. Does annual report reveal pledge of directors, management and majority of shareholders?

9. Does annual report reveal training of board directors and supervisors?

10. Does annual report reveal discussion of governance?

11. Does annual report reveal top 10 employees, who get stock option, with names and job title?

12. Does annual report reveal name, job title, and shares of top 10 employees who get bonus?

13. Does annual report reveal management name listing, shares holding and employee stock options shares?

14. Does annual report reveal EPS after employee bonus and directors/supervisors compensation?

15. Does annual report reveal EPS after employee stock bonus?

16. Does annual report reveal names, ratio and shares of shareholders who own over 5% of share capital?

17. Does annual report reveal top 10 shareholders with their holding shares and ratio?

18. Does annual report reveal execution of action items of stockholders‘ meeting?


134

References

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(2004). What determines corporate transparency.

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6. Claessens, S., Djankov, S.; Fan, Js., & Lang L. H. P.

(1999). Expropriation on minority shareholders:

Evidence from East Asia. Policy Research. Working

Paper 2088, The World Bank.

7. Gelb, D. S. (2000). Managerial ownership and

accounting disclosure: an empirical study. Review of

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475-508.

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W. C. (1995). Multivariate data analysis with

readings. New York: Prentice-Hall.

11. Ho, S. M., & Wong, K. S. (2001). A study of the

relationship between corporate governance structures

and the extent of voluntary disclosure. Journal of

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139-156.

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Voluntary disclosure in an emerging capital market:

some empirical evidence from companies listed on the

Kuala Lumpur Stock Exchange. International Journal

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13. Jensen, J., & Meckling, W. (1976). Theory of the firm:

managerial behavior, agency costs and ownership

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(1994). Family groupings on performance of portfolio

selection in the Hong Kong Stock market. Journal of

Banking and Finance, 18(4), 725-742.

15. Meek, G. K., Robert, C. B., & Gray, S., J. (1995, Third

Quarter). Factors influencing voluntary annual report

disclosures by US, UK and continental European

multinational corporations. Journal of International

Business Studies, 555-572.

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33-48.


135

РАЗДЕЛ 3 КОРПОРАТИВНОЕ

УПРАВЛЕНИЕ В МАЛАЙЗИИ

SECTION 3 СORPORATE GOVERNANCE: MALAYSIA

CORPORATE GOVERNANCE IN FAMILY RUN BUSINESS – A MALAYSIAN CASE STUDY

C.H. Ponnu*, C.K. Lee*, Geron Tan*, T.H. Khor*, Adelyn Leong*

Abstract This paper addresses the debate on family run business and corporate governance before and after the Asian Financial Crisis in 1997. As there are only few studies on the corporate governance of family businesses in Malaysia, this paper aims to provide a broad view of the corporate governance practises of family run companies in Malaysia. The majority of family-run companies in Malaysia are operated by ethnic Chinese families in Malaysia. To understand the practices of corporate governance in these companies, this study selected 3 of the top 10 family run companies by market capitalization in Malaysia. This paper discusses the issues and problems related to family run businesses in the light of the separation of ownership and control, lack of board independence and protection of minority shareholders, lack of independence of external auditors, lack of transparency and disclosure as well as managerial entrenchment. Keywords: corporate governance, family run business, Malaysia

*University of Malaya, Malaysia

1. Introduction to Family-Based Business in Asia

In many countries of East Asia, ownership is

concentrated within founding families (La Porta et al.,

1999; Claessens et al., 2002). According to Claessens

et al. (1999), analysis of ownership control conducted

by world bank found that ten largest families in

Indonesia, the Philippines, and Thailand control half

the corporate sector (in terms of market capitalization),

while the ten largest in Hong Kong and Korea control

about a third. More extreme, in Indonesia and the

Philippines ultimate control of about 17 percent of

market capitalization can be traced to a single family

and also in Malaysia, 28.3 percent of market

capitalization was controlled by 15 families.

According to Suehiro (1993) the family business

can be thought of “ … as a form of enterprise in

which both ownership and management are controlled

by a family kinship group, either nuclear or extended,

and the fruits of which remain inside that group, being

distributed in some way among its members.” (p.

378).

Suehiro (1993) draws his inspiration from

Chandler (1977) who defines family business in the

following way:

―In some firms the entrepreneur and his close

associates (and their families) who built the

enterprise continued to hold the majority of stock.

They maintained a close personal relationship with

their managers, and they retained a major say in top

management decisions, particularly those concerning


136

financial policies, allocation of resources, and the

selection of senior managers. Such a modern business

enterprise may be termed an entrepreneurial or family

one, and an economy or sectors of an economy

dominated by such firms may be considered a system

of entrepreneurial or family capitalism‖.

Interestingly, many Asian family firms are

owned and operated by Chinese (Tan & Fock, 2001).

In Malaysia, the Chinese (typically family oriented)

controls more than half of the public listed companies

in Bursa Malaysia (Low, 2003). Their strong presence

has made sense for this article to analyse the

characteristics of Chinese family business in order to

understand how the family run businesses in Malaysia

work. The aggressive nature of entrepreneurship and

strong cohesiveness of families are key factors in

Chinese family businesses (Yen, 1994). Zapalska &

Edwards (2001) also found that there are significant

links between Chinese culture and entrepreneurial

activities in China. There are, however, significant

differences between the Chinese and Western culture

as regards business activity (Pistrui et al, 2001;

Gatfield & Youseff, 2001; Begley & Tan, 2001).

Many aspects of Chinese culture, influenced by

Confucianism, combine to promote collectivism and

traditional respect for age, hierarchy, and authority in

the Asian business environment (Zapalska & Edwards,

2001). Confucian culture emphasizes the values of

paternalism and collectivism, both of which

contribute to Asian business relations. More

importantly, Chinese culture advocates conformity

rather than individuality (Begley & Tan, 2001) and

this is important in shaping managerial style (Hugh,

1986). The centralization of decision-making is

acceptable in such a cultural context. Moreover,

Chinese have a strong commitment to family, and thus

business is perceived as an extension of the family

system (Zapalska & Edwards, 2001).

Taiwanese family CEOs‘ sense of

professionalism and family loyalty are derived from

the enterprise system and the family system which

coalesce in family firms (Yen, 1996). Informal family

influence is more powerful than formal authority in

family firms because CEOs and top management are

also family members (Yen, 1996). The family system

is designed to increase family welfare and status and

preserve them for future family members. The family

mentality of local entrepreneurs is a key motivator in

the growth stage of an organization; but it may also

obstruct the development of family firms (Yen, 1994).

Recently, Chinese corporate culture has been

experiencing dramatic changes. Lee and Chan (1998)

found that the second generation of Singaporean

entrepreneurs is quite different from their parents

because they have absorbed many values of Western

culture. Moreover, the division of family properties is,

as a rule, rigid in Chinese culture, though it is also a

factor in business diversification (Yen, 1994).

2. Research Objective and Methodology

This paper makes references to the corporate

structures of Genting, IOI, YTL and Public Bank

Berhad, to understand the practice of corporate

governance in the context of Malaysian family run

businesses. These 3 companies are the top 10 family

run companies based on Starbiz‘s Malaysia Top 100

Companies by market Capitalization on 7th

August

2008. As there is only limited literature in Malaysia

on family-based corporate governance, we review a

broad cross section of the literature from Asia and

Europe to analyse the issues and problems of

family-run companies to gain better insight. This

paper also elaborates on some of the good practises of

corporate governance in Malaysian family-run

companies. Having presented both the weaknesses

and strengths of family run businesses, we look into

some of the reforms that can be explored to improve

the overall corporate governance of family-run

companies by maintaining some of the key features

while implementing the western based corporate

governance system. In this study, data and literature

were mainly secondary.

3. Family-Based Corporate Governance

Even before the crisis in Asia, extensive debate was

taking place in Europe, the United States and Japan

about the relative merits of different types of

corporate governance systems. Broadly speaking, two

general types of corporate governance structures have

been discussed.

The first type can be called a shareholder or

equity market-based governance system of the

Anglo-American type (EMS). This is usually

contrasted with the continental European or

Japanese-type stakeholder or relationship model. In

this model (for example, the Japanese main bank

system) banks rather than equity markets play a key

role in monitoring the performance of corporations.

Therefore, this type of governance structure could be

called a bank-led governance system (BLS). Note that

BLS can either be a Japanese-style main bank system

as mentioned above, or a German-type of universal

banking system. However, the BLS and EMS are not

the only two possible types of corporate governance

systems.

In both Northeast and Southeast Asia there is a

preponderance of family-based firms that are not

necessarily controlled by banks or by equity markets.

Nevertheless they do operate as economic entities

within the context of a relationship-based system.

Thus corporate governance of family businesses or

family-based corporate governance system (FBS) can

constitute a third type of corporate governance.


137

Table 1. Comparison of EMS, BLS and FBS system of Corporate Governance

Type of Corporate Governance System

Equity Market-Based

System (EMS)

Bank-Led System (BLS) Family-Based System

(FBS)

Share of

control-oriented

Finance

Low High High initially, but may

vary as family groups get

bank and equity financing

from outside

Equity markets Large, highly liquid Not necessarily small but less

liquid than EMS

Small, less liquid

Share of all firms

listed on

Exchanges

Large Not necessarily small Usually small

Ownership of debt

and equity

Dispersed Concentrated Concentrated

Investor orientation Portfolio-oriented Control-oriented Control-oriented for

family groups

Shareholder rights Strong Weak Weak for outsiders

Creditor rights

Strong Strong for close creditors but

applied according to a

―contingent governance

structure‖ (Aoki)

Strong for close creditors;

Weak for arm‘s length

creditors

Dominant agency

conflict

Shareholders vs. management Banks vs. management;

Workers may be important

stakeholders as in Aoki‘s

model of the Japanese firm

Controlling vs. minority

investors

Role of board of

directors

Important Limited, but less so than in the

case of FBS

Limited

Role of hostile

takeovers

Potentially important Quite limited Almost absent

Role of insolvency

and

bankruptcy*

Potentially important Potentially important; but

possible systemic crisis may

postpone bankruptcies

Potentially important

Monitoring of

non-financial

enterprises

(NFE)

Not mentioned Not mentioned Information asymmetry

and agency costs rise with

the growth of firms,

making monitoring more

costly.

Self-monitoring Not mentioned Not mentioned Initially, self-monitoring is

effective because of

non-separation of owner

and management. Later

stages present monitoring

problems as agency costs

rise due to separation of

owner-managers and

outside financiers.

* Note: Berglöf uses the term insolvency but the problem of exit of insolvent firms is directly related to

bankruptcy laws and procedures.

** Source: Berglöf (1997), “Reforming Corporate Governance”, Economic Policy 24, and Khan (1999),

“Corporate Governance of Family Businesses in Asia – What‟s Right and What‟s Wrong?”, ADBI Working Paper

No.3, and modified.

Given this threefold division, we can now ask:

what are the relevant dimensions in which these

systems can be compared and contrasted? Berglof

(1997) developed a set of criteria to answer this


138

question for EMS and BLS types of corporate

governance. Table 3.1 compares and contrasts the

EMS, BLS and FBS types of corporate governance,

using Berglöf‘s and Khan‘s original criteria with

modification of layout arrangement.

In discussing family business in East Asia, the

emphasis will be on ultimate control and de facto

control rights more than on formal ownership. In their

studies of corporate control in Hong Kong, China,

Indonesia, Korea, Malaysia and Thailand, Claessens,

Djankov, Fan and Lang (1998, 1999b) and Claessens,

Djankov and Lang (1998, 1999) have pointed out two

important features of industrial organization in East

Asia. These are:

a) Families have control over the majority of

corporations.

b) Such control is also magnified ―… through

the use of pyramid structures, crossholdings and

deviations from one-share-one-vote rules‖ (Claessens,

Djankov, Fan and Lang, 1999b, p. 3).

In addition to Berglofs original criteria for

comparing the BLS and EMS, Khan (1999)

introduced two additional features related specifically

to corporate governance of family businesses. The

first is monitoring of non-financial enterprises by the

system, i.e., how the managers of corporations are

monitored by outside financiers such as banks on the

one hand, and equity markets or shareholders, on the

other. This type of governance is intimately associated

with how corporations are financed, i.e., corporate

finance. Such monitoring by the firms‘ financiers is

clearly an important function of the financial system.

The monitoring of non-financial enterprises by the

financiers has special relevance because a priori it is

not clear if the financial distress of family-based firms

is always signalled accurately to the outside financiers.

Secondly and more generally, the issue of

self-monitoring needs to be addressed.

Self-monitoring is important because without some

degree of self-monitoring FBS cannot function

adequately.

Both BLS and EMS are closely associated with

the dominant modes of corporate finance by banks

and equity markets, respectively. In the case of FBS in

East Asia, the financing can come from three different

sources. First, under FBS in the initial phases of

growth of family businesses, firms could be financed

internally. Second, as the enterprise grows over time,

the role of banks becomes more prominent. Third, at

some point in time equity markets may become an

even more significant source of corporate finance.

However, the key difference between FBS as a

governance system and BLS and EMS lies in the fact

that neither the banks nor the equity markets

ultimately control or oversee the family business

groups. That control resides with the family (or

families) in the final analysis. This is because of

various mechanisms of control such as control

through subsidiaries that are at the disposal of the

family groups, as will be discussed in the next

sections.

4. Issues and Problems of Corporate Governance in Family-Based System

In general, discussions on corporate governance relate

issues to 5 major areas: rights and responsibilities of

shareholders, role of shareholders, equitable treatment

of shareholders, disclosure and transparency and

duties and responsibilities of the board. Other issues

include internal controls and independence of the

company‘s auditors, oversight and management risk,

oversight of the preparation of the company‘s

financial statement, review of the compensation

arrangements for CEO and other senior executives,

the resources made available to directors in carrying

out their duties, the way in which individuals are

nominated for positions on the board and dividend

policy Jaffer & Sohail (2007)

There are some specific problems in corporate

governance in relation to family-based business.

These are:

4.1. Lack of Separation of Ownership and Control

In Malaysia, the Listing Requirements are modeled

after the Anglo Saxon model more particularly the

UK Codes comprising of the Cadbury, Greenbury and

Hampel Report (Kang, 2001). Besides, the Malaysia

Code of Corporate Governance (MCCG) is also

modeled from these reports. In relation to the MCCG,

the code requires the separation of ownership and

control.

The code suggests that the separation of

ownership and control in order to stay objective when

making strategic policy decision (Robert, 2002). The

separation of two roles is to ensure effective check

and balance over the management performance

(Haniffa and Cooke, 2002). If the owner also becomes

the manager and chairman, he will be unlikely to

monitor the activities of the management in an

independent and objective matter (Lai, 2007). This is

due to the fact that the Chairman of the board is also

responsible for the selection of new board members,

monitoring the performance of the executive directors

and settling any conflicts which arise within the board

(Laing and Weir, 1999). Therefore, the separation is to

prevent the owner to make any decision for his own

benefit or own-self-interest at the expense of

shareholders and to avoid concentration of power.

However, this separation of ownership and

control can hardly be seen in Malaysia‘s

family-owned companies. We can see many FBS

companies are owned and managed by the founder or

their generations such as Genting Berhad, YTL


139

Corporation Berhad and IOI Corporation Berhad.

Referring to the Table 2, we can see that the owners of

the family-owned companies always assume the role

of Chairman and CEO. For example, Tan Sri Lim Kok

Thay from Genting Berhad is the owner, Chairman in

the board and also the CEO for the corporation. For

IOI, Tan Sri Dato‘ Lee is the owner and he is the

Chairman and CEO of the company. For TYL

Corporation, Tan Sri Dato‘ (Dr) Yeoh Tiong Lay is the

owner and Chairman of the company, his eldest son

Tan Sri Dato‘ (Dr) Francis Yeoh is the Managing

Director for the company.

Table 2. Duality Roles of Owners in Malaysian FBS

IOI Corporation Berhad Genting Berhad YTL Corporation Berhad

Chairman/ Owner

Tan Sri Dato' Lee Shin Cheng

Tan Sri Lim Kok Thay

Tan Sri Dato‘ Seri (Dr) Yeoh Tiong Lay

CEO/ MD Tan Sri Dato‘ (Dr) Francis Yeoh Sock Ping

The duality of roles of the owners in the above

family-owned companies is not recommended in

MCCG. The MCCG requires a balance of power and

authority between the Chairman and CEO, so that no

one individual has unfettered powers of decision.

In summary, the lack of the separation of

ownership and control is one of the major problems of

corporate governance in Malaysian family run

companies. The family run businesses do not have

separation and may well exert substantial influencing

power on the board of directors which in turn may

influence dividend policy and investment (Claessens

et al. 2000) and also the remuneration policy. The

audit committees and remuneration committees may

not be able to mute the concentration of power in such

few hands.

4.2 Lack of Independence on the Board

Board independence is associated with the entry of

outsiders into the board (Zulkafli, Samad and Ismail,

2006). The board should consist of two types of

director, namely executive and non-executive (Weir

and Laing 2001). The executive directors are

responsible for day-to-day management of the

company. They have direct responsibility for aspects

the business such as finance and marketing. They also

help to formulate and implement corporate strategy.

They should have brought in specialised expertise and

a wealth of knowledge to the business. Whereas, the

non-executive directors are in the monitoring roles as

mentioned in the Cadbury Report. Dare (1993) argues

that non-executive directors are effective in

monitoring when they question company strategy and

ask awkward questions. They should able to provide

independent judgement when dealing with executive

directors in areas such as pay rewards, executive

director appointments and dismissals.

In the Malaysian context, the MCCG requires all

listed companies to have at least one third of the

board comprised of independent directors and the size

of the board should reflect its effectiveness. The

independence of board of directors is one of the main

issue in Malaysian FBS. Normally, in the FBS, the

degree of concentration of ownership is high (La

Porta et al. 1999; Faccio and Lang 2002; Claessens,

Djankov and Lang 2000; Lemmons and Lins 2003).

As a result, the high degree of the concentration of

ownership will make the independence of the board

questionable and reduced its effectiveness.

Referring to Table 3 we can see the

independence of the board is questionable. For

example, in IOI Corporation, there are 3 family

members in an 8 member‘s board. Although the

appointment of the directors is decided by nomination

committee which comprises of independent directors,

but the strong influences of 3 family members can

affect the nomination committee‘s decisions. This is

very obvious in YTL Corporation; there are 7 family

members in the 13 members‘ board. Even though the

appointment of the directors is undertaken by the

board, but it was through the recommendation of the

managing director (MD) who is the son of the founder.

As a result, this may influence the board‘s decision

and effectiveness. Besides, the MD is also sitting in

the audit committee. It shows that the owners‘

influence is very strong in YTL Corporation. For

Genting Berhad, it has 8 directors on the board; one is

chairman and chief executive (Tan Sri Lim), one

deputy chairman, one executive director, two

non-independent non-executive directors and three

independent non-executive directors. This

composition fulfills the requirements of the MCCG

where it is recommended that at least three be

non-executive directors. However, the independence

of the board is not guaranteed because the founding

family holds at least 39% of the 3 companies

mentioned. Such a big shareholding allows the family

to have substantial influence over management and

the board. Therefore, we can see that lack of

independence of the board in these 3 family-owned

companies.


140

Table 3. IOI Corporation Bhd, Genting Bhd and YTL Corporation Bhd: Family Members in the Board, Members

in Audit and Remuneration Committee

IOI Corporation Berhad Genting Berhad YTL Corporation Berhad

% - Family

control

40.79 39.6 52.64

Board 3 family members in the 8 member‘s board.

Executive Chairman

Tan Sri Dato‘ Lee Shin Cheng (He is an

Executive Chairman and CEO)

Executive Director

Dato‘ Lee Yeow Chor (Also Group

Executive Director)

Non-Independent Non-Executive Director

Puan Sri Datin Hoong May Kuan (Wife of

Tan Sri Dato‘s Lee Shin Cheng)

1 family member in the 8 member‘s

board

Chairman

Tan Sri Lim Kok Thay (Also a CEO of

the Group)

7 family members in the 13 member‘s

board.

Executive Chairman

Tan Sri Dato‘ Seri (Dr) Yeoh Tiong Lay

Managing Director

Tan Sri Dato‘ (Dr) Francis Yeoh Sock Ping

Deputy Managing Director

Dato‘ Yeoh Seok Kian

Directors

Dato‘ Yeoh Soo Min

Dato‘ Yeoh Seok Hong

Dato‘ Michael Yeoh Sock Siong

Dato‘ Yeoh Soo Keng

Dato‘ Mark Yeoh Seok Kah

Audit

Committee (AC)

1. YM Raja Said Abidin b Raja Shahrome –

63 years. Appointed on 1 December 1999.

(Chairman / Independent Non-Executive

Director)

2. Datuk Prof Zainuddin b Muhammad - 63

years. Appointed on 24 July 2001.

(Member / Independent Non-Executive

Director)

3. Quah Poh Keat – 56 years. Appointed on

15 August 2008.

(Member / Independent Non-Executive

Director)

1. Tan Sri Dr. Lin See Yan – 69 years.

Appointed on 28 November 2001.

Chairman/Independent Non-Executive

Director

2. Dato‘ Paduka Nik Hashim bin Nik

Yusoff – 71 years. Appointed on 8 June

1979

Member/Independent Non-Executive

Director

3. Mr Chin Kwai Yoong – 60 years.

Appointed on 23 August 2007.

Member/Independent Non-Executive

Director

4. Mr Quah Chek Tin – 57 years.

Appointed on 12 April 1999.

Member/ Non-Independent

Non-Executive Director

1. Dato‘ (Dr) Yahya Bin Ismail – 80 years.

Appointed on 6 April 1984.

(Chairman/Independent Non-Executive

Director)

2. Tan Sri Dato‘ (Dr) Francis Yeoh Sock

Ping – 54 years. Appointed on 6 April

1984.

(Member/Managing Director)

3. Mej Jen (B) Dato‘ Haron Bin Mohd Taib

– 73 years. Appointed on 3 July 1990.

(Member/Independent Non-Executive

Director)

4. Dato‘ Cheong Keap Tai – 60 years.

Appointed 30 September 2004.

(Member/Independent Non-Executive

Director)

Remuneration

Committee (RC)

1. Tan Sri Dato‘ Lee Shin Cheng

(Chairman)

2. YM Raja Said Abidin b Raja Shahrome

3. Datuk Prof Zainuddin b Muhammad


Yusoff


Director

2. Tan Sri Dr. Lin See Yan

3. Tan Sri Lim Kok Thay

Not available

Nomination

Committee (NC)

The Nomination Committee of the

Company comprises the independent

directors. The Nomination Committee is

responsible for making recommendations

for any appointments to the Board.

1. Tan Sri Dr. Lin See Yan


Director


Yusoff

The appointment of Directors is

undertaken by the Board as a whole. The

Managing Director recommends

candidates suitable for

appointment to the Board, and the final

decision lies with the

entire Board.

Source: IOI Corporation Berhad‟s Audited Report 2008; YTL Corporation Berhad‟s Audited Report 2007;

Genting Berhad‟ Audited Report 2007.


141

In addition, the independence of non-executive

directors is difficult to justify when he or she is

appointed to the board many times and for more than

3 years. According to O‘Sullivan and Wong (1999),

non-executive directors with many years of

experience on the same board may become less

effective monitors as they build up close relationships

with executive director/ owner/dominant shareholders

in FBS. For example, one of the independent

non-executive director has sat on the Genting board

since June 1979. This is similar to YTL Corporation

and IOI Corporation as we look at the members of

audit committee in YTL and IOI in Table 4.2 above.

This close relationship has caused problems for the

independence board of directors in FBS.

4.3 Lack of Protection for Minority Shareholders in Family-Based System

PricewaterhouseCoopers Corporate Governance

Survey of 2002 showed that many public listed

companies have substantial shareholders who act as

directors and are involved in the management as well

(Satkunasingam and Shanmugan, 2006). As a result,

minority shareholders under such conditions have

very little say in the management, ethics and practices

of these types of corporations (Reed, 2002;

Thillainathan, 1999). Under such circumstances, will

the minority shareholders in family-based companies

take action against the errant corporations on their

own?

According to Satkunasingam and Shanmugan

(2006), minority shareholders in Malaysia are at a

greater disadvantage than minority shareholders in

developed countries like Australia because they do not

only have to contend with conflicting interests with

dominant shareholders at times, but they also have to

contend with government interference that at times

prevents even dominant shareholders from exercising

their rights as shareholders; a move which may

indirectly harm minority shareholders who seldom

have the clout to make themselves heard. It is

therefore left to the minority shareholders to represent

their own interests. They are unlikely to do this in

light of the local culture and politics. Even with the

Minority Shareholder Watchdog Group (MSWG), the

minority shareholders‘ interest still can not be

guaranteed in the FBS because the dominant

shareholders or concentration of shareholding can rule

over any minority shareholders‘ decision in the

Annual General Meeting (AGM).

In FBS, although shareholders including

minority shareholders can enjoy one-share-one-vote

rule, with proxy voting legally allowed and practiced.

However, the minority shareholders could not

influence the vote, and there is no real discussion of

board decisions during such meetings. As a result,

many major transactions of the FBS companies such

as amendment of the articles, bonded indebtedness,

sale of major corporate assets, investments in other

companies and mergers managed approved by

two-thirds majority vote of shareholders. In short, all

these created problem of exploitation of minority

shareholders‘ interests in FBS.

4.4 Lack of Independence of External Auditor

In FBS, the appointment and removal of a director is

done according to simple majority vote by

shareholders. Therefore, major shareholders such as

family-owned companies would have a

disproportionate influence over the proceedings (RHB,

2008). The same method applied to appointing

external auditor; therefore, auditor independence

could be weakened due to the influence of dominant

shareholders. Some auditors may even collude with

the management in order to continue providing

services to the company.

4.5 Lack of Transparency and Disclosure: Continuous Disclosure and Related-Party Transactions

In FBS, small investors are often at a great

informational disadvantage compared with controlling

family shareholders. Normally, the information flow

very fast to the family members because of the duality

roles of owners in FBS. It is arguably of greater

importance for family companies to effectively

implement a policy of continuous public disclosure of

relevant operational, financial, and corporate events to

enhance transparency for all shareholders.

Although the FBS companies fulfil the

requirements of Bursa by publicising the Audited

Report annually and continuously providing important

information to Securities of Commission (SC) and

Bursa Malaysia, yet we cannot guarantee there is no

insider trading in FBS companies. This is because the

owners have access to non-public information about

the company.

4.6 Managerial Entrenchment

Due to the strong influence of founding family in the

board, there is high chance that the nomination

committee may not appointing directors out of pure

merit consideration, particularly the position of CEO.

Likewise, this invisible hand may also influence the

selection process of the professionals to run the

various functions of the company‘s operation. This

will deprive the family run companies of efficient

labour market which is enjoyed by non family-run

public listed company (Schulze, et al. 2001). Further

supporting this claim, studies done in Europe

suggested that family-run companies are more


142

exposed to managerial entrenchment (e.g.

Gomez-Mejia, Nunez-Nickel and Gutierrez, 2001;

Thomsen and Pedersen, 2000). The problem of

managerial entrenchment is due to perception that

family-run companies have natural inclination to

favour applicants related to the founding family, this

perception could subsequently reduce the quality of

applicants for key managerial positions in the

company.

5. The Benefits of the Family-based System

Despite the problems and issues raised above, family

based corporate governance system certainly are still

relevant to the corporate world not just the East Asia,

where families still control sizeable businesses across

the world, but also in the United States where families

control as much as 30 percent of the largest public

firms and participate in management of as much as

one third of these (Kang, 2000). The key strengths of

FBS include reduced agency cost and altruistic

behaviours, efficient leadership structure and business

continuity.

5.1 Reduce Agency Cost and Altruism

There is no current literature exploring the benefit and

strength of family-run companies in terms of agency

cost and altruism in the context of Malaysia.

Fortunately, we can draw on some of the research

carried out in Europe to understand the strength in this

regard. Dalton and Daily (1992) argued that

family-run companies are one of the most efficient

forms of organizations because of the little separation

between control and management decisions. This

alignment between control and management reduce

the agency cost which is typically associated with the

widely held public companies (Berle and Means,

1932). In widely held public companies, the

alignment of control and management requires the

incentive schemes such as performance based salary

or stock options, external monitoring from auditors

and capital financers, as well as close monitoring and

regulations from statuary boards to ensure both

director board and management act in the interest of

the company in both short and long time horizon.

In contrary, family-run companies may benefit

from employment relationships based on altruism and

trust. Altruism refers to decisions that are made for

selfless reasons to benefit others, rather than decisions

made for selfish reasons typically assumed by

classical economics literature (Lunati, 1997). In fact,

researchers in several fields have long recognized the

value of altruism in employment contracts. For

instance, Chami and Fullenkamp (2002) recognized

that developing trust via mutual, reciprocal altruism

can reduce the necessity of increase monitoring and

incentive-based pay. Moreover, this altruistic

behaviour reduces excessive private consumption of

perks and effort aversion of managers at the expense

of the company owner. De Paola and Scoppa (2001)

also suggested that altruism within the family could

lead to superior employment contracts by the

companies. In addition, because of

owner-management alignment in family-run

companies, both parties are naturally patient investors

with a long time horizon (Kang, 2000). A founder

who plans to pass his business to an heir will be more

likely to use firm resources efficiently than a founder

who does not plan on transferring the business to a

family member. Another demonstration of altruistic

behaviour is the synonyms of company with the

family, thus giving the company leader as the

patriarch, the motivation to run the business with the

interest of company in mind (Lai, 2007). Moreover,

Family ties, loyalty, insurance, and stability provide

the necessary incentives for family managements to

make decisions according to market rules (James,

1999).

5.2 Structure of Leadership for Family Based System Corporation

Leadership structure has important impacts on the

nature of decision making process for a company.

Politically correct ―good corporate governance‖ in this

regard, means transparency on decision making

process by encouraging various groups to form the

committees and votes on the decision openly, however

this process may take long time to reach consensus,

and also subjected to the possibility of confidential

information leakage to competitors, this is in contrary

to family based system, which emphasis on trust and

believe important decision should be made privately

for the interest of the company. The founder often

unilaterally makes business decisions, and seeks board

endorsements subsequently (Yueng & Soh, 2000).

This unitary leadership structure becomes important in

maintaining the decision making process to sustain

competitive advantage in the market, because it offers

a clear mandate to a single leader to react faster to

external events (Fan, Lau and Wu, 2002).

Normally founding family members assume

positions of chairman and CEO to preserve the

powers to decide within the corporate structure. This

arrangement is always attacked by EMS‘ s school of

thought followers, however one must not forget that

companies like Enron, World-com, Vivendi and

Deutsche Telecom practised the separate management

and board and yet the scandals could not be avoided

(Sonnenfeld, 2004).

As shown in Table 4.2, typically the Malaysian

family run companies have founding family members

for the position of Chairman and CEO, this is same as

FBS in other countries such as Hong Kong. For


143

example property tycoon Mr. Li Ka Shing (Asia‘s

richest man) holds the chairman position at the

Cheung Kong Holdings while his elder son, Mr. Vitor

Li is the Managing Director.

5.3 Business Continuity (Absence of Hostile Takeover)

Family run companies compared to widely held

public companies, have lower risk of hostile takeover

by other companies, this is mainly due to the nature of

ownership structure that enable the founding family to

have more control power than their actual share

ownership represent (Khan, 1999). This in turn, leads

to business continuity that provides more focused

strategic direction and facilitate restructuring and

long-term commitment (Shleifer and Vishny, 1986).

Moreover, with the guidance of founding family, the

company can expect to benefit from a continuity of

entrepreneurial vision which may be throttled should

the potential of hostile takeover is pre-occupying the

mind of the management. Typically family run

companies employ two methods for takeover defences:

(1) multiple share classes with unequal voting power

resulting in incumbent management holding shares

with higher voting power, or (2) a pyramid ownership

structure (popular in Malaysia). In Genting Berhad,

the founding Lim family uses various vehicles to own

up to about 39 percent of the total ownership to

ensure hostile takeover is of distant possibility. This

approach is very similar to the Hong Kong

conglomerate, Cheong Kong Holding (HK) which

both Li Ka Shing and his son control about 77% of

the total share through various vehicles. The

ownership of Genting Holding Berhad that takes the

following forms (Figure 1) will make the takeover

almost impossible:

Genting Berhad

Kien Huat Realty Sdn. Bhd.

Share: 23.719%

CIMB Group Nominees (Tempatan) Sdn Bhd

Mandurah Limited for Kien Huat Realty Sdn Berhad (49279

Lint)

Share: 8.508%

World Management Sdn. Bhd.

Share: 1.592%

Alocasia Sdn. Bhd.

Share: 1.526%

Tinehay Holding Limited.

Share: 3.295%

Mr. Lim Chee Wah

Share: 0.445%

Figure 1. Ownership Structure of Genting Berhad

6. Reforming Family-Based System of Corporate Governance

In previous sections, we have discussed the strengths

and weaknesses of FBS, thus the question to ask is:

should FBS be retained or reformed? What kind of

changes (firms‘ internal structure, external

institutional, capital financing and etc.)? Khan

(1999b) has argued that FBS is essential during the

earlier capital accumulation stage due to its low

agency cost and effective internal control; this

practically had been proven after the 1997 Asia

Financial Crisis, where most companies who survived

through and grew faster are followers of FBS. This

however does not mean that FBS is flawless, as we

have identified in earlier sections that it has many

corporate governance issues. BLS and EMS have

many good features that can be served as part of

long-term model for FBS to move forward. Randoy

and Jenssen (2003) proposed unique combination of

features of both FBS and BLS/EMS to obtain the

agency advantages due to altruism as well as capital


144

and managerial advantages inherent from BLS/ EMS.

This hybrid of system will require reformation in both

the internal structure initiated by family run

companies and institutional change by the statuary

boards.

6.1 Internal Structural Reforms (Separation of Chairman and CEO)

Some of the problems due to lack of separation of

ownership and management can be mitigated by

having a corporate structure as proposed by Randoy

and Jenssen, in which the founding family holds the

position of non executive chairman and elect external

professional as the CEO. Having founding family

members to assume the position of non executives has

several advantages.

First, the reduction of agency cost. By aligning

the interest of shareholders, either in the form of both

economic and altruistic incentives, will lower the

agency cost of hiring an external professional as the

CEO (Steier, 2003). Second, by hierarchically

occupying at a higher level than CEO would provide

effective and close monitoring of CEO‘s behaviour

and check agency loss due to CEO as the agent. The

owner also has the legitimate power to initiate move

to replace CEO should the performance is under par.

Third, founding family would be more inclined to

preserve and continue the family‘s overall vision and

plan the long-term goals of the company, one of the

key advantages of a family firm (Ward and Aronoff,

1994; Litz and Kleysen, 2001; Athanassiou,

Crittenden, Kelly and Marquez, 2002)

Another benefit of this arrangement is that it

addresses the managerial entrenchment problem faced

by family-run companies. It will enable the company

to scout for talent most suitable for the success of the

company‘s operation. Having an external professional

as CEO will also change the perception of new recruit

as well as providing motivation to the existing staff

that the company is practicing merit based

employment.

One of Malaysian family-run companies that has

moved towards this corporate structure, is notably

(Table 6.1), Public Bank Berhad where the founder of

the company, Tan Sri Dato‘ Sri Dr. Teh Hong Piow

assumes the position of non executive Chairman with

the CEO position being held by Dato‘ Sri Tay Ah Lek,

a professional banker with 30 years experience in

banking sector. This change in leadership structure

has set a good example for the rest of the companies

in Malaysia to emulate. Understandably, Public Banks

was awarded a number of accolades under the

category of good corporate governance, for example:

1) Ranked 2nd in Best Corporate

Governance (for Malaysia) by Euromoney in 2007

2) Best Corporate Governance in Asia by

FinanceAsia in 2008

3) Corporate Governance Asia Recognition

Award by Corporate Governance Asia in 2008

Table 4. Ownership and Board of Public Bank Berhad

Source: Public Bank Berhad‟s Audited Report 2007; Public Bank Berhad official website:

ww2.publicbank.com.my

6.2 Takeover Defence

One limitation to this separation of Chairman and

CEO is the effective monitoring mechanism to

evaluate the Chairman‘s performance of his or her

monitoring duties; this could result in corruption on

the part of the Chairman and the negligence or slack

in his or her duties (Henry, 2002). While, incentive

alignment with both economic and altruistic means,

may sound reasonable, its effectiveness will need a

longer time to assess. Randoy and Jenssen (2003)

found that family-run companies with a founding

family member as Chairman and without takeover

defence outperformed those companies that employed

takeover defence. In previous section, it was asserted

that takeover defence could lead to business

Public Bank Berhad

% -Founding Family control 22.9%

Board Non-Executive Chairman

Tan Sri Dato‘ Sri Dr. Teh Hong Piow

Independent Non-Executive Chairman

Tan Sri Dato‘ Thong Yaw Hong

Independent Non-Executive Co- Chairman

Dato‘ Sri Tay Ah Lek

Chief Executive Officer

And others

Audit Committee (AC) The Remuneration Committee is made up entirely of Independent Non-Executive Directors

Remuneration Committee (RC) The Remuneration Committee is made up entirely of Independent Non-Executive Directors

Nomination Committee (NC) The Remuneration Committee is made up entirely of Independent Non-Executive Directors


145

continuity, however the drawback is that, without the

risk of losing control, the comfort zone may breed

errant and unrepentant Chairman, therefore, it must be

a trade off between business continuity for stable

growth and effective check on the performance of the

Chairman. In the case of family-run companies in

Malaysia with high ownership concentration, it will

not be an easy task to have the founding family giving

up some of the controlling power, unless, the state

formulates statuary requirement to increase the

floating share in the capital market for family-run

companies. The reform in this aspect will not happen

in the near future, however, if the founding family

recognizes the benefit of trade off between ownership

control and efficient external capital financing, the

FBS will be more robust and transparent, thus being

able to provide an alternative system to EMS / BLS.

6.3 Institutional Reform for FBS

In principle, EMS is by far the more efficient system

of corporate governance compared to FBS. Whilst we

cannot ignore the current recession due to the fall of

financial institutions in EMS-based corporations such

as Merrill Lynch, Bear Stearns and Lehman Brothers

in the US, as well as Northern Rock and Bradford &

Bingley in the UK; in terms of corporate governance,

the EMS system still shows reasonable accountability

and transparency compared to that of the FBS. Taking

Hong Kong as example, they had recovered a lot

faster than other East Asia countries‘ FBS-based

companies such as Thailand, Indonesia, and South

Korea. The significant difference is that Hong Kong

has comparably stronger banks and equity markets

unlike Malaysia where the government opts to

intervene in the market.

Khan (1999b) has suggested a few ways of

reforming FBS in Malaysia, by taking into account

Malaysia‘s social and political environment:

a. Financial firm’s managerial expertise

Recruitment and training competent professionals so

that financial institutions can understand and monitor

the firms they finance efficiently and effectively.

b. Role of competition and contestability of the

market structure

The elimination of inefficient firms and encouraging

the entry of new firms through competition will

improve corporate governance and firm performance.

Shareholder activism is another important aspect

of corporate governance to protect the rights of

minority shareholders. As a result, Minority

Shareholder Watchdog Group (MSWG) was

established in 2000 to provide assistance to minority

shareholders and to act as a watchdog over companies.

The group‘s five founding shareholders were PNB,

the Employees Provident Fund, Lembaga Tabung

Angkatan Tentera (LTAT), Lembaga Tabung Haji

(LTH) and Pertubuhan Keselamatan Sosial

(PERKESO) which are government investment

agencies. This is certainly the correct path for

promoting greater transparency when these

shareholders take ownership of the family-run

companies, however this is merely first step towards

shareholders activism, these founding shareholders

must take more proactive approach by demanding

participation in the board activities or minimum,

constantly applying pressure to the board when there

is sign of exploitation on the rights of minority

shareholders

7. Conclusion

Family-run businesses, especially the public listed

companies in Malaysia and East Asia have their own

set of corporate governance compared to western

based or Japan based systems. While, the western

based system, particularly the Anglo Saxon model has

gained traction in many Asian countries, which

prompted the governments to impose some corporate

governance practices into local companies, this

enforcement has resulted the divergence of corporate

governance practices and policies among the Asian

companies. Nonetheless, many family-run companies

in Hong Kong, Korea, Taiwan, Thailand, Malaysia

and others still uphold few key elements of their

corporate governance characteristics. We have

examined many of the issues and problems of

family-run companies in the perspective of prevailing

EMS, it is no surprise that the separation of

owner/management, lack of transparency and an

independent board, exploitation of minority

shareholders‘ rights are the major problems of the

FBS. Family-run companies encompass different

management values than those of the equity based

company.

The biggest advantage of FBS would be the

altruistic behaviours that naturally align the interest of

the board and management, thus ensuring internal

control is effective and less costly. Yet, we think that

internal control is insufficient to ensure good

corporate governance as a whole. From past studies, it

is evident that institutional reforms such as the

financier‘s monitoring as well as minority

shareholders activism could provide extra monitoring

of the family run companies. This multi pronged

approach could be the best mean to ensure effective

corporate governance for family run companies.

The altruistic behaviours in relation to corporate

governance have not been verified in the Malaysian

context empirically, thus it will be a valuable insight

in this regard by future studies of these behaviours.

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148

CORPORATE GOVERNANCE COMPLIANCE VERSUS SYARIA’ COMPLIANCE AND ITS LINK TO FIRM’S PERFORMANCE IN

MALAYSIA

Noriza Mohd Saad*

Abstract

The purpose of this study is to investigate level of compliance by corporate governance (CG) code of best practices and sharia’ principles among public listed companies in main board of Bursa Malaysia and to provide insights view in determining significance association between the corporate governance and sharia’ compliance with firm’s performance. Corporate governance compliance was measured by three board of directors (henceforth; BOD) facets; (i) director’s remuneration, (ii) directors training and (iii) number of family members. Meanwhile, syaria’ compliance is based on six proxies, (i) riba, (ii) gambling, (iii) sale of non halal product, (iv) conventional insurance, (v) entertainment and (vi) stockbroking. The data are gathered from the analysis of companies’ annual report and Thompson DataStream for a sample of 147 companies (for corporate governance compliance) and 36 companies (for syaria’ compliance) over the period of 2003 to 2007. The study employs multiple regression analyses, independent sample T-test and Pearson correlation on the hypotheses tested. The preliminary results reveal most of the company has complied well with the code of best practices and syaria’ principles and there is a significant association to the firm’s performance besides syaria’ compliance firms show a better performance compared to corporate governance compliance firms. Keywords: Corporate Governance, Syariah, Compliance, Firm’s Performance, Board of Directors’ Facets

*Universiti Tenaga Nasional, Kampus Sultan Haji Ahmad Shah, Pahang, Malaysia, [email protected]

1. Introduction

Corporate governance is important for several reasons.

First, corporate governance is most often viewed as

both the structure and the relationships which

determine corporate direction and performance.

Second, the board of directors is typically central to

corporate governance. Its relationship to the other

primary participants, typically shareholders and

management, is critical. Additional participants

include employees, customers, suppliers, and

creditors. The corporate governance framework also

depends on the legal, regulatory, institutional and

ethical environment of the community. Whereas the

20th century might be viewed as the age of

management, the early 21st century is predicted to be

more focused on governance. Both terms address

control of corporations but governance has always

required an examination of underlying purpose and

legitimacy.

The evidence on the empirical failure of the

Enron and others mentioned has brought attention to

the duties and responsibility played by the board of

directors (BOD) in the company. It failure also

produced discussion of further regulations that will, it

is hoped, can prevent another company collapse that

similar to the Enron. For that reason, after detailed

study and recommendation by the high level finance

committee which was formed in 1998, Malaysian

Code of Corporate Governance was introduce in

March 2000 with the objectives of improving the

corporate governance practice by the corporate sectors.

In this code of best practice, it was highlight that the

company was highly recommended to comply with

the code such as the company should disclose the

number of board meeting during the financial year in

the annual report to make sure the interest of the

company and the goal can be achieved. The company

also should have a detail of level remuneration

received per directors, have a clear job description on

BOD in order to avoid management conflict

especially those who have family members among

company‘s director. Besides, also disclose in

companies‘ annual report on the training attended by

BOD for Mandatory Accreditation Program (MAP) as

highlighted in the MCCG code of best practices.

A Compliant to syaria‘ principle is different with

corporate governance where it does not have a code of

best practices to follow. However, the Syariah

Advisory Council (SAC) has applied a standard

criterion in focusing on the activities of the companies

listed on Bursa Malaysia. As such, subject to certain


149

conditions, companies whose activities are not

contrary to the Sharia‘ principles will be classified as

Sharia‘-compliant securities. On the other hand,

companies will be classified as Sharia‘ non-compliant

securities if they are involved in the following core

activities such as financial services based on riba

(interest), gambling and gaming, manufacture or sale

of non-halal products or related products,

conventional insurance, entertainment activities that

are non-permissible according to Sharia‘, manufacture

or sale of tobacco-based products or related products

and stockbroking or share trading in Sharia‘

non-compliant securities and other activities deemed

non-permissible according to Sharia‘.

In this new era, most of the investors are

demanding nearly perfect information to analyze the

companies‘ performance to make sure their

investment can generate income and increase their

satisfaction in the business market. Measuring

companies‘ performance is importance especially to

the management, shareholders, government,

customers, suppliers, and other stakeholders that have

interest to the company directly or indirectly.

Consider to this issue, this study was used three

important financial ratios to measure the companies‘

performance, that is return on assets (ROA), return on

equity (ROE) and operating profit margin (OPM). It

also used to forecast the future success of companies,

while the researcher's main interest is to develop

models exploiting this ratio.

The remainder of the study is structured as

follows. Section 2 review the existing literature on

corporate governance and syaria‘ compliance towards

firm‘s performance. Section 3 describes the data and

methodology. Section 4 presents the findings and

discussion on the results while, section 5 concludes

and recommendations to the company.

2. Literature review

The discussion on Corporate Governance in Malaysia

as well as other East Asian countries should be

initiated from the event of East Asian economies

collapsed in the second half of 1997.The period

placed a greater concern and recognition of Corporate

Governance to the public and private sector in those

countries. The financial crisis was triggered in

Thailand when foreign investors lost their confidence

and started to withdraw capital due to currency

devaluation. The problems transmitted to other

neighboring countries. The most affected countries

included Indonesia, Malaysia, South Korea, and the

Philippines. In Malaysia, attempts to contain further

devaluation caused higher level of interest rate and

credit contraction. This created severe contractions in

output and corporate profitability which was reflected

in massive fall of equity prices. The Kuala Lumpur

Composite Index declined by 72% during the period

from end-June 1997 to end-August 1998. Real estate

markets declined sharply due to high interest rates and

in crisis environment. Banks, which had significant

portion of their loan exposure in the construction and

real estate sector; and stock purchase financing, were

badly affected.

From the economic perspective, corporate

governance is an important element of achieving an

allocative efficiency in which scarce funds are moved

to investment project with the highest returns. In

practice, efficiency is achieved when at given level of

risk, investments project offer the highest return

exceeding its cost of capital. The crisis indicated how

the failure to regulate good governance affected the

mobilization of funds in an effective way. Corporate

finance on the other hand, concerns on the

effectiveness of corporate governance as an assurance

in protecting the invested funds and to generate

returns. As highlighted by Scheifer and Vishny (1997),

corporate governance mechanisms assure investor in

organizations that they will receive adequate returns

in their investments.

Hollis Ashbaugh-Skaife, Daniel W. Collins, and

Ryan LaFond (2006) investigate whether firms with

strong corporate governance benefit from higher

credit ratings relative to firms with weaker

governance. They concluded that weak corporate

governance has been singled out as the leading cause

for recent high-profile cases of corporate fraud. They

provide evidence that, CEOs of firms with

speculative-grade credit ratings are overcompensated

to a greater degree than their counterparts at firms

with investment-grade ratings, thus providing one

explanation for why some firms operate with weak

governance. Allan Chang Aik Leng (2004) analyzes

the impacts of corporate governance practices with

the firm‘s performance. Using return on equity as the

dependent variables, the degree of impact on firm‘s

performance followed a quadratic fashion, with

performance increase with the size of the firm, up to

an optimal size of RM8, 839 million in turnover.

Beyond that size, firm‘s performance declined with

the increasing size. Another definition is corporate

governance is about promoting corporate fairness,

transparency and accountability. It was defined by J.

Wolfensohn, president of the Word bank, as quoted by

an article in Financial Times, June 21, 1999.

As highlighted by Scheifer and Vishny (1997),

corporate governance mechanisms assure investor in

organizations that they will receive adequate returns

in their investments. To relate this with the crisis, it is

concluded that efforts on shareholders protection were

inadequate during the crisis and as such contributed to

the destruction of the value of their investment.

Furthermore, Abdul Hadi bin Zulkafli (2006) defined

from the economic perspective, corporate governance

is an important element of achieving an allocate

efficiency in which scarce funds are moved to


150

investment project with the highest returns. In

practice, efficiency is achieved when at given level of

risk, investments project offer the highest return

exceeding its cost of capital. The crisis indicated how

the failure to regulate good governance affected the

mobilization of funds in an effective way. Corporate

finance on the other hand, concerns on the

effectiveness of corporate governance as an assurance

in protecting the invested funds and to generate

returns.

From the Securities Commission Malaysia Book,

(Nov 2007). List of Shariah-compliant Securities by

the Shariah Advisory Council of the Securities

Commission, pp 15, and paragraph 2 said that, the

SAC also takes into account the level of contribution

of interest income received by the company from

conventional fixed deposits or other interest bearing

financial instruments. In addition, dividends received

from investment in Sharia‘ non-compliant securities

are also considered in the analysis carried out by the

SAC. For companies with activities comprising both

permissible and non-permissible elements, the SAC

considers two additional criteria which is the public

perception or image of the company must be good and

the core activities of the company are important and

considered maslahah (―benefit‖ in general) to the

Muslim ummah (nation) and the country, and the

non-permissible element is very small and involves

matters such as `umum balwa (common plight and

difficult to avoid), `uruf (custom) and the rights of the

non-Muslim community which are accepted by Islam.

The first reasoning holds for Sharia‘ compliance

in that price, competitive and profitability differences

may accrue from adherence to Islamic principles.

However, it is not clear how Sharia‘ compliance may

improve efficiency or create new opportunities

relative to a non-constrained universe. If the universe

for Islamic investment is defined differently, then

there is, in theory, no inefficiency or loss in

opportunities. At the property-investment level, there

is a belief held by some investors that Sharia‘

compliance leads to a poorer portfolio performance,

even though there is no clear consensus view

( Ibrahim, Ong and Parsa, 2006).

3. Research methodology 3.1 Data Sampling

This study utilizes the secondary data , which are

gathered from the analysis of companies‘ annual

report taken from a sample of 147 companies for

corporate governance compliance and 36 companies

for syaria‘ compliance firms listed in the Main Board,

Bursa Malaysia had been randomly selected in year

2003 to 2007. The industry that involved in this

corporate governance analysis is consumer product,

industrial product, trading & service, construction,

plantation, properties and hotels. Data on firm‘s

performance were gathered from Thompson

DataStream and Bloomberg software.

3.2 Variables

For this study, it differentiates the variables into two

parts, which is dependent and independent variables.

The dependent variables for the corporate governance

and sharia‘ compliance consists of return on asset,

return on equity and operating profit margin while the

independent variables for the corporate governance

are board remuneration, board training, and board

family members while for the sharia‘ compliance are

gambling, riba, sale/ manufacture non halal product,

conventional insurance, entertainment activities and

stockbroking transaction that are non permissible

according to sharia‘ principle.

3.3 Methodology

There are three main purposes of this study which is

1) to identify the level of compliance in corporate

governance and syaria‘ practices by using descriptive

statistics, 2) to analyze an association between BOD

facets and syaria‘ principles towards companies‘ ROA,

ROE and OPM by using multiple regression and

Pearson correlation method and 3) to compare the

firm‘s performance between corporate governance

compliance firms and syaria‘ compliance firms by

using independent sample T-test.

Then, the companies‘ ROA, ROE and OPM is

calculated using the following equation;

ii sTotalAsset

ofitNetROA

Pr

i

ii yTotalEquit

ofitNetROE

Pr

i

ii Sales

ofitOperatingOPM

Pr

Where iofitNet Pr = Net profit of the ith

company for each year,

isTotalAsset = Total assets of the ith company for

each year,

iyTotalEquit = Total equity of the ith company for

each year, and

iSales = Sales of the ith company for each year.

Next, the relationship between the BOD facets

and syaria‘ principles to the firm‘s performance will

be estimated using the following regression equations

model:

iiiii FMDTBRROA )()()( 321 (1)

iiiii FMDTBRROE )()()( 321 (2)

iiiii FMDTBROPM )()()( 321 (3)

iiiiiiii SBENTCINHPGBRBROA )()()()()()( 654321

(4)

iiiiiiii SBENTCINHPGBRBROE )()()()()()( 654321

(5)

iiiiiiii SBENTCINHPGBRBOPM )()()()()()( 654321


151

(6)

Where = the constant term,

= the slope or coefficient estimates of the

explanatory variables,

iBR = the Board renumeration of the ith company,

iDT = the directors training of the ith company,

iFM = the board of family members of the ith

company,

iRB = the riba of the ith company,

iGB = the gambling of the ith company,

iNHP = the non halal product of the ith company,

iCI = the conventional insurance of the ith company,

iENT = the entertainment of the ith company,

iSB = the stockbroking of the ith company,

iROA = the return on assets of the ith company,

iROE = the return on equity of the ith company, and

iOPM = the operating profit margin of the ith

company.

3.4 The Hypothesis

The hypothesis of the study is developed to cater for

the pooling regression model. The hypotheses are:

Hypothesis 1

Ho: There is no relationship between dependent

variables and all independent variables among BOD

facets.

Ha: There is a relationship between dependent

variables and all independent variables among BOD

facets.

Hypothesis 2

Ho: There is no relationship between dependent

variables and all independent variables on syaria‘

principles.

Ha: There is a relationship between dependent

variables and all independent variables on syaria‘

principles.

Hypothesis 3

Ho: There is no significant mean different between

corporate governance compliance firms and syaria‘

compliance firms in their performance.

Ha: There is no significant mean different between

corporate governance compliance firms and syaria‘

compliance firms in their performance.

4. Results and discussion 4.1 Analysis of Descriptive Statistics on Corporate Governance Compliance in Malaysia 4.1.1 Board Remuneration

Figure 1. Level of Directors‘ Remuneration

Malaysia code of corporate governance practices

stated that the level of remuneration must be adequate

to attract and hold the required directors in running

the business. The level also should be reasonable and

appropriate with the expertise and experience of the

directors. The amounts of remuneration are

recommended to be represented in the annual repot of

the company for stakeholder review. By referring to

the figure 1, it was found that for 5 successive years

from 2003 to 2007, majority of the company (around

52%) spend the total remuneration below 1 million a

year to attract and retain the directors needed to run

the company successfully. In the study also, it was

found that the total remuneration of 1.1 million to 2.1

million has increased from 2003 till 2006 meanwhile

the total remuneration below 1 million from year to

year starting from 2004 decrease means that the

companies might starting to pay more to their

directors to make sure their directors give a full

commitment and good performance to achieve their

goal in organization.

4.1.2Director Training For the board training in starting in 2003, all the

companies listed in Bursa Malaysia have to send their

directors to the Mandatory Accreditation Program

(MAP) conducted by the Research Institute of

Investment Analysts Malaysia (RIIAM) in accordance

with the Listing Requirements of the Bursa Malaysia

Securities Berhad in order to have a good director in

their rank. The program also can be assumed as the

formal orientation program that could be a one or two

day program that involve educating the director as to

the environment of the business, the company‘s

current issues and the corporate strategy, the prospect

of the company with reference to input from director

50 27 14 9

52 20 17 11

46 34 15 5

40 35 12 13

35 29 10 26

0 20 40 60 80 100

2003

2005

2007

Board Renumeration

<1 M1.1M-2.1M2.1M-3.1M>3.1M


152

and the common responsibilities of directors. In the

analysis, for the year 2003 majority of the companies

(82%) does not send their directors to the MAP for

their formal orientation program instead only 18% of

the companies did sent their directors to the MAP.

Based on the figure 2 above, the statistics show that

for 4 continuous years, majority of the companies sent

their directors to the MAP despite the fact that small

amount of the companies still does not comply with

the code. Overall, since the introductions of the

Malaysian Code on Corporate Governance by the

Finance Committee in 2000, most of the companies

complied with the code of best practice.

Figure 2. Training attended by directors

4.1.3 Number of Family Members in Board of Directors

Figure 3. Numbers of Family Members in Board of Directors

Several directors in companies tend to appoint

their family as the executive or non-executive

directors. The presence of family members in the

board of directors will lead to conflict of interest

among the directors. To make it more wary, what if

more than half of the directors have family

connections. The information might be not transparent

due to easy access for internal activities and

stakeholder‘s interest is not well protected. Based on

figure 3, an average of 37% of the companies did not

have any family members who sit in the board from

2003 till 2007.The annually percentage comparison

from 2006 and 2007 show similarity. Company with

existing family members on board is likely want to

have their family to pursue the business as inheritance.

Where else, company with no family members might

have policy not to appoint their relatives in the board

to avoid conflict of interest.

4.2 Analysis of Descriptive Statistics on Sharia’ Compliance among companies in Malaysia. 4.2.1 Number of companies involve in Riba

Figure 4. Financial service based on Riba

Riba means usury and is forbidden in Islamic

economic jurisprudence. According to some, this

refers to excessive or exploitative charging of interest,

though according to others, it refers to the concept of

interest itself. Based on figure 4, in 2003, there were

71% of the companies not involve in riba

18 82

74 26

89 11

93 7

96 4

0% 20% 40% 60% 80% 100%

2003

2005

2007

Directors Training

Yes

No

44 56

51 49

65 35

76 24

79 21

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

2003

2005

2007

Family Members

Yes

No

29 71

24 76

11 89

10 90

2 98

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

2003

2004

2005

2006

2007

Riba

Yes No

http://en.wikipedia.org/wiki/Usury

http://en.wikipedia.org/wiki/Islamic_economic_jurisprudence



http://en.wikipedia.org/wiki/Interest


153

meanwhile the total number of companies not

involve in riba increased 13% from 2005 to 2006

and 8% from 2006 to 2007.The number of the

companies not involve in riba increased from year to

year starting in 2003 till 2004.

4.2.2 Number of companies involve in Gambling

Figure 5. Gambling

Gambling has a specific economic definition,

referring to wagering money or something of material

value on an event with an uncertain outcome with the

primary intent of winning additional money and or

material goods. Typically, the outcome of the wager is

evident within a short period of time. Based on the

figure 5, there were 53% of the companies not involve

in gambling in 2003, meanwhile the total number of

the companies not involve in gambling increased 13%

from 2004 to 2005 and 10% from 2006 to 2007.The

number of the companies not involve in gambling

decreased from year to year from 2003 till 2007.

4.2.3 Number of companies involve in Non Halal Product

Figure 6: Manufacture / sale Non Halal Products

Halal applies not only to food products but to all

aspects of life and social context. One may hear

mention of, "Halal Money‖. Money derived from

gambling, the selling of alcohol, drug trafficking,

illicit social vices, or any illegal activity is considered

haram or detrimental to society and therefore not

acceptable or considered a halal income. Based on the

figure 6, there were 39% of the companies involve in

Non Halal Product. In 2004, 65% of the companies

not involved in non halal product and the number

decreased from 4 %( 2004), 8% (2005), 12% (2006)

and 4% (2007). The number of the companies not

involve in non halal product decreased from year to

year from 2003 till 2007.

4.2.4 Number of companies involve in Conventional Insurance

Figure 7. Conventional Insurance

Conventional insurance products are in conflict

with Islamic beliefs for three reasons. Insurance

involves an element of uncertainty, gambling and the

charging of interest, which are prohibited by the

Quran. Based on the figure 7, there were 78% of the

companies not involve in Conventional Insurance in

2003, meanwhile the total number of the companies

involve in Conventional Insurance increased 8% in

2004 but slightly decreased 3% in 2005. In 2006 the

number of the company not involve in Conventional

Insurance increased from 9% and 3% in 2007. The

number of the companies not involve in Conventional

47 53

36 64

23 77

11 89

1 99

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

2003

2005

2007

Gambling

Yes No

22 78

14 86

17 83

8 92

5 95

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

2003

2005

2007

Conventional Insurance

Yes

No

39 61

35 65

27 73

15 85

9 91

0% 20% 40% 60% 80% 100%

2003

2004

2005

2006

2007

Non Halal Product

Ye s No

http://en.wikipedia.org/wiki/Economics

http://en.wikipedia.org/wiki/Definition

http://en.wikipedia.org/wiki/Money

http://en.wikipedia.org/wiki/Value_%28personal_and_cultural%29


154

Insurance decreased from year to year from 2005 till

2007.

4.2.5Number of companies involve in Entertainment

Figure 8. Entertainment Activities

Entertainment is an activity designed to give

pleasure or relaxation to an audience (although in the

case of a computer game the "audience" may be only

one person). The audience may participate in the

entertainment passively as in watching opera or a

movie, or actively as in computer games. Based on

the figure 8, there were 51% of the companies in 2003

not involved in entertainment activities that are not

permissible according to Sharia‘, and in 2004, the

number of the companies not involves increased 12%,

meanwhile the total number slightly decreased 25%

from 2005 (80%) but the number of companies not

involve in entertainment decreased till 2007.

4.2.6 Number of companies involve in Stockbroking

Figure 9. Stockbroking

Islamic Stockbroking (ISB) is an alternative of

investment tools allowed an investor to invest based

on sharia‘ principles. ISB allows investors to deal

only in 'halal' securities approved and reviewed

periodically by the Shariah Advisory Council of the

Securities Commission. Halal securities are

investments in companies listed on the Bursa

Securities whom,se activities do not contravene

sharia‘ principles. For the stockbroking which is not

permissible according to sharia‘, based on the figure 9,

there were 66% of the companies not involved in

2003, meanwhile the total number of the companies

not involve in stockbroking increased 4% in 2004 but

slightly decreased 7% in 2005. The number of

companies not involve in non permissible

stockbroking decreased from year to year until 2007.

4.3 Relationship between Dependent and Independent variables 4.3.1 Corporate Governance and Syaria’ Principles with the Firm’s Performance

Based on table1 (panel A), there is no relationship

between FM, BR and DT. Therefore the alternate

hypothesis was accepted at this level. BR is not

related to ROA with the significance level of 0.939

with T-Ratio is 0.076 while DT also not related to

ROA with 0.298 significant levels with their T-Ratio

value is 1.043. But when we look to the value of R, its

indicate 10.5% and it‘s not a strong relationship and

the R-Square indicates that 1.1% of the variation in

ROA is explained by the variation in the corporate

governance. None of the independent variables have

significant relationship with ROE. Thus, the null

hypothesis is rejected. The R value indicates the

model have a relationship but not strong enough, only

9.1% while the value of R Square indicates only 0.8%

of the variation in ROE is explained in the corporate

governance. So, the null hypothesis was rejected

because all the P-Value has value less than 0.05

significant levels. There is relationship between OPM

with BR and the relationship is significant 0.048

levels and the T-Ratio value indicates 1.980. The

standardized coefficient of 0.093 indicates the parallel

relationship between OPM and BR. So, the null

hypothesis was rejected at this level. The R-Square

indicates only 0.9% of the variation in OPM is

explained by the variation in corporate governance

49 51

37 63

20 80

45 55

12 88

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

2003

2004

2005

2006

2007

Entertainment

Yes

No

34 66

30 70

37 63

15 85

4 96

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

2003

2004

2005

2006

2007

Stockbroking

Yes

No

http://en.wikipedia.org/wiki/Relaxation

http://en.wikipedia.org/wiki/Computer_game

http://en.wikipedia.org/wiki/Opera

http://en.wikipedia.org/wiki/Movie


155

while the R value indicates that the model do not have

a strong relationship (9.4%). Panel B shows that

there is a relationship between RB, NHP, CI and ENT.

Therefore the alternate hypothesis was accepted at

this level. RB is negative related to ROA with the

significance level of 0.002 with T-Ratio is -3.148

while NHP also have negative related to ROA with

0.006 significant levels with their T-Ratio value is

-2.807 same with CI and ENT both have a negative

related which is -1.904 and -4.011 with the significant

level of 0.058 and 0.000. But when we look to the

value of R, its indicate 40.9% and it‘s not a strong

relationship and the R-Square indicates that 16.7%%

of the variation in ROA is explained by the variation

in the Sharia‘ compliance. It‘s mean that the good

Sharia‘ compliance can help the company to increase

their profit and achieve their organizational goals.

However, none of the independent variables have

significant relationship with ROE. Thus, the null

hypothesis is rejected. The R value indicates the

model have a relationship but not strong enough, only

9.1% while the value of R Square indicates only 0.8%

of the variation in ROE is explained in the corporate

governance. So, the null hypothesis was rejected

because all the P-Value has value less than 0.05

significant levels. There is relationship between OPM

with GB and the relationship is significant 0.025

levels and the T-Ratio value indicates 2.254. The

standardized coefficient of 0.170 indicates the parallel

relationship between OPM and GB. So, the null

hypothesis is rejected at this level. The R-Square

indicates only 4.4 % of the variation in OPM is

explained by the variation in Sharia‘ compliance

while the R value indicates that the model do not have

a strong relationship (20.9%).

Table 1. The Results of Multiple Regression Analysis

ROA ROE OPM

Variables Model 1 Model 2 Model 3

Panel A: CORPORATE GOVERNANCE COMPLIANCE

Constant 3.419 3.313 0.228

0.001 0.001 0.820

Board Renumeration (BR) 0.076 -1.453 1.980

0.939 0.147 0.048**

Directors' Training (DT) 1.043 0.862 0.021

0.298 0.389 0.983

Family Members (FM) -1.406 -0.953 -0.007

0.160 0.341 0.995

R 0.105 0.091 0.094

R Square 0.011 0.008 0.009

Adj. R 0.005 0.003 0.003

F-Statistic change 2.001 1.497 1.623

Std. Error of the Estimate 12.562 19.867 38.729

Panel B: SYARIA' COMPLIANCE Model 4 Model 5 Model 6

Constant 3.698 2.684 0.341

0.000 0.008 0.734

Riba (RB) -3.148 -1.874 -0.311

0.002*** 0.063* 0.756

Gambling (GB) 1.580 1.531 2.254

0.116 0.128 0.025**

Non Halal Product (NHP) -2.807 -1.708 -0.812

0.006*** 0.089* 0.418

Conventional Insurance (CI) -1.904 -1.993 -0.828

0.058* 0.048** 0.409

Entertainment (ENT) -4.011 -2.575 -0.638

0.000*** 0.011** 0.524

Stockbroking (SB) -0.098 -1.032 0.047

0.922 0.303 0.963

R 0.409 0.302 0.209

R Square 0.167 0.091 0.044

Adj. R 0.14 0.061 0.012

F-Statistic change 6.128*** 3.059*** 1.388

Std. Error of the Estimate 6.268 18.499 46.087

Notes: In each cell, t-value appears in the first row and p-value (sig.) is in the second row. Symbols

* indicates significance at the 10 percent level while ** indicates significance at the 5 percent level

and *** indicates significance at the 1 percent level.


156

4.4 Pearson Correlation analysis among variables

Table 2. The Results of Pearson Correlation Analysis

Panel B: SYARIA' COMPLIANCE

Variables Correlation ROA ROE OPM RB GB NHP CI ENT SB

ROA Pearson 1

Sig. (2-tailed)

ROE Pearson 0.903** 1

Sig. (2-tailed) 0.000

OPM Pearson 0.480** 0.520** 1

Sig. (2-tailed) 0.000 0.000

RB Pearson -0.168 -0.092 -0.016 1

Sig. (2-tailed) 0.021 0.206 0.829

GB Pearson 0.188** 0.177* 0.189** -0.041 1

Sig. (2-tailed) 0.009 0.014 0.009 0.575

NHP Pearson -0.149 -0.085 -0.070 -0.098 -0.118 1

Sig. (2-tailed) 0.041 0.245 0.339 0.180 0.106

CI Pearson -0.088 -0.113 -0.066 -0.069 -0.083 -0.079 1

Sig. (2-tailed) 0.225 0.120 0.366 0.344 0.254 0.281

ENT Pearson 0.243** 0.156* -0.055 -0.095 -0.114 -0.108 -0.076 1

Sig. (2-tailed) 0.001 0.032 0.454 0.194 0.117 0.139 0.296

SB Pearson 0.074 -0.025 0.003 -0.111 -0.134 -0.127 -0.900 -0.123 1

Sig. (2-tailed) 0.308 0.736 0.972 0.126 0.065 0.081 0.219 0.190

Notes: In all cases of Pearson correlation the symbols * indicates correlation is significant at the ≤ 5 percent level

while ** indicates correlation is significant at the ≤1 percent level (2-tailed).

Based on table 2 in panel A, the presence of

independent directors resulted with insignificant value.

There is no relationship between ROA with the Board

Remuneration proxies. Director‘s remuneration

results indicate that a good deal of salary has no

impact towards the firm‘s stock price. For the

director‘s training and family members, there is a

relationship between both of the proxies. Although the

board had complied with the code by holding the

director‘s training, there is an effect to the ROA which

has a negative correlation of at 5% significant level

and same with the family members, ROE not

correlated with any proxies in corporate governance

while OPM with the board remuneration at 5%

significant level. Thus, the decision is to reject H0 for

hypothesis H1 and H2. Other proxies are more than

5% significant level. Therefore, the decision is to

reject Ho. This argument is supported by the

correlation coefficient and R2

where both value show

0.9% and 9.4% which are considered weak. Refers to

panel B, there are significant relationship between the

ROA and the sharia‘ compliance proxies for riba,

Panel A: CORPORATE GOVERNANCE COMPLIANCE

Variables Correlation ROA ROE OPM BR DT FM

ROA Pearson 1

Sig. (2-tailed)

ROE Pearson 0.515** 1

Sig. (2-tailed) 0.000

OPM Pearson 0.480** 0.200** 1

Sig. (2-tailed) 0.000 0.000

BR Pearson -0.036 -0.079 0.094* 1

Sig. (2-tailed) 0.403 0.065 0.028

DT Pearson -0.086 -0.048 0.041 0.404** 1

Sig. (2-tailed) 0.000 0.266 0.336 0.000

FM Pearson -0.095 -0.055 0.042 0.410* 0.985** 1

Sig. (2-tailed) 0.027 0.201 0.331 0.000 0.000


157

gambling, non halal products and entertainment. The

proxies are greater than 5% for the riba and non halal

product and 1% for gambling and entertainment. ROE

correlated at the significant level of 5% only for

gambling and entertainment while OPM has a positive

correlated 0.189 at 1% significant level. Thus, the

decision is to accept hypothesis H1 and H2. Other

proxies are more than 5% significant level. Therefore,

the decision is to reject Ho.

The key result (refer table 3 to look at the

significant mean different) is that sharia‘ compliance

seems to create a higher profitability on ROA

(3.8466) and ROE (6.4749) compared to corporate

governance compliance firms with ROA (2.9306) and

ROE (5.0738). However, corporate governance

compliance firms indicate a higher mean different in

term of OPM at 10.1511 compared to 9.6557 for

sharia‘ compliance firms, so, accept Ha and reject Ho

for H3. Based on this results, the corporate

governance less restrictive then sharia‘ compliance

where the sharia‘ compliance appear to provide better

historical returns. Levene‘s test for equality of

variances result shows that only ROA was significant

at 10 percent (0.079) and F value at 3.086. Meaning to

say that, Sharia‘ compliance rules and regulations

must be strict to the newly classified

sharia‘-compliant securities to ensure the better

performance and protect stakeholder‘s interest.

Table 3. The Results of Independent Sample T-test and Levene‘s Test for Equality of Variances

Performance Category Mean Std.Deviation Std. Error Mean Levene‘s Test

ROA CG Firms

SC Firms

2.9306

3.8466

12.59699

6.75927

0.53960

0.49037

F = 3.086

Sig.= 0.079

ROE CG Firms

SC Firms

5.0738

6.4749

19.89490

19.09438

0.85220

1.38525

F = 0.127

Sig.= 0.722

OPM CG Firms

SC Firms

10.1511

9.6557

38.79600

46.37038

1.66184

3.36406

F = 1.306

Sig.= 0.254

5. Conclusion and Recommendations

In this study, it can be conclude that majority of the

companies that listed in Bursa Malaysia have

complied very well with the corporate governance

code of best practices and syaria‘ principles. But,

based on the statistics in chapter four, it‘s proved

that the Corporate Governance companies‘

independent variables are not significant with the

dependent variables which are ROA and ROE and

only significant for the OPM. These results are

broadly consistent with other studies (eg. Shamsul

Nahar Abdullah (2004) and Klapper & Love (2004).

From the findings, Sharia‘ compliance proxies which

are non-permissible according to sharia‘ has also been

gathered to examine the relationship independent

variables in sharia‘ compliant are significant with the

dependent variable (ROA, ROE, and OPM). The

statistical result of the correlation coefficient is

substantiated at the 5% level (p-value< 0.05). The null

hypothesis was rejected at the 5% level of significant.

From the analysis, indicated that significant on ROA

and ROE tends to sharia‘ compliance over the period

between 2003 till 2007. Sharia‘ compliance firms

show the best performance for the ROA and ROE.

Overall this study had found that there is a proof that

the sharia‘ compliant can help company achieve their

organizational goals and good in firm‘s performance

the company who did not comply with sharia‘

compliance, they should follow the practice because it

will bring a lot of benefit to the company. However,

corporate governance does not mean that are not

considered and allowing for differing sensitivities to

benchmark its profitability returns because it still have

a link with OPM. In summary, corporate governance

regulators must be strict in ensuring all the companies

comply with code of conduct and exercise fair

treatment. Companies itself should take own initiative

to comply or make continuous improvement their

corporate governance practices. In ethical view,

corporate governance has a positive effect towards the

company‘s performance. So, it will be highly

recommended for the company to comply with the

code and principles because it will give the investor

confidence to put their money to the company.

6. References

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and Md Ishak Ismail (2002), Corporate Governance in

Malaysia, Unpublished Paper, University of Malaya.

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governance practices on firms‘ financial performance:

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(564)

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158

6. Black et al. (2005), Does Corporate Governance

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Working paper N 86/2005, http://ssrn.com/

abstract=311275

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http://ssrn.com/%20abstract=311275




http://www.sc.com.my/


159

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