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Corporate Ownership & Control / Volume 5, Issue 1, Fall 2007 – Continued - 3

411

CORPORATE

OWNERSHIP & CONTROL

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412

EDITORIAL

Dear readers!

This issue of the journal Corporate Ownership and Control is devoted to several issues of corporate governance. VG Sridharan, Farshid Navissi and Alexander Kostyuk examine the economic reasons underlying the behavior of some senior managers to inflate their firms’ reported earnings. While the extant literature cites accounting and corporate governance structure as potential reasons that facilitate the inflating tendency, they conjecture that opportunism at different hierarchical levels within firms do not leave much scope for some senior managers to improve firms’ fundamental performance. To protect their personal utility, they resort to inflating tendency, but only if the firms’ corporate governance has loopholes. A major solution offered here is to improve firms’ internal management control system which could reduce within-firm opportunism. However, this solution must accompany improvements to corporate governance. Gary L. Caton presents tests of several theoretical hypotheses that are potential determinants of the choice to abandon production in declining industries. A binary qualitative choice model of the abandonment decision is estimated. The probability of choosing abandonment is found to be positively related to the firm's debt ratio, and negatively related to liquidity at the firm level, the level of efficiency of the operating unit, and uncertainty about liquidity at the operating unit level as measured by output and input price variability. Results are also presented for a multinomial choice model accounting for the full menu of capacity decisions open to the firm over time. The results are robust across all specifications as well as to alternative statistical assumptions. Enrico Maria Cervellati and Eleonora Fioriti describe the three main theoretical supervisory models proposed in the literature: vertical, horizontal, centralised. In practice, however, it is difficult to find a pure application of these models, while the actual supervisory systems are the result of the different legal frameworks of the member States and of the way in which their financial systems developed. Moreover, although the Lamfalussy Report can be considered an important step towards a more integrated financial supervisory system at the European level, the supervisory arrangements are still very different among member States. This work provides an analysis of the different systems of financial supervision in Europe: showing how the differences that still exist among their systems make it more difficult to achieve a real European integration in financial supervision.

Joshua Onome Imoniana, Marly Cavalcanti and Marcelo de Souza Bispo study the concept low cost, low fare as strategy in the market of Brazilian commercial air transport, taking as parameter the case study of Gol Air Transport S.A. For the achievement of the presented objectives the following questions are made: a) what it takes an airline company to take a strategy of low cost low fare? b) The option of low cost low fare, would have contributed to generate a new managerial model in the traditional forms of strategic management in the area of commercial air transport ? c) The constructed scenery tends to be lasting? Sami Basly analyzes how organizational’s conservatism impacts the financial choices of family SME. Through family SME main governance bodies i.e. the owner-manager and board of directors, conservatism influences decision-making and particularly financial decisions and choices. Michael Nwogugu analyzes the efficiency of the Sarbanes-Oxley Act (“SOX”; 2002, USA) and introduces new quantitative models of Willingness-To-Comply which is a statistical measure of the employee/company’s propensity to comply with SOX and similar regulations. Martin Bugeja and Raymond da Silva Rosa test the prevalence of these explanations using Australian takeover targets from 1990 to 2002. They find that the vast majority of target firms are unlikely candidates for disciplinary action. Contrary to the disciplinary hypothesis, we find that target shareholdings are highly concentrated and are more concentrated than non-target firms. Unlike Agrawal and Jaffe’s (2003) US study, they find ASX targets are typically poor performers but, contrary to the inefficient management hypothesis, they find that takeover success is higher for better performing targets. Jamie D. Collins, Christopher R. Reutzel and Dan Li address how a multinational’s entry mode influences the firm’s reaction to negative subsidiary performance. Specifically, they argue that the entry mode (ownership structure of a multinational’s subsidiary) affects the firm’s potential for escalation of commitment to a poorly performing subsidiary. Further, they argue that the relationship between entry mode and a multinational’s escalation of commitment is moderated by three factors – institutional distance between the home and the host country, cost of exiting the host market, and the parent firm’s prior performance.

Corporate Ownership & Control / Volume 5, Issue 1, Fall 2007 (Continued)

413

CORPORATE OWNERSHIP & CONTROL

Volume 5, Issue 1, Fall 2007 – Continued - 3

CONTENTS

Editorial 412

WHY DO SOME SENIOR MANAGERS INFLATE FIRMS’ REPORTED EARNINGS? ECONOMIC CAUSES AND POTENTIAL SOLUTIONS 415 VG Sridharan, Farshid Navissi, Alexander Kostyuk LIQUIDITY AND THE CHOICE TO ABANDON PRODUCTION IN DECLINING INDUSTRIES 418 Gary L. Caton FINANCIAL SUPERVISION IN EU COUNTRIES 432 Enrico Maria Cervellati, Eleonora Fioriti LOW COST & LOW FARE : STRATEGY IN REVENUE MANAGEMENT FOR GOL AIR TRANSPORT S.A 440 Joshua Onome Imoniana, Marly Cavalcanti, Marcelo de Souza Bispo EFFICIENCY OF SARBANES-OXLEY ACT: WILLINGNESS-TO-COMPLY AND AGENCY PROBLEMS 449 Michael Nwogugu CONSERVATISM: AN EXPLANATION OF THE FINANCIAL CHOICES OF THE SMALL AND MEDIUM FAMILY ENTERPRISE 459 Sami Basly THE INEFFICIENT MANAGEMENT AND DISCIPLINARY MOTIVES FOR TAKEOVER IN AUSTRALIA 469 Martin Bugeja, Raymond da Silva Rosa THE IMPACT OF ENTRY MODE ON SUBSEQUENT COMMITMENT TO POORLY PERFORMING SUBSIDIARIES 482 Jamie D. Collins, Christopher R. Reutzel, Dan Li

CORPORATE GOVERNANCE OF STATE-OWNED ENTERPRISES IN CHINA 493 Miaojie Yu


414

WHY DO SOME SENIOR MANAGERS INFLATE FIRMS’ REPORTED EARNINGS? ECONOMIC CAUSES AND POTENTIAL SOLUTIONS

VG Sridharan*, Farshid Navissi**, Alexander Kostyuk***

Abstract

We examine the economic reasons underlying the behavior of some senior managers to inflate their firms’ reported earnings. While the extant literature cites accounting and corporate governance structure as potential reasons that facilitate the inflating tendency, we conjecture that opportunism at different hierarchical levels within firms do not leave much scope for some senior managers to improve firms’ fundamental performance. To protect their personal utility, they resort to inflating tendency, but only if the firms’ corporate governance has loopholes. A major solution offered here is to improve firms’ internal management control system which could reduce within-firm opportunism. However, this solution must accompany improvements to corporate governance. Keywords: earnings, managers, corporate governance *Department of Accounting and Business Information Systems, The University of Melbourne, Parkville, Melbourne City VIC 3010, Australia Email: [email protected], Phone: +61 3 8344 6793 **Department of Accounting and Finance, Monash University, Caulfield, Melbourne VIC 3145 Email: [email protected], Phone: +61 3 9903 2029 ***Department of International Economics, Ukrainian Academy of Banking, 40030 Sumy, Ukraine Email: [email protected], Phone: +380 542 61 1025 Acknowledgments: We thank Chris Akroyd of University of Auckland, New Zealand for his helpful comments.

1. Introduction

“On March 19, 2003, the Securities

Exchange Commission (SEC) charged

HealthSouth Corporation and its CEO with

accounting fraud. The SEC’s complaint

alleged that HealthSouth had systematically

overstated its earnings by at least $1.4 billion

since 1999. Apart from the SEC’s finding, the

U.S. Justice Department used information

gathered from HealthSouth executives to

identify another $1.1 billion of overstated

earnings” (Weld, Bergevin and Magrath,

2004).

HealthSouth is just one of the many firms that

adopted Enron‘s infamous path in inflating their

reported earnings. The outcome of this inflation is

well documented. The market prices reflect a value

which is more than the underlying economic value of

the firm. Over time, the gap between market

expectations and firm value becomes so high that the

firm becomes incapable of meeting the expectations

which, in turn, leads to ‗over-valued equity‘ (Jensen,

2005). Unfortunately, the fact of inflated earnings

typically becomes transparent to the market only after

the over-valuation arises. At this stage, the ‗bubble‘

bursts. Legal actions are initiated; courts conduct

inquiry, order liquidation and final settlement takes

place after several years. If liquidation is ordered for

several firms in an economy, the economy suffers an

investment decline and enters a downturn.

Earlier studies such as Weld et al. (2004) offer

empirical evidence on such over-valuation. The

reasons center around managerial opportunism: some

senior managers inflate their firms‘ earnings to obtain

their bonus which is tied to the better market price

performance (Cheng and Warfield, 2005). The

underlying assumption here is that increase in firm

earnings leads to a rise in the market price. As the

market price rises, the senior managers are motivated

to maintain this inflating tendency with a view to

avoid any potential market price decline and seize

greater personal wealth. We believe that this

managerial opportunism logic does not provide a

complete economic rationale for the senior managers‘

inflating tendency, particularly in the light of the

following argument.

Better firm earnings can be posted by one of the

two routes; either (a) enhance fundamental

performance or (b) inflate reported earnings.

Enhancing performance refer to improving

fundamental variables such as capacity, quality, lead

time and delivery. However, much in line with the

saying, ―if you can‘t make it, fake it‖, some senior





415

managers systematically adopt the inflating route

until the day the over-valuation bubble bursts. A

more important question is that why do some senior

managers adopt inflating route to better results

instead of improving firm fundamentals? In this

paper, we examine this research problem and offer

some potential solutions.

The remainder of the paper is organized as

follows. In Section 2, we identify the economic

causes that offer scope for some managers to indulge

in inflating their firms‘ reported earnings. Potential

solutions to the economic causes are discussed in

Section 3. Section 4 concludes the paper.

2. Economic Causes 2.1 Review of Lliterature

One stream of the extant literature (e.g., Jickling,

2003; Litan, 2002) cites the inherent lapses in the

accounting regulation as the main cause for the

inflating tendency. This stream argues that a

multitude of accounting choices that are available

often provide scope for accountants and senior

managers to develop the inflating tendency. In

Litan‘s words, ―the fact is that for many kinds of

transactions, there are no single ‗right‘ answers…The

lack of specifics allows accountants greater discretion

in deciding how to justify various transactions‖. For

instance, future revenues that do not accrue are

falsely recognized in the current period resulting in

undue increase in gross profits. Similarly, several

provisions are cut a little bit from their normal write-

down amounts to create a sizeable increase in net

profits. Though not many solutions are identified to

this cause, a few studies focus on improving

fundamental auditing legislation such as the

Sarbanes-Oxley Act in the US.

Another stream of the literature (e.g., Downes

and Russ, 2005; Jensen, 2005) focuses largely on the

corporate governance argument. They examine the

structure of firms‘ existing corporate governance

which includes the composition (external versus

internal directors), directorship tenure, entrenchment

in committees, formulation of ethics code and

validation procedures of the board of directors and

how this corporate governance structure allows the

inflating tendency to flourish in firms. If a firm, for

instance, has more non-permanent external directors

depending on the CEO, who also chairs the board,

then the CEO is more likely in a convenient position

to inflate reported earnings. In sum, prior studies

identify market price-related bonus in the presence of

multiple accounting choices and ‗easy‘ corporate

governance enable some senior managers to inflate

reported earnings.

The above two streams of the extant literature

are valid in their own perspectives but we believe that

they still answer only a part of our research problem.

By adopting the first route of improving the firm

fundamentals to post better results, not only can the

senior managers enhance their own utility such as

bonus but do so in perfectly legal and ethical manner

devoid of any lurking fear of punishment. And so, a

question remains. What prevents these managers

from not seeking to improve the firm fundamentals?

We believe that the answer to this question is

important to complete our research problem and

hence forms the core economic argument of this

paper.

One answer is that enhancing fundamentals

takes a long time as against a quick adjustment to the

reported earnings. This is not entirely correct given

the fact that the market price-related bonus (such as

stock options and grants) is awarded typically on a

long term basis and thus most senior managers has

one or more years to improve their firms‘

fundamental performance. If some senior managers

do not resort to improving firm performance even

when they have this time, there must be a stronger

underlying economic reasons causing their inflating

behavior.

2.2 Economic Causes

Let us first examine the process by which some

senior managers inflate reported earnings which, in

turn, leads to over-valued equity. Throughout the

period of inflated earnings, the firm acts as a ‗black-

box‘ to outsiders, which means that very little

decision-relevant information about the firm flows to

the market until the stage of over-valuation.

The ‗black-box‘ assumption is also implicitly

held in other studies (e.g., Jensen and Meckling, 1992

and Williamson, 1981) that examine transactions

within firms. In most firms, no one person is likely

to hold complete information about all parts of the

firm. Even senior managers with large spans of

control are no exception. Jensen and Meckling

(1992) suggest specific knowledge, a knowledge

piece that is difficult to transfer or acquire as one

major reason. A worker‘s long experience in

comprehending customer needs, which is costly to

acquire, is an example of specific knowledge.

The specific knowledge that a person holds can

induce opportunistic actions in certain circumstances.

When does opportunism arise within firms and how

do firms control the problems of opportunism are

matters examined in economic theories such as

agency and transaction cost economics. In general,

these theories suggest if a firm invests in specific

knowledge, scope for opportunism within firms is

high when the accompanying incentive and control

structures are not tuned to manage the potential

problems of specific knowledge. A major problem

which arises in specific knowledge is ‗asymmetry‘,

which means that one party holds more decision-

relevant information than the other. The party can

potentially use such information to augment his/her

own utility at the cost of the other.

Two examples of opportunistic actions within

firms are as follows. At the lower levels of a firm‘s


416

hierarchy, a worker can use specific knowledge to

hide his/her inefficiency from the manager but still

claim the bonus. At a higher level, a divisional

manager can also depend on specific knowledge on

discretionary budgets to postpone spending on a

critical activity such as research advertisement in

order to show better divisional incomes, which, in

turn, can fetch higher bonus from the CEO. Note that

opportunism within firms has a negative outcome of

eroding firms‘ economic value. Not only a part of

shareholders‘ wealth is seized by different employee

groups; but also there is a likely decline in the firms‘

overall profitability because of reduced productivity

of the employees who act in opportunism.

We now link this ‗within-the-firm‘ opportunism

with senior managers‘ tendency to inflate reported

earnings. Though senior managers are able to see the

negative outcome, they are not able to detect the

underlying reasons because of the calculated

opportunism that can occur within firms. Therefore,

senior managers are not always able to improve their

firms‘ fundamental performance. If the senior

managers of all the firms that invest in specific

knowledge (or any other specific resource) are

affected by potential within-the-firm opportunism,

then why only some managers tend to apply inflating

practices? The answer lies in the nature of corporate

governance in firms. Though most senior managers

are rewarded by share price based bonus and they

have access to multiple accounting choices, only

some managers enjoy ‗easy‘ corporate governance,

which is too tempting to ignore. Hence, some senior

managers resort to the second route, which is to

inflate the reported earnings.

(INSERT FIGURE 1 HERE)

Figure 1 summarizes the link between the

within-the-firm opportunism and the senior

managers‘ inflating tendency.

3. Potential Solutions

We now turn to examine the potential solutions for

firms to discourage inflating tendency. One way,

though not the best solution, is to remove the market-

price related bonus for the senior managers. Note

however that this way cannot solve the within-the-

firm opportunism, which is often the driving

economic cause for the inflating tendency. A better

solution is to start reforming firms‘ internal

management control system (hereafter MCS). MCS

must cover three inter-related elements: 1) who will

do what job and how much; 2) how will the job

performance be assessed; and 3) how can the

performance be motivated. These three elements are

cited as the legs of a ‗three-legged stool‘ (Brickley,

Smith and Zimmerman, 2001). MCS goes out of tune

whenever one (or two) of its elements are not

compatible with other elements. For instance, if a

manager gives more decision rights to a worker but

continues to assess the worker‘s performance based

on earlier authority level, then the additional rights

may be used by the person for his own welfare.

Improving a firm‘s MCS at the lower and higher

levels of hierarchy can be handled at the senior

manager‘s level. But a key question remains here.

Where does the motivation lie for the senior

managers to reform his/her firm‘s MCS? This is

where the importance of reforming a firm‘s corporate

governance arises1. Firms need to have ‗tight‘

corporate governance structure. For instance, firms

must need a balance between external and internal

directors; rotate the membership in committees and a

rigorous decision evaluation criteria based on both

profitability and ethics for board functioning. Note

that the ‗tightness‘ in the corporate governance

structure serves two objectives. First, it can oversee

the CEOs‘ performance in terms of reforming MCS.

Second, it can also ensure that the CEO and other

senior managers do not steer the firm into the second

route of inflating reported earnings.

4. Conclusion

In this paper, we examine the tendency of some

senior managers to inflate firms‘ reported earnings

instead of improving fundamentals such as quality,

capacity and costs. Identifying a new relation

between the opportunism that occurs within-the firm

and the inflating tendency, we conjecture that when

senior managers are less able to curb the within-the-

firm opportunism which erodes firm value, they

resort to inflating earnings. We offer a potential

solution to discourage inflating tendency in the form

of improved MCS in conjunction with a tight

corporate governance structure. One limitation of our

paper is the lack of empirical evidence to analyze if

the theoretical predictions laid out hold well in the

real-world. In this direction, a useful extension to

this paper is to test the theoretic predictions through

experimental research method wherein the problem

and the solution variables can be manipulated to

analyze the effects.

Another extension in terms of theoretical

research is in the potential solution to our research

problem. One could examine if all the stakeholders

beginning with workers and then managers, CEOs

and share holders could be considered in a multiple

but linked stakeholder value chain. Each stakeholder

link can be linked to the next link through a set of

1 The term MCS is used in a broad sense in the management accounting literature (see Chenhall, 2003) which includes even the corporate governance structure. However, for the purpose of easy exposition, we distinguish the two terms in our paper as follows. While MCS relates to controls at lower and higher hierarchical levels of management, corporate governance refers exclusively to structure of board of directors.


417

principal-agent relationships. For instance, while

shareholders and CEO can be treated as a principal

and agent respectively, the CEO and the managers

can also be treated as principal and agent

simultaneously. Each agent could then be

compensated on a uniform basis though at different

rates to suit the nature and risks associated with

different agents‘ jobs. The purpose of this solution is

to see how value can be generated to shareholders

(the first link in the stakeholder value chain) value

whenever a worker (the last link in the stakeholder

value chain) earns bonus for carrying out his/her job

efficiently.

References

1. Brickley, J.A., Smith, C.W., Zimmerman, J.L.,

(2001). Managerial Economics and Organizational

Architecture. Irwin McGraw Hill, Boston.

2. Cheng., Q., Warfield, T., (2005). Equity incentives

and earnings management, The Accounting Review, 80

(2): 441-476.

3. Chenhall, R., (2003). Management control system

design within organizational context: findings from

contingency based research and directions for future.

Accounting, Organizations and Society 28, 127-168.

4. Downes, M., Russ, G.S., (2005). Antecedents and

Consequences of Failed Governance: The Enron

Example, Corporate Governance, 5, 5. pp. 84-98.

5. Jensen, M.C., (2005). Agency Costs of Overvalued

Equity, Financial Management, Spring, 34, 1. pp 5-

19. Vanderbilt University, Nashville

6. Jensen, M.C., Meckling, W.H., (1992). Specific and

general knowledge, and organizational structure.

Chapter 9 in Contract Economics, Edited by Lars

Werin and Hans Wijkander, Blackwell Limited,

Oxford.

7. Jickling, M., ((2003). Accounting Problems Reported

in Major Companies Since Enron. Congressional

Research Service Report RS 21269 The United States

Library of Congress.

8. Litan, R., (2002). The Enron Failure and the State of

Corporate Disclosure, The Brookings Institution

Economic Studies Policy Brief 97, April, Brookings,

Washington.

9. Weld, L., Bergevin, P., Magrath, L., (2004). Anatomy

of a Financial Fraud: A Forensic Examination of

HealthSouth, The CPA Journal October, A New York

State Society of CPAs publication, New York.

10. Williamson, O.E., (1981). The economics of

organization: the transaction cost approach. American

Journal of Sociology 87, 548-577.

Appendices Failure of internal control systems Over-valued Equity

Opportunistic actions at Firm value erosion Inflating reported earnings

Level 1 Level 2 Higher market value

Fear of loss of bonus Greater market expectations

Workers----Managers-----CEOs in the presence of Repeating inflating practice

‘ Easy’ corporate governance and (periods 2 to n)

Availability of accounting choices Over-valuation of equity

(bursting of the ‘bubble’)

Figure 1


418

LIQUIDITY AND THE CHOICE TO ABANDON PRODUCTION IN DECLINING INDUSTRIES

Gary L. Caton*

Abstract The study presents tests of several theoretical hypotheses that are potential determinants of the choice to abandon production in declining industries. A binary qualitative choice model of the abandonment decision is estimated. The probability of choosing abandonment is found to be positively related to the firm's debt ratio, and negatively related to liquidity at the firm level, the level of efficiency of the operating unit, and uncertainty about liquidity at the operating unit level as measured by output and input price variability. Results are also presented for a multinomial choice model accounting for the full menu of capacity decisions open to the firm over time. The results are robust across all specifications as well as to alternative statistical assumptions. Keywords: Capacity choice; Abandonment; Cash flow volatility; Liquidity; Efficiency

* Corresponding Author College of Business, Montana State University, Bozeman, MT 59717-3040, USA Phone: 406-994-3889, Fax: 406-994-6206 Email: [email protected] I am grateful to Scott Linn, Louis Ederington, Gary Emery, Nandu Nayar, and participants in the seminar series at SUNY-Buffalo, the Universities of Otago and Oklahoma, and Chapman University for comments on earlier drafts of the paper. The usual caveats apply. A previous version of this paper circulated under the title "Exit and Price Volatility".

1. Introduction

The decision to expand or contract production

generalizes the more specific problem of when to

enter into an activity and when to exit. This study

presents an empirical analysis of how financial, real

and product market forces influence expansion and

contraction. Special emphasis, however, is placed on

the abandonment decision. As the issue is likely to be

most acute in declining industries, the data examined

herein are drawn from such situations.

Declining industries will generally be associated

with temporary overcapacity (Jensen, 1993). Reasons

for the emergence of overcapacity include the

development of less expensive or better substitute

products, a decrease in demand for follow-on

products, higher input costs, newly discovered

toxicity of the product or its follow-on products,

changes in consumer tastes and changes in production

technology.

Whatever the reason for overcapacity, as

demand decreases industry output must also decline

or a state of disequilibrium will arise. When industry

overcapacity becomes large and prices fall, firms must

either cut capacity or abandon production in order to

survive, consequently allowing a new equilibrium to

emerge (Kreps, 1990). Empirical observation

suggests the firms comprising a declining industry do

not shrink plant capacity simultaneously with the

decline in aggregate demand for their products but

rather react with a lag.2 We examine the influence of

three factors suggested in the literature on corporate

investment that are potential candidates for explaining

this observation regarding the decision to abandon:

The liquidity of the producer and the level of the

producer‘s debt obligations, and the efficiency of the

operating unit.

Deily (1988) argues that firms in declining

industries decrease or completely terminate

reinvestment in depreciating assets anticipating future

abandonment. Without the need to reinvest in plants

earmarked for abandonment, these firms may find

themselves with excess cash. The misuse of excess

funds through empire building or the consumption of

excess perquisites by managers is a well-known

agency problem (Jensen, 1986). Jensen (1986)

postulates that debt can mitigate the managerial

misuse of cash in excess of investment needs. Stulz

(1990) and Harris and Raviv (1990) develop models

in which this agency problem is minimized through

the optimal choice of debt levels. The implication is

firms with higher debt levels are more apt to walk

away from a declining industry.

Another implication of excess liquidity on the

choice to abandon is the strategic advantage it may

impart to the firm faced with making the decision. In

a war of attrition, (Tirole, 1992), characteristic of a

2 Lieberman (1990).


419

declining industry, a firm may be able to use its

superior liquidity position to wait out the

abandonment decisions of its liquidity-poor rivals.

Excess economic rents may then be possible once the

industry has shrunk.

A third factor that may influence the choice to

exit is the efficiency of the operation (Jovanovic,

1982; Fudenberg and Tirole, 1986; Dunne, Roberts

and Samuelson, 1989; Lieberman, 1990). More

efficient operations should, ceteris paribus, be better

able to sustain a presence in the industry longer than

less efficient operations.

Our study has several unique features. First, the

sample focuses on product markets that were in

decline, candidates ideally suited for assessing factors

that may increase or decrease the probability of

abandonment. Second, the data set includes year-by-

year plant capacity choices for fourteen chemical

products across all producers of those products in the

U.S. These data provide us with the opportunity to

examine both a binary specification of the

abandon/not-abandon decision, as well as to explore

the robustness of our conclusions about abandonment

within the context of a multinomial model of capacity

choice. In the latter case we account for the full menu

of possible choices, abandonment, capacity reduction

without abandonment, the decision to not change

capacity, as well as expansion of capacity and entry.

Third the data permit an analysis of the role of the

financial characteristics of producers, specifically the

influence of debt and liquidity, as well as the

efficiency of the production units on the decision to

exit. The firm-level liquidity measure we employ

captures the variability of cash flow at the firm level.

We also add the important dimension of examining

the influence of aspects of plant-level cash flow

variability by examining the relation between input

and output price variability and the abandonment

choice.

The emphasis of our study is close in spirit to the

recent studies by Fan (2000) and Minton and Schrand

(1999). Fan (2000) examines the effect of input price

uncertainty on vertical integration in the

petrochemical industry. His focus is on the influence

of the oil shocks that took place during the 1970‘s on

the choice of how to organize continuing operations.

Although our sample of chemical products contains

some of the products Fan examines, our focus is

different. We concentrate on the financial and real

determinants of the choice to abandon production

rather than on how companies choose to organize

continuing production. Minton and Schrand (1999)

extend the literature on the relation between cash flow

(liquidity) and investment (for instance, Fazzari,

Hubbard and Petersen, 1988, 2000; Hubbard,

Kashyap and Whited, 1995; Kaplan and Zingales,

1997; Cleary, 1999) by asking how cash flow

variability influences investment spending. They

find higher cash flow variability is associated with

lower investment spending. Our study examines the

decision to expand or contract and how it is related to

firm-level liquidity but specifically takes into account

the efficiency of the assets involved as well as the

influence of debt on that decision. In addition our

inclusion of the underlying variability of the input and

output prices faced by individual plants allows us to

capture aspects of the variability of cash flows at the

plant-level deepening our understanding of the

influence of cash flow and liquidity.

The results of estimating binomial and

multinomial qualitative choice models offer several

interesting insights about the determinants of the

abandonment decision in declining markets. The

probability of choosing exit is positively related to the

firm's debt ratio, and negatively related to liquidity at

the firm level, the level of efficiency of the operating

plant, and uncertainty about liquidity at the plant level

as measured by output and input price variability.

Further, our results are robust to an accounting for the

full menu of capacity decisions open to the firm over

time as well as to alternative statistical assumptions.

The study of business investment spending has a

long history. Excellent surveys of this literature

include, Jorgensen (1971), Chirinko (1993) and

Hubbard (1998). The authors of several empirical

studies conclude that liquidity and cash flow in

general influence investment (Fazzari, Hubbard and

Petersen, 1988, 2000; Hubbard, Kashyap and Whited,

1995, among others), but the interpretation of why the

relation is observed has not been fully resolved

(Kaplan and Zingales, 1997; Cleary, 1999). In

addition, Minton and Schrand (1999) have recently

extended this literature to include an examination of

the relation between investment and cash flow

variability. Their results suggest that higher cash flow

variability is associated with lower total firm

investment spending. Evans and Jovanovic (1989)

and Huberman (1984) develop models that highlight

the importance of liquidity in the investment decision.

Lambrecht (2001) presents a model in which liquidity

and the debt level jointly determine the choice to exit,

and predicts that firms with more liquidity and less

debt are less likely to abandon. Recent contributions

to the empirical literature include Zingales (1998)

who studies exit choice in the trucking industry and

finds that more efficient firms are more likely to

survive following deregulation, but that this is

conditional on pre-deregulation debt levels.

Kovenock and Phillips (1997) study the investment

decisions of firms in industries where one of the

majors undertook a leveraged buyout. They find that

the debt level influences exit only in highly

concentrated industries. Chevalier (1995) studies exit

decisions in the supermarket industry when

competitors engaged in leveraged buyouts and

concludes that unleveraged firms are less likely to

exit.

The next two sections describe the data on

capacity choice and the financial and market

characteristics of the firm‘s involved. Section 4

develops the empirical model of abandonment choice

we use to test the hypotheses. In Section 5 we present


420

estimation results for a binary choice model. Section

6 presents estimation results for a full multinomial

choice model designed to confirm the robustness of

the conclusions drawn in Section 5. The final section

presents a summary of our findings.

2. The sample

The initial sample consists of 144 different companies

that produce one or more of 14 chemical products

whose demand as identified by Lieberman (1990) was

in decline during the period we study. Markets in

decline offer an excellent opportunity for assessing

the behavior of producers as such markets are natural

candidates from which firms would exit. All fourteen

of the chemicals represented in the sample are

commodities and are inputs into other production

processes. Thus, none of the products is a retail

product nor do the manufacture and marketing of any

require large expenditures on research and

development or advertising. As commodities,

however, they are subject to economies of scale.

Table 1 presents a list of the chemical products and

the documented reasons for the decline in the

respective markets for these products.3

The chemicals listed as type O in Table 1 are

organic chemicals and those listed as type I are

inorganic. The column labeled "Beginning of

decline" indicates the first year aggregate annual

production declined. Column three presents reasons

for the decline in demand.

The data reported in the Directory of Chemical

Producers published by SRI International were used

to identify changes in capacity for each plant in the

sample. The Directory of Chemical Producers

provides the names of all companies involved in

domestic U.S. chemical production along with the

names and capacities of the plants they operate, listed

by chemical product. Companies producing each of

the 14 chemical products represented in the final

sample were identified in the Directory. A time series

of annual capacity levels for each plant manufacturing

a sample product, arranged by the company owning

the plant, was then constructed. Each of the plants

examined had capacity levels in the millions of tons,

consistent with the importance of economies of scale

in production.

There are five possibilities for changes in the

reported capacity of each plant from one year to the

next. We make the following assumptions about

these reported changes in plant capacity. Reported

capacity increases (decreases) are due to partial

expansion (contraction) of the existing plant.

Reported capacity for a plant not previously listed is

3 The reasons listed are based upon the discussion in

Lieberman (1990) along with our independent assessment as

formed by a review of government statistics and industry

analyses published by several sources including reports

published in trade journals.

due to a new entrant, while delisting of a plant from

the Directory indicates abandonment of the plant.

Finally, when reported capacity remains unchanged

we assume no changes to the plant were made from

one year to the next. The actual change in capacity

should occur with a lag relative to the time the

decision was made due to such things as bureaucratic

as well as construction lags. We therefore assume

the actual decision was made in the year prior to the

change reported in the Directory.

Plant closure is not the only method of

abandonment. Abandonment can also occur when a

firm sells, or spins-off a plant. The indicator of a sell-

off or spin-off is a change in the name of the firm that

owns the plant as reported in the Directory. Moody's

Manuals and the Wall Street Journal Index are used to

uncover the reason for each name change listed in the

Directory. Name changes that were a result of a

spinoff or sell-off are regarded as decisions to

abandon while changes due to a simple corporate

name change or merger, are not.

In our analysis of the determinants of capacity

choice, several financial characteristics of the

companies involved are employed. The Compustat

Industrial files are the source of these financial data.

The final sample consists of 996 data

observations from fifty-three firms operating 134

plants spanning the period 1977-1990. The 996

individual plant investment decisions include 57 exits,

126 capacity reductions (not including exit), 115

capacity expansions (not including entries), 27 entry

decisions and 671 cases of no change in capacity.

The relative distribution of events in the total sample

is representative of the relative distributions by year:

exit (5.7%), capacity reductions but not exits (12.7

%), no change in capacity (67.4 %), capacity

expansions excluding entries (11.5 %) and entries (2.7

%). Table 2 presents statistics describing the sample

firms. The companies in the sample have average

sales of $10.5 billion, average total assets of $9.7

billion, and average market value of equity of $5.2

billion. The average cash flow generated equals $1.1

billion per year, and cash flow as a percent of total

assets is on average equal to 11%.

3. The choice to abandon

The ability to sustain a plant from the cash flows of

the company, the influence of efficiency and the

variability of output and input prices are as we have

suggested factors that may influence the choice to

abandon. We discuss each below.

3.1 The effects of firm-level cash flow and liquidity

Numerous authors have suggested that the greater the

extent to which a firm‘s managers have discretionary

control over its free cash flow, the greater the

possibility for inefficient investment, or through a

logical extension of the argument, the greater the


421

possibility of the prolongation of production activities

which should be terminated (Jensen, 1986; Stulz,

1990; Harris and Raviv, 1990). This problem may be

even more acute when the product market is in

decline. The firm's use of debt can mitigate this

problem by reducing managements‘ discretionary

control over free cash flow. Jensen (1986, page 324)

for instance has argued:

"The control function of debt is more important

in organizations that generate large cash flows but

have low growth prospects, and even more important

in organizations that must shrink. In these

organizations the pressures to waste cash flows by

investing them in uneconomic projects is most

serious."

This is precisely the situation faced by

companies in declining markets. This hypothesis

suggests that a firm‘s leverage as well as the

behaviour of its free cash flow may influence the

choice of whether to abandon production or not. In

contrast if leverage is irrelevant then we should

observe no relation between the level of debt and the

choice to exit.

We define leverage in the following manner

DEBTj(i),t = long-term debtj(i),t / total assetsj(i),t

where the notation j(i) associates the leverage of

the owner firm j with plant i. The book values of

long-term debt and total assets are from the

Compustat files. Leverage is measured at the end of

the year prior to when a capacity change decision is

made.

Firms with the highest levels of debt are

predicted to have the greatest motivation to seek out

more productive uses of their limited capital and

should be more apt to exit from a shrinking industry

(Jensen, 1986; Stulz, 1990; Harris and Raviv, 1990).

If this is true then the probability of exit should be

positively related to leverage. The average DEBT

variable for our sample firms is .23 with a median of

.21. The comparison reported in Table 3 indicates

that the mean debt ratio for the abandonment sample

exceeds the mean for the non-abandonment sample.

A t-test of the null hypothesis that the means of the

two samples are equal, against the alternative that the

mean of the abandonment sample is larger, rejects the

null at the .10 level.

The firm‘s access to excess cash flow, what we

will call financial liquidity, may also be important

when it is considering whether or not to continue

operating in a declining industry. The excess free-

cash flow hypothesis (Jensen, 1986) would predict a

negative relation between the probability of

abandonment and financial liquidity if managers,

ceteris paribus, have incentives to continue production

when the optimal choice should be to abandon.

Alternatively, Tirole (1992) presents a war of attrition

model for an industry that contains too many

competitors, i.e. some must exit for the others to

survive. In his model each competitor plays a waiting

strategy hoping rival firms will quit the industry first.

Under these circumstances liquidity-rich firms are

able to induce liquidity-poor firms to abandon

production before they otherwise would. Hence,

liquidity-rich firms may be less likely to exit.

Fazzari, Hubbard and Petersen (1988), and

Hubbard, Kashyap and Whited (1995) among others,

present results suggesting that investment activity is

related to internally generated cash flow, broadly

consistent with the view that external financing is

costly (Myers, 1984a; Myers and Majluf, 1984b;

Greenwald, Stiglitz and Weiss,1984). These studies

find that investment by firms with low access to

capital markets is more sensitive to internally

generated cash flow. Conclusions regarding these

results are however mixed. Kaplan and Zingales

(1997) have questioned the reasons for the

investment-cash flow sensitivities suggested by

Hubbard and his coauthors, and recent empirical

results presented by Cleary (1999) also raises

questions regarding interpretation. If liquidity is

nonetheless relevant, liquidity-poor firms could be

more likely to abandon.

Minton and Schrand (1999) in a recent study

extending the investment-cash flow literature, present

results indicating firm-level cash flow variability may

have a negative effect on firm-level investment. They

suggest that higher cash flow variability causes firms

to forego investment spending because smoothing

cash needs over time means using costly external

financing, where external financing is potentially

costly due to circumstances as described in Myers and

Majluf (1984b).

A measure of financial liquidity should reflect

the ability to immediately capture cash, but also the

overall prospects of cash flow generation and it‘s

stochastic properties. The liquidity measure

developed by Emery and Cogger (1982) reflects these

characteristics. Let the probability of negative net

cash flow be given by

where

= probability of default

= the standard normal distribution function

= (cash + marketable securities + ) /

= average cash flow over previous five years

= standard deviation of cash flow over

previous five years.

Then the probability of positive net cash flow is

given by4

1L

4 The full liquidity measure as defined by Emery and

Cogger (1982), what they label F(T), is composed of two

terms. The first term is the probability of negative net cash

flow assessed at date t, as above. The second term is a

correction factor that conditions for the fact that the firm has

remained solvent up to the time t. Emery and Cogger

studied the behavior of F(T) and and found that rankings

based on each measure were not significantly different.


422

The variable L is scaled so that it measures the

firm's liquidity relative to its closest competitors:

LIQUIDITYj(i),t = Lj(i),t / (median L)q(i),t

where (median L) is the median value of L for

companies operating plants manufacturing the same

product q as plant i in year t, and the notation j(i)

associates the measure L for owner firm j with plant i.

The data used to calculate the liquidity measure

come from the Compustat files. Cash flow for

calculation of μ and σ is defined as earnings before

interest, taxes, and depreciation. The terms μ and σ

are calculated over a rolling five-year period

beginning five years prior to the decision year. The

comparison reported in Table 3 indicates the variable

LIQUIDITY is smaller for the abandonment sample.

A t-test of the null hypothesis that the means of the

two samples are equal, against the alternative that the

mean of the abandonment sample is smaller, rejects

the null at the .05 level.

3.2 The effects of efficiency

Jovanovic (1982), Fudenberg and Tirole (1986),

Dunne, Roberts and Samuelson (1989) and Lieberman

(1990) have all argued that the efficiency of a plant

should play an important role in the decision to

change capacity. Jovanovic (1982) presents a model

for markets similar in nature to the types in which

commodity chemicals are sold and shows that plant

size is positively related to efficiency and survival.

Dunne, Roberts and Samuelson (1989) and Lieberman

(1990) present empirical results consistent with the

proposition that efficiency is related to the choice to

abandon production. These authors employ a

measure of size as their proxy for efficiency. Aside

from this evidence, consideration of the technology

used in the production of chemicals leads to a similar

conclusion. In the chemical industry economies of

scale are of great importance. Therefore, a chemical

plant's size as measured by its output capacity, should

be an excellent proxy for its operating efficiency.5

In order to compare plant capacity across

different chemical products we construct the

following measure of capacity size

CAPACITYi,t = plant capacityi,t / (median

capacity)q(i),t6

5 Profit contribution from a specific plant is not available.

However, if we can argue that more efficient plants have

lower costs, and hence, ceteris paribus, contribute more to

overall firm profitability, then we can also argue that for this

industry, larger plants typically contribute more because

they are better able to exploit economies of scale in

production.

6 All the chemical groups report capacity similarly so that

plant capacity can be compared directly within chemical

groups. However, plant capacity for different chemical

groups may be reported in different units of measure.

Scaling capacity by the median of the group allows cross-

group comparisons.

where the subscript i is for plant i and t is for

year t. The quantity (median capacity)q(i),t is the

median capacity in year t of the capacities of all plants

manufacturing the same product q as plant i in year t.

This normalization creates a relative plant size

variable that is comparable across all product groups.

If large plant capacity implies significant

economies of scale, which is likely in the chemical

industry, then it would be less likely that larger, more

efficient plants would be closed in any year, ceteris

paribus. Plant capacity data are collected from the

annual Directory of Chemical Producers.7 The

comparison reported in Table 3 indicates that the

mean of the variable CAPACITY for the abandonment

sample is smaller than the mean for the non-

abandonment sample. A t-test of the null hypothesis

that the two sample means are equal, against the

alternative that the mean of the abandonment sample

is smaller, rejects the null at the .05 level.

3.3 Cash flow variability at the plant level

Plant-level cash flow variability may also influence

the choice to abandon. One might for instance argue

greater cash flow variability gives poorly performing

investments a greater chance of recovering, and hence

should be associated with a lower likelihood of

abandonment.

For example, suppose a chemical plant faces a

constant marginal cost of production but the price of

the chemical produced is highly variable, so that the

plant‘s cash flow is also highly variable. It may

benefit the company to continue production even

though demand for the product is declining, in hopes

that the price will later rise. If, on the other hand, the

price has little variability, thus giving little hope cash

flow would recover to acceptable levels, the company

would be more likely to abandon production.

Analogously, if the prices of input materials are

highly variable the company may hold on for a

7 The results in Deily (1990) suggest capital investment in a

plant may predict future abandonment decisions. Actual

dollar investments in plants are not available for our sample.

However, the change in capacity prior to an event decision

may be correlated with net new investment during that same

period. We investigate the predictive power of the

percentage change in capacity for a plant over the two years

prior to the capacity choice decision and find no relation.

We also investigated the relation between investment

capacity choice and Tobin‘s Q ratio for the firm as a whole.

The latter relation was not statistically significant, nor did

the introduction of the firm level Q ratio as an independent

variable influence the results presented below. However, as

we show below, efficiency at the plant level is a significant

predictor of abandonment. If it was possible to construct a

plant level Q ratio we suspect that it to be significantly

related to efficiency. Unfortunately, the data required for

the calculation of plant level Q ratios is unavailable.


423

possible reduction in its cost of production.8

We use the crude oil price index and the price

index for "nonferrous metals" both computed by the

Bureau of Labor Statistics, U.S. Department of Labor,

as proxies for input prices. If a plant manufactures an

organic chemical then crude oil will be a major input.

The inorganic chemicals in the sample are all

nonferrous which is the justification for using the

nonferrous metals price index as the input price

proxy. Monthly observations on these price indices

were obtained from the DRI Basic Economics

database, which compiles the data from sources

produced by the Bureau of Labor Statistics.

We obtain output price data from issues of the

Chemical Marketing Reporter, which reports weekly

prices for hundreds of chemicals. The Chemical

Marketing Reporter presents price data in terms of

units of output, such as gallons, pounds, or barrels

depending on the particular chemical product. We

account for these different units of measurement by

standardizing our measure of the variability of output

and input prices as follows.

CVINPUTi,t = coefficient of variation of input

price for plant i in year t

CVOUTPUTi,t = coefficient of variation of

product price for plant i in year t

Our measures of variability are computed in the

same spirit as the cash flow variability measure

utilized by Minton and Schrand (1999) who employ

the coefficient of variation of firm-level cash flow in

their analysis. We compute each of the variability

measures for each year that a company is in the

sample using a rolling twenty-four month period

beginning two years prior to the year of interest.

Table 3 presents descriptive statistics for the two

variables we use as measures of price variability for

those cases defined as abandonment decisions and

separately for those cases in which abandonment did

not occur. For the output price, the mean coefficient

of variation across the sample plants and years for the

abandonment sample is .057. In comparison the mean

value for the non-abandonment sample is .098.

Therefore, CVOUTPUT is smaller for the cases in

which exit was the decision. For the input price

variability measure, we see that the sample mean for

the abandonment sample (3.515) is smaller than that

for the non-abandonment cases (4.699). T-tests of the

hypothesis that the mean values of CVOUTPUT and

CVINPUT are equal for the two samples against the

alternative that the means for the abandonment

sample are smaller reject the null at the .05 level

(Table 3). These results are consistent with the

prediction that abandonment is less likely to occur the

greater are output and input price variability. We turn

next to a joint test of the aforementioned relations.

8 Dixit (1989) presents a model in which the variability of

cash flow, through the variability of output prices, affects

the ultimate decision of whether or not to exit.

4. Modeling capacity choice

We assume that the managers of a parent company

perform an evaluation of the capacity of plant i each

period and choose the capacity level that gives the

maximum value conditional on the firm and market

level characteristics discussed in Section 3. Consider

the following capacity choice set j = {abandon,

contract but do not abandon, enter, expand an existing

plant, leave capacity unchanged}. Let the net benefit

of the choice j for plant i be represented by

ijijij XNB (1)

where X is a vector of factors that influence the

decision‘s value, is a vector of parameters and ij

is a unique factor capturing effects which might be

specific to the plant in question. The managers who

administer plant i make choice j when

.jkNBNB ikij

Estimation of model (1) could tell us a great deal

about the decision process. The values of NB are

however not observable. What we can observe are the

choices the managers actually made.

McFadden (1974, 1981) has shown that under

the assumption of maximization and assuming the

ij in equation (1) are independent and identically

distributed with Weibull density functions, the

following probabilistic choice system is implied:

e

e = P

j,i

ji,

X J

1=j

X

ji,

(2)

where J represents the number of possible

discrete choices available, and Pi,j is the probability of

choice j for plant i.9

We initially model the decision as a binary

choice problem where the two choices are abandon or

do not abandon and the errors in equation (1) have a

logistic distribution. One feature of modeling the

decision in this way is that the resulting predicted

values can be interpreted as the predicted probability

of abandonment. The binary model reduces to

e + 1

e = P

ji,

i,1

X

X

i,1

(3)

where Pi,1 represents the probability of

abandonment. Define the limited dependent variable

y, where y takes the value 1 if the decision to abandon

is made and 0 otherwise. The assumption behind the

model is: 1,i1,i XFP1yobPr where

the function F depends upon the distributional

assumption made regarding the errors in (1). We

9 We also estimate the model assuming that the errors in (1)

are iid normal (the probit model) and find that the results are

robust to which of these distributional assumptions is made.


424

estimate models (2) and (3) using maximum

likelihood methods.10

5. Empirical results 5.1 Estimation results and the economic hypotheses

The estimated coefficients for model (3) under the

assumption that the errors in (1) have the logistic

distribution are as follows:

X = -2.03 + 1.93 DEBT - 11.28 LIQUIDITY -

0.36 CAPACITY - 2.78 CVOUTPUT - 0.09

CVINPUT . (.0705)

(.0500) (.0382) (.0587)

(.0158)

The limited dependent variable y identifying the

capacity choice takes the value 1 for abandonment

and 0 for non-abandonment decisions. The p-values

associated with tests of the predicted relations are

presented in parentheses

Jensen (1986) points out that firms in declining

industries may have a greater potential agency

problem due to the possibility of large cash flow

coupled with few growth opportunities. For these

firms debt payments would be even more important

than usual in minimizing the agency costs of excess

free-cash flow. This hypothesis predicts a positive

relation between a firm‘s level of debt financing and

the probability of abandonment. The coefficient

estimate for the variable DEBT (1.93) is positive and

reliably significant (p=.0705), indicating that the

greater the firm's use of debt the more likely it is to

abandon assets in declining industries. This result is

consistent with the agency cost of free-cash flow

hypothesis.

As outlined earlier, a corollary to the above

hypothesis is that firms with financial liquidity may

be motivated to remain in a declining industry,

thereby fighting a war of attrition, despite the fact that

such a decision may run counter to the interests of

shareholders.11

This hypothesis predicts an inverse

relationship between liquidity and the probability of

abandonment. The estimated coefficient on the

variable LIQUIDITY (-11.28, p=.0500) is consistent

with this hypothesis. Firms with greater amounts of

financial liquidity tend to remain rather than retreat.

The estimated coefficient for the efficiency

proxy, CAPACITY is negative, -0.36, indicating that

10 See Greene (2000, Ch. 19) for details on estimating

qualitative choice models.

11 There are circumstances under which the use of financial

liquidity to win the ―war of attrition‖ could lead to gains to

shareholders. For instance, if the industry becomes less

competitive as a result of a reduction in the number of firms

producin, those firms that remain may later exert

oligopolistic power. Whether coalitions of such a nature

can be sustained in commodity markets is suspect.

efficiency as we measure it is inversely related to

abandonment. The p-value for the coefficient on

CAPACITY (.0382) indicates that we can reliably

reject the null hypothesis that plant efficiency has no

bearing on the choice to abandon. This result is

consistent with the hypothesis that more efficient

plants are less likely to be abandoned.

Finally, the estimated coefficients on

CVOUTPUT (-2.78) and CVINPUT (-0.09) are

negative with p-values indicating that they are reliably

negative (.0587 and .0158 respectively).12

These

results are consistent with the hypothesis that in the

presence of higher variability of plant-level cash flow,

proxied by output and input prices, firms are less

likely to discontinue production.

5.2 Specification tests

We calculate a likelihood ratio test of the intercept-

only model versus the full model. The test statistic is

distributed asymptotically Chi-square with degrees of

freedom equal to the number of independent

variables. The Chi-square statistic for this test is 18.6,

which, with five degrees of freedom, is significant at

the one percent level (p-value = .002) indicating that

the model we propose is significantly better than an

intercept only model.

A goodness-of-fit test often used in the analysis

of logistic regression models is Somer‘s D statistic.13

This statistic has the intuitive appeal that it is based

on the predictive ability of the model. Let the

decision response for firm i be classified as yi = 1

when an abandonment occurs, and yi = 0 when the

firm does not abandon. Somer‘s D relies on a

comparison of every possible pairing of responses

with non-responses. A pairing is said to be

concordant (discordant) if the predicted probability of

the event response is greater (less) than the predicted

probability of its paired non-response. The statistic is

defined as D = (c - d) / n = c/n – d/n where c is the

number of concordant pairs and c/n is the percentage

of all pairs that are concordant (64.2%); d is the

number of discordant pairs and d/n is the percentage

of all pairs that are discordant (34.4%); and n is the

total number of pairs. A value of zero for the statistic

implies the model has no predictive value. Somer's D

12 One might think that the input price variability variable is

little more than a dummy variable for whether the chemical

is organic or inorganic. We estimated the models

substituting such a dummy variable for the variability

measures. The results indicate that such a dummy is not a

substitute for CVINPUT.

13 As Greene (2000, Ch. 19) points out, goodness-of-fit may

be a misnomer for logistic regression. In ordinary

regression the goal is to minimize the sum of the squared

residuals, which also maximizes the fit of the model. The

method of maximum likelihood, on the other hand, sets out

to maximize the density of the dependent variable to

provide the best possible parameter estimates.


425

for the model in column one of Table 4 is .298

(=.642-.344) which, when divided by its asymptotic

standard error of .025 (Freeman, 1987), results in a Z-

statistic of 11.9 (p < .0001), suggesting that the model

has significant predictive ability.14

5.3 The probability of exit

The coefficient estimates presented above do not

represent the marginal effects of the respective

independent variables on the probability of

abandonment. However, those effects can be

computed by using the structural form for the

probability and the estimated coefficients of the

model. The constructed probability is

e + 1

e = P̂

Xˆ

Xˆ

ti,ti,

ti,

(4)

where carats indicate the point estimates of the

relevant coefficients of the model. Substituting in the

point estimates for the coefficients and the mean

values of the explanatory variables from Table 3

yields the expected probability of abandonment. By

increasing or decreasing one variable at a time we can

compute the marginal effects of changes in the

explanatory variables on the probability of

abandonment. Column (1) in Table 4 reports the

coefficients of the estimated equation. Columns (2)

and (3) present the means and standard deviations,

respectively, of the independent variables. Columns

(4) and (5) show the effects on the estimated

probability of abandonment of a plus or minus one

standard deviation change in the value of each

explanatory variable from its mean.

The expected probability of abandonment, 7.7%,

is found by setting all of the explanatory variables

equal to their means. When all variables are set to

one standard deviation above their respective means

the probability of abandonment is 2.4%; when all are

set to one standard deviation below their respective

means the probability of abandonment increases to

28.0%. These represent changes of roughly –69

percent and +264 percent, respectively, from the

baseline value of 7.7%. Regarding the effects of the

individual regressors, a positive (negative) change in

DEBT of one standard deviation from its mean,

holding every other regressor constant, leads to a

probability of abandonment of 10.8% (6.9%) a change

of +40 percent (-10 percent). The other four

regressors are inversely related to the probability of

abandonment. When LIQUIDITY is increased

(decreased) one standard deviation, the predicted

probability of abandonment decreases (increases) –5

(+32) percent. A one standard deviation increase

(decrease) in the plant efficiency measure CAPACITY

14 Results based upon the assumption of iid normal errors

are qualitatively the same, with all of the estimated

coefficients having the same sign as those shown and

roughly equal or smaller p-values.

produces a -13 (+55) percent change in the probability

of exit. Changes in output price variability have the

greatest effect on the predicted probability of

abandonment. A positive (negative) change in output

price variability by one standard deviation from the

mean leads to a predicted probability of 4.6%

(13.1%), a decrease (increase) in abandonment

probability of -40 (+70) percent relative to the

expected probability of 7.7%. A one standard

deviation change in input price variability produces a

-31(+45) percent change in the probability of exit.

Correlations among the independent variables

can influence the coefficient estimates and their

significance levels. Table 5 presents the estimated

correlation coefficients for the independent variables.

None of the computed correlations have an absolute

value greater than .10 and only two are reliably

significant at the .05 level. We conclude from these

statistics that correlation between the independent

variables is not an issue as far as interpretation of the

estimation results is concerned.

6. Robustness tests 6.1 Further specification issues

We examine the robustness of our findings that

financial characteristics of the firm are important

determinants in the abandonment choice. As we have

discussed, the data set includes information on entry,

expansion and contraction, in addition to

abandonment and the case of no modifications to

capacity (no change). A natural reformulation would

involve the specification of a model in which all five

capacity choice decisions are jointly accounted for.

We discuss the robustness of the effects documented

in Section 5 on the probability of abandonment for

two such multinomial choice models.15

In order to estimate a model in which all five

choices are jointly represented, one of the decisions

must be chosen to act as the reference decision. The

decision to "do nothing" is the reference decision in

the multinomial models we estimate. The model in

general form:

e ji,X β j

J

1=j + 1

1 = )nothing" do" = yiProb(

nothing" do" j choicecapacity for

e ji,X β j

J

1=j + 1

e ji,X j

β

= j) = yiProb(

Each of the five decisions has its own structural

model so that the vector of sensitivity coefficients for

decision j is unique to decision j. Within this

framework however the probability of abandonment

is a complex function of the coefficients of the

estimated equations. The multinomial model is

estimated using maximum likelihood methods under

15 The general k-choice multinomial model is the analogue

of the general k-vector multivariate regression model

(Greene (2000, Ch. 19)).


426

the assumption that the errors are iid and have

Weibull density functions.

6.2 Accounting for fixed effects

We begin by commenting on a restricted case in

which only the intercepts of the respective models are

permitted to vary across capacity choices. The

validity of this structural form rests on the null

hypothesis that the estimated coefficients other than

the intercept are constant across models. While we

found that the intercepts do differ across the models,

additional tests lead us to reject the null hypothesis

that the slope coefficients of all five plant capacity

decisions were equal. Thus the constraint on the

slope coefficients is inappropriate. We therefore turn

next to a more general specification.16

6.3 An unordered general choice model

A full multivariate model in which not only the

intercepts but also the slope coefficients are free to

vary across the five alternative capacity choices was

estimated. Table 6 presents the maximum likelihood

analysis of variance results for an unconditional,

unordered multinomial model. This structure allows

joint estimation of models for all five decisions where

"do nothing" is the reference decision. The results

presented in Table 6 show that within this more

general structural framework, DEBT becomes less

statistically significant, although the p-value still

remains at a tolerable level (p=.15). The variables

LIQUIDITY, CAPACITY, CVOUTPUT and CVINPUT

all remain significantly related to the plant capacity

decision at significance levels below the .05 level.

The null hypothesis for the likelihood ratio test

presented at the bottom of Table 6 is that the total

variability of the dependent variable vector is

explained by the system. The likelihood ratio test

statistic has a distribution under the null

hypothesis. The calculated value of the test statistic

has a value of 1934, which, with 3888 degrees of

freedom is insignificant (p=1.0), indicating that we do

not reject the null that the model fits the data well.

The unordered multinomial regression provides

a set of four estimated equations, 24 coefficients

altogether (including intercepts). However, the

coefficients of these equations are difficult to directly

interpret because they interact in a complex nonlinear

manner in the determination of the probability of any

particular choice (Greene, 2000, Ch. 19)). A

preferred and more intuitive way to interpret the

estimated model is, as we have done previously in

Table 4, to examine the marginal effects on the

probability of abandonment that arise from changes in

16 For brevity we do not present the results for the common

coefficient model. The results will be made available upon

request.

the values of the independent variables. We begin by

identifying the benchmark expected probability of

abandonment using the respective mean values of the

independent variables. This baseline estimated

probability is equal to 5%. Then, one at a time, we

vary the mean values of the independent variables by

plus one standard deviation. Table 7 presents the

results of these calculations.17

The column labelled

"none" presents the benchmark probability of

abandonment. Each of the columns to its right varies

one independent variable at a time by plus one

standard deviation from its mean. The table presents

the level of the probability as well as the percentage

difference from the baseline probability. The results

in Table 7 indicate that the probability of

abandonment is positively related to changes in the

variable DEBT and negatively related to changes in

the variables LIQUIDITY, CAPACITY, CVOUTPUT,

and CVINPUT, consistent with the results presented

earlier. The percentage changes for the probability of

abandonment reported in Table 7 all agree with

respect to sign with the binary model. We conclude

that our prior results on the marginal effects on the

probability of abandonment that arise from changes in

the debt level of the firm, its financial liquidity, the

plant‘s efficiency, and output and input price

variability are the same within a multinomial

framework that accounts for all of the possible

choices available to management.

7. Summary

This study examines how financial, real and product

market forces influence the decision to abandon

production. Our sample represents investments in

products that are in decline, products for which

abandonment may be the most efficient decision.

Extant theory suggests that discretionary control over

a firm‘s free cash flow can lead to inefficient

investment decisions. Jensen (1986) argues that debt

financing can help mitigate this agency problem.

Hence we expect firms with greater levels of debt will

be more likely to abandon production in declining

markets. However, Tirole (1992) develops a ―war of

attrition‖ model in which competing firms play a

waiting strategy hoping that rivals will abandon

production before they are forced to do so themselves.

In this setting financial liquidity may prove to be an

important weapon in the ―war‖ and we do not expect

firms with greater liquidity to make the exit decision

as frequently as those with less liquidity. Several

empirical studies suggest that cash flow and

investment are related (Fazzari, Hubbard and

Petersen, 1988, 2000; Hubbard, Kashyap and Whited,

1995). The study by Minton and Schrand (1999)

17 We restrict the table to the analysis of only increases in

the dependent variables. The effects of decreases in the

independent variables are largely symmetric to those

presented.


427

further suggests that firm-level cash flow variability

and firm-level investment are related. Finally,

Leiberman (1990) and others have shown that firms

are more likely to abandon production at less efficient

plants. We test these propositions using a data set

containing plant level capacity choices for products

whose markets are in decline. We find that the

probability of abandonment increases with a firm‘s

level of debt financing and decreases with its level of

financial liquidity, both of which are consistent with

the agency arguments outlined above. We also find,

consistent with Leiberman, firms tend to abandon

smaller, less efficient plants. Finally the choice to

abandon is inversely related to aspects of plant-level

cash flow variability proxied by output and input

price variability for the plant‘s product. These

propositions are first confirmed within the framework

of a binary choice model in which the choices are

abandon and do not abandon and then within a

multinomial framework in which all five possible

capacity choices are accounted for.

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Appendices

Table 1. Chemical products whose manufacturers are represented in the sample

Producta

Type

Beginning of decline

Reason for decline

Acetone O 1981 1

Acrylic fibers O 1981 2

Adipic Acid O 1979 0

Carbon black O 1975 3

Cresylic acid O 1982 4

Ethyl chloride O 1976 1

Fumaric acid O 1972 2,4

Hydrofluoric acid O 1974 1,4

Isopropyle alcohol O 1981 5

Melamine O 1972 4

Sodium bichromate I 1979 4,6

Sodium phosphate I 1979 7

Sodium sulfite I 1976 6,7

Sodium tetraborate I 1978 0

a Chemical products produced at the plants in the final sample of facilities for which the decision to abandon is

examined. The label Type indicates whether the chemical product is organic (O) or inorganic (I). The table indicates the first

year that demand for the product began to decline and the reasons for the decline, which are: 0 - unknown, 1 - downstream

product found to be hazardous, 2 - substitute found for downstream product, 3 - downstream product changed, 4 - displaced

by imports, 5 - downstream product manufacturing process changed, 6 - substitute found for chemical, 7 - chemical found to

be hazardous.

Table 2. Descriptive statistics for the firms owning and operating the chemical plants in the sample

Variablea

Mean

Median

Standard

Deviation

SALES $10.5 $6.4 $13.2

TOTAL ASSETS $9.7 $5.8 $11.5

DEBT 23% 21% 10%

MVE $5.2 $2.7 $7.0

Operating Cash Flow $1.1 $0.6 $1.4

a All balance sheet quantities measured as of the end of the fiscal year; all flow quantities are based upon fiscal year

performance. DEBT= long-term debt / total assets, MVE= market value of equity (stock price times number of outstanding


429

shares), Operating Cash Flow = net income before extraordinary expenses plus depreciation. All dollar values are measured in

billions. Data sources include the Compustat and CRSP files. Measurement is over all manufacturers and years.

Table 3. Descriptive statistics for the explanatory variables by abandon and Not-abandon cases

Variablea Exits Does Not Exit tb

Mean Median Mean Median

DEBT 0.246 0.210 0.223 0.214 1.64**

LIQUIDITY -0.006 0.000 -0.002 0.000 2.01*

CAPACITY 0.855 0.821 1.085 1.000 1.88*

CVOUTPUT 0.057 0.041 0.098 0.051 1.69**

CVINPUT 3.515 2.289 4.699 3.796 2.25*

a Abandon and not-abandon cases are identified from the annual record of capacity choice decisions made at 134

chemical manufacturing plants over the period 1977-1990. Fifty-three corporations are represented in the final sample, and

728 choices are represented in the table. The variables listed in the table are defined as: DEBT= long-term debt / total assets

for the corporation that operates the chemical plant in year t, LIQUIDITY= Emery and Cogger (1982) liquidity measure. Let

the probability of negative net cash flow be given by where = probability of default, = the standard

normal distribution function, = (cash + marketable securities + ) / , = average cash flow over previous five years,

= standard deviation of cash flow over previous five years. Then the probability of positive net cash flow is given by

1L . The variable L is scaled so that it measures the firm's liquidity relative to their closest competitors:

LIQUIDITYj(i),t = Lj(i),t / (median L)q(i),t, where (median L) is the median value of L for companies operating plants

manufacturing the same product q as plant i in year t, and the notation j(i) associates the measure L for owner firm j with

plant i, CAPACITY= plant capacity / median plant capacity for plants manufacturing the same chemical in the same year,

CVOUTPUT= coefficient of variation of product price, CVINPUT= coefficient of variation of input good price. b Absolute value of the t-statistic for tests of the hypothesis that the reported means are equal against the alternative

that the means of a) CVOUTPUT, CVINPUT, CAPACITY, and LIQUIDITY are smaller for the abandon sample than for the

not-abandon sample, and b) for the variable DEBT that the mean for the abandon sample is greater than for the not-abandon

sample. * (**) indicates that the null is rejected in favor of the alternative at the .05 (.10) level.

Table 4. Marginal effects on the probability of abandonment from changes in explanatory variables

Variablea

Model

Coefficients

(1)

Variable Mean

(2)

Variable

Standard

Deviation

(3)

P+1

(%)

(4)

P-1

(%)

(5)

Intercept -2.03

DEBT 1.93 0.023 0.099 10.8 6.9

LIQUIDITY -11.28 -0.0003 0.014 7.3 10.2

CAPACITY -0.36 1.07 0.887 6.7 11.9

CVOUTPUT -2.78 0.09 0.17 4.6 13.1

CVINPUT -0.09 4.61 3.82 5.3 11.2

a This table uses the estimated model reported in column 2 of Table 4 to find the marginal effects of changes in the

independent variables on the predicted probability of abandonment. There are 728 decisions represented, and are restricted to

"abandon" and "not-abandon", excluding the decisions "reduce capacity", "expand capacity" and "entry". The variables listed

in the table are defined as: DEBT= long-term debt / total assets for the corporation that operates the chemical plant in year t,

LIQUIDITY= Emery and Cogger (1982) liquidity measure. Let the probability of negative net cash flow be given by

where = probability of default, = the standard normal distribution function, = (cash + marketable

securities + ) / , = average cash flow over previous five years, = standard deviation of cash flow over previous

five years. Then the probability of positive net cash flow is given by 1L . The variable L is scaled so that it

measures the firm's liquidity relative to their closest competitors: LIQUIDITYj(i),t = Lj(i),t / (median L)q(i),t, where (median L) is

the median value of L for companies operating plants manufacturing the same product q as plant i in year t, and the notation

j(i) associates the measure L for owner firm j with plant i, CAPACITY= plant capacity / median plant capacity for plants


430

manufacturing the same chemical in the same year, CVOUTPUT= coefficient of variation of product price, CVINPUT=

coefficient of variation of input good price. Sample means and standard deviations of the independent variables are reported

in columns 2 and 3. Predicted probabilities of abandonment after increasing the respective variable‘s value by one standard

deviation above the mean are reported in column 4 as P+1. Predicted probabilities of abandonment after decreasing the

respective variable‘s value by one standard deviation below the mean are reported in column 5 as P-1. The expected

probability of abandonment 7.7% is found by setting all variables equal to their means. When all variables are set to one

standard deviation above their respective means the probability of abandonment is 2.4%; when all are set to one standard

deviation below their respective means the probability of abandonment increases to 28.0%.

Table 5. Correlations among the explanatory variablesa

LIQUIDITY DEBT CAPACITY CVOUTPUT CVINPUT

DEBT 1 -.01 -.03 -.08* .07*

LIQUIDITY 1 -.00 -.06 .01

CAPACITY 1 -.01 -.03

CVOUTPUT 1 -.03

CVINPUT 1

*Correlations of ± .07 to .09 in absolute value are significant at the 5% level. a The variables listed in the table are defined as: DEBT= long-term debt / total assets for the corporation that

operates the chemical plant in year t, LIQUIDITY= Emery and Cogger (1982) liquidity measure. Let the probability of

negative net cash flow be given by where = probability of default, = the standard normal distribution

function, = (cash + marketable securities + ) / , = average cash flow over previous five years, = standard

deviation of cash flow over previous five years. Then the probability of positive net cash flow is given by 1L . The

variable L is scaled so that it measures the firm's liquidity relative to their closest competitors: LIQUIDITYj(i),t = Lj(i),t /

(median L)q(i),t, where (median L) is the median value of L for companies operating plants manufacturing the same product q

as plant i in year t, and the notation j(i) associates the measure L for owner firm j with plant i, CAPACITY= plant capacity /

median plant capacity for plants manufacturing the same chemical in the same year, CVOUTPUT= coefficient of variation of

product price, CVINPUT= coefficient of variation of input good price.

Table 6

Analysis of variance results for the full multinomial model of capacity choice

Variablea Df 2 Prob>

2

Intercept 4 84.01 <.000

DEBT 4 6.66 .155

LIQUIDITY 4 30.68 <.000

CAPACITY 4 31.68 <.000

CVOUTPUT 4 15.75 .0034

CVINPUT 4 10.00 .0405

Likelihood ratiob 3888 1934 1.000

a Maximum-likelihood analysis-of-variance results from a multinomial logistic regression including each of the

capacity decisions as a separate category in the analysis. These tests are run using the full set of 996 observations, accounting

for all five possible decisions; abandon, reduce capacity but do not abandon, entry, expand capacity, and do nothing. The

explanatory variables are: DEBT= long-term debt / total assets for the corporation that operates the chemical plant in year t,

LIQUIDITY= Emery and Cogger (1982) liquidity measure. Let the probability of negative net cash flow be given by

where = probability of default, = the standard normal distribution function, = (cash + marketable

securities + ) / , = average cash flow over previous five years, = standard deviation of cash flow over previous

five years. Then the probability of positive net cash flow is given by 1L . The variable L is scaled so that it

measures the firm's liquidity relative to their closest competitors: LIQUIDITYj(i),t = Lj(i),t / (median L)q(i),t, where (median L) is

the median value of L for companies operating plants manufacturing the same product q as plant i in year t, and the notation

j(i) associates the measure L for owner firm j with plant i, CAPACITY= plant capacity / median plant capacity for plants


431

manufacturing the same chemical in the same year, CVOUTPUT= coefficient of variation of product price, CVINPUT=

coefficient of variation of input good price. b The null hypothesis for the likelihood ratio test is that the total variability of the dependent variable vector is

explained by the system estimated. The likelihood ratio test statistic has a value of 1934 which, with 3888 degrees of freedom

is insignificant (p=1.0), indicating that the model fits very well.

Table 7. Marginal effects on the probability of abandonment from changes in all explanatory variables: Full multinomial

model of capacity choice

Explanatory Variable Varieda

None

(Base Case)

DEBT LIQUIDITY CAPACITY CVOUTPUT CVINPUT

Probability of

abandonment (%)

5.0

6.1

4.2

3.2

2.8

3.6

% Prob relative to

Base Case

23.5%

-16.2%

-34.9%

-42.6%

-27.7%

a This table uses the parameters estimated by a full multinomial logistic regression to find the marginal effects of

changes in the independent variables on the predicted probability of abandonment. The model is estimated using the full set

of 996 observations, accounting for all five possible decisions; abandon, reduce capacity but do not abandon, entry, expand

capacity, and do nothing. Column 1 presents the estimated probability of abandonment when each of the independent

variables is set to its sample mean value. Columns 2 through 6 present the probability of abandonment when the mean value

of each respective variable is increased by one standard deviation. The second row of the table presents the percentage change

in the probability of abandonment. The explanatory variables are: DEBT= long-term debt / total assets for the corporation that

operates the chemical plant in year t, LIQUIDITY= Emery and Cogger (1982) liquidity measure. Let the probability of

negative net cash flow be given by where = probability of default, = the standard normal distribution

function, = (cash + marketable securities + ) / , = average cash flow over previous five years, = standard

deviation of cash flow over previous five years. Then the probability of positive net cash flow is given by 1L . The

variable L is scaled so that it measures the firm's liquidity relative to their closest competitors: LIQUIDITYj(i),t = Lj(i),t /

(median L)q(i),t, where (median L) is the median value of L for companies operating plants manufacturing the same product q

as plant i in year t, and the notation j(i) associates the measure L for owner firm j with plant i, CAPACITY= plant capacity /

median plant capacity for plants manufacturing the same chemical in the same year, CVOUTPUT= coefficient of variation of

product price, CVINPUT= coefficient of variation of input good price.


432

FINANCIAL SUPERVISION IN EU COUNTRIES

Enrico Maria Cervellati*, Eleonora Fioriti

Abstract

Today there are about thirty authorities supervising national financial markets and institutions in the EU-15 countries. The member States have chosen different models for supervising their financial systems. We describe the three main theoretical supervisory models proposed in the literature: vertical, horizontal, centralised. In practice, however, it is difficult to find a pure application of these models, while the actual supervisory systems are the result of the different legal frameworks of the member States and of the way in which their financial systems developed. Moreover, although the Lamfalussy Report can be considered an important step towards a more integrated financial supervisory system at the European level, the supervisory arrangements are still very different among member States. This work provides an analysis of the different systems of financial supervision in Europe: showing how the differences that still exist among their systems make it more difficult to achieve a real European integration in financial supervision. Keywords: financial system, Europe, supervision

*Department of Management - University of Bologna Via Capo di Lucca, 34 – 40126 Bologna Tel: +39 (0)51 2098103 - Fax: +39 (0)51 246411 e-mail: [email protected], [email protected]

Corresponding author.

This paper is an updated version of a previous work entitled “Financial Regulation and Supervision in EU Countries”, presented at the 2003 EFMA Annual Meeting, Helsinky, 25-29 June 2003. While the present analysis focuses in the supervisory arrangements in EU countries, the 2003 version includes more details on the regulatory differences among member States. We are very grateful to Giuseppe Artizzu at Lehman Brothers that helped us getting in touch with Elena Pagnoni at Freshfield Bruckhaus Deringer that provided us the 2005 version of the book “How Countries Supervise their Banks, Insurers and Securities Markets”, in which we found some information that constituted the basis for this paper. The usual disclaimers apply.

Introduction

The need to find a remedy for market imperfections

and distributive problems of available resources can

be considered as the theoretical foundations for public

intervention in the economy aimed at guaranteeing the

pursuit of stability, fairness on the distribution of

resources and efficiency in their employment.

All the theories that support the need of a

stronger regulation on banks and other financial

institutions find their common denominator on the

presence of particular forms of market failures in the

credit and financial sectors.

The Great Crisis of the 1930s stressed the

incapacity of the market to ensure the optimal

combination between stability and efficiency and

required the urgent need to re-think the supervisory

systems of financial markets and institutions in order

to safeguard the integrity and the stability of the

financial sector.

In the US, the Securities Act of 1933, was the

first example of regulation in the securities, followed

by the Securities and Exchange Act of 1934 that set

up the Securities and Exchange Commission which

was the first supervisory authority with

responsibilities to guarantee disclosure and to protect

investors.

The Securities Act of 1933 was the first example

of regulation in the securities field: it imposed that

investors had all the necessary information about the

securities that they wanted to buy and it ensured their

correct circulation, avoiding frauds and manipulations

in the public offers. Today, the Act is still one of the

most important measures for the US securities market

regulation.

The Securities Exchange Act of 1934 created the

Securities and Exchange Commission that is still the

Authority which has to supervise the correct

circulation of securities and to safeguard investors‘

interests.

In Europe, the first authority in charge of

regulating and supervising the securities markets was

the Commission des Opérations de Bourse,

established in France in 1967, with the aim of

protecting investors. The New York stock market

crash of 1929 caused an exceptional crisis that had




433

repercussions in all the European and Asian

continents in a very short time. This disastrous event

drew the national governments attention on the need

of re-thinking their structure on the regulation and

supervision of financial markets: during the period

following the second world war many States tried to

remodel their national systems to avert their financial

instability.

Afterward, in 1974, Italy set up the Commissione

Nazionale per le Società e la Borsa to regulate

securities markets, protect investors and ensure

efficiency and transparency. The Italian financial

market has always been strongly oriented towards

bank brokers: until the 1893 there wasn‘t a specific

discipline for the securities market; its regulations is

completely new and it dates back to 1974. At the

beginning of twentieth century the Italian Stock

Exhange was characterized by a full and

indiscriminate growth: the crisis of 1907 stressed the

importance of remodelling the Stock organization.

The first and most important change was introduced

with the law 7 june 1974 n.216 that instituted the

CONSOB (Commissione Nazionale per le Società e la

Borsa) and it created a specific discipline for listed

companies.

Nowadays, one of the main open questions is

about the appropriate model for financial supervision:

a problem for which economic theory does not have a

unique solution to put forward.18

In fact, it is possible to identify, at least, three

fundamental models that are currently in force in EU

member States:19

vertical model (or institutional

supervision): follows the traditional

segmentation of the financial system in three

main sectors (banking, securities and insurance)

and is based on a strict division of competences,

i.e. the institutions in one segment are supervised

separately from the ones in different sectors

irrespectively of the matter under control;

horizontal model (or supervision by

objectives): in this approach each supervisory

function (microeconomic and macroeconomic

stability, disclosure, competition) is under the

jurisdiction of a given authority, independently

of the supervised subject; therefore there is no

strict separation between sectors, instead each

authority has cross-sector regulatory and

supervisory powers in pursuing is function;

18 See Goodhart (2000, 1998). 19 Di Giorgio and Di Noia (2005, 2001) argue that there is a

fourth model, called ―Functional Supervision‖, in which

there is a supervisor for each function performed by

financial intermediaries, irrespectively of the legal form ot

the intermediary itself or of the objective of supervision to

be achieved. This model is based on the definition of six

basic functions in which it is possible to divide the financial

system. This model, however, is not well suited in practice,

since it does not focus on real institutions but on abstract

activities, furthermore, it does not consider the objective of

regulation.

centralised model (or single

supervisor): this model provides only one

supervisory authority which responsibilities over

all financial markets and sectors.

However, it should be highlighted that in the

centralised model, the supervision can be approached

with focus on institutions, or to the objectives of

regulation.20

The financial supervisory systems of the single

member States in Europe are still heterogeneous,

reflecting the variety of domestic financial markets

and different legislations. An important role in the

construction of the European system of financial

regulation can be attributed to the Directives.

European legislation on financial markets is based on

the concept of ―competition among rules‖, i.e. on the

idea that given the existing differences among EU

countries, each member should recognise the validity

of laws, regulation and standards of the other ones. In

this respect, the principle of mutual recognition was

included in the Second Banking Coordination

Directive of 1989 providing a list of activities that

were included in the ―Single Passport‖, i.e. that could

be performed in every member State by a credit

institution that is allowed to perform such activities in

its country of origin. The principle of mutual

recognition is based on two important concepts:

―home country control‖ and ―harmonisation of

minimum standards‖. Equivalent rules for investment

firms were introduced in 1993 by the Investment

Services Directive that extended the home country

control principle to investment firms and provides

them with the European passport.

The objective of the paper is to compare the

different institutional settings in EU member States,

highlighting the differences in the supervisory

architectures.

In the following paragraphs we present,

respectively, the centralised, vertical and horizontal

models, while in the last one we present our

conclusive remarks.

The Centralised Model

During last years, the great changes that have

characterized financial systems, like the fast growth of

conglomerates, have pushed several national

governments to review the architecture of financial

sector supervision. Currently, many EU States

(Scandinavian countries, United Kingdom, Germany,

Austria, Ireland, Belgium) have adopted the

centralised model. This single supervisor model

dominated the early stage of financial systems when

the central bank was, in several countries, the only

supervisory institution, given the importance of banks

in developed countries. Nowadays, the single

supervisor usually differs from the central bank, and

is responsible for supervising and regulating all the

segments of the financial sector (banking, securities

20 See, on this point, Masciandaro (2005).


434

markets, insurance) having regard to all the regulatory

objectives: micro and macro stability, transparency

and competition. In Europe, the model of the

integrated supervisor model was first developed in

Scandinavian countries (Norway, Denmark and

Sweden) in the mid-1980s.

On 1 January 1988, Denmark established its

single supervisor, the Finanstilsynet (Danish

Financial Supervisory Authority), as part of the

reorganization of the Ministry of the Industry. The

authority resulted from the integration between the

banking and insurance regulatory authorities.

Currently, the Danish FSA has tasks and

responsibilities about the supervision of financial

undertakings and of the securities market, the draft of

financial laws, the issue of executive orders and the

circulation of information.

As a consequence of the banking crisis of early

1990s, instead, Sweden set up its Integrated

Supervisory Authority, the Finansinspektionen, in

1991. The Authority is now responsible for

supervising activities in the securities market, as well

as in the credit and insurance sectors; it promotes the

stability and the efficiency of the financial system and

ensures the protection of consumers. Apart from

supervisory functions, the Swedish FSA performs also

a regulatory activity, by issuing norms that market

participants have to respect.

The integration of financial markets, the fast

growth of financial conglomerates and the scandal of

Barings Bank, have led the United Kingdom to

choose the single-regulator model to rationalise its

supervisory architecture and improve efficiency and

efficacy.21

In October 1997, the former Securities and

Investment Board (SIB) changed its name in the

Financial Services Authority (FSA). With the Bank of

England Act of 1998, all the regulatory powers on

prudential supervision, that were previously attributed

to the Bank of England, were transferred to the FSA;

while the Bank retained its responsibility for systemic

stability. Then, the Financial Services and Markets

Act (FSMA) of 2000, transformed the FSA in the

single regulator de jure when it came into force, the

1st December 2001. The FSA was invested with tasks

and responsibilities which formerly fell within the

brief of other organisations. The FMSA set standards

for banks, insurance and investment firms, giving to

the FSA rule-making, investigatory and enforcement

powers to pursue four fundamental statutory

objectives: to enhance investors‘ confidence, to

support public understanding of financial mechanisms

and products, to guarantee investors‘ protection and to

reduce crimes in the financial sector. The FSA is a

private company and can be considered as an

institution independent from the government, even

thought its board is appointed by the Treasury. It is

also an autonomous body since the greates part of its

budget comes from regulated entitities. The FSA is

subject to the so-called ―Principles of Good

21 See Hall (2001).

Regulation‖, highlighting the need to act in an

economic way and to minimize the negative effects of

regulatory measures on UK competitive system.

In recent years, Germany, Austria, Ireland and

Belgium have established their supervisory

architecture on the single-regulator model.

Germany had not a uniform regulatory

framework until the passing of the Banking Act of

10th

July 1961. The failure of Bankhaus I.D. Herstatt

in 1974 required the amendment of the Banking Act

in 1976 to close the gaps in banking supervision. On

the 25th

January 2001, the finance minister announced

a radical reform of the financial supervisory system

and the 1st May 2002 the Federal Financial Services

Supervisory Authority (Bundesanstalt fữr

Finanzdienstleistungsaufsicht – BaFin) was

established as the single supervisor, while the Central

Bank (Bundesbank) conserved a significant role in

banking prudential supervision.

The ―Act Establishing the Federal Financial

Supervisory Authority‖ of 22th April 2002 is now the

basic legal source for the constitution of BaFin. Its

supervisory activity on financial markets is based on

three pillars of supervision which include tasks and

duties previously attributed to three separate

authorities: the BAKred, responsible for banking

supervision; the BAWe that regulated securities and

derivatives markets, and the BAV, which guaranteed

the vigilance on insurance companies. In addition,

there are three ―cross-sectoral units‖ to ensure

consumer protection, supervise money laundering and

pension product issues. The federal States, instead,

retain the supervision of the local exchanges. BaFin‘s

overall objective is to ensure the stability and the

integrity of the financial sector; to guarantee the

protection of consumers and investors‘ interests and

to safeguard the solvency of banks, financial services

institutions and insurance undertakings. BaFin is an

institution provided with a functional and

organizational autonomy, even if it is under a legal

and supervisory control of the Ministry of Finance.

Almost simultaneously to Germany, on 1st April

2002 was created the Austrian Financial Market

Authority (Finanzmarktaufsichtsbehorde) to supervise

banks, securities markets, insurers and pension funds.

The previous supervisory system was based on the

attribution of several powers to the Federal Minister

of Finance (Bundesministerium fur Finanzen) for the

supervision of banking and insurance sectors and to

the Federal Securities Authority (Bundes-

Wertpapieraufsicht) for securities markets. Then, the

tasks and the responsibilities of both authorities have

been transferred to the single supervisory authority,

according to the Financial Market Superivison Act.

The FMA‘s independence is guaranteed by

constitutional provision, but some powers remain to

the Minister of Finance.

Also in Ireland, about one year after Germany

and Austria, on the 1st May 2003, the responsibility

for financial supervision in Ireland was transferred to

the Irish Financial Services Regulatory Authority, an


435

autonomous body set up within the Central Bank and

Financial Services Authority of Ireland as the single

supervisor. It has responsibilities previously held by

the Central Bank and other supervisory institutions,

but also has a strong new role in consumer and

investors protection.

Belgium was the last EU member State to switch

to the centralised model. Since the 1st January 2004,

the Banking, Finance and Insurance Commission is

the only Belgian authority that supervise the financial

sector. Before the establishment of this authority, the

financial supervisory system was made up of two

authorities: the Commission Bancaire et Financière

(Banking and Finance Commission), created by Royal

Decree n. 185 of 9th

July 1935, was the regulator and

supervisor of the banking and securities sector; the

insurance sector was supervised by the Office de

Controle des Assurances (Insurance Control Office),

instituted by the Law of 9th

July 1975 and responsible

for the supervision of insurance companies, mortgage

companies, pension funds and insurance brokers.

Finland and Luxemburg also have a centralised

model of supervision, in which a single authority

supervise both the banking sector and the stock

exchanges, with the exception of the insurance sector

that has been left to a separate authority.

At the centre of Finnish supervisory system, in

fact, the Financial Supervision Authority promotes

financial stability and efficiency, but also the

confidence of market participants; it is responsible of

transparency and proper functioning of securities

markets. The Insurance Supervisory Authority is

instead responsible for supervising insurance

undertakings, protecting the interests of the insured,

promoting security and efficiency in the insurance

markets and strengthening confidence in the Finnish

insurance system.

All financial intermediaries and markets in

Luxembourg are under the supervision of the

Commission de Surveillance du Secteur Financier

(CSSF), that started its activities on 1st January 1999,

except for the insurance sector which is under the

jurisdiction of the Commissariat aux Assurances. The

CSSF took over the former stock exchange regulator

– the Commissariat aux Bourses - and the prudential

supervision tasks of the Banque Centrale du

Luxemboug and now is responsible for the

surveillance of credit institutions, financial firms and

stock exchanges.

The Vertical Model

The institutional supervision or vertical model,

developed as response to the great crises of 1930s,

follows the traditional segmentation of the financial

markets in three basic sectors: banking, insurance,

securities markets. As a whole, there are generally

three authorities, each of those exercises all

supervisory and regulatory powers in the area that is

under its jurisdiction.

This vertical approach facilitates the practical

implementation of supervisory powers, it avoids

useless duplications of controls and can reduce

regulatory costs; conversely, it is not able to ensure a

stabilizing system of controls in a context

characterized by a fast growth of financial

conglomerates, progressive integration of financial

markets, blurred borders of the financial sectors.

In Europe, Greece is the only example of pure

application of the vertical model, with three

authorities that have responsibilities over,

respectively, the banking sector, the securities market

and the insurance segment: the Central Bank, the

Hellenic Capital Market Commission and the

Directorate of Insurance Enterprises and Actuaries of

the Ministry of Development, General Secretariat of

Commerce.

The Supervision Division of the Bank of Greece

supervise credit institutions, verifying the conformity

with the rules of capital adequacy, liquidity, quality of

assets and provisions. The Hellenic Capital Market

Commission is a self-governing institution which acts

under the jurisdiction of the Ministry of National

Economy: it supports the stability of the capital

market, it safeguards investors‘ interests and it

enforces their confidence on a smooth functioning of

the market. The Directorate of Insurance Enterprises

and Actuaries has tasks and competences about the

regulation of the insurance sector, focusing its

attention on the solvency of the insurance companies.

Even if they present elements of supervision by

objectives, the supervisory architecture of Spain and

Portugal are based on the vertical model.

The Spanish supervisory system includes, as a

whole, four institutions: the Banco de España (Bank

of Spain), the Comision Nacional del Mercado de

Valores (National Securities Market Commission),

the Dirección General de Seguros y Fondos de

Pensiones (General Insurance and Pension Funds

Directorate) and the Dirección General del Tesoro

(Directorate General Treasury). While the Bank of

Spain supervises credit institutions; the Comision

Nacional del Mercado de Valores is the authority in

charge of the supervision of the capital markets and

ensures their stability and transparency as well as

investors‘ protection; whereas the Dirección General

de Seguros y Fondos de Pensiones (General Insurance

and Pension Funds Directorate) is a public institution

within the Ministry of Economy responsible for

supervising the insurance sector.

Currently, three authorities regulate also the

financial system in Portugal: the Banco de Portugal

(Central Bank of Portugal), the Comissao do Mercado

de Valores Mobiliarios (Securities Market

Commission) and the Instituto de Seguros de Portugal

(Portuguese Insurance Institute). The recent

establishment of the National Council of Financial

Supervisors on September 2000 is going, however, in

the direction of reacting to the development of the

financial system and the need of cooperation among

supervisory authorities.


436

The Functional Model

Italy is a peculiar case with regard to financial

supervisory architecture since it is based on the

institutional model, but mainly includes elements of

the supervision by objectives, as well as other

peculiarities. The vertical model at the basis of the

Italian system provides that the Banca d’Italia (Bank

of Italy) is responsible for the banking sector, Isvap

(Insurance Commission) for the insurance segment

and Consob (Securities Commission) for the

securities markets. In addition, there is indeed a fouth

authority, Covip (Pension Funds Commission) that

supervise pension funds, and the Autorità Garante

della Concorrenza e del Mercato (Antitrust

Authority), even thought the antitrust supervision of

credit institutions remains responsibility of the

Central Bank of Italy. The institutional model has

been implemented in the insurance and banking

sectors while the functional approach characterises the

supervision on securities markets (Consob ensures

transparency and correctness of behaviours, while the

Bank of Italy checks patrimonial stability and the

controls risk) and the regulation of the capital markets

(Consob provides for market transparency; the

Central Bank has responsibilities on market stability).

The Italian financial system is regulated by two basic

legal provisions: the Testo Unico Bancario (Banking

Law) and the Testo Unico delle disposizioni in

materia di intermediazione finanziaria (Securities

Law). There are two authorities that supervise and

regulate the Italian banking sector: The Credit

Committee and the Ministry of the Treasury. The first

one is an inter-ministerial committee, presided by the

Ministry of the Treasury, which enacts general and

political directives; the Minister of Treasury, instead,

issues ordinances.

The Bank includes a General assembly of

participants, a superior council, which has

administrative and advisory tasks and a Governor,

appointed for life, who represents the Bank and has

responsibilities for financial and credit supervision.

Independence and impartiality have always been

considered as the basic values of the Bank of Italy,

however recent scandals have mined the reputation of

the Governor in charge, as well as the image of the

Bank itself. In these days, furthermore, we assist at

open conflicts between the Italian government and the

Bank, raising old problems, not only about autonomy

and independence of the central bank, but also of its

accountability. This is also due to the fact that the

Bank of Italy, from a legal point of view, is a private

company which shareholders are the same banks that

the central bank has to supervise. In other words, the

supervisor is owned by the supervised banks. This

anomaly can cause conflicts of interests, worsening

the trade-off that sometimes can exist between the

objective of competition and the one of stability.

With regard to the supervision of securities

markets, it should be highlighted the

contemporaneous presence of multiple authorities in

charge of pursuing different objectives. The Consob

has not responsibilities about the access in the

securities market but it has an exclusive vigilance on

the investors‘ protection and on the transparency and

efficiency of the financial market, with particular

attention to the correctness of behaviour of market

participants and the spread of information. The

Commission is provided with partial financial

independence22

and functional autonomy. It performs

normative, supervisory and administrative functions:

issue regulations (about insider trading, controls on

investment firms and regulated markets); enacts

resolutions, communications and recommendations;

supervise the compliance of market participants with

laws and other legal acts in order to ensure an

adequate spread of information and the observance of

behaviour codes. Not only Italy, but also France is an

example of an hybrid supervisory system, in which

elements of the institutional and functional models

overlap.

The legislative framework on which the French

supervisory system is based is composed by few

fundamental acts: the Securities and Exchange

Ordinance of 1967, that established the Commission

des Opérations de Bourse (COB), the first Stock

Exchange Commission in Europe; the French

Banking Act 84-46 (―Act on the activity and

supervision of credit institutions‖) of 1984 and the

Statute of the Bank of France of 1993, as well as the

Insurance Code that regulates the activity of the

Commission De Controle des Assurances des

Mutuelles et des Institutions de Prevoyance

(Insurance Commission).

The Banking Act established three supervisors:

the Comité de la réglementation bancaire (Banking

Regulatory Committee); the Comité des

établissements de crédit (Credit Institutions

Committee); and the Commission bancaire (Banking

Commission). In 1996, however, the Financial

Activity Modernization Act 96-597, transposed the

European Investment Services Directive into the

French legislative system, amending the Banking Act.

The Modernization Act extended the jurisdiction of

the above-mentioned supervisory authorities and of

the Conseil National du Crédit (National Credit

Council) to cover all investment service providers, i.e.

not only credit institutions but also investment firms.

The names of the first two bodies were modified

accordingly to the new and broader range of activity

in: Comité de la réglementation bancaire et financière

- CRBF (Banking and Financial Regulatory

Committee) and Comité des établissements de crédit

et des entreprises d’investissement – CECEI (Credit

Institutions and Investment Firms Committee).

While the CRBF is the in charge of issuing the

general regulation regarding credit institutions and

investment firms with a wide variety of powers, the

22 The main financial sources for the activity of the

Authority are the State budget and the fees that market

participants pay out for the services offered.


437

CECEI has the responsibility for decisions such as

authorisations for new institutions or for major

changes in the conditions needed for the

authorisation. The Banking Commission, instead,

supervise investment firms and credit institutions,

checking for any violations of the basic regulations in

place.

In November 2003, there has been a structural

change in the French securities markets supervisory

system. Until that date, there were two securities

market regulators and supervisors: the Conseil des

Marchés Financiers (CMF) and the Commission des

Opérations de Bourse (COB). Now, in France, there

is a single authority supervising the securities

markets, the Autorité des Marches Financiers (AMF)

in which the previous two authorities have merged

together with the Conseil de Discipline de la Gestion

Financière. The reorganisation of the regulatory

authorities has taken place to make the French

supervisory system more efficient and transparent,

with the aims to safeguard investments in financial

instruments; to ensure information disclosure and

maintain the correct functioning of securities markets.

The AMF is organised as an independent public

authority with legal personality. It comprises two

separate bodies: a managing board and a sanctions

committee. In sum, while the insurance sector is

supervised following the vertical approach, different

authorities share the responsibility for the securities

and banking segments: prudential supervision is

assigned to the Banking Commission, the task of

licensing is given to the CECEI, while the Ministry of

Economy and the CRBF set general regulations and

the AMF supervise securities markets.

A more simple supervisory system is the one of

the Netherlands that is also an example of shift from

the institutional to the functional model of

supervision. Formerly, the supervision system on

insurance and banking sectors was industry based: the

Nederlandsche Bank mainly supervised credit

institutions while the Pensioen & Verzekeringskamer

(Insurance Supervisory Authority) supervised pension

funds and insurance companies. On 30th

October

2004, the Central Bank and the Pension and Insurance

Supervisory Authority of the Netherlands merged into

a single supervisory authority. The supervision on

securities market, instead, has been attributed to the

Netherlands Authority for the Financial Markets since

1 March 2002. Therefore, if in the past supervision

had been focused on different segments of the

financial sector, nowadays it is along functional lines:

the Central Bank and the Insurance Supervisory

Authority are responsible for ensuring prudential

supervision, while the Authority for Financial

Markets performs conduct of business supervision.

Conclusion

As we have shown, the EU member States have

chosen quite different models for supervising

their financial systems.23

In this paper, we have described the three

principal theoretical supervisory models

proposed in the literature: vertical, horizontal,

centralised. In practice, however, it is difficult to

find a pure application of these models, while the

actual supervisory systems are the result of the

different legal frameworks of the member States

and of the way in which their financial systems

developed. Moreover, although the Lamfalussy

Report can be considered an important step

towards a more integrated financial supervisory

system at the European level, the supervisory

arrangements are still very different among

member States. This work provides an analysis

of the different systems of financial supervision

in Europe: showing how the differences that still

exist among their systems make it more difficult

to achieve a real European integration in

financial supervision.

Our main result is that the supervisory systems

are still too different. Therefore, if one would think to

construct a supervisory framework at the EU level it

will be forced to cope with this fragmentation.

References 1. Cervellati, E.M. (2003) ―Financial Regulation and

Supervision in EU Countries‖, paper presented at

the 2003 EFMA Annual Meeting, Helsinky, 25-29

June 2003.

2. Di Giorgio, G. and Di Noia, C. (2005) ―Towards a

New Architecture for Financial Regulation and

Supervision in Europe‖, Journal of Financial

Trasformation, Vol. 14, pp. 145-156.

3. Di Giorgio, G. and Di Noia, C. (2001) ―Financial

Regulation and Supervision in the euro Area: A

Four-Peak Proposal‖, Financial Institutions

Center, The Wharton School.

4. Freshfields Bruckhaus Deringer (2005) How

Countries Supervise their Banks, Insurers and

Securities Markets, Central Banking Publications.

5. Goodhart C. A. E. (1988) ―The costs of

regulation‖, in Seldon A., Financial Regulation or

Over-Regulation, Institute of Economic Affairs,

London (1988).

6. Goodhart C. A. E. (2000) ―The Organisational

23 In every European State the adoption of a particular

model for the regulation and supervision of financial

markets has always been influenced by the evolution of the

national financial systems and also by the characteristics of

the legislative apparatus. While at national level, the States

have issued many measures to guarantee an appropriate

supervision on their financial markets, at community level

there isn‘t yet a unique law that defines the adoption of a

single supervision model. Consequently, the current

structure of the national control systems is strongly

heterogeneous, diversified and characterized by the

presence of different regulation models. In particular, it is

true in the field of financial supervision where every State

has an Authority for every surveillance line; on the contrary,

there is a good level of integration in the field of regulation,

thanks to the role that the European Directives have played.


438

Structure of Banking Supervision‖; paper

presented at the conference ―Financial

Supervision of Banks and Specialized Banks in

the EU‖, European University Institute, Florence.

7. Hall, M.J.B. (2001) ―The Evolution of Financial

Regulation and Supervision in the UK: Why We

Ended Up with the Financial Supervisory

Authority‖, Banca Impresa e Società, n. 3/2001.

8. Lannoo, K. (2000) ―Updating EU Securities

Market Regulation‖ presented at the conference

―Financial Supervision of Banks and Specialized

Banks in the EU‖ EUI, Florence.

9. Masciandaro, D. (2005) ―Reforming Financial

Supervision Institutions: An International

Comparison‖, Journal of Financial

Trasformation, Vol. 14, pp. 157-164.

Appendix

Table 1. Supervision in Banking, Securities and Insurance in the EU: the Authorities

COUNTRY BANKS SECURITIES INSURANCE

AUSTRIA FMA (Austrian Financial

Market Authority)

FMA (Austrian Financial

Market Authority)

FMA (Austrian Financial

Market Authority)

BELGIUM CBFA (Banking, Finance

and Insurance Commission)

CBFA (Banking, Finance


CBFA (Banking, Finance


DENMARK Finanstilsynet (Danish

Financial Supervisory Authority)

Finanstilsynet (Danish


Finanstilsynet (Danish


FINLAND Financial Supervision

Authority

Financial Supervision

Authority

Insurance Supervision

Authority

FRANCE CRBF Comité de la

réglementation bancaire et

financière.

CECEI Comité des

établissements de crédit et des

entreprises d’investissement

(Credit Institutions and Investment

firms Committee).

CB Commission Bancaire.

AMF Autorité des Marchés

Financiers (has substituted the

COB Commission des Opérations

de Bourse; the CMF Conseil des

Marchés Financiers, and the

CDGF Conseil de Discipline de la

Gestion Financière.

Commission de Contrôle des

Assurances. Ministère de

l’Economie (Insurance Regulation

Commission).

GERMANY Bundesanstalt für

Finanzdienstleistungsaufsicht or

BAFin (Federal Financial Services

Supervisory Authority)

Bundesanstalt für




Bundesanstalt für




GREECE Banking Supervision

Division - Bank of Greece

Hellenic Capital Market

Commission

Ministry of Development,

General Secretariat of Commerce

IRELAND IFSRA (Irish Financial

Services Regulatory Authority)

IFSRA (Irish Financial


IFSRA (Irish Financial


ITALY Banca d’Italia (Bank of

Italy)

Consob Commissione

Nazionale per le Società e la

Borsa

Isvap Istituto per la

Vigilanza sulle Assicurazioni

Private e di interesse collettivo

LUXEMBOU

RG

Commission de Surveillance

du Secteur Financier (CSSF)

Commission de Surveillance

du Secteur Financier (CSSF)

Commissariat aux

Assurances

NETHERLAN

DS

De Nederlandsche Bank NV Autoriteit Financiele

Markten

De Nederlandsche Bank NV

PORTUGAL Banco de Portugal CMVM Comissao do

Mercado de Valores Mobiliarios

(Securities Market Commission)

Instituto de Seguros de

Portugal (Portuguese Insurance

Institute)

SWEDEN Swedish Financial

Supervisory Authority

(Finansinspektionen)

Swedish Financial



Swedish Financial



SPAIN Banco de España CNMV Comisiòn Nacional

del Mercado de Valores

General Directorate of

Insurance and Pension Funds

UNITED

KINGDOM

FSA Financial Services

Authority


Authority


Authority

Source: our elaboration of information from documents and websites of various supervisors


439

Table 2. Supervision in Banking, Securities and Insurance in the EU: the Models

Country Banking Securities Insurance

Austria SS SS SS

Belgium SS SS SS

Denmark SS SS SS

Finland BS BS I

France B, CB S I

Germany SS SS SS

Greece CB S G

Ireland SS SS SS

Italy CB S I

Luxemburg BS BS I

Netherlands CB S CB

Portugal CB S I

Spain CB S I

Sweden SS SS SS

United

Kingdom SS SS SS

Legenda: CB: Central Bank; BS: banking and securities supervisor; B: banking supervisor; S: securities

supervisor; I: insurance supervisor; G: government department; SS: Single Supervisor.

Source: our elaboration of information from documents and websites of the main supervisory authorities.

See also Lannoo (2000) and Di Giorgio and Di Noia (2005).


440

LOW COST & LOW FARE : STRATEGY IN REVENUE MANAGEMENT FOR GOL AIR TRANSPORT S.A

Joshua Onome Imoniana*, Marly Cavalcanti**, Marcelo de Souza Bispo***

Abstract

The intention of this paper is to study the concept low cost, low fare as strategy in the market of Brazilian commercial air transport, taking as parameter the case study of Gol Air Transport S.A. For the achievement of the presented objectives the following questions are made: a) what it takes an airline company to take a strategy of low cost low fare? b) The option of low cost low fare, would have contributed to generate a new managerial model in the traditional forms of strategic management in the area of commercial air transport ? c) The constructed scenery tends to be lasting? Adopting the methodological approach of case study and analysis of events, a qualitative and quantitative research was fullfilled on the basis of the studies of Denzin & Lincoln. The results of the analyses indicate the deepening of the phenomenon of low cost & low fare that it is used in world-wide commercial aviation and makes to conclude the relevance and the potentiality of the concept low cost & low fare if it is extend to the tourist industry that suggests a new balance for the traditional companies in the strategic management. Keywords:Low cost, low fare, Gol Air Transport S.A, Commercial Aviation, Strategy. *Titular Professor at Universidade Metodista de São Paulo, Rua do Sacramento, 230, Rudge Ramos-São Bernardo do Campo Cep: 09641-000, Phone 55-11-3288-0497 Fax: 55-11-3284-3139 email: [email protected] **Titular Professor at Universidade Metodista de São Paulo, Av. Brigadeiro Luis Antônio, 1930 Ap.111 - 01318-002 – São Paulo –SP - Brazil Phone: 55-11-3288-0497 Fax: 55-11-3284-3139 e-mail: [email protected] ***Master of Science from Universidade Metodista de São Paulo, Rua do Sacramento, 230, Rudge Ramos-São Bernardo do Campo Cep: 09641-000, Phone 55-11-3288-0497 Fax: 55-11-3284-3139 email: [email protected]

1.Introduction

Brazilian commercial civil aviation comes passing

for a transformation in the last years, traditional

companies as the Transbrasil, the Vasp and Varig

does not operate more, Varig has many years passes

for a deep financial difficulty, now Gol Air Transport

S.A made the aquisition of Varig, and civil aviation

lives a crisis in airports. On the other hand, new

companies had appeared as the Ocean Air, Webjet,

the BRA and most exponential of the last years, the

Gol Air Transport S.A. The numbers of embarkments

and landings of passengers increase to each year,

however, the financial difficulty of the airlines in

Brazil seems not to have end. In this scene of great

competition and costs of operation raised in virtue of

aviation to have the dollar as official currency, high

tax burden and the demand of great infrastructure. In

this scenery, cost appears in Brazilian companies

with the concept low cost & low fare, or either, low

costs and low tariffs. The first Brazilian company

with this concept was the Gol Air Transport, followed

by the BRA and more recently for the Webjet novice.

When entering in the Brazilian market of commercial

civil aviation, the Gol had as main purpose, create a

new market, to reach people of average and low

income, that normally travelled by bus, so that these

people could make its trips using the air

transportation, offering lower prices that before have

no existence in the market until then. However, as to

practise accessible prices to mencioned social class,

with the costs so raised that Brazilian aviation could

do? It will be exactly possible that an airline could

compete with a company of road transport? How? All

these questions can be answered analyzing the

strategy adopted for these companies, mainly for the

Gol, the greater of them and with more significant

results. The concept low cost low fare, had its

beginning in the United States, where this practical is

very common in the present time, having as main

company the Southwest, that for signal, was the

inspired model of the Gol in Brazil. The bases of the

concept, are in the evaluation of the processes to

optimize them of the best possible form, using





441

strategies as to use the available airplanes the more

possible time flying, to simplify or not to use edge

service, to elaborate special maintenance programs so

that the motionless airplanes are the lesser possible

time, to create routes that make possible a high

occupation of seats (load factor). Consequently, the

cost of the passenger for flied kilometer is lesser of

that of the too much other companies, what it makes

possible to practise lower prices in the market.

2.Principal Questions

To understand the intentions of this research, the

following questions must be clarified: What it takes

the company of the commercial aviation to take a

strategy of low cost low fare? The option of low cost

low fare, would have contributed to generate a new to

look at the traditional forms of strategic management

in the area of commercial aviation? The constructed

scenery tends to be lasting? The objectives of the

inquiry: the study it has focus of independent analysis,

what it tends to identify the phenomena that lead to

the choice of the strategy by means of the following

objectives:

3. Generalities

To study the concept low cost, low fare as strategy in

the market of Brazilian commercial aviation, using

itself as case study the Gol Air transportation; To

analyze the concept of low cost, low tariffs while

enterprise strategy, presenting the potentialities and

possible weaknesses in the operation choice in this

way

a. Specific

To identify what consists the strategy of success of

the case Gol; To confirm if the strategies taken for the

Gol, they had stimulated forms of rethink a new

paradigm for Brazilian commercial aviation. to verefy

if the recent fall of the Boing of the Gol Air Transport

S.A in the Amazonian rain forest, affected the

businesses of the company?

b. Justification of the Considered Objectives

The survey of the aspects of the strategic

management, low cost and low fare is important not

only in terms of mapping of that it lacks to traditional

companies of the commercial area of Brazilian

aviation, as in terms of technology of management, in

comparison with its competitors, but also it is of great

value to confirm some cognitiv aspects, that the

philosophy and new managerial paradigms in the

area of aviation supported for companies as Gol

When approaching cited aspects above, the can be

reflected on the works of some authors: Davis &

Newstrom (1992, 2002), Bowditch & Anthony

(1999), Flamholtz (1979), amongst others. In

accordance with them the managerial control is seen

as the process to influence the behavior of the

members of the organization, being established a

series of projected mechanisms to increase the

probability of the people, in order to reach the

objectives of the organization (Flamholtz, 1979). This

author in the truth, emphasizes a control strategy that

is one of the important topics regarding the subject in

quarrel. The work, in the direction to supply to the

controlling of companies of the area of Brazilian

commercial aviation, a study with based reflection

that rethink paradigms of costs control, and of the

occured changes in management environment

recently, actualy, considered as surpassed for the

problems brought by the age of information, for

example: security of information, risks and

governance.

4. Methodology of Work

This research assumes neopositivist context, a

theoretical referencial to understand the phenomenon

of low cost & low fare, besides searching empirical

evidences that support the concept. The methodologic

approach also considered exploratory work, with

quantitative vision that helps to analyze the proposed

questions in analytical and qualitative form, that

makes possible to understand the aspects of events

you manage and are operational involved. A

qualitative approach proposal for Denzin & Lincoln

(1994) perfectly take care of the objectives of this

research (vide table 1), mainly, when strategical

vision based in resources is applied in 3 Phase (low

cost & low fare) and analyzes the involved events in

Phase 4, and in Phase 5 interpretations.

The research in question, has focus of case study

at the first moment and this guides for the necessary

deepening for the study. However, in the posterior

processes it is intended to extend for multi-cases

where the diagnosis of the phenomenon will make

possible for the companies of the Brazilian

commercial aviation in a more including form,

preventing precipitated prognostics of the strategical

information of each one of the companies of the

sector.

5.State of arts of the literature Generalizations about costs. During the decades of

1960 the 1980, the cost was subject of the financial

area that dominated the strategic scenery, entering

into an alliance the productivity necessities. This

subject, comes exactly with turbulent environment of

management of the businesses, even so not so intense

in the beginning of the age of information, in which it

speaks in such a way as corporate governance, risks

management and securty of systems of information.

These perspectives do not cause newness, therefore

cost is a basic element of organizacional management.


442

Table 1. The research process

Phase 1: The

investigator as

multicultural

subject

Phase 2: Theoretical

paradigms and the

perspectives

Phase 3: Strategies of

the research

Phase 4: Methods of

data collection and

analysis

Phase 5: Art of

interpretation and

representation

Histories and the

Tradition in the

Neopositivism

Research

Positivism

Neopositivism

Drawing of the Study

of the Case

Interviews .

Comment of events

.Criterion To judge

Consistencies

Self concept Construtivism Human view Data analysis Politics of Interpretation

Ethic and research

politic

Human beings Participant

Observation

Visual method

Interpretation

Ethnic models Human beings

resources

Method of Personal

Experience

Politics

Marxist models Theoretical Base Method of

Management of Data

Evaluation

Traditional Cultural

models

Cultural Models Historical Action

Method and Applied

Research Analysis

Computer Methods of

Applied Research

Applied Research

Clinic research Textual analysis

Fonte: Adaptaded de Denzin & Lincoln (1994, p. 12-14)

Therefore, Leone (2000) prefers to characterize

costs as activity that if is similar to a processing

center of information, that receives (or it gets) given,

accumulates them in organized form, analyzes them

and interprets them, producing information of costs

for the diverse management levels. Martins (2001)

preferred to appraise cost, as also an expense, that

only recognized as such, that is, as cost, at the

moment of the use of the production factors (goods

and services), for the manufacture of a product or

execution of a service. Examples: the raw material

was an expense in its acquisition, is of new an

investment, since he is activated until its sell. In

complement to this, Iudicibus (1998), in turn, it adds

that since that the scholars always find explanations

for its "cientific beliefs", that are exactly not

necessarily correct, we would have to clarify that the

original direction of the word cost, applied to the

accounting. Is mentioned, clearly the phase where the

production factors are removed from the supply chain

and placed in the productive process. It still affirms

with property, what it is basic, therefore has real

interest in evaluating globally the unitary cost of the

product (Iudicibus, 1998). The commented relevance

above, also receives support in Kaplan (1982), the

politics of price of the product is something most

important and difficult of decisions to be taken for the

controlling. The decision affects the scales of

operations, the mix of the products and in long range

period, the profitability.

6.Discussing the Concept Low Cost & Low Fare

The concept of airlines low cost, low fare appeared

after the deregulation of commercial aviation in

North America 1978, until then, practically all the

airlines in the world was kept for the governments of

the countries where they had headquarters, they were

flag countries. Such regulation provoked an

oligopoly, in which when the companies had its costs

raised for some reason, quickly this cost was repassed

for final consumer (FREIBERG; FREIBERG, 2000).

The end of the regulation of American commercial

aviation, initiated a process of competition between

companies of the segment, extending itself later for

the Europe and too much emmergent countries. In this

new scenery, many companies had broken, fusing had

happened and the dispute for passengers incited,

mainly, because at this moment, already existed a

dispute of prices between companies, this made

possible that in 1971 in the United States, a new

company with a new concept appeared, that had as

premise to vender the cheaper aerial tickets of the

market, called Southwest. It starts then, a new

moment in American commercial aviation. For Herb

Kelleher (FREIBERG; FREIBERG, 2000) one of the

idealizers of the Southwest, the main one for an

airline is to carry the passenger from a point A to a

point B, without perfume, this, ally to a standardized

fleet of aircraft, reduction of points of connection of

passengers, greater number of seats inside of the

airplanes. These actions make possible that the

company keeps its aircraft a longer time in air,

consequently increases the prescription and the profit

of the company. More recently, after the evolution of

the Internet, the companies of low cost, low tariff, had

made use of this new instrument as great chance of

business and also cost reduction, for emission and

sales of tickets, the new technologies are basic allied

for these companies who see in these instruments

significant possibilities of increase of reach of the

business and significant reduction of the cost. In

Brazil this possibility of price war was initiated in the

decade of 90, in the Collor government, also by

means of the deregulation of the commercial aviation

that, as well as in other places of the world, provoked


443

enormous crisis in the sector, a time that, the

companies were not prepared to face the new context.

A new reality took account of the Brazilian market of

commercial aviation. Thus in 2001, the Brazilian

Gol Air Transport S.A implements of the concept low

cost, low fare in Brazil.

Based in a business-oriented model of low cost,

Gol Air Transport S.A closed 2005 boarding 13

million people, for 10% of them, was its first trip, in

this year invoiced USS 1.1 billion, 27% more than

2004, when it reached profit of USS 167 million.

Each airplane of the Gol Air Transport S.A is seen as

business unit cell, the fleet is composed for boings

737-700 and 737-800 of last generation, that

consume 12% less of fuel. Its 320 commanders are

trained as controllers of cells, each one carrying

laptops with flight routes, photos of satellite and

manuals. The passenger of the Gol Air Transport S.A

purchase in the Internet or travel agency, the company

does not emit tickets, only ship's receipt in the day of

the trip, the annual economy in the meals is of USS 1

million for airplane, the company not have any store,

and the cleanness of its devices is made by only two

employees.

7.The sustentability of the economy of the Concept Low Cost, Low Fare

The concept low cost, low fare have as a basic

premise, the otimization of material and human

resources for its consolidation. However, the control

of costs that is necessary for the efetivation of this

concept, is mixed to the economic stability of the

country in which the company is based, therefore

cambial, insum questions of oil (mainly combustible),

beyond taxes and control of the inflation, is basic for

the increment of the control of costs and strategic

planning of the companies low cost, low fare, after

all, as to compete with low costs in an inflated

economic scenery, or with crises in the fuel supply, or

still with tax of unstable exchange? Beyond these

points, a economy with solid bases also provides a

economic growth that also makes possible the

increase in the demand in some segments, also in

commercial aviation. The changes carried through in

the Brazilian economy in last the 11 years, since the

implantation of the Real Plan, had provided favorable

conditions of investment in the national market, in

this context in 2001 the Brazilian Gol Air Transport

S.A Gol can appear and to expand its businesses,

reaching in 2005 a significant place (DAC, 2005) in

the domestic market of passengers with

approximately 27% of market . Economic the crises

deriving from 11 of September of 2001, had caused

great global social and economic damages mainly, in

the United States the country that more suffered with

the terrorist attempted against them, since then,

innumerable companies between them American air

companies, had entered in deep financial crisis, also

companies with the concept of low cost, low fare as

Southwest and the Jet Blue. Turbulences as this, had

provoked in these companies a significant loss of

demand of passengers, an increase in the price of the

aviation gas and a depreciation of the American dollar

by means of the other currencies as the Euro ( market

community) and the Yen (Japanese). Example as this,

mainly shows to the sensitivity of the market of

commercial aviation and companies of this segment

who adopt the concept of low cost, low fare as

strategy.

Table 2. Comparison between commercial air companies

Characteristics Traditional companies Companies low cost, low fare

Aircraft varied Models of aircraft Only one model of aircraft

Edge Service Elaborated with options Without service or extremely simple

Salling of Fare

Through great number of

store, agents of trips and use of

GDS Store in the airports,

Agents of trips and InterNet

Time of daily use of the aircraft Average of 8 hours Average of 10 the 12 hours

Seats Good space between armchairs Maximum Number of armchairs allowed for the

manufacturer

Routes and lines Operation in main airports and

with flights right-handers

Operation in secondary airports, few connections

and flights with scale

Font: Elaborate by the authors


444

Gol Intelligent Airlines ADR Stock Report ( GOL)

Daily Price

History

2003 2004 2005 2006 2007

Dividend History 12-02 12-03 12-04 12-05 12-06

Dividend $ 0.00 0.00 0.00 0.12 0.67

Year-end Yield % 0.00 0.00 0.00 0.42 2.34

S&P 500 Yield % 1.58 1.93 1.44 1.50 1.64


5 Year History Splits and Dividends Amount Per Share

12-20-06 Cash Dividend 0.0640









Total Returns % 2002 2003 2004 2005 2006 YTD

Stock --- --- - -- 78.5 3.9 2.6

+/- Industry --- --- --- 66.0 -30.0 -1.0

+/- S&P 500 --- --- --- 75.5 -9.7 2.2


Revenue Management

Revenue Management is the term used to manage the

quality of the produced prescription. This means that

through a composition of load factor and average cost

for seat, can be applied different tariffs for one same

flight, so that this has the biggest possible yield.

A company does not advance if practise

excessive prices for an aerial ticket, therefore the risk

of selling below of the waited becomes inevitable, a

time where the market that determines the price, in

on the other hand, a tariff extremely reduced with a

crowded airplane, also is not guarantee of income-

producing flight, the prescription of the flight can be

inferior to the cost of the operation. Therefore, the

Revenue Management, searchs a balance between

practised tariff and busy seats, thus a flight can take

off inside with the biggest possible yield of that the

demand of the market provides. For better agreement

of the concept of Revenue Management, let us see the

examples below: Data: Stretch: São Paulo/Salvador

Capacity of the aircraft: 120 seats Operational cost

hour/flight: USS 5,000 dollars Block time São

Paulo/Salvador: 2 hours Cost of the seat (unit): USS

83,33 dollars

Example 1: Tariff 120 seats for: USS 120,00

dollars the Load unit factor: 90% (108 seats)

Example 2: Tariff 120 seats for: USS 200,00

dollars the Load unit factor: 55% (66 seats)

Example 3 Tariffs: - 10 seats for 100,00 dollars -

15 seats for 120,00 dollars - 30 seats for 150,00

dollars - 50 seats for 200,00 dollars - 15 seats for

250,00 Load dollars factor: 75% (90 seats)

Obs: For the composition of the 90 seats

(example 3) the seats of the lesser tariffs until the

biggest available tariffs had been used. With the

examples above, if it can perceive that load factor is

not the best pointer of yield of a flight, therefore the

first example in which the exploitation of seats it was

most good with 90% of occupation, was also, the

flight with lesser prescription, a time that the tariff

practised for all the seats was very low. In the

example number 2, the flight with only one tariff is

superior better than the first example, however, this

whas made with the exploitation of the flight more

lower still yes the prescription was superior to the

first example. Finally in the third example, in which a

composition of tariffs was practised and the concept

of Revenue Management, it is noticed that the

occupation of the flight was superior to the example

and the prescription better that the first one and

according to example, exactly having been some


445

seats with lesser prices of that the first example and

other greaters that in as in the example. Therefore, it

is in the work of this composition of tariffs and

occupation of seats, that the Revenue Management,

searchs a balance so that it is possible to reach the

biggest yield in a flight. In the case of the companies

low cost, low fare, this work of Revenue, is made

with much criterion so that seats with compatible

prices with the demand are offered, however inferior

to the practised ones for the competition. The tariffs

lowest are offered by the InterNet and for people who

buy with antecedence, in case that contrary, tickets

bought in the airport in the day of the embarkment,

are so expensive how much of the other companies

that they do not use the concept of low cost, decreases

tariffs.

The company is part of the Golden group, that is

one of the biggest groups of road transport of

passengers of Brazil and has in its owner Mr.

Constantino de Oliveira, its icon. Gol arrived at the

market with a proposal to provide to accessible aerial

tickets the favored the public who until then used the

road transport for its trips, as the American Company

Southwest, brought for Brazil the concept cost, low

fare. In the beginning of its operations, the Gol

counted on 7 aircraft, currently the fleet of the

company possesss approximately 40 airplanes all of

the model Boeing 737-700/800, the number of

employees is around 3.500 and carries monthly about

900 a thousand passengers. The strategy of the Gol, is

mounted in that Porter (1992) flame of strategy based

on costs, or either, the efficient process in the

management of the costs, mainly in the sector of

operations of the company, makes with that the Gol

obtains to practise inferior prices the competing

companies. In the process of entrance in the market,

the company invested strong in its plan of marketing,

having as message that the Gol was arriving to

democratize the trips of airplane in Brazil, with a new

concept, obtained to establish the idea of that the

cheaper aerial company of Brazil and with most good

and the new fleet of airplanes was. With this strategy,

the company comes consideravelmente growing in

size, participation of market and number of carried

passengers.

Despite the quarrels on the part of authors as

Pankaj (2000); Mintzberg; Ahlstrand; Lampel (2000)

on the theory of Porter (1992), questioning the based

competitive advantages in three described generic

strategies in leaderships in costs, differentiation of the

product or service, for believing that companies exist

want to conciliate competitive advantages in costs as

much in differentiation, as for example the

McDonald's in its prosperous period of years 80, the

case of the Gol, exactly not acting in a market that can

be considered commoditie, when Pankaj (2000) says

to be one of the few cases where the differentiation

must be in costs for being to deal with similar

products, the Brazilian market that consumes the air

transportation seems to be sufficiently sensible the

question price, exactly in the case of the executive

travellers. As cited previously, the macroeconomic

conditions of Brazil, allied to the growth of the

market of commercial aviation that according to

Infraero grew around 17% of January the October of

2005 in comparison to the same period of 2004, are

79,3 million passengers carried in 2005 against 67,7

million in 2004, this exactly represents 1,52 million of

landings and takes-off in this period of January the

October of 2005. It adds these numbers, the

difficulties of competitors as the Vasp and Transbrasil

who had left to operate, the Varig that passes for

strong financial crisis, a possibility so that the Gol

could quickly increase its participation in the market

as seen in the previous table and to consolidate until

the present moment the success of the business based

on the concept low cost low fare.

Profitability more 12-31-05

Stock Industry S&P 500

ROA % 19.0 5.0 8.0

ROE % 49.7 16.4 20.1

Net Margin % 19.2 7.5 14.2

Asset Turnover 1.0 0.8 0.8

Fin Leverage 2.6 4.7 5.0

Sales/Employee

$Thousands 422.1 --- ---



446

2003 2004 2005 2005 2005 2006

(in thousands)

EBITDA Reconciliation:

Net income (loss) R$175,459 R$384,710 R$513,230 US$219,263 R$131,084 R$179,790

Plus (minus)

Net interest and financial expense 77,591 (10,979) (96,171) (41,086) (23,515) (24,795)

Income taxes 88,676 202,570 204,292 87,278 69,677 68,840

Depreciation 13,844 21,242 35,014 14,959 6,803 12,529

EBITDA R$355,570 R$597,543 R$656,365 US$280,414 R$184,049 R$236,364


Thus, the Gol possesss as main competitive

advantages - Maintenance of low operational costs:

efficient use of the fleet with a average of 13, 9 hours

per day, making possible the distribution of fixed

costs. - Operation of homogeneous fleet: use of only

one model of aircraft Boeing 737-700/800 with only

one classroom (economic). - competitive

Terceirização: for control of costs and for believing

that services support ground to the passengers,

manuscript of luggage and call to center are carried

through of more efficient form for the rendering of

services, all they are - High ratio of selling in the

InterNet: 81,3% of tickets are for the Gol, exactly

when carried through for agents of trips they are made

by the site in the InterNet, others 12% of selling are

made by call center. - Better practicies of air

company of low cost: use of simplified services, not

having rooms vips, program of miles, edge service

with light snacks and drinks, not the physical ticket

use (they are all electronic), thus obtaining one better

control of costs. In this way the strategy of leadership

in costs of the Gol is the continuing offering a quality

service, however simplified. With the necessity of

scenery prospection for better composition of the

strategy (MARCIAL;GRUMBACH, 2005) the Gol

has as basic elements.

2005 2006

(In thousands)

Net operating revenues:

Passenger R$565,181 R$829,858

Cargo and other 23,978 33,158

Total net operating revenues 589,159 863,016

Operating expenses:

Salaries, wages and benefits 54,647 81,484

Aircraft fuel 146,170 254,306

Aircraft rent 51,869 66,487

Sales and marketing 72,081 99,330

Landing fees 19,046 30,34 1

Aircraft and traffic servicing 17,766 31,621

Maintenance, materials and repairs 13,848 26,115

Depreciation 6,803 12,529

Other operating expenses 29,683 36,968

Total operating expenses 411,913 639,181

Operating income 177,246 223,835

Other expenses:

Interest expense (5,161) (3,263)

Financial income (expense), net 28,676 28,058

Income before income taxes 200,761 248,630

Income taxes (69,677) (68,840)

Net income 131,084 179,790

Earnings per share, basic R$0.70 R$0.92

Earnings per share, diluted R$0.70 R$0.92

Earnings per ADS, basic R$0.70 R$0.92

Earnings (loss) per ADS, diluted R$0.70 R$0.92

Dividends per ADS - R$0.19

Dividends per ADS, diluted - R$0.19


To expand the base of customers by means of

offers of services in routes with high demand and

routes little taken care of, to continue reducing

operational costs, to keep offers of simplified and

convenient services the customer, to stimulate the

demand offering low tariffs and flexibility in the

payment. Another interesting point to be cited in the

composition of the strategy of the Gol is the adoption


447

on the part of the company of a management model

prioritizing the corporative governança, that

Rodrigues (2004) points as a trend in the management

of the corporations, a time that the governança

concept results in valuation of the companies, in

consequence of adjusted strategical conceptions and

implementations and viable projects of magnifying

and implantation of new enterprises. Based in

transparency, equity, rendering of accounts and ethics,

the corporate governance makes of the process more

efficient and increases the credibility of the company

by means of stakeholders and stokeholders, currently,

the Gol Air Transport S.A also became a company of

opened capital with options negotiated in the stock

markets of São Paulo (Governance type 2) and in

New Iorque, ADRs.

8.Final Remarks

To the end of this work, was possible to understand

the concept better cost, low fare that it is used in

world-wide commercial aviation and that recently

arrived at Brazil through the development of the Gol

Air Transport S.A. The presented case, shows a good

strategy until the present moment, after all, the Gol in

only 4 years of operation had a significant growth in

Brazilian commercial aviation, notices that the use of

high technology, makes possible a great increment on

the control of costs, the sufficiently reduced, adding

value to business. However, it is important to stand

out the marketing moment where the Gol entered in

the market, in which two airlines Vasp and

Transbrasil had stopped to operate. The Varig, with

its financial crisis, reduced its size consequently and

the participation of market. Beyond the favorable

questions in relation the competition, a significant

growth of the demand for air transportation and the

Brazilian tourist sector in general, had contributed for

the significant growth of the Gol in the market. Thus,

it is given credit in this way that is necessary to

evaluate the real potentiality of the concept cost low

fare of the Gol, when will have an adverse situation of

market, in a scene of economic crisis and retraction of

market, therefore, understands that it will be more

difficult to control costs in commercial aviation with

competitive tariffs, therefore is exactly in the control

of costs, that the main differential of the business

inhabits, exactly acting with small edges of profit, a

time that is in the scope that if it processes the profit

of companies that they use cost softly as strategy. In

searched literature, the application of the concept did

not meet low cost, low fare in other segments of

market. However, making a parallel, as diversification

business-oriented, can be cited the companies

assembly plants of vehicles as an example, when in its

portifolio they present popular automobiles, which

has its cost of reduced manufacture and therefore, is

possible to sell them with accessible price in

comparison to other models. Also in hotels exists a

case that approaches to the presented one in

commercial aviation, hotels of the Accor company, in

its called enterprises Formula 1, which the business

are based exactly on offering to the guest a simple

room, however with quality, what it reduces the costs

and it makes possible the practical one of daily a very

lesser one in comparison to other hotels, in this

business, the Accor mark is quality assurance for to

be traditional and one of the greaters companies of

tourism of the world. Thus customers sensible to

price, can take up quarters in a hotel of quality with

accessible price. Finally, despite these based cases in

low competitive cost as distinguishing, that it is a

strategy with high degree of risk, in a time that is very

sensible the economic crisis, without counting that in

the present time all the companies have in costs one

of its main focus, the competitors can reach similar

levels to the management of costs and could incite

the market dispute and not having another competitive

differential, the business could suffer significant

instability, until making the business impracticable.

Actualy BRA-Tranportes Aéreos or Brazil Aerial is a

Brazilian airline, that operated only freighted flights

initially (Charter), for international destinations or

inside of the country and from 2005 it started its

operations as regular company, inside of the concept

of low cost, low fare (low cost, low tariffs). Currently

it flies for more than 30 destinations, with composed

fleet of spurts 737 Boeing and Boeing 767 and threat

the Strategical development of Gol. An investment in

the ADSs or Gol Intelligent Airline Inc. preferred

shares involves a high degree of risk. Annual Report

on Form 20-F for the year ended December 31, 2005,

describes the risks with respect to the company, the

airline industry and operating environment,

particularly Brazil.We should carefully consider these

risks and the ones set forth below before making

investment decision. The business, financial

condition and results of operations could be materially

and adversely affected by any of these risks. The

trading price of the ADSs could decline due to any of

these risks or other factors, and provoke lose all or

part of investment. These risks are those that we

currently believe may materially affect us.The relative

volatility and illiquidity of the Brazilian securities

markets may substantially limit the ability to sell the

preferred shares underlying the ADSs at the price and

time desired. Investing in securities that trade in

emerging markets, such as Brazil, often involves

greater risk than investing in securities of issuers in

the United States, and such investments are generally

considered to be more speculative in nature. The

Brazilian securities market is substantially smaller,

less liquid, more concentrated and can be more

volatile than major securities markets in the United

States. The ten largest companies in terms of market

capitalization represented approximately 52% of the

aggregate market capitalization of the BOVESPA as

of December 31, 2005. The top ten stocks in terms of

trading volume accounted for approximately 53%,

45% and 51% of all shares traded on the BOVESPA

in 2003, 2004 and 2005, respectively. Holders of the

ADSs and Gol Intelligent Airline Inc. preferred


448

shares may not receive any dividends. According to

our by-laws, we must generally pay our shareholders

at least 25% of our annual net income as dividends, as

determined and adjusted under Brazilian GAAP. This

adjusted income may be capitalized, used to absorb

losses or otherwise appropriated as allowed under the

Brazilian corporation law and may not be available to

be paid as dividends. Gol may not pay dividends to

shareholders in any particular fiscal year if the board

of directors determines that such distributions would

be inadvisable in view of our financial condition.

If surrender ADSs and withdraw preferred

shares the risk of losing the ability to remit foreign

currency abroad and certain Brazilian tax advantages.

As an ADS holder, you the benefit from the electronic

certificate of foreign capital registration obtained by

the custodian for preferred shares underlying the

ADSs in Brazil, which permits the custodian to

convert dividends and other distributions with respect

to the preferred shares into non-Brazilian currency

and remit the proceeds abroad. If surrender your

ADSs and withdraw preferred shares, this will be

entitled to continue to rely on the custodian‘s

electronic certificate of foreign capital registration for

only five business days from the date of withdrawal.

Thereafter, upon the disposition of or distributions

relating to the preferred shares, they will not be able

to remit abroad non-Brazilian currency unless obtain

your electronic certificate of foreign capital

registration or qualify under Brazilian foreign

investment regulations that entitle some foreign

investors to buy and sell shares on Brazilian stock

exchanges without obtaining separate electronic

certificates of foreign capital registration. If do not

qualify under the foreign investment regulations will

generally be subject to less favorable tax treatment of

dividends and distributions on, and the proceeds from

any sale of preferred shares. The depositary‘s

electronic certificate of foreign capital registration

may also be adversely affected by future legislative

changes and competition.

9. References

1. Davis K., & Newstrom J. human Comportamento in

the work: A Psychological boarding in Rensis Likert.

São Paulo: Pioneer 2002

2. ______. the Primer on Organizational Behavior, São

Paulo: Pioneer 1992

3. Bowditch, James L., Anthony F. Buono. Elements of

organizacional behavior. São Paulo: Pioneer, 1999.

4. Flamholtz, And G. ' Behavioral Aspects of

Accounting/Control Systems ', in Kerr, S. (ed.)

Organizational Behavior, p.289-316, Columbus, 1979.

5. Freiberg, Kevin; Freiberg, Jackie. NUTS!:As creative

solutions of the Southwest Airlines for the personal

success and in the businesses. Translation: Maria of

Lourdes Giannini. São Paulo: Manole, 2000

6. Iudicibus, Sergio of. Managemental Accounting. 6ª

Ed. São Paulo: Atlases, 1998. Kaplan, Robert S.

Advanced Management Accounting: Management

Accounting, New Jersey: Prentice-hall, 1982.

7. Leone, George S. Guerra. COSTS: Planning,

Implantation and Control. São Paulo: Atlases, 2000.

8. Martial, Elaine C; Grumbach, Raúl J. S. prospectivos

Scenes: as to construct a better future. 3 ed. Rio De

Janeiro: FGV, 2005.

9. Martins, Eliseu, Accounting of Costs: It includes the

Activity Based Costing (ABC) 8ª Ed. São Paulo:

Atlases, 2001.

10. Mintzberg, H; Ahlstrand, B; Lampel, J. Safári de

Estratégia. Translation: Nivaldo Montingelli Jr Porto

Alegre: Bookman, 2000.

11. Pankaj, Ghemawat. The Strategy and the Scene of the

Businesses. Translation: Nivaldo Montingelli Jr Porto

Alegre: Bookman, 2000.

12. Porter, Michael And Competitive Vantagem: creating

and supporting a performance superior. 7 ed. Rio De

Janeiro: Campus, 1992.

13. Rodrigues, Jose Antonio; Mendes, Gilmar de Melo.

Corporative Governança: strategy for value

generation. Rio De Janeiro: Qualitymark, 2004.


449

EFFICIENCY OF SARBANES-OXLEY ACT: WILLINGNESS-TO-COMPLY AND AGENCY PROBLEMS

Michael Nwogugu*

Abstract Using the events that occurred in a series of corporate transactions in the US (Nwogugu (2004)), this article analyzes the efficiency of the Sarbanes-Oxley Act (“SOX”; 2002, USA) and introduces new quantitative models of Willingness-To-Comply which is a statistical measure of the employee/company’s propensity to comply with SOX and similar regulations. Keywords: Sarbanes Oxley Act; deterrence effect and fraud; Willingness-To-Comply, complexity; disclosure; due diligence. * Certified Public Accountant (Maryland, USA). Address: P. O. Box 170002, Brooklyn, NY 11217, USA. Phone/Fax: 1-718-638-6270; Emails: [email protected]. [email protected].

Introduction

See: Nwogugu (2003); Leung & Cooper (2003).

Encompass Services Corp. (―ESR‖) was formed in

2000 by the two-phase restructuring and merger of

Building One Services Corp. (―BOSS‖), and Group

Maintenance America (―GMAC‖) which was

announced on November 3, 1999 and approved by

shareholders of both companies on February 22, 2000.

ESR provided maintenance and electrical/mechanical

services and installation of building equipment at

various types of facilities in many industries and

residential buildings. ESR, formerly a Fortune–500

was subsequently de-listed from the New York Stock

Exchange and now trades on the NASDAQ Pink

sheets (‗ESVN‖). Shortly after the merger, a

confluence of events resulted in ESR‘s financial

distress. On October 18, 2002, some of ESR‘s

creditors proposed a restructuring and a pre-packed

bankruptcy filing, but there was no agreement among

the creditors and ESR. On or around November 19,

2002, ESR filed for Chapter Eleven bankruptcy

protection in the Federal Bankruptcy Court in Texas,

USA. While under bankruptcy protection, ESR‘s

25,000 employees in 200+ offices, provide

mechanical services, electrical services, cleaning

systems/services and network technologies to

commercial and residential buildings in the US.

As of September 2002, ESR had about $1.2

billion of indebtedness ($589 million Secured Credit

Facility; $339 million of unsecured bonds and note

obligations; $309 million of outstanding mandatorily

redeemable convertible preferred stock; and trade

obligations).

Sarbanes-Oxley Act and The Role of Internal Auditors In Technology Companies and In Banks

Its worth noting that in its present form, the Sarbanes-

Oxley Act (2002) (henceforth, ―SOX‖) would not

have prevented:

The internal control problems and string of

fraudulent conveyances at BOSS, and GMAC.

The internal control problems and fraud

implicit in the ESR transactions.

The inaction of banks – ie. inadequate due

diligence and improper monitoring of existing

loans;

Inaction of bond trustees. Sarbanes-Oxley

Act applies only to companies that meet the

definition of ‗issuer‘.

Inaction of external auditors – moral hazard.

See: Tackett (2004); Duke (2003); Greene &

Pierre-Marie (2005); Jahangar, Kamran & Henry

(2004); Ge & McVay (2004); James (2004); Leuz &

Verrechia (2000); McTamaney (august 2002);

Ribstein (2002); Rezaee & Jain (2004); Cunningham

(2003); Jain, Kim & Rezaee (March 2004); Klein

(2003); Romano (2004); Rosenthal , Gleason &

Madura (2005); Carney (Feb. 2005) Nielsen & Main

(Oct. 2004); Yakhou & Dorweiler (2005); Leung &

Cooper (2003); Brickey (2003); Leech (Nov. 2003);

Leech (April 2003); Braddock (2006); Perino

(October 2002); Moberly (2006); Baynes (2002);

Cherry (2004); Bainbridge & Johnson (2004); Gordon

(2002); Langevort (2004); Konstant (2004); Krawiec

(2003); Cunningham (2004); Darley (2005); Posner

(1996); Backer (2004); Linck et al (August 2005);

Murphy (2003); Kaplow (1995); Sutinen & Kuperan

(1999); Cullis & Lewis (1997); Cason &

Gangadharan (2006); Cullis & Lewis (1997); Alm,

Sanchez & De Juan (1995); Murphy (2003); Bose

(1995). Bose (1995); Stiglitz & Uy (1996); Stiglitz



450

(1994); Macey & O‘Hara (1999); Schmidt (2005); Liu

(2005).

The key aspects of Sarbanes-Oxley Act that

could have been applicable to BOSS, GMAC and

ESR are:

Section 302: Corporate Responsibility For

Financial Reports - requires certification of

information by company CEOs and CFOs. The

maximum penalties for willful and knowing

violations of this section are a fine of not more than

$500,000 and/or imprisonment of up to five years.

However, this isnt adequate incentive for CEOs and

CFOs to comply, where as in the ESR case,

substantial amounts of money and potentially

unlimited incentive compensation were at stake.

Empowerment of audit committees to engage

and approve the services provided by independent

auditors.

Auditor independence standards.

Section 404 – reports on internal controls.

Most of the internal control reports would have

missed financing-related problems. Senior

management of BOSS and GMAC, and Apollo were

intent on consummating the series of mergers, and

had a history of M&A transactions involving bankrupt

entities. Most internal control reports focus on

operational issues as opposed to loan covenants. Ge &

McVay (2004); Geiger (2002). Greene & Pierre-Mari

(2005).

Section 303: Improper Influence on Conduct

of Audits (by officers or directors of the company).

ESR, BOSS and GMAC‘s senior management clearly

had substantial influence on the conduct of audits of

BOSS and GMAC – which resulted in non-disclosure

of the bankruptcy/insolvency of BOSS and GMAC

for many years. Execution of both GMAC‘s and

BOSS‘s industry consolidation strategies depended on

good audit reports regardless of compliance with loan

covenants.

Section 204: Auditor Reports to Audit

Committees - the external auditor must report to the

audit committee all "critical accounting policies and

practices to be used all alternative treatments of

financial information within [GAAP] that have been

discussed with management ramifications of the use

of such alternative disclosures and treatments, and the

treatment preferred" by the firm. A close review of

BOSS‘s and GMAC‘s SEC filings will reveal that

their external auditors did not reveal obvious

problems related to their insolvencies. Doing so

would probably have cost the accounting firms

substantial business from the industry consolidation

transactions.

Section 305: Officer And Director Bars And

Penalties.

Section 401(a): Disclosures In Periodic

Reports; Disclosures Required. The periodic

disclosures made by BOSS, GMAC and ESR were

grossly insufficient.

Section 409: Real Time Disclosure - Issuers

must disclose information on material changes in the

financial condition or operations of the issuer on a

rapid and current basis. BOSS, ESR and GMAC

omitted required disclosures.

The Sarbanes-Oxley Act incorporates the

SEC Act of 1934 - a violation of Rules of the Public

Company Accounting Oversight Board is considered

as a violation of the '34 Act, and results in the same

penalties that may be imposed for violations of the

1934 Act.

Ineffectiveness Of SOX

See: Linciano (2003); Jain, Kim & Rezaee (March

2004); Cunningham (2003); Rezaee & Jain (2004);

Stiglitz & Uy (1996); Stiglitz (1994); Macey &

O‘Hara (1999); Schmidt (2005); Liu (2005). The

effectiveness of SOX should be measured in terms of:

Reduction of costs of compliance.

Companys‘ and employee Willingness-To-

Comply with SOX.

Maximization of deterrence-effect of

sanctions implicit in SOX.

Reduction of investigation and prosecution

costs.

Reduction/elimination of divergencies in

interpretation of information presented to

users of financial statements.

Hence, the methods used in Linciano (2003) to

evaluate the effectiveness and economics of a new

laws/regulations are inappropriate in this, and most

instances. Granted that one of the aims of SOX is to

reduce information assymetry, that is not the primary

objective of SOX. The wording and intent of SOX is

geared towards reducing fraud and illegal wealth

transfers, but without much consideration for

transaction costs inherent in implementation (as is

evidenced in current compliance costs).

Social, Economic and Psychological Issues That Affect Effectiveness

The possible reasons for the ineffectiveness of SOX

are explained as follows. Recine (2002); Gupta &

Leech (2005); Palter, Munck & Leverette (Jan./Feb.

2006); Fairfax (2002); Rouse, Weirich & Hambleton

(May/June 2005); Tackett, Wolf & Claypool (2006);

Linsley (2003); Ribstein (Oct. 2003); Ribstein (Sept.

2002); Kamar & Karaca-Mandic (2006).

Expectations for profits – which is the primary

motivation for fraud. SOX‘s wording and legislative

history and intent does not show any attempt to curtail

expectations of legal and illegal profits from

disclosure, fraud, manipulation or other misconduct –

SOX‘s focus is on obvious disclosure issues. See:

Blanton & Christie (2003); Adams (1997); Arlen

(1994); Arlen & Kraakman (1997); Cialdini &

Goldstein (2004); Croley (1998); Depoers (2000);

Ehrlich (1996); Engelen (2004). Mixter (2001) has


451

analyzed individual civil liability. Byam (1982) has

argued that corporate criminal liability is inefficient –

in a world with transaction costs, information

asymmetry and information costs, this contention is

reasonable. SOX focuses on placing liability on

corporate entities - although sections of SOX require

penalties for offending individuals (monetary fines

and jail sentences): a) the required standard of proof

for finding individual liability under SOX is high and

probably expensive to achieve, and such costs of

evidence and discovery discourages prosecution and

civil lawsuits, b) the percentage of possible

offenses/violations/non-compliances for which SOX

mandates individual liability is relatively small, c)

since SOX expressly incorporates SEC rules (1934

Act), courts are very likely to (formally or informally)

use the same sentencing guidelines for both 1934 Act

and SOX offenses, d)

Insufficient Statutory Definitions. Apparently,

given the ESR case, there should be more statutory

definitions of matters that should be put to a vote of

shareholders and those that should be decided by the

boards of directors, because shareholders would

probably have reacted much differently than decisions

made by BOSS‘s, GMAC‘s and ESR‘s boards of

directors.

SOX Does not Address Discovery Issues

Sufficiently. SOX does not address pre-litigation and

post-conviction discovery issues properly. Hughes

(1994). This results in high expected litigation costs

(discovery and evidence) which discourages

investigation and prosecution.

SOX Does Not Address Excessive Management

Discretion In Disclosure. The ESR transactions

shows that management typically has a lot of

discretion in highly leveraged transactions and

situations of financial distress, and that such

discretion can and is often abused. SOX does not

address this excessive discretion. SOX does not

distinguish between: a) regimes of company growth,

stabilization and decline, b) regimes of profitability,

financial distress, bankruptcy and post-bankruptcy

recovery, c) regimes of turbulence or relative calm in

financial markets (equity markets, etc.). In all these

regimes, the information disclosures mandated by

SOX have substantial information content that creates

un-necessary volatility. Dann (1993); Bergstrom,

Eisenberg & Sundgren (2001); Berkovitch & Khanna

(1991). The SEC has rejected several proposals to

exempt small companies from SOX compliance on

the basis of excessive compliance costs. costs.

The Substantial Information Content Of SOX

Requirements. Most of the disclosures and

certifications required by SOX carry valuable

information content. Jain & Rezaee (2004). Jain, Kim

& Rezaee (March 2004) have analyzed the effect of

SOX on stock markets. SOX requires disclosure of a

stream of information by the firm, almost

continuously and at various times during the year.

Furthermore, the disclosure required by SOX is now

more relevant to a company‘s suppliers and

customers, than previously required disclosures.

Hence, apart from its accounting impact, SOX has

substantial financial and information effects, and

effects on the company‘s supply chain. The net effect

is increased volatility of share prices, and more

information asymmetry among a larger group of

entities. SOX fails to distinguish between

compliance, corporate privacy and efficient

disclosure. Because of potentially substantial

information effects and the advent of the Internet

(which ensures rapid information diffusion), SOX

should have made some disclosures restricted from

public view, while being accessible only to regulators

– this will reduce adverse selection and moral hazard

inherent in the company‘s, auditor‘s choices of the

amount and quality of information to disclose.

Richardson & Welker (2001).

SOX Does Not State Minimum Standards For

Internal Audits. See: James (2003). While SOX states

internal control requirements, SOX does not state

minimum standards for the organization of internal

audits - in this instance, audit organization is just as

important as, and determines the quality of internal

audit reports.

SOX Does Not Address Major accounting Issues.

To the extent that SOX did not expressly or impliedly

resolve or even address existing major accounting

standards issues (intangibles, goodwill, employee

stock options, pensions accounting and leases),

disclosures made by SOX don‘t have a meaningful

effect in terms of reducing information asymmetry –

instead, additional disclosures simply magnify

information asymmetry problems.

SOX does not address the Role Of Bond Trustees

And US Securities And Exchange Commission’s

Approval Processes (although SOX expressly

incorporates SEC rules (The 1934 Act). The ESR

transactions involved the sale of publicly traded

bonds. In the case of publicly traded bonds, the role

of the bond trustee should be mandatorily expanded to

include periodic certifications that the issuer is

solvent, and such reports should be made mandatory

SEC filings. The second issue is whether bond

indentures should contain specific language about

bondholders‘ recourse if the issuer is deemed

insolvent – bank loans and private debt often contain

such terms and conditions. The inaction of the bond

trustee in the ESR case illustrates why the SEC should

improve their processes for pre-transaction and post

transaction due diligence in leveraged transactions.

The very essence of disclosure filings at the SEC is

the protection of holders of public securities. The

SEC has an implied duty to the holders of publicly

traded bonds to monitor filings for the types of

problems that arose in the BOSS, GMAC and ESR

filings. The Sarbanes-Oxley Act requires certification

by CEOs and CFO as to accuracy of financial

statements; but does not explicitly require tests for

solvency, or certification as to solvency, and does not

require solvency certification from external auditors,

internal auditors and lawyers. Defond & Jiambalvo


452

(1994). Geiger (2002); Hodder, Koonce & McAnally

(2001); Hope (2003); Langevoort (1997); Schmitz, et.

al. (1998); Abarbanell & Meyendorff (1997).

SOX does not address moral hazard,

information asymmetry, and adverse selection

inherent in relationships between banks/lenders and

corporate clients. Chen & Daley (1996). The ESR

case illustrates the importance and consequences of

transparency, disclosure and monitoring in these

relationships.

SOX Does Not Sufficiently Address The Role Of

The Audit Committee. SOX does not address the role

of the audit committee adequately in a manner that

compels pro-active over-sight and coordination. The

ESR transactions also indicates that the audit

committees of the boards of directors of banks must

be statutorily required to: a) Establish and ensure

conformance with standards for loan reviews and

monitoring of portfolio companies; b) Become very

familiar with risk management procedures as they

pertain to capital adequacy and default risk; c)

Establish and ensure conformance to standards and

procedures for dealing with non-performing loans; d)

Establish and regularly review standards for loan

originations and related-party transactions; e)

Establish and regularly review standards purchasing

of syndicated loans; f) Establish and regularly review

standards for compliance with regulations; g) Monitor

and assess activities and quality of external auditors.

In essence the audit committees now have a broader

implied mandate with respect to risk management,

risk reduction and compliance issues at banks. In

particular, the ESR transactions indicate that the audit

committees of the boards of directors of technology

companies must now be required to become more

involved in the activities of the internal audit team,

and must closely monitor the quality/performance of

external auditors and third-party consultants (that are

retained to assess intangible assets). The audit

committee‘s implied and actual mandate now includes

bringing critical issues before the full board of

directors, and constantly identifying issues,

legal/regulatory problems and potential liabilities that

may affect firm value. Given that many technology

companies have substantial intangible assets, the audit

committee must be statutorily required to develop

acceptable and defensible standards for accounting,

impairment of, and valuation of intangible assets.

The audit committee now has a justifiably broader

implied mandate with regard to the operations of

technology companies.

SOX does not address inherent conflict between

corporate strategy and corporate disclosure

requirements. In the ESR case (Nwogugu (2004)),

execution of BOSS‘s and GMAC‘s corporate strategy

was more important to them than compliance with

GAAP and SEC rules, and this choice eventually led

to the collapse/bankruptcy of ESR. In many

instances, there is often inherent conflict between

corporate strategy and corporate disclosure

requirements, primarily because: a) disclosure has

information effects that may complicate or deter

corporate strategy, b) disclosure requirements and

execution of corporate strategy can have

opposing/conflicting and simultaneous effects on

incentive compensation schemes. These issues are

not addressed by SOX. There should be specific and

express rules that mandate approval of corporate

strategy by the audit committee of the board of

directors, and certification by senior executives

without public disclosure (much like SOX requires

certification of financial statements.

SOX compliance and analysis has substantial

opportunity costs. The immediately obvious

opportunity costs of SOX include: a) additional

auditing costs, b) distraction of management and

employees that now have to spend more time on

compliance and controls matters. Braddock (2006:

194-196). The other opportunity cost attributable to

SOX compliance include: a) reduced capital

formation opportunities – companies that would have

otherwise become public, remain in the private

markets; b) reduced transparency – as more

companies remain in the private market, there less

overall transparency since less information is in the

public domain; c) increased volatility – due to more

market-changing information; d) increased transaction

costs which are distinct from compliance costs – with

SOX, the costs of executing corporate transactions.

SOX does not address group decision processes

at banks and at investment firms. These entities have

access to as much information, and sometimes have as

much influence on company management as law

firms and accounting firms, but are not subject to the

same expectations/standards/rules pertaining to due

diligence and disclosure.

SOX does not address moral hazard and adverse

selection in external auditors. There should have

been mechanisms/statutes that would have triggered

the removal of BOSS‘s and GMAC‘s external

auditors during their industry consolidation

acquisitions.

SOX complicates the Agency problems inherent

in hiring external auditors. SOX does not address,

and complicates the principal-agent problems inherent

in hiring external auditors. Under SOX, the external

auditor‘s role has become much more prominent, and

the external auditor‘s compensation has increased.

Under SOX, the external auditor‘s incentives to report

fraud to regulators are much lower, because: a) the

external auditor is likely to loose both SOX and

traditional audit work, if the relationship deteriorates

– loss of SOX engagements at one client is likely to

substantially affect the accounting firm‘s probability

of getting other audit or SOX engagements; b) SOX

has shifted more responsibility for accuracy of

disclosure to company management (via

certifications); c) SOX has broadened the potential

pool of claimants that can sue external auditors.

These principal-agent problems are compounded

by the fact that under SOX, external auditors

effectively serve as the agents of various parties – the


453

public, investors/shareholders, regulators and the

company‘s management. The external auditor‘s role

as an agent of shareholders directly conflicts with the

external auditor‘s duty to the public and to regulators.

With regard to external auditors, there are substantial

moral hazard problems and principal-agent problems

in implementation of SOX - accounting firms have an

inherent incentive to delay the reporting of negative

financial information about clients. Cialdini &

Goldstein (2004); Diamond (1980); King & Wallin

(1995); Lai-Yee & Leung (2005); Street & Gray

(2001); Lerner & Tetlock (1999); Verrecchia (2001).

These moral hazard problems can be solved or

reduced by statutory restrictions and guidelines which

are lacking in many national jurisdictions. SOX has

only worsened the moral hazard problems by

effectively granting more control over companys‘

internal controls to public accounting firms.

SOX’s requirement that CEOs and CFOs certify

financial statements increases principal-agent

problems and provides more incentives for fraud.

This requirement places undue psychological burdens

on executives who are already burdened with

management responsibilities, accountability to

shareholders, burden. The certification requirement

does not help in terms of apportioning liability (for

misconduct) among employees, because many of the

documents that require certification are large complex

documents, produced from many departments by

many people over time. These people may have

different departmental cultures, incentive/

compensation systems, performance measurement

systems, departmental internal controls and education.

Essentially holding one person criminally responsible

for internal controls of the firm is not reasonable,

logical or appropriate.

These points raise the issue of the role of internal

auditors in large multinational technology companies.

Most of the problems at BOSS and GMAC could

have been identified by effective internal audits

conducted by independent internal audit teams that

report only to the board of directors, coordinate with

external auditors and have proper incentive

compensation – that, the hiring criteria, performance

criteria and incentive compensation for internal audit

professionals are tied directly to the quality of

external audits, incidences of fraud, improvement in

operations, quality of recommendations, reduction of

business risk, and reduction/elimination of

existing/potential/contingent liabilities. The internal

audit function must now go beyond traditional

analysis of operations, marketing and finance

functions, and mandatorily include legal, regulatory,

political, labor and environmental analysis.

Similarly, at banks, the internal audit function

has become more relevant and has to be changed.

The hiring criteria, performance criteria and incentive

compensation for internal audit professionals should

be directly linked to abilities pertaining to the quality

of external audits, incidences of fraud, improvement

in operations, quality of recommendations, reduction

of business risk, and reduction/elimination of

existing/potential/contingent liabilities.

Compliance Costs

The costs of complying with SOX have been higher

than expected. See: Braddock (2006); Leech (Nov.

2003); Leung & Cooper (2003). Only public

companies with market capitalization of $75 million

or more are required to comply with the Sarbanes-

Oxley rules in 2005, but smaller companies must

comply by 2006. A 2005 study estimated that the

annual cost of SOX implementation at US companies

is about $1.4 trillion. The SOX burden is heavy for

small and medium sized companies. Some reports

have estimated that compliance with SOX in 2005

incured about $35 billion of additional costs for

American companies in 2005 — this about twenty

times more than the US SEC originally estimated.

Although Sarbanes-Oxley has introduced some

beneficial reforms, much of this good is outweighed

by the unexpected negative consequences of SOX‘s

Section 404, which regulates internal company

controls. According to a July 2004 report by

Financial Executives International (FEI), the total cost

of Section 404 compliance per company was

estimated at $3.14 million. Public companies expect

to spend an average of 25,667 internal hours and

5,037 external hours for compliance with Section 404.

Companies also expect to spend an additional

$1,037,100 on software and IT consulting.

Furthermore, with SOX, the external public auditing

firms that cause many of the corporate fraud scandals

(arising from inadequate disclosure) now have more

power than before, and effectively regulate the

information technology operations of publicly-traded

US companies. The crux of the problem is that under

SOX, while revenues of public accounting firms have

increased, their role as a balance against executive

malfeasance and corporate crime has not changed

substantially. This is directly attributable to the

drafting and specifications of SOX. SOX focuses on

micro-operational details of companies, and (Section

404) does not adequately regulate the high-level fraud

and deception perpetrated by top management (such

as reserves, capitalization instead of expensing some

items, asset values, etc.).

Unfortunately, SOX has the most impact on

small public companies and venture capital start-ups,

which generate more than seventy percent of new jobs

in the United States. Because of SOX, many start-ups

have been hesitant to execute IPOs; and

approximately one-fifth of all small publicly-traded

companies in the US have considered going private

because of the costs of complying with SOX (source:

Thomson Venture Economics, and the National

Venture Capital Association). In addition, and for the

first time in the history of US capital markets, during

2004-2006, many US companies were considering de-

listing from traditional stock exchanges to pink-

sheets, or to go private. This exodus also involves


454

foreign-domiciled companies who must comply with

Sarbanes-Oxley because of being listed on one of the

U.S. stock exchanges.

Table 1. Costs of Compliance With Sarbanes-Oxley Act (including internal costs and auditing).

Company revenue Average cost

Less than $100 million $800,000

$100 million to $499 million $1 million

$500 million to $999 million $1.3 million

$1 billion to $4.9 billion $2.4 million

Over $5 billion $8 million

Source: Financial Executives International

Willingness To Comply

SOX raises the issue of employees‘ Willingness-To-

Comply (WTC)with laws/regulations, which in this

instance, is intertwined with the Willingness-to-

disclose (WTD) financial information. Laussel & Le

Breton (2001); Arora & Gangopadhyay (1995);

Zheng (2002). Ge & McVay (2004); Jahangar,

Kamran & Henry (2004); Leuz & Verrechia (2000);

Tackett (2004); Carney (Feb. 2005); Teles (2004).

Chapman (1996); Ehrlich (1996); Kyung & In-Gyu

(2001); Healy & Palepu (2001). Lai-Yee & Leung

(2005); Lerner & Tetlock (1999); Blanton & Christie

(2003); Braun, Mukherji & Runkle (1996); Street &

Gray (2001); Verrecchia (2001); King & Wallin

(1995); Cialdini & Goldstein (2004); Diamond

(1980); Byam (1982); Croley (1998); Arlen (1994);

Arlen & Kraakman (1997); Hughes (1994); Khanna

(1996); Kornhauser (1982); Feinstein (1990);

Kingston, Schafer & Vandenberghe (2004); Hage

(2001); Schild (1998); Tata (1998); Raghupatti,

Schkade, Bapi & Levine (1991); Franklin (2003);

Jackson (2004); Zeleznikow (2002). SOX has both

civil and criminal penalties for non-compliance. The

deterrence effect of SOX has not been proven or

analyzed in detail – indeed, even after its

implementation, companies are still reporting

problems with internal controls. The ideal level of

deterrence is complete deterrence (ie. Complete-

compliance, which is different from over-

compliance). Hence, the sanction must be sufficient

to prevent recurrence by sufficiently reducing

perpetrators‘ resources and providing a deterrence

effect (or sufficiently reduce the probability of

recurrence).

Let:

Ppn = probability of prosecution under non-

compliance. Ppn (0, 1).

Ppc = probability of prosecution under complete-

compliance. Ppc (0, 1).

Pta = probability of corporate tax audit. Pta (0,1).

Fc = estimated/statutory fine/penalty for company if

convicted – lost wages, monetary fines, etc. Fc (0,

∞).

Fe = estimated/statutory total fines/penalties for top

ten managers if convicted. Fe (0, ∞).

Cc = company‘s compliance costs required to achieve

complete compliance with SOX.

Gc = present value of potential benefits to company

from falsifications in reporting period t. more ESO

awards, higher repricing, etc.. Gc (-∞, ∞).

Ge = present value of potential benefits to employee

from falsifications in reporting period t. Ge (-∞, ∞).

M = average employee propensity to commit fraud.

M (0, 1). M 1, as the employee becomes more

likely to commit fraud.

CE = control environment – company size, culture,

geographic scope of operations,

centralized/decentralized operations, manager‘s

ability to coordinate fraud, etc.. CE (0, 1). CE 1,

as the Control Environment becomes stricter, and

management has more control over

procedures/processes.

S = savings from complete compliance with SOX –

absence of investigations, fraud, etc.

Le = percentage of total liability imposed on

employee, upon conviction.

Lc = percentage of total liability imposed on

company, upon conviction.

R = company‘s/employee‘s Regret. R (-1,1). R

1, as the employee/company becomes more likely to

regret any misconduct, due to prior penalties,

financial position or fear of consequences.

H = horizon of influence/falsification (time in

years/months/week). H (0, ∞).

Tcr = transaction costs involved in falsifying corporate

records. Tcr (-∞, ∞).

Tp = company‘s transaction costs for prosecuting

falsification. Tp (-∞, ∞).

Ti = company‘s transaction costs for investigating

falsification. Ti (-∞, ∞).

Tpg = government‘s transaction costs for prosecuting

falsification. Tpg (0, ∞).

Tig = government‘s transaction costs for investigating

falsification. Tig (0, ∞).

EM = employee collusion-motivation index.

0 < EM < 1. This factor refers as to the degree of

estimated and feasible collusion among employees,

and between employees and external auditors. EM

1, as the employee becomes more likely to collude

with other employees and external audit staff,

suppliers and vendors

SR = expected stock market reaction from

any major change in reporting. SR (-1,1). SR 1,


455

as the stock market reacts more positively to any

change (positive or negative) in ESO reporting, and

vice versa.

EP = employee‘s propensity to falsify

records. EP = (P, T,I,C,K,PI,IR,D,E). EP (0,1).

EP is different from EM because EM pertains to

collusion with internal staff and auditors, while EP

pertains to possibility of actual fraud by the employee.

EP 1, as the employee‘s propensity to falsify

records increases.

Where:

P = personality; T = amount of company‘s

tax burden before falsification, I = intensity of

enforcement efforts; C = complexity of the tax

system; K = employee‘s knowledge and skills in law

and accounting; PI = peer influence; IR = influence of

reference groups; DE = employee‘s direct experience

with the government‘s tax system.

P,T,I,C,K,PI,IR,D,E (0,1)

IN = perceived inequity index – which

reflects the average employee‘s perceptions about

inequity of the tax system/regime and internal

controls. IN (0,1). IN 1, as the average

employee‘s perception of the tax system as

inequitable increases.

WTC1 = [LN{((1 – Ppc)*(S-Cc)) /(((1-Ppn)*(Gc+ Ge))

– ((Fc+Fe)*Ppn))}]*M*CE-1

WTC2 = 0H {([(Ppn Pta)*(Le)] / [(SR*(Lc)*(1-

(PpnPta)) ])}

WTC3 = 0H {([(Ppn Pta)*(Le)] / [(SR*(Lc)*(1- (Ppn

Pta)) ])} * {∂(Tp+Ti)/ ∂(Tpg+Tig)}*( ∂CE /∂EM ) *

(∂EP/∂IN)*(∂(Tpg+Tig)/∂EM)

WTC4 =

[(Lc/Le)*{(Tp+Ti)/(Teg+Tig)}*(CE/EM)*(EP/IN)*(SR/

CE)*(EP/EM)*(IN/(CE*SR*EM))]

WTC (-, +).

WTC 1, as the company becomes more likely to

comply with SOX standards.

Knowledge Management in Technology Companies and Banks

ESR‘s transactions and subsequent bankruptcy is

partly attributable to its management‘s failure to

manage knowledge creation and knowledge delivery.

Beesley (2004); Gal (2004); Camelo-Ordaz,

Fernandez-Alles, et al (2004); Christensen & Bang

(2003); Wagner (2003); Perez & Ordonez De Pablos

(2003); Cimon (2004). ESR‘s main assets were its

human capital. ESR‘s business was providing expert

services and advisory services in building/facilities

engineering. The merger resulted in BOSS providing

services in new segments where it was not previously

active. The combination of inadequate union

involvement in critical decisions, and failure to

adequately manage knowledge-based work teams, and

also customers‘ negative perceptions of ESR‘s ability

to deliver adequate services eventually resulted in

ESR‘s inability to win enough profitable service

contracts. This phenomenon occurred even though

immediately after the merger in April 2000, ESR was

the industry leader, and had the most resources (in the

industry) to provide such services – but customers

actually choose to hire smaller competitors with

presumably less knowledge and geographical

coverage. ESR apparently failed to develop

marketable and well-defined internal systems of

knowledge creation, or knowledge management or

knowledge storage, that prospective clients could rely

on for adequate service. Any additional skills that

BOSS/GMAC did not have could have been

developed in-house or obtained using strategic

alliances and joint ventures. Nwogugu (2004).

Several principles can be derived from the ESR

transactions:

Management‘s ability to manage knowledge

is a direct function of worker cohesion and

status of labor unions.

Management‘s ability to manage knowledge

across partner organizations (strategic

alliances) or recently merged companies is a

direct function of integration of information

systems, ability to assess customer needs,

strength of client relations, and assessment of

workers‘ skills.

Similarly, that the ESR‘s advisors allowed

the transactions to occur, is also attributable to

knowledge management problems. Human capital is

the key distinguishing factor at banks, accounting

firms, law firms and consultants that worked on

BOSS, GMAC and ESR‘s transactions. These entities

were apparently not able to manage knowledge

networks within their organizations and outside their

organizations. The loan origination function, the

credit function, the risk management function and

advisory function of banks are all knowledge-

intensive processes. The modern bank and financial

institution are essentially technology companies that

rely heavily on information management in their daily

operations. Thus, senior management and the boards

of directors at banks must emphasize and implement

knowledge creation and knowledge management

processes in order to reduce risk and increase

shareholder value. Government regulators should

also develop and implement supervision rules that

require financial institutions to develop better

knowledge creation and knowledge management

systems, and to file periodic reports about the

configurations and performance of such knowledge

management systems.

Knowledge management must be

coordinated with internal audit and corporate

governance efforts. Unfortunately, SOX does not

address or establish standards for integrating

knowledge management and internal audit systems.


456

Conclusion:

The ESR transactions illustrate some of the

inadequacies of the Sarbanes-Oxley Act. The

implementation and enforcement of the Sarbanes-

Oxley Act often results in excessive compliance costs,

over-compliance, agency problems, regulatory

friction, misallocation of liability, inadequate/

improper penalties, and information asymmetry.

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459

CONSERVATISM: AN EXPLANATION OF THE FINANCIAL CHOICES OF THE SMALL AND MEDIUM FAMILY ENTERPRISE

Sami Basly*

*IRGO (Institut de Recherche en Gestion des Organisations) University of Bordeaux Pôle Universitaire de Sciences de Gestion 35 avenue Abadie 33072 Bordeaux Tel: +33 (0) 5 56 00 96 33 [email protected]

Introduction

The financial behavior of the family firm is a recurring

topic in the literature. Hirigoyen‘s pioneer

research (1984) reveals the specificity of the financial

behaviors of industrial family medium-sized

companies24

compared to those of the other categories of

firms. This type of firms set out effective structures

enabling them a better financial management because,

on the one hand, they have a long term vision and, on the

other hand, are not accountable for short-term results

(Dreux, 1990), especially for unquoted firms. In

addition, the desire to transmit the firm to the next

generations would more encourage the effective

management of capital (Gallo and Vilaseca, 1996).

Precisely, the long-term horizons of the family firm

make it possible to qualify its capital as ―patient financial

capital‖ (Reynolds, 1992). Indeed, this capital is invested

for long periods without threat of liquidation contrary to

―ordinary‖ financial capital which generally have a due

limit corresponding to the end of investment

(Dobrzynski, 1993). The firms having this type of capital

would be able to pursue more creative and innovating

strategies.

Besides, family firms, of small and medium size

especially, are characterized by the lack of financial

resources. Ward (1987) observes that poverty in capital

which is necessary to finance the needs of the family and

the business is a factor which inhibits growth. Two

explanations justify the lack of financial resources in

SME. The first makes responsible the financial markets.

Indeed, investors would be very hesitant as for investing

in these firms (Mahérault and Lyagoubi, 2002). Many

family firms SME are not able to meet the necessary

conditions, or sometimes unwilling to set up the

adequate organizational answers, to facilitate their access

to the external capital (Davis and ali., 2000). The second

explanation is about internal obstacles. To achieve its

24 The recurring problem of the family firm definition will

not be tackled. On this question, see: Allouche and Aman

(2000).

goal of durability, the family firm tries to evolve in a

more or less hermetic universe. Accordingly, external

financial intervention is avoided because it can

deteriorate the independence of the firm.

The small and medium family enterprise is

characterized by a strong conservative attitude. How

does conservative orientation influence the financial

choices of the small and medium family enterprise? This

theoretical contribution tries to answer this question. For

Kreiser and ali. (2002), the family firm in general adopts

a strategy of a conservative growth dedicating the ―living

company‖ model. Such a company consecrates long-

term survival instead of financial performance as the

main objective to be pursued. Accordingly, highly aware

of its identity, it privileges financial conservatism and

maintains a narrow control on strategic decisions in

family hands. The analyzes of Hirigoyen (1985) join this

idea since the author emphasizes that the industrial

family SME does not furnish a true effort to increase its

market share because it is mainly preoccupied by

controlled growth.

The analysis will be done in two steps. After

pointing out the main dimensions of the financial

conservatism of family SME: internal financing and

avoidance of the external financial involvement, the

analysis will explain the manifestations of conservatism

and its sources. The paper will be concluded by

reflections as for the strategies enabling to avoid, limit or

even eliminate the impacts of conservatism.

1. Independence orientation and financial choices

Family SME seeks to be financially independent. The

theory of resource dependency provides an explanation

to this attitude: the higher the dependence on capital is,

the more the potential financier would dispose of an

increased influence in the decision-making within the

firm (Davis and ali., 2000). As the requested resources

are lower than the available resources, the suppliers have

the right to exert a considerable control on those which

require the supply (Pfeffer and Salancick, 1978). From


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the agency theory point of view, external financing in

family SME, even if it does not involve agency problems

between owner and managers may draw its specific

batch of agency problems with outsider financier (banks

and minority shareholders). Thus conflicts can occur as

the outsiders‘ objectives relating to the control of

organizational performance and, for the financial ones in

particular, to the liquidity, payback and the debt interest,

would be opposed to those of the insiders pursuing

growth, value creation, and profitability or growing

returns for the shareholder (Davis and ali., 2000). These

antagonisms are exacerbated because of information

asymmetry which could develop, on the one hand,

between the owner (as a borrower) and the bankers and,

on the other hand, between the owner (as an issuer of

shares) and the purchasers of these shares.

Ultimately, the family firm appears to be resistant

to the adoption of financing modes other than internal

ones. Conservative and independent, it seems strongly

predisposed to implement or at least to adhere to the

recommendations of the theory of hierarchical financing.

The assumption of pecking order theory was developed

by Myers and Majluf (1984). In addition, its origins go

back to Donaldson (1961) who observed that firms

usually abstain from issuing shares and borrow only if

the investment requires more funds than the existing

cash-flows. Accordingly, there would be an order of

adoption of financing modes: internal financing, long-

term loans and finally issue of equity. In their empirical

study, Belletante and Paranque (1998) corroborate this

thesis when observing that the management of quoted

SMEs expresses a real reserve to practice capital

increase thus translating a hierarchy in their financing

preferences. The research carried out by these authors

shows that the call for capital stocks is the last

solution considered by management of quoted SMEs

(even if they could chose it more easily than the

management of unquoted SME), although they

believe that this resource is less expensive than debt

(Belletante and Paranque, 1998). Particularly to the

family firm, Khan (2000) observes that this entity,

when obliged to make evolve its financial structure,

should adopt a path formed by three phases of financing:

Initially, during the first phases of growth, internal

financing is privileged (1.1), then a first external phase

through debt is considered (1.2.1) and finally a second

external phase, through financial markets or opening of

capital could be envisaged (1.2.2).

1.1. Internal financing: privileged source of financing

―The cash flow is the first accounting line which I look

at, well before the benefit‖, declares Michel Haag,

chairman of Météor, a French family firm. His father and

uncle voluntarily pursued the same policy by limiting the

distributed benefit. Accordingly, the firm invested each

year 12% of its sales turnover while having a minimum

recourse to debt. In general, the family firm favors

internal financing of its activities by the retention of

profits and the constitution of reserves. In addition, since

the indebtedness is not always easy because of the

mistrust of banks with regard to small and medium

firms, most of the time it would be simpler to be self-

financed.

Internal financing is a process which consists in

financing the needs by means of resources drawn from

the firm‘s activity. Thus, it enables to avoid the recourse

to external funds. Two benefits are required. On the one

hand, the risk of the firm does not increase contrary to

debt. In addition, the firm prevents from creating

conflicts of interests between shareholder (owner) and

creditor. Moreover, contrary to the issue of equity,

internal financing is not accompanied by a dilution

effect. Finally, it has the advantage of avoiding revealing

information, relating for example to future projects and

investments, to investors in case of external financing.

The family firm which decides to internally finance

its needs would make it at the expense of other financial

decisions. There is an opposed relation between internal

financing and distribution of dividends. Hirigoyen (1982,

1984) observes that the majority of unquoted family

firms do not distribute dividends. Likewise, the results

obtained by Calvi-Reveyron (2000) show that family

firms are less generous than other categories of firms as

for the distribution of dividends25

. Thus, the percentage

of capital held by management seems to have a negative

impact on the rate of distribution (Calvi-Reveyron,

2000). Indeed, a generous dividend policy limits, all

things being equal, internal financing and then intensifies

the need for recourse to financial markets for the

realization of investments (Easterbrook, 1984). In

addition, it increases the financial risk of the firm (Calvi-

Reveyron, 2000) and limits the free cash-flows26

available to the management. In sum, the family firm is

able to draw on its incomes in order to constitute internal

financing. Therefore, Jenster and Malone (1991) observe

that many of these firms hold abundant liquidities which

do not necessarily find relevant uses.

However, the internal constitution of financial

funds is not always easy. Indeed, some family firm‘s

specific events could involve a consumption of its

financial resources. The financing of succession

planning, retirement or other personal projects can push

the owners to quickly harvest the ―fruits‖ of the activity

rather than to reinvest them (Ward, 1988). Galbraith

(2003) observes, for example, that a particular event like

divorce or separation would draw a decrease of short-

term financial performance which suggests that a

consumption of financial resources occurs. Sometimes

25 Currently, in France the direction of this relation seems to

be reversed since the family firms are tending to distribute

more dividends because of the ISF (French Tax on Wealth). 26 Free Cash-Flows are the cash-flows in excess after the

distribution of the funds necessary to projects having a

positive net present value with a correct cost of capital.

JENSEN (1986) recommends distributing the free cash-

flows to shareholders in order to reduce the resources

controlled by managers and thus their power. Indeed, the

disadvantage of such a situation would be that management

escapes from market control by carrying out non-profitable

investments.


461

also, it is necessary to satisfy the shareholders‘ major

requirement which is distribution of dividends or

generally funds to family members. Ward (1988)

underlines, nevertheless, that a good growth of the

business may sometimes not satisfy the economic needs

of a family growing in size and standards of living.

1.2. External financing

Family SME is reticent to open up financially to outside.

The pecking order theory suggests that between debt and

equity issue, the firm primarily chooses the first method,

because its cost, i.e. interest, would be generally lower

than probable dividends to be distributed. We will

discuss the position of family SME with respect to debt

and opening of capital.

1.2.1. Debt

Family SME avoids external financing and debt, in

particular. Schulze and Dino (1998) observe that

approximately a third of American family firms affirm

not to have debt and that the 2/3 asserts to have a ―debt/

equity‖ ratio lower than 25%. A more recent study

shows that, on average, family firms have not less debt

than nonfamily firms (Hagelin and ali., 2006). However,

owners with high ―voting rights/capital‖ ratio are

associated with firms with less debt (Hagelin and ali.,

2006). For Minton and Wruck (2001), many firms adopt

a conservative financial policy implying less debt than

dominant financial theories predict. These firms hold a

lot of available funds as well as a balanced treasury

which enable them to finance their expenditures in an

internal way. Thus, by relying on costly internal capital,

there would be a negative impact on growth and

financial performance because those firms do not benefit

from debt leverage effect. Besides, for Schulze and ali.

(2003), the behavior of owner-managers with respect to

debt depends on the market state. They would be more

favorable to debt in periods of market growth than in

periods of stagnation. Moreover, Minton and Wruck

(2001) observe that financial conservatism is temporary.

Indeed, 70% of the firms they observed change posture

as for debt and 50% do it in the five years. Theoretically,

Schulze and ali. (2003) believe that altruism and family

firm specific relationships can render owners more

disposed to be involved in debt and to assume risk that

debt may entail as for their individual wealth (Schulze

and ali., 2003).

1.2.2. Opening of capital

The opening of capital has other specificities. Quotation,

for example, could involve a major change of the

ownership structure and thus the firm‘s governance

because of the entry of external shareholders. Davis and

ali. (2000) explain that the family firms are obliged to

share governance responsibilities in order to facilitate the

acquisition of critical resources while remaining

sensitive to the expectations of family members. The

influence of outsiders, within the board of directors, for

example, would be more intense as the need for an

external financing and an access to the money markets

increases. For Ehrhardt and Nowak (2003), a sale of

shareholders' equity by initial public offerings involves a

second consequence: because of the importance of the

initial returns, it causes a wealth transfer from the current

owners to the new shareholders.

The opening of capital, and to the extreme the

dependence27

, worry the family firms because it is likely

to create an agency relation between at least two unequal

poles of shareholders of different nature (Adam-

Ledunois and Vigoureux, 1998). In opposition to the

process of opening of the firm by an engagement in a

cooperation relation, which can affect only one

activity or a function of the firm, the dependence of

the family firm has a more global direct effect which

limits the firm‘s independence as for the whole

strategic decisions (Adam-Ledunois and Vigoureux,

1998). Indeed, the capacity and the willingness of the

external entity to direct the strategic decisions would

involve an attenuation of firm‘s independence.

Generally, the minority shareholder in a medium-sized

company is not regarded like a simple holder of a

receivable amount indexed on the firm‘s prosperity and

does not agree to give up completely the main

prerogatives of his voting rights at the profit of the

majority (Adam-Ledunois and Vigoureux, 1998). Two

reasons explain this position. First of all, because the

supplier of external capital (the principal) would hardly

control the majority‘s actions (assimilated to the

manager: the agent) due to weak information

transparency (e.g. non-quotation of the firm, absence of a

market of managers), agency costs would be important.

Thus, the need for controlling as well as possible these

costs, in situation of opening of capital, constitutes an

explanatory factor of the necessary implication of the

external entity in the decision-making process of

medium-sized companies. The second reason is that

none non-controlling associate in medium-sized

companies can do without a minimal implication

because of the weak liquidity of its investment (when

there is no quotation).

Risk aversion, search of durability and the will of

preservation and transmission of the family heritage

underlie the logic of financial independence. Overall, a

―state of mind‖ hostile to change is likely to be

disseminated within the organization: conservatism.

2. Conservatism: a dominating context

Conservatism is the attachment to the choices of past

(Timur, 1988). The literature treating about political

conservatism28

speaks about ex post conservatism

27 A firm becomes dependent if its equity is controlled by a

coalition of persons (e.g. a family) together with minority

shareholders such as financial institutions, banks, or venture

capitalists. 28 Derived from the Latin term conservare and applied to

identify the political movements and intellectuals whose

purpose is the preservation of social order and the re-


462

consisting in a high prudence as for the choices preferred

and carried out by a group, and about ex ante

conservatism consisting in an aversion testing new ideas

(Dearden, Ickes and Samuelson, 1990).

For the literature about cultural identities,

conservatism is a cultural dimension related to the look

which societies have on the individual as an autonomous

entity or as a member a social group. This cultural

character would be present in societies dedicating the

values of harmony and convenience in relations/groups

(Johnson and Lenartowicz, 199829

). Values such as

moderation, social order, security, tradition and

reciprocity of favors are crucial in conservative societies.

The maintenance of the status quo and also of the

harmonious relations not only within the group, but also

within society is crucial. Schwartz (1994) identifies three

components of conservatism as a collective cultural

dimension:

- harmonious working relationships and a social

harmony: this characteristic implies, inter alia, the

dedication of the group interest at the expense of

individual‘s even if the group decisions go against what

the individuals prefer.

- safeguarding of public image: this image is likely

to be ruined when the individuals do not manage

carrying out what is expected from them. Some

managers try to preserve their image and thus act in a

conservative way.

- security, conformism and tradition: this implies a

propensity to devote an autocratic and paternalist style of

management (Chui and ali. 2002) which can be

reflected, for example, in the firm financing choices.

The impact of conservatism is observed and

exerted on the level of firm‘s governance bodies (2.1),

mainly the manager and the board of directors. Even if

the family logic and the owner-family‘s expectations can

explain conservative behavior, other explanations are

found in past performance and in the founder‘s age.

Often, succession constitutes a crucial opportunity to

break free from organizational conservatism (2.2).

2.1. The firm’s governance: resistance to change

Which effects does conservatism have on the

governance of family SME?

Conservative organizations and particularly family

firms are characterized by the persistence and substantial

power of old generations who exert a strong supervision

on the owner-manager. Thus, conservative firms would

have a risk-averse, a not-innovating, passive and reactive

style of management (Covin, 1991). Generally,

conservatism is associated with the owner-manager

(founder) (2.1.1). Indeed, his role in the strategic

orientation adopted by the firm is of primary importance.

establishment of a former order founded in their eyes on

natural laws or transcendent data. 29 Cited by A. Chui and ali. (2002).

In addition, board of directors30

exhibits a lack of

effectiveness and does not fully play his role (2.2.2).

2.1.1. The owner-manager

The owner-manager of the family firm plays an

important role in the strategic posture of his firm. The

cultural configuration of the family and the role it gives

to the founder explain its disposition to change (Jenster

and Malone, 1991). Indeed, when it is patriarchal, i.e.

highly depending on its founder, the organization would

be less inclined to change and to challenging values and

family relations (Moloktos, 1991). A patriarchal family

controlling a paternalist organization is the ultimate case

of figure (Jenster and Malone, 1991): being dependent to

a high degree on its founder, the organization would be

unable to promote change as it is not instigated by the

founder. However, the founder or owner-manager may

be unwilling to promote change. Hambrick, Geletkanycz

and Fredrickson (1993) call this tendency to slow down

the change ―commitment to the status quo‖ (CSQ). The

management believes in the permanent accuracy of

current strategies or organizational behaviors (Hambrick

et al., 1993). Thus, this type of owner-manager even in

fact perceives only one weak need for adjustment of

critical changes in the external environment.

A first explanation of the stagnancy of the family

firm‘s owner-manager is psychological. Indeed, the

founder depends on his firm in order to be defined and to

assert himself. The firm is emotionally charged

(Moloktos, 1991). In addition, it seems that owner-

manager‘s conservatism would be stronger as his

psychological dependence on his deceased or retired

father was high (Miller and &li., 2003). Besides, family

firms‘ founders tend to be identified with their own

vision of the organization, an inevitably subjective if not

erroneous vision. They conceive the organization as an

extension of their own identities, and try to maintain,

sometimes within nonreasonable limits, an adequacy

between the organization and their personal identity. In

this sense, Ranft and O' Neill (2001) explain that the

desire to maintain the organization in the founder‘s

personally-preferred state constitute a demonstration of a

narcissistic behavior and Hubris31

. The consequence of

these observations is that the strong personal implication

and the commitment become obstacles to opening up

and search of change. This individual‘s attachment to the

organization should increase with age. The founder tends

to privilege security by avoiding the use of resources to

increase growth and therefore causing the stagnation of

the business. As he becomes aged, the founder becomes

increasingly conservative and risk-averse.

Besides, the owner-manager‘s conservatism is

explained by his neglect of entrepreneurial initiative. For

Jenster and Malone (1991), the family firm‘s founder is

likely to reach a state of plateauing manifested by a

30 For the firms which adopt one. 31 The hybris is a Greek concept which can be translated by

―excessiveness‖. It is a violent feeling inspired by passions

and more particularly, by pride.


463

situation of stagnancy which has negative impacts on the

firm. He is not aggressive and proactive any more but

rests on his laurels. He is less involved in the firm but

more in other social activities. Ranft and O' Neill (2001)

observe that founders who were successful in the

development of their firms see their managerial

responsibilities pushing around and limiting their

entrepreneurial responsibilities as the firm grows or

opens to more owners. From now on, the needs of

business management consume more the time and

attention of the founder who will devote less time to

creative activities such as research and development.

Ultimately, the ―mixture‖ of managerial activity and

entrepreneurial activity leads to a reduction of the latter.

Accordingly, Rubenson and Gupta (1991) recommend

that the style of management must change as the firm

evolves. Concretely, the founder‘s attitude must evolve

from passionate commitment to non passionate

objectivity. The neglect of entrepreneurial initiative is all

the more serious as the firm lives a delegation crisis and

an absence of decentralization to children for example.

The owner-manager will be unable or unwilling to give

up his prerogatives of control but maintains

responsibilities and authority in his own hands. As a

consequence, the rigidity of the firm will increase.

2.1.2. The board of directors

The board of directors is strategic source of initiative and

relevant information and also source of expertise,

consulting and control since it must also correct the

trajectory in case of deviating management.

Schematically, it achieves two missions: a mission of

control and a mission of service. According to agency

theory, control relates to the appointment, remuneration,

discipline and dismissal of management. It is also about

adopting the initiatives suggested by the latter and

evaluating their performance (Johnson and ali., 1996).

The task of service includes the activities intended to

improve the reputation and competitiveness of the firm:

it is about consulting given to management,

establishment of links with the outside and

representation of the firm within the community.

However, its role within family SME needs to be

moderated. Mustakallio and Autio (2001) argue that the

role of the board of directors, measured by its

composition and by the intensity of the control it exerts,

would be more significant as the implication of the

family members in the management decreases -

suggesting at the opposite that the more the family is

involved, the less decisive the role of the board would

be. In general, the traditional family firm is known to

have a board of directors whose members, selected

according to their status and influence within the family

and not according to their knowledge of the activity or

industry, occupy their positions for long periods and

have insufficient or inadequate professional

competences. According to this description, they

constitute a barrier to any attempt of change which

potentially threats the stability of the firm. Ranft and

O'Neill (2001), notice that the founders of high-

performing firms are even tempted to weaken

deliberately the board of directors of their firms in order

to maintain the status quo. The inward orientation is

more corroborated in some family firms who simply do

not implement such a body (Melin and Nordqvist, 2000).

2.2. The family: source or remedy against conservatism?

According to the analysis of Harris and ali. (1994), the

family firm exhibits some rigidity when a change of

paradigm is necessary. These rigidities are due to the fact

that:

- It privileges internal succession, which is one of

its objectives, and dedicates loyalty, whereas new

paradigms are more likely to originate from external

employees or management;

- The in-house trained successors have a weak

external experience whereas new paradigms can be

formed on the basis of the variety of personal

experiences;

- The heir of the entrepreneur could suffer from a

lack of self-confidence whereas the possibility of

emergence of new paradigms generally requires a great

confidence in its own judgment.

Insofar, does the family constitute the single source

of organizational conservatism?

2.2.1. Conservatism and its multiple origins

What are the explanations of the conservative attitude

adopted by the family firm? First of all, the interaction

between the family and business systems is the central

element which prevents the firm from quickly adapting

to new conditions (Moloktos, 1991). For Moloktos

(1991), when the life cycles of these two systems do not

evolve at the same pace, risks of crisis would be

important. Because of their interdependence, transition

and change are issues to be managed all at the same time

by the firm and the family. An illustration of this life

cycle non-parallelism could be seen in the passage from

the entrepreneurial phase to the administrative phase

(Ward, 1987). Indeed, this transition is generally

accompanied by a family resistance to change and to

accompany the necessary development of the firm.

Mustakallio and Autio (2002) advance other reasons

influencing family firm‘s entrepreneurial orientation.

First of all, the strategic and operational decision-making

processes are often not separated, because the owner-

family furnishes at the same time one or more directors

and one or more operational managers. The influence

exerted by operational decision-making on strategic

decision-making combined with the fact that these

processes are not explicit would lead to the avoidance of

strategic initiative (Mustakallio and Autio, 2002).

In addition, potential conflicts between family

members stick on the firm. Thus, the family quarrels can

constitute a barrier to the implementation of

development plans and then reduce the capacity of the

firm to adopt a proactive posture. Moreover, because of


464

the investment of the totality of its wealth in the firm, the

family will tend to avoid risk taking. Another

explanation of conservatism is about the weak liquidity

of the firms‘ stocks which, in consequence, exempt it

from external control of strategies (Mustakallio and

Autio, 2002). In addition, because it is difficult to

determine the right price of these stocks and to integrate

the prospects for future growth into this price, the firm is

not interested by its growth and that of the future benefits

but rather by the increase in its balance-sheet value

(Mustakallio and Autio, 2002).

The former performance plays also an important

role in shaping the conservative behavior of the firm.

Indeed, various studies observe that the success of the

firm creates personal and organizational forces

manifested by a certain form of arrogance as for

competitive pressures (Ranft and O' Neill, 2001).

Personal paradigms which by the past proved their

efficacy constitute inhibitors to change. Thus, in spite of

the evolution of the environment and performance

requirements, the owner-manager could become

inflexible and rigid by promoting practices and strategies

resulting from past successes and avoiding decisions

which can threaten his image or his economic wealth

(Ward, 1997). Consequently, he perceives a weak need

for adjustment even in case of critical changes in the

external environment. The sociologists speak about an

impregnation process which occurs during the first

stages of existence of the organization. The members of

the firm create and learn various routines contributing to

firm‘s performance. However, during time these routines

are transformed into habits which in their turn become

traditions tending to preserve the initial conditions of

success (Kelly and Amburgey, 1991). In addition, a high

performance coupled with the firm‘s age and the

duration of founder‘s activity would exacerbate the

forces leading to impregnation and traditionalism. For

Mustakallio and Autio (2002), organizations lose their

entrepreneurial orientation as they become aged. The

more the firm is aged the more it tends to exploit its

initial specific advantages. Moreover, the more it learns

how to exploit its initial advantage, the less it will be

inclined to explore new advantages. Thus, firms having

made successfu breakthroughs tend more to privilege

exploitation for longer periods and are characterized by a

greater inertia (Levinthal and March, 1993). In sum,

giving a high importance to traditions and emotionally

attached to the firm and stability of ownership, the

family firm shows a greater reduction of its innovativity

and proactivity than other firms.

In short, family SME exhibits a high strategic

conservatism when the strategy hitherto adopted showed

its effectiveness. The feeling of stability and acquired

profitability constitute a barrier in front of the

willingness to discover new outlets for firms‘ products.

A strategy which functions or which functioned well in

the past has all the chances to be set up as the firm‘s

strategic paradigm. Therefore, the management is

reticent to seek other performance paths and prefers to

stick to the strategy which proved reliable in the past

(Jenster and Malone, 1991).

A characteristic of family SME is that it is prone to

succession which can take place within the family circle.

Since founder‘s and family‘s attitudes, paradigms and

schemas could not be (or hardly) amended, succession

constitutes the major opportunity to release the

organization from conservatism.

2.2.2. Succession: a solution to conservatism

The firm‘s controlling generation is a variable exerting a

strong influence on governance and the strategy of the

family firm. In spite of the risk which the succession

could provoke on the firm since it can imply the

fragmentation of control and ownership and the

reduction of size if the firm is divided into separate

entities (Yeung, 2000), succession would have beneficial

effects as for the strategic orientation. Miller and ali.

(2003) identify three types of succession for the family

firm: The succession can be conservative, hesitant or

rebel. In this last configuration, the general strategy

should undergo great changes which touch the extent of

product/market portfolio and functional marketing

strategies (Miller and ali., 2003). Jenster and Malone

(1991) confirm the correlation between succession and

change since the adoption of change depends above all

on firm‘s leadership: Indeed, organizational transitions

would have more chance to be carried out if a leadership

change occurs through firm‘s transfer from the founder

to the successors. The new owner-manager can choose

acquisitions, investment withdrawals, expansions,

changes of product or market and changes of firm‘s

general policy. However, it is possible that changes

induced by this transmission will not be founded on a

real will to seize new opportunities but rather by the

desire of the successor to leave his own print and to flee

the past. Indeed, it seems that a rebel succession is more

likely to occur when there is a conflict between father

and son (Miller and ali., 2003). In this case, the new

owner-manager rejects the legacy of the former

generation and the detachment from past and its

practices is total. It is undeniable that the competence of

the successor and his leadership qualities constitute

necessary conditions to the success of the strategic

revival. In this vein, Ward (1987) stresses that if

successor‘s qualities of leadership are weak and its

competences limited then the future growth of the family

firm would be inhibited (Ward, 1987). For this author,

the weak leadership is explained by security and

inherited wealth which would deprive younger

generations of the desire, the need and the eagerness

required to be good entrepreneurs and thus to be able to

assume the management responsibilities. If competence

is absent or insufficient, strong leadership can thus be

followed by periods of conservative strategies and

organizational behavior.

Conclusion

This paper analyzes how organizational‘s conservatism

impacts the financial choices of family SME. Through


465

family SME main governance bodies i.e. the owner-

manager and board of directors, conservatism influences

decision-making and particularly financial decisions and

choices.

The successful and sustainable family firm has to

renew its business strategy several times as the market

and competitive pressures evolve (Ward, 1988).

However, the literature suggests that the family system

attempts to create and maintain a cohesiveness that

supports the family "paradigm" which is described as the

core assumptions, beliefs, and convictions that the family

holds in relation to its environment (Gudmundson and

ali., 1999). Information that is not consistent with this

paradigm is resisted or ignored (Davis, 1983). The more

the family is conservative the less it works for change.

For this reason, Harris and ali. (1994) suggest that

the family firm must carry out some critical tasks to

strategy development: Reinterpreting the role of the

entrepreneurial hero (the founder); challenging old

strategic paradigms and promoting strategic

development as process of continuous change.

The succession is an event which is favorable to

change. Other favorable actions deserve to be

mentioned. Thus, the revitalization of the board of

directors may permit to struggle against conservative

―temptations‖. In particular, outside directors‘

contribution would be valuable. This role can be

emphasized through the two missions they must achieve:

control and consulting. For the first, it is known that

outside directors would be more independent and able to

defend the shareholders‘ interests. As for the second,

outsiders would prevent from the dominance of a single

line of thought by challenging the assumptions

underlying the firm‘s strategies and injecting external

knowledge. Empirically, research indicates that boards

with high proportion of external directors are more

intensely involved in strategic decision-making (Judge

and Zeithaml, 1992), are ready to analyze the firm‘s

forces and weaknesses and act as a change catalyst

(Muelle, 198832

).

Under the assumption of attenuated conservatism,

Corbetta and Montemerlo (1995) stress that, in order to

receive external financing, family SME must exhibit

solid and transparent financial and patrimonial

structures. Accordingly, the firm must choose the ―rich

firm – poor family‖ model at the expense of the ―poor

firm – rich family‖ one. Actually, this latter implies that

the family regularly withdraws money from the firm and

reinvests it privately thus causing an over-estimation of

debt and an inaccurate image of firm‘s finance. Besides,

Yeung (2002) recommends to the family firm seeking

financing on the money market to conform to overall

governance, banking and accounting standards. In sum,

it is necessary to set up adequate organizational

responses to the requests and expectations of financial

parties in order to increase the legitimacy of the firm and

permit access to capital.

32 Cited by P. SHARMA and ali. (1997).

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469

THE INEFFICIENT MANAGEMENT AND DISCIPLINARY MOTIVES FOR TAKEOVER IN AUSTRALIA

Martin Bugeja*, Raymond da Silva Rosa**

Abstract The disciplinary motive and removal of inefficient target management are widely cited as explanations for takeovers. This study tests the prevalence of these explanations using Australian takeover targets from 1990 to 2002. We find that the vast majority of target firms are unlikely candidates for disciplinary action. Contrary to the disciplinary hypothesis, we find that target shareholdings are highly concentrated and are more concentrated than non-target firms. Unlike Agrawal and Jaffe’s (2003) US study, we find ASX targets are typically poor performers but, contrary to the inefficient management hypothesis, we find that takeover success is higher for better performing targets. Keywords: Mergers and Acquisitions, Takeovers, Disciplinary Motive, Corporate Governance * Corresponding author. Martin Bugeja, School of Business, The University of Sydney, 2006, New South Wales, Australia. Telephone + 61 2 9351 3079, fax + 61 2 9351 6638. E-mail address: [email protected] **University of Western Australia, Business School Acknowledgments: The authors wish to thank Terry Walter and Whitney Hudson for their comments.

1. Introduction

Takeover activity has many potential causes

including: the prospect of the generation of synergies,

gaining monopoly power, taking advantage of under-

valued companies and hubris on the part of acquiring

managers. The diverse possible motives and other

salient features of takeover activity, such as its

increased incidence in share market ―boom‖ periods

and concentration in a few industries at any time,

leave room for many competing explanations of

M&As. Nevertheless, in the legal and economic

literature, the disciplinary motive or hypothesis for

takeover has attained remarkable prominence. For

example, Mitchell and Netter (1989) argue that the

anticipated passage of legislation that would have

reduced the profitability of hostile (i.e., disciplinary)

takeovers in the US triggered the 1987 stock market

crash. Further, Shliefer and Vishny (1997, p. 756)

observe that ―takeovers are widely interpreted as the

critical corporate governance mechanism in the

United States, without which managerial discretion

cannot be effectively controlled.‖ This proposition

has been assumed to apply in Australia as well. For

instance, Paper No 4 of the Corporate Economic and

Law Reform Program (CLERP No 4) on takeovers

recommends reforms based, in part, on the premise

that ―the prospect of a takeover acts to overcome the

principal-agent problems inherent in the separation of

company ownership and control, for example, where

it is impracticable or too costly for shareholders to

ensure that directors act in their interests‖ (1997,

p.7).33

The main research question tested in this study

tests is whether the disciplinary hypothesis is relevant

for Australian takeover targets from 1990 to 2002.

The disciplinary hypothesis of takeover activity

rests on the premise that managers further their own

interests at the expense of shareholders. In instances

where failure of the firm‘s internal monitoring

mechanisms results in managers‘ non-value

maximizing behaviour being egregiously large,

hostile takeovers reassert the interests of shareholders

by replacing the incumbent managers and transferring

to shareholders, via the takeover premium, a portion

of the expected gains from value-increasing

management (Manne 1965). Internal monitoring

mechanisms are most likely to be ineffective in firms

characterized by diffuse share ownership and excess

liquidity, which frees the manager from the discipline

of the capital market.34

The disciplinary hypothesis is sometimes termed

the inefficient management hypothesis (e.g., Agrawal

and Jaffe, 2003). The conflation is understandable

since both hypotheses imply the replacement of the

incumbent management team with another that is

expected to be more value-increasing for

shareholders. Nevertheless, it is useful to maintain a

33 Another example, Thompson (2002, p.323) in ―Takeover

regulation after the ‗convergence‘ of corporate law‖

discusses the role for takeover regulation in a dispersed

ownership system, a reach designed to be broad enough to

encompass the American and Australian legal systems as

well as the United Kingdom (emphasis in italics added). 34 Shleifer and Vishny (1988) discuss other common

weaknesses in firms' internal control mechanisms.



470

distinction between the two hypotheses. The

disciplinary hypothesis implies a divergence in

managers‘ and shareholders‘ interests whilst the

inefficient management hypothesis does not. As Dodd

(1987, p. 5) observes, ―management need not be

incompetent in some absolute sense, nor the board of

directors neglectful of shareholders‘ interests, for

takeovers to perform a useful, economically important

role‖. Disciplinary takeovers are a subset of those

takeovers motivated by a perceived or expected

difference in the relative efficiency of competing

management teams to maximize shareholder return.

The prevalence of the disciplinary motive is an

important issue, in part, because of a view becoming

more widely held that much acquisitive activity is

symptomatic of market inefficiency (e.g., Shleifer and

Vishny, 2003; Rhodes-Kropf and Viswanathan, 2004)

rather than ameliorative of it. If the disciplinary

motive does not feature in a substantial proportion of

takeovers, it undermines one of the most oft-cited

reasons for viewing them in a benign light.

Managerial resistance to a takeover bid is also more

likely to be viewed more positively if it is established

that the resistance does not reflect a divergence of

interests in the outcome of the bid between the target

firm‘s managers and its shareholders.35

The basis of

takeover regulation may also need to be reconsidered,

in particular, the view expressed by a prominent legal

scholar that ―much of current academic scholarship

suggests a convergence in [regulatory] competition

[across countries] toward the dispersed ownership

model with its reliance on strong securities markets,

extensive disclosure and the use of the market for

corporate control to discipline management

(Thompson, 2002, p. 323, emphasis in italics added).

Finally, testing the validity of the disciplinary

hypothesis outside the US is important also because,

as our results illustrate, US-based findings are not

always generalisable, even to equity markets

commonly thought to share very similar

characteristics with their US counterpart.

Agrawal and Jaffe (2003) investigate whether

US target firms under-perform in the pre-acquisition

period using both operating and share returns. They

find little evidence on both measures that target firms

perform poorly, even among sub-samples that they

identify as being more likely candidates for

disciplinary takeovers. We follow Agrawal and Jaffe

(2003) in reviewing target firms‘ pre-bid share market

performance to assess whether they under-perform as

35 It is pertinent to note that hostile deals are not necessarily

disciplinary in nature. Further, counting the incidence of

bids classified as ―hostile‖ on the basis of overt or at least

publicly observable signs of management resistance is an

unreliable measure of the true incidence of hostility.

Schwert‘s (2000) study of the characteristics of ostensibly

hostile M&A bids in the US reveals that ―most deals

described as hostile in the press as not distinguishable from

friendly deals in economic terms, except that hostile

transactions involve publicity as part of the bargaining

process‖ (p. 2599).

a group. We also investigate performance amongst

various sub-samples that are more likely to be a target

for disciplinary reasons. To investigate the prevalence

of the disciplinary motive we use a variable -

ownership concentration - that is closely related to

separation of ownership and control and the attendant

agency costs. This allows us to undertake a stronger

test of the disciplinary motive by identifying those

takeovers that are most likely to exhibit agency

problems.

Consistent with the presence of agency costs,

our results show that target firms are characterized by

low managerial ownership. However, target firm

ownership concentration is such that in over 90% of

cases, the top 20 shareholders have control of the

target firm. This finding is consistent with Dignam

and Galanis (2005) who contend that Australia‘s

equity market has many of the characteristics

associated with ―insider‖ systems in which

shareholders and creditors are more actively involved

in the control of companies. Remarkably, we find that

firms subject to takeover bids are even more

concentrated in ownership than the typical firm,

which further reduces the credibility of the claim that

the market for corporate control in Australia plays a

significant role in resolving problems associated with

the separation of ownership and control.

An important difference between our analysis

and that of Agarwal and Jaffe (2003) should be noted.

Agarwal and Jaffe conclude that evidence in support

of the disciplinary hypothesis is weak because US

target firms are typically not under-performers. In

contrast, we conclude that the disciplinary hypothesis

is largely irrelevant in Australia because there is no

substantive separation of ownership and control and

not because the targets are indistinguishable from the

market in terms of performance. In fact, unlike

Agrawal and Jaffe (2003), we find that target firms

have significant negative abnormal returns prior to the

bid. This result is consistent with the inefficient

management hypothesis but even here the evidence is

not unequivocal. We find that poorer performing

targets are more and not less likely to resist a

takeover, using board recommendation to accept or

reject a bid as an indicator of resistance. Schwert‘s

(2000) analysis of hostile bids suggests that bid

resistance may simply reflect a rational bargaining

strategy, however, even when we review bid outcome

rather than resistance, we find no relationship

between the target‘s pre-bid performance and the

likelihood of a takeover bid succeeding. In sum,

whilst poor performance makes it more likely that a

firm will be the subject of a bid, we find that the

success of takeovers is unrelated to prior firm

performance, which indicates that target firms‘

controlling shareholders do not necessarily consider a

takeover as the best mechanism to improve their share

returns. We leave further exploration of this issue to

future research.


471

The rest of the paper is organized as follows. Section

2 reviews prior research relevant to the inefficient

management and disciplinary motives for takeover

and points to writings that show takeover related

legislation reflects an assumption that ownership of

capital is highly dispersed, generating a pre-

occupation with agency costs. Section 3 describes the

sample and presents results whilst section 4 comprises

a conclusion and suggestions for future research.

2. Prior research

The removal of inefficient target managers is often

raised as motivation for corporate takeovers. The

evidence in support of this hypothesis is, nevertheless,

inconsistent. Agrawal and Jaffe (2003) review twelve

prior studies and find that only two present evidence

of significant target underperformance prior to the

takeover. Their own study of US takeovers between

1926 and 1996 reveals no evidence that target firms

under-perform the market in the period leading up to

the takeover. Similarly, Bishop, Dodd and Officer

(1987) find that Australian (i.e., ASX-listed) target

firms earn an average cumulative abnormal return

(CAR) of 2% over the period [-36,-11] months before

the takeover announcement.36

However, for takeovers

of ASX-listed firms made between 1981 to 1989,

Bugeja and Walter (1995) document an average CAR

of -16.8% over the period [36,-11] months prior to the

takeover bid announcement.

An alternative way of assessing if target firms

are under-performing prior to the takeover is to

examine if target performance influences the

probability of a firm being subject to a takeover offer.

Weir (1997) and O‘Sullivan and Wong (1999) find a

negative relationship between return on assets and the

probability of a firm being a takeover target in the

UK. However, Weir (1997) finds industry-adjusted

return on assets is insignificant in explaining takeover

likelihood. Similar inconsistent results are reported in

US-based studies. Ambrose and Megginson (1992)

find prior period excess returns and sales growth do

not contribute to the probability of a firm being

acquired. Song and Walkling (1993) find sales

growth and return on equity are insignificant in

explaining the probability of being a takeover target.

Similarly, insignificant results are found in North

(2001) for return on assets and sales growth.

Whether takeovers result in the target‘s

incumbent management team being replaced has been

extensively investigated in the US. The general

conclusion is that CEO and director turnover is

significantly higher in the period following a

successful takeover (e.g., Walsh and Ellwood, 1991;

Martin and McConnell, 1991; Agrawal and Walkling,

36 Bishop, Dodd and Officer (1987) did not control for the

well known negative relationship between firm size and

returns. Brown and Da Silva Rosa (1998) show that not

controlling for firm size results in an upward bias to

recorded abnormal returns to target firms.

1994; Harford, 2003; and Kini, Kracaw and Mian,

2004). Pertinently, the evidence also indicates a

negative relationship between prior target

performance and management turnover (e.g., Harford,

2003; and Kini, Kracaw and Mian, 2004).37

Consistent with the disciplinary hypothesis,

Australian takeover research generally reports that

target firms have low levels of management

ownership. For example, Henry (2004), in a study of

the determinants of takeover outcome reports that

takeover targets between 1990 and 2000 have average

directors‘ ownership of approximately 9%. In earlier

research, Bugeja and Walter (1995) report average

holdings of 10.4%. These findings are in line with

US results. For example, North (2001) reports mean

(median) ownership by directors of 15% (6%) in

acquired firms between 1990 and 1997.

At first glance, these findings are consistent with

the disciplinary motive for takeover as they suggest a

widely dispersed shareholding structure in which

individual shareholders lack the incentive to monitor

target firm management. Such a conclusion, however,

fails take into account the size of holdings of non-

management shareholders. If non-management

shareholdings are highly concentrated, it is likely that

these shareholders will actively monitor target

management (Shleifer and Vishny, 1986). Some

evidence of non-management share ownership in

Australia is provided in Henry (2004). This study

reports average institutional holdings and outside

block ownership in target firms of 17% and 19%

respectively.38

In the US, North (2001) finds non-

affiliated blockholders own an average of 18% of

target share ownership.

The assumption that ownership of share capital

is highly dispersed is reflected in Australian

takeover‘s legislation. For instance, the Companies

and Securities Law Review Committee‘s Takeover

Threshold Report notes that the Eggleston Committee,

meeting in 1969, stated that:

―we consider that any

person who is seeking to

gain control of 15% or

more of the voting power

is likely to be aiming at

control of the company

itself.‖

The assumption is not just an Australian

phenomenon. Legislators and business commentators

in the US and UK have held it as well. In their

landmark study, Corporate Ownership Around the

37 The authors are not aware of any published Australian

research that investigates the turnover of directors and

executives post-takeover.

38 Blockholders are defined as those shareholders with an

ownership of 5% or more. Institutional shareholders are

defined as holdings in the top 20 shareholders held by:

insurance companies, superannuation funds, funds

management companies, investment companies and

investment trust companies (p425).


472

World, which shows shareholdings are more highly

concentrated than is commonly believed, La Porta,

Lopez-de-Silanes, and Shleifer (1999) contend that

Berle and Means‘ 1932 classic, The Modern

Corporation and Private Property, is responsible for

popularising the view that ownership of capital is

widely dispersed among small shareholders, giving

rise to the assumption that holdings of as little as 15%

may be close to yielding effective control to a single

shareholder.

La Porta et al‘s evidence on ownership

concentration among the largest 20 firms (by market

capitalisation) in each stock exchange around the

world shows that the Australian sharemarket indeed

ranks among the least concentrated, along with the

US, UK, Canada, Ireland and Japan. However, La

Porta et al adopt a very loose definition of dispersion,

classifying each firm as widely held only if a single

shareholder does not control more than 20% of voting

rights.39

This means, for instance, that a firm would

still be defined as widely held where the top five or

top twenty shareholders controlled 90% of voting

rights despite small (i.e., retail) investors having

negligible influence on corporate decisions.

Additionally, as La Porta et al study the largest firms

on each exchange their results are likely to understate

the degree of ownership concentration of target firms

which are typically relatively smaller listed firms.

As the CLERP No 4 paper on takeovers

indicates, takeovers‘ legislation in Australia is

predominantly concerned with the rights of retail

investors,40

that is, it is concerned with protecting the

interests of the overwhelming majority of the 5.7

million Australians with a direct investment in the

stock market (2004 ASX Share Ownership Study),

who do not rank among the top 20 shareholders in any

of the 1,400 or so companies listed on the ASX.

Legislative recognition that the top 20 shareholders

are likely to have a disproportionate influence on

company affairs and, by extension, are well placed to

protect their own interest is evident in the requirement

that they be listed in public companies‘ annual

reports, along with the number of issued shares they

own.

We make use of this mandatory revelation of the

top 20 shareholders in Australian public companies to

39 La Porta et al‘s analysis arguably overestimates the

degree of dispersion of ownership even in the US.

Gadhoum, Lang, and Young (2005) report that ―in all size

ranges, the USA has more corporations controlled by

families than by financial institutions. In almost all size

ranges, it has a higher percentage of family-controlled

corporations than any of the next four largest economies.‖ 40 CLERP Paper no 4 on Takeovers states that ―the basic

objective of takeover regulation is to improve market

efficiency. Specifically, regulation is directed at achieving

an appropriate balance between encouraging efficient

management and ensuring a sound investor protection

regime, particularly for minority investors‖ (p. 7, emphasis

in italics added).

identify the proportion of outstanding shares held by

them in 751 ASX listed companies that were subject

to a formal takeover bid between January 1990 and

December 2002. This analysis will determine the

extent to which the votes of shareholders outside the

top 20 matter in determining the outcome of each

takeover. In short, we take the view that, in terms of

the aims of the takeover legislation, an economically

sensible definition of shareholder concentration is the

proportion of shares held by the top 20 largest

shareholders.

3. Sample and results

All takeovers announced for companies listed on the

Australian Stock Exchange (ASX) between 1990 and

2002 were identified using the Current Takeovers

section of the Australian Financial Review. The

Connect 4 Mergers and Acquisition database was

used to confirm the sample for the period 1997 to

2002. This search identified 751 takeover bids. The

announcement date and bid outcome were identified

by searching announcements made to the ASX. Table

1 presents the distribution of the sample over the

period of the study classified by takeover outcome.

The number of takeovers is highest in the first two

years of the sample period. Just below 65% of

takeover offers lead to a successful acquisition, where

success is defined as the bidding firm acquiring over

50% of the outstanding issued shares of the target

company.

INSERT TABLE 1 HERE

Target firm financial statements for the year prior to

the takeover announcement were used to hand collect

summary financial information on the targets. Data

was collected on total assets, total liabilities, and total

owners‘ equity. Information was also collected on

profit after tax and cash from operations for the two

years prior to the bid. Table 2 presents a summary of

this information.

INSERT TABLE 2 HERE

The average target firm has assets of $205 million,

although the size distribution is skewed with median

assets being $32 million. Mean and median target

firm profit are respectively $2.3 million and $296,000

in the year prior to the offer. Target firms also

disclose a profit, on average, two years before the bid.

Further examination reveals that 44% of targets report

a loss in the year preceding the offer, with 41%

making a loss two years before the takeover.

However, these proportions are not dramatically

different to those that apply to the population of ASX-

listed firms. Balkrishna (2004) reports that over the 12

years from 1992 to 2003, the proportion of all ASX-

listed firms that reported a loss in each year was

36.6%, on average. In 2001 and 2002, the proportions

were 43.9% and 47.3% respectively. The majority of


473

target firms disclose positive cash-flow from

operations in the year prior to the bid (69%) and two

years before the bid (67%).

3.1 Target ownership structure and the disciplinary motive for takeovers

Crucial to the argument that takeovers act as a

disciplinary mechanism is the assumption that target

firms are characterized by a separation of ownership

and control.41

Information on the ownership of target

firm directors is obtained from the Part B/Target‘s

Statement lodged with the ASX during the takeover

contest.42

The average level of ownership is 12.2%.

This percentage, however, conceals the distribution of

managerial ownership. In Table 3, data is presented

on the number of target firms within bands of

management ownership. A striking finding is that

managerial ownership is less than 1% in 39% of target

firms, and is less than 3% in just over half of targets.

INSERT TABLE 3 HERE

Although the low level of managerial ownership

presented in Table 3 is consistent with the presence of

agency costs, this assumes that non-managerial

ownership in the target firm is widely dispersed so

that these shareholders lack the incentive to monitor

target firm managers. To assess if this is the case, the

dispersion of target share ownership is estimated from

the share ownership held by the top 20 shareholders in

the target firm disclosed in the financial report

immediately preceding the takeover offer. Where the

target firm also provided a breakdown of the

individual ownership of each of the top twenty

shareholders (rather than just giving the total

percentage held) the percentage ownership interest of

the top 5 shareholders was manually collected. Panel

A of Table 4 summaries the ownership concentration

of the target firms.

INSERT TABLE 4 HERE

41 Mikkleson and Partch (1989) find that management

ownership in the US is inversely related to the probability

that a firm will be subject to a takeover. Other studies find

similar results (see Shivdasani, 1989; Song and Walkling,

1993; and North, 2001). UK studies also find that the

holdings of executive directors are negatively related to the

probability of receiving a takeover bid (see Weir, 1997; and

O‘Sullivan and Wong, 1999). 42 In response to a takeover bid, the Corporations Law

(2001) requires the target to prepare a Target's Statement.

This document requires the target to provide all information

that would be reasonably required by shareholders in

deciding whether or not to accept the bid. Typically, the

Target's Statement includes a recommendation from the

target board to shareholders on whether the offer should be

accepted. Prior to the Corporate Law Economic Reform

Program, Target Statements were referred to as Part B

statements.

Inconsistent with targets having a dispersed

ownership structure, the total holdings of the top 20

shareholders comprise an average (median) 75%

(79%) of target shares at the financial year-end prior

to the takeover. The total holdings of the top 5

shareholders alone constitute an average 57% (58%)

of total outstanding shares. The last average figure is

substantially above the 28.8% average holdings held

by the top 5 shareholders in Fortune 500 firms

reported in Shleifer and Vishny (1986). These

findings lend credence to Dignam and Galanis‘ (2005)

view that Australian-listed firms are more accurately

described as insider-controlled organizations than as

companies with significant separation of ownership

and control. Dignam and Galanis observe that

―blockholders exercise control as to the key decision

over the sale of the company‖ (p. 20).

Further examination reveals the extent to which

target firms are closely held. In 91% of bids, the top

20 shareholders own more than 50% of target shares.

Similarly, the top 5 shareholders hold greater than

50% target ownership in 63% of targets. These

statistics are inconsistent with target firms generating

substantial agency costs arising from a separation of

ownership and control. The results also indicate that

in most takeover bids retail shareholders outside the

top 20 have little part to play in determining bid

outcome.

Unlike Henry (2004), nominee shareholdings

listed in the top 20 shareholdings have been retained

when measuring ownership concentration. This option

was preferred because as described by Stapledon

(1999) nominee shareholdings are typically used to

register the holdings of superannuation funds and unit

trusts. Since nominee shareholdings are typically

owned by institutions, to exclude their ownership

would understate the holdings of owners that would

be more likely to actively monitor the performance of

management. Nevertheless to ensure our findings are

not driven by the holdings of nominees, data was

collected on the percentage of shares held by

nominees in the top 20 shareholders list of the target

firms in our sample. The mean (median) holdings of

nominees in the top 20 shareholders were respectively

16% and 10%. The total holdings of nominees in the

top 5 shareholders comprise an average (median) 12%

(6%). Panel B of Table 4 presents the ownership

concentration of target firms after excluding nominee

shareholdings. Consistent with the data in Panel A,

non-nominee shareholders in the top 20 list of target

firms on average control the majority (58%) of voting

rights. Similarly, on average the top 5 non-nominee

shareholders in target firms own 45% of shares giving

them substantial influence in determining the outcome

of takeovers.

Due to the typically high proportion of total

shares owned by the top 20 shareholders in target

firms we do not believe that bids for them are

prompted by agency costs associated with the

separation of ownership and control. We however,

acknowledge La Porta et al‘s (1999, p. 476) point,


474

that there is no theoretical model of shareholder

interaction that allows us to test the proposition

formally. It could be the case that although the top 20

shareholders collectively control enough shares to

control their companies, they are unable to coordinate

their monitoring thus giving rise to agency problems.

However, if this is true of firms that are subject to a

takeover bid, we would expect them to have top 20

shareholders who are either less concentrated in their

ownership or at least equally concentrated as the rest

of the population of firms. The data in Table 5 does

not support the proposition that target firms are more

likely to have agency problems associated with

separation of ownership and control. If we assume

that top 20 ownership holdings for ASX-listed firms

in 2003 are representative of such holdings over our

entire sample period, Table 5 shows that across all

firm size ranges, target firms are more concentrated

than the rest of the population. In short, our data

suggests that ownership concentration facilitates

rather than impedes the making of takeover bids.

INSERT TABLE 5 HERE

3.2 Target firm performance and the removal of inefficient target management

As a measure of target firm performance prior to the

takeover, cumulative abnormal returns (CARs) are

calculated over the following event windows:

i) the period from 36 months to 6 months prior

to the bid;

ii) the period from 24 months to 6

months prior to the bid.

CARs are calculated by subtracting expected

return from the buy-and-hold equity return (adjusted

for dividends and changes in basis of quotation) to our

sample firms over the relevant event-window.

Expected return is proxied in several ways to check

for robustness: (a) the equally weighted average buy-

and-hold return to all listed companies with share

price data over the relevant event-window, (b) the

value-weighted buy-and-hold return to all listed

companies with share price data over the relevant

event-window, (c) the equally-weighted buy-and-hold

return to all listed companies in the same size-decile

(based on market capitalization as at the start of the

event-window) with share price data over the relevant

event-window, and (d) the value-weighted buy-and-

hold return to all listed companies in the same size-

decile with share price data over the relevant event-

window. Prior performance is measured to six

months preceding the bid to ensure information

leakage from the takeover is not captured in the event

windows.

Abnormal performance is shown in Table 6.

Panel A presents results for the event window

commencing three years prior to the offer, whilst

Panel B shows returns for the shorter event window.

In both panels, results are given for market-adjusted

and size-adjusted returns and within these groupings

for equally-weighted and value-weighted returns.

INSERT TABLE 6 HERE

Average target firm abnormal returns over the (-36,-6)

event window are negative and significant except for

the market-adjusted value-weighted portfolio. When

performance is measured over the shorter event

window, performance is significant only for the

market-adjusted equally-weighted portfolio. It is

noticeable that the distribution of returns is skewed

with median performance indicating much lower prior

performance for target firms than the mean. Detailed

analysis reveals that the percentage of targets that

exhibit positive performance prior to the bid ranges

from 25.5%, when CARs are measured using market-

adjusted equally weighted returns over the (-36,-6)

window, to 37% when CARs are measured using

market-adjusted value weighted over the (-24,-6)

window. We conclude that, inconsistent with the US

evidence, target firms are typically underperforming

in the period prior to the takeover.

Evidence that firm performance is related to

managerial ownership is presented in Morck, Shleifer

and Vishny (1988). To examine if target firm

performance pre-offer is associated with managerial

ownership, Table 7 presents mean CARs for each of

the managerial ownership bands presented earlier in

Table 3. Inconsistent with an association between

target firm performance and managerial ownership,

there is no discernible relationship evident in Table 7.

INSERT TABLE 7 HERE

3.3 Takeover characteristics and target prior performance 3.3.1 Management resistance Morck, Shleifer and Vishny (1988) argue inefficient

management will be hostile to takeovers. Agrawal and

Jaffe (2003) present limited evidence consistent with

this argument. They find that target firms with

negative operating performance are more likely to

resist the takeover. To see if this finding applies in

Australia, we compare CARs to those targets where

the board recommends rejection against CARs to

targets where directors recommended acceptance (see

Table 8, Panel A). CARs are measured on a market-

adjusted equally weighted basis.43

Consistent with the

argument of Morck et al, returns are lower where

management recommends rejection. The difference

however is insignificant.

INSERT TABLE 8 HERE

43 All the results in Table 8 are unchanged if CARs are

calculated using the alternative measures of abnormal

returns.


475

As an additional test, following the approach of

Agrawal and Jaffe (2003), target firms are classified

(for the remainder of this study) as being ―poor

performers‖ if they have a negative CAR over the

period (-36,-6). The proportion of ―poor performers‖

that recommend rejection is then compared to the

proportion for other targets. The comparison

presented in Panel A Table 9 indicates that targets

with negative prior performance are significantly

more likely to resist the takeover.

INSERT TABLE 9 HERE

To assess whether the results are sensitive to using an

accounting measure of performance, target return on

assets (ROA) and cashflow return on assets (CFROA)

were calculated for the financial year-end prior to the

takeover. The average for each of these performance

measures is then compared across directors‘

recommendation with the results shown in Table 8.

Consistent with the sharemarket results, there is no

difference in accounting performance between reject

and accept recommendations. As a final test, target

firms were classified as ―poor performers‖ if,

respectively, their ROA and CFROA were negative.

The proportion of firms that provided an accept

recommendation was then compared across the two

groups with the results presented in Panels B and C of

Table 9. For both ratios, there was no significant

difference in the proportion of firms that issued an

accept recommendation. Overall, the results indicate

that target management resistance in takeovers is

unrelated to prior firm performance.

3.3.2 Competing bidders Agrawal and Jaffe (2003) argue that targets exhibiting

greater under-performance will attract competing

offers as a higher level of improvement can be

achieved post-bid. In support of this argument, they

find that poorly performing targets (i.e., those with

negative CARs) are significantly more likely to

receive competing bids. In Panel B of Table 8, CARs

and accounting performance for targets that receive

single bids are compared to those that receive

multiple bids. Inconsistent with Agrawal and Jaffe

(2003), there is no evidence of an association between

prior target performance and the number of bidders.

As an alternative test, the proportion of ―poorly-

performing‖ targets that receive multiple bids is

compared to the proportion for other targets. This

comparison is shown using the alternative measures

of performance in Table 9. The results are

insignificant when performance is measured using

ROA and CARs. For CFROA, inconsistent with the

argument of Agrawal and Jaffe (2003), there is a

higher proportion of competing bids for targets that

have positive performance.

3.3.3 Method of payment Mayer and Walker (1996) find that bidders are more

likely to use cash as payment where management

resists the bid. Following the argument in Morck,

Shleifer and Vishny (1988) that management

resistance is higher in disciplinary takeovers, one

would expect that the use of cash would be negatively

related to target firm performance prior to the offer.

Table 8 compares CARs and accounting performance

in cash bids to the returns in non-cash bids. Consistent

with expectations, share returns are lower in cash

takeovers the difference however is insignificant. The

results for accounting performance are opposite to

expectations with cash bids being associated with

higher performance with the difference significant for

CFROA.

In Table 9, the use of cash to bid for ―poorly

performing‖ targets is compared to the use of cash for

other targets. The result is again insignificant when

performance is measured using CARs with cash

actually used more frequently for targets with positive

pre-offer performance. Both measures of accounting

performance indicate that cash is used more often

when target firms have positive prior performance.

This finding is consistent with the model of Fishman

(1989), who argues that bidders offer equity for its

contingent pricing effect. When targets are

performing poorly an equity offer forces target

shareholders to share in the risk that performance will

not improve post-merger.

3.3.4 Takeover outcome

As the removal of inefficient target management is

frequently put forward as a justification for takeover

activity, it is interesting to examine whether takeover

outcome is related to prior target firm performance. It

can be argued that if the role of takeovers is to remove

non-performing management then it is in the public

interest that takeovers succeed more frequently where

target performance is worst.

Table 8 compares target performance prior to the

offer classified by takeover outcome. There is no

evidence that takeover outcome is related to prior

sharemarket performance. However, the accounting

performance ratios indicate that targets successfully

acquired are actually performing significantly better

that those not acquired. This result is consistent with

Henry (2004), who finds that successfully acquired

Australian firms have significantly higher operating

cash flows to total assets.

In Table 9, the proportion of successful

takeovers where the target is ―poorly-performing‖ is

compared to the rate of success for other targets. For

all three performance measures the results indicate

that the proportion of takeovers that are successful is

lower where the target is a poor performer with the

difference significant for the two accounting

performance measures. The failure to find evidence

that takeover success is higher for the poorer

performing targets casts doubts on whether the

takeover process is successful in removing the most

under-performing managers.


476

3.3.5 Takeover premium

Bugeja and Walter (1995) find there is no association

between takeover premiums and target firm

performance prior to the bid using a sample of

takeovers drawn from the 1980s. To assess if

consistent results are found using a sample from a

later time period, the takeover premium measured

over the three months prior to the takeover until three

months after are calculated using a market-adjusted

equally-weighted approach. Consistent with prior

research, target shareholders gain substantially from

the takeover announcement with average CARs of

22.5%.

The final row of each panel in Table 9 compares

takeover premiums offered for ―poorly performing‖

targets to those offered for other targets. In contrast

to Bugeja and Walter (1995), the results indicate that

takeover premiums are significantly higher for targets

with positive sharemarket performance prior to the

takeover. The results for the accounting performance

measures are insignificant.

Consistent with the disciplinary motive for

takeover, Moeller‘s (2005) study indicates that

takeover premiums during the 1990s are higher at

managerial ownership levels below 5%. To determine

if similar results are found in Australia, takeover

premiums for target firms where management

ownership is below 5% are compared to takeover

premiums for other targets. Although the average

premium (28.4%) for targets with ownership below

5% was higher than for other targets (22.3%), a t-test

indicated the difference was not statistically different

(p = 0.42).44

4. Conclusions and discussion

It is frequently argued that takeovers are motivated by

a need to discipline the management of the takeover

target or to remove inefficient target management.

Although our results are consistent with the inefficient

management hypothesis we however obtain only

limited support for the disciplining of target

management in Australian takeovers. We find that

target firms have a low level of management

ownership consistent with the disciplinary motive for

takeovers. However, the high degree of ownership

concentration in target firms means it is unlikely that

these firms exhibit agency problems associated with a

separation of ownership and control. This conclusion

is reinforced by the finding that in 90% of takeovers,

control of the target can be achieved by acquiring

only the interest of the top 20 shareholders. The

assumption, reflected in takeover legislation, that

target share ownership is widely dispersed is clearly

inaccurate. Our findings suggest that it may be

44 A comparison of premiums was also conducted using

10% ownership as the cut-off. The difference in premiums

was again insignificant.

worthwhile for the takeover provisions of the

Corporations Law to be revisited.

In contrast to the US results in Agrawal and

Jaffe (2003), this study finds that the majority of

target firms in Australia under-perform the stock

market in the three-year period prior to the bid. This

result is consistent with the removal of relatively

inefficient target management as a motivation for

takeover. However, we find no association between

management ownership and target firm performance

prior to the bid. This reiterates Dodd‘s (1987) point

that relative incompetence is not always symptomatic

of the agency costs of separation of ownership and

control.

This study also examines whether prior target

firm accounting and share market performance is

related to various takeover characteristics. The

majority of results show that the directors‘

recommendations, takeover premium and the number

of competing bidders appear unrelated to target

performance. Consistent with a contingent pricing

effect of equity, accounting measures of performance

show that bidders use equity as payment when the

target firm is underperforming. Finally, the results

indicate that the rate of takeover success is higher for

better performing targets. This finding questions

whether takeovers are an effective mechanism for

removing inefficient target management.

Although this study indicates that Australian

target firms are underperforming, consistent with the

removal of inefficient management as a motivation

for takeovers, this study only provides indirect

evidence on this hypothesis. A more direct approach

to testing this hypothesis is to examine whether the

turnover of target management is greater for

underperforming firms. Despite their being a

substantial body of literature in the US which shows

an increased turnover of directors and executives

subsequent to a takeover bid, this matter remains

untested in Australia. Such research is particularly

important given the findings of this study that indicate

the rate of takeover success is higher for better

performing firms. This being the case, it is important

to examine whether the internal monitoring

mechanisms of firms in unsuccessful takeovers are

able to remove inefficient management after the bid.

We leave this question for future research.

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http://www.treasury.gov.au/contentitem.asp?NavId=&ContentID=284

http://www.treasury.gov.au/contentitem.asp?NavId=&ContentID=284


478

Appendices

Table 1. Frequency Distribution of Takeovers

The sample is identified from all takeover announcements for ASX-listed companies between 1990 and 2000. Takeovers

announced over this period are identified from the Current Takeovers section of the Australian Financial Review and the

Connect 4 Mergers & Acquisitions Database. ―Year of takeover‖ is the year in which the takeover bid was announced.

Year of takeover Successful

takeovers

Unsuccessful

takeovers

Withdrawn

takeovers

Total

takeovers

1990 67 14 6 87

1991 45 24 11 80

1992 31 11 6 48

1993 35 15 6 56

1994 21 8 5 34

1995 42 9 12 63

1996 45 12 5 62

1997 34 8 4 46

1998 39 14 5 58

1999 32 8 11 51

2000 35 18 13 66

2001 35 11 10 56

2002 26 9 9 44

Total 487 161 103 751

Table 2. Descriptive Statistics

Selected financial information collected from the financial statements prepared in the year immediately preceding the takeover

announcement.

Variable N Mean Median Std. Dev Min. Max.

Total assets ($000) 742 205,953 32,247 653,591 1 8,429,800

Total liabilities ($000) 742 108,386 11,756 406,023 7 6,265,700

Total equity ($000) 742 97,543 17,064 291,476 -30,579 4,964,200

Operating profit after

tax ($000): (one year

prior)

742 2,344

296 32,910 -240,249 371,500

Operating profit after

tax ($000): (two years

prior)

721 2,997

430 46,517 -860,000 331,200

Cash from operations

($000): (one year

prior)

742 16,659

1,512 57,175 -44,325 646,400

Cash from operations

($000): (two years

prior)

721 15,053

1,560 53,935 -148,927 774,300

* The total number of target firms on which financial information could be collected is lower that the total sample as target

firms only listed on the ASX in the one and two years prior to the takeover announcement.

Table 3. Target firm management ownership

Management ownership in the target firm is collected from the Part B/Target‘s Statement provided to the ASX during the

takeover period.

Ownership interest Number of

targets*

% Cum.

%

Zero ownership 39 6.00% 6.00%

>0%, ≤ 1% 216 33.23% 39.23%

>1%, ≤ 2% 51 7.85% 47.08%

>2%, ≤ 3% 27 4.15% 51.23%

>3%, ≤ 4% 18 2.77% 54.00%

>4%, ≤ 5% 18 2.77% 56.77%

> 5% ≤ 10% 56 8.62% 65.38%

> 10% ≤ 20% 71 10.93% 76.31%

> 20% ≤ 30% 64 9.84% 86.15%

> 30% ≤ 50% 52 8.00% 94.15%

50% or above 38 5.85% 100.00%

Total 650

* The total number of target firms on which management ownership data could be collected is lower than the total sample due

to the takeover offer being withdrawn prior to the issue of a Part B/Target‘s Statement.


479

Table 4. Target firm ownership concentration

Information on target firm ownership is collected from the disclosure of the top 20 shareholders in the annual report for the

financial year immediately prior to the takeover announcement

Mean Median Min Max Std dev N

Panel A: All holdings

Top20 75.29% 78.61% 19.89% 99.58% 16.49% 710

Top 5 57.09% 57.58% 10.96% 98.22% 19.87% 592

Panel B:

Non-nominee holdings

Top20 57.58% 60.16% 4.02% 98.98% 24.20% 592

Top 5 45.04% 45.20% 0.00% 98.22% 25.77% 592

Table 5. Average proportion of shares held by the largest 20 shareholders in target and non-target firms, classified by size

range (measured in total assets)

Target firms are ASX-listed companies subject to a takeover bid by another ASX-listed firm over the period 1992 to 2002.

Data on their top 20 shareholders and size of firm assets are drawn from their annual report in the year prior to their becoming

a target. Non-target firms are all ASX companies in Aspect Financial database as at May 2004 not subject to a takeover bid at

that time. Their data were drawn from their 2003 annual reports.

Total assets Targets

Number

Firms Non-Targets Number Firms

Up to $1 million 78.98% 17 58.53% 35

Between $1m and $10m 70.35% 96 59.36% 293

Between $10m and $20m 74.83% 82 61.98% 146

Between $20m and $50m 76.46% 93 65.66% 166

Between $50m and $100m 72.08% 73 65.28% 82

Between $100m and $200m 73.49% 60 65.42% 77

Between $200m and $500m 71.98% 66 60.88% 71

Between 500m and $1 billion 74.11% 29 58.92% 53

Over $1 billion 69.09% 29 62.80% 92

Average (total) 73.24% 545 62.44% 1,015

Table 6. Target firm abnormal returns prior to the takeover

Target firm CARs in the period prior to the takeover. Abnormal returns are measured over two event windows. In Panel A

CARs, are measured from the period running from 36 months to 6 months before the takeover announcement. In Panel B,

CARs are measured from the period running from 24 months to 6 months before the takeover announcement. The table

presents the results of testing the null hypothesis that mean abnormal returns are equal to zero.

Panel A: Perf. over

(-36,-6) months

Mean Median 25% 75% Std dev %

Positive

N

Size adj equally

weighted

-10.72%*** -26.55% -57.68% 14.12% 107.76% 33.5 632

Size adj value

weighted

-10.22%*** -26.65% -58.32% 13.44% 106.99% 32.3 632

Mkt adj equally

weighted

-18.91%*** -34.57% -64.67% 1.25% 111.27% 25.5 632

Mkt adj value

Weighted

-0.14% -24.07% -58.49% 18.75% 115.01% 35.4 632

Panel B: Perf. over

(-24,-6) months

Size adj equally

weighted

-4.66% -16.19% -45.34% 17.81% 95.92% 36.4 682

Size adj value

weighted

-4.75% -16.37% -46.15% 16.18% 96.04% 36.2 682

Mkt adj equally

weighted

-9.98%*** -21.97% -56.43% 13.01% 99.14% 32.3 682

Mkt adj value

Weighted

1.49% -13.37% -45.10% 17.87% 99.90% 37.0 682

*** Significant at 0.01 level


480

Table 7. Target firm abnormal returns prior to the takeover classified by management ownership bands

Target firm CARs in the period prior to the takeover. Mean abnormal returns are measured over two event windows: the

period running from 36 months to 6 months before the takeover announcement and alternatively the period running from 24

months to 6 months before the takeover announcement. Managerial ownership is collected from the Part B/Target‘s

Statement.

Event window (-36,-6) Event window (-24,-6)

Ownership interest SizeEq SizeVal MktEq MktVal SizeEq SizeVal MktEq MktVal

Zero ownership -20.80% -18.00% -23.14% -14.32% -4.63% -3.61% -2.76% 10.85%

>0%, ≤ 1% -19.67% -20.00% -31.86% -16.41% -12.85% -13.25% -21.99% -12.69%

>1%, ≤ 2% 10.33% 9.61% 2.49% 27.42% 1.02% 0.20% -9.25% 10.21%

>2%, ≤ 3% 8.22% 9.28% -1.20% 21.08% 23.46% 24.14% 14.76% 39.37%

>3%, ≤ 4% -17.03% -16.25% -32.40% -25.14% -12.34% -12.24% -18.17% -11.64%

>4%, ≤ 5% -15.76% -14.89% -37.68% -11.47% -9.67% -10.34% -25.92% -7.66%

>5%, ≤ 10% -30.06% -29.26% -32.08% -11.36% -12.74% -12.33% -15.05% 0.12%

>10%, ≤ 20% -14.38% -14.23% -9.16% -9.43% -4.91% -5.67% -0.23% -5.99%

>20%, ≤ 30% 21.72% 21.86% 16.92% 23.30% 5.35% 5.43% 2.63% 8.23%

>30%, ≤ 50% -17.70% -15.94% -26.01% 8.45% -12.80% -12.39% -16.59% 2.45%

50% or above -15.63% -11.21% -9.97% 21.78% -11.64% -11.92% -8.95% 7.61%

Table 8. Performance for subsamples of targets

A comparison of sharemarket and accounting performance for various subsamples of target firms. Sharemarket performance

is measured as the mean market-adjusted equally weighted CARs prior to the takeover. Accounting performance is measured

as return on assets (i.e., ROA) or cashflow return on assets (i.e., CFROA) for the financial year-end prior to the takeover

announcement. The initial directors‘ recommendation, presence of multiple bidders, method of payment and takeover

outcome are obtained from target and bidder takeover documents lodged with the ASX.

Panel A: Directors‘ recommendation

Perf.

measure

Accept

(n = 295)

Reject

(n = 205)

t-Stat

CAR (-36,-6) -13.74% -28.07% 1.62

CAR (-24,-6) -10.75% -17.16% 0.99

ROA -5.82% -8.48% 0.61

CFROA 3.30% 4.26% -0.49

Panel B: Number of bidders

Perf.

Measure

Multiple

(n = 134)

Single

(n = 498)

t-Stat

CAR (-36,-6) -27.41% -16.62% -1.30

CAR (-24,-6) -15.54% -9.49% -0.78

ROA -19.0% -10.8% -1.17

CFROA 3.38% 3.18% 0.08

Panel C: Method of payment

Perf.

Measure

Cash

(n = 419)

Non-cash

(n = 213)

t-Stat

CAR (-36,-6) -21.01% -14.77% -0.59

CAR (-24,-6) -12.24% -7.88% -0.42

ROA -11.07% -15.46% 0.88

CFROA 4.85% 0.02% 2.47**

Panel D: Takeover outcome

Perf.

Measure

Successful

(n = 416)

Unsuccessful

(n = 216)

t-Stat

CAR (-36,-6) -17.42% -21.78% 0.46

CAR (-24,-6) -13.04% -6.39% -0.65

ROA -7.87% -21.37% 2.42**

CFROA 5.15% -0.01% 2.58***

*** Significant at the 1% level

** Significant at the 5% level


481

Table 9. Takeover characteristics by prior stock returns

A comparison of takeover deal characteristics for poor and good performing target firms. In Panel A, poor performing target

firms are defined as those targets where the market-adjusted equally weighted CARs over the period (-36,-6) are negative. In

Panel B, poor performing targets are defined as those targets that report a negative return on assets for the financial year-end

prior to the takeover.

Takeover Characteristics Poor performing

targets

(n = 471)

Good performing

targets

(n = 161)

z-stat

Panel A: Performance measured using CARs

Accept recommendation 44.8% 52.2% -1.62*

Multiple bidders 22.1% 18.6% 0.92

Cash payment 65.6% 68.3% -0.633

Successful outcome 64.3% 70.2% -1.35

Takeover premium 24.7% 96.7% -5.00***

Panel B: Performance measured using ROA

Poor performing

targets

(n = 327)

Good performing

targets

(n = 413)

z-stat

Accept recommendation 60.5% 59.6% 0.22

Multiple bidders 19.6% 23.9% -1.42

Cash payment 57.2% 71.3% -3.99***

Successful outcome 59.6% 69.1% -2.68***

Takeover premium 25.1% 20.6% 0.55

Panel C: Performance measured using CFROA

Poor performing

targets

(n = 230)

Good performing

targets

(n = 510)

z-stat

Accept recommendation 62.0% 59.1% 0.64

Multiple bidders 17.0% 24.3% -2.23**

Cash payment 54.8% 69.6% -3.91***

Successful outcome 58.3% 67.8% -2.53**

Takeover premium 15.1% 26.1% -1.06

* Significant at the 0.10 level

** Significant at the 0.05 level

*** Significant at 0.01 level


482

THE IMPACT OF ENTRY MODE ON SUBSEQUENT COMMITMENT TO POORLY PERFORMING SUBSIDIARIES

Jamie D. Collins*, Christopher R. Reutzel**, Dan Li***

Abstract Despite of the extensive research on the choice of how to structure a new foreign subsidiary in the international business literature, few studies have explored how the initial foreign entry mode impacts a multinational’s subsequent activities in the host market. Drawing insights from prospect theory, this paper addresses how a multinational’s entry mode influences the firm’s reaction to negative subsidiary performance. Specifically, we argue that the entry mode (ownership structure of a multinational’s subsidiary) affects the firm’s potential for escalation of commitment to a poorly performing subsidiary. Further, we argue that the relationship between entry mode and a multinational’s escalation of commitment is moderated by three factors – institutional distance between the home and the host country, cost of exiting the host market, and the parent firm’s prior performance. This paper contributes to the literature by presenting the case that initial entry mode influences a multinational’s post-entry activities.

Keywords: subsidiary performance, parent firm commitment, entry mode, ownership structure, escalation

*Baylor University, Hankamer School of Business, Department of Management & Entrepreneurship Waco, TX 76798 Phone: 281-844-7544, [email protected] **Assistant Professor, Department of Management, Utah State University, Logan, UT 84321 [email protected] ***Indiana University, Kelley School of Business, Business, Suite 630, 1309 East Tenth Street Bloomington, Indiana 47405-1701 Phone: 812-855-5967, [email protected] Acknowledgement: The authors wish to thank Asghar Zardkoohi for his insightful comments on earlier versions of this paper.

Introduction

Despite the rich literature on firms‘

internationalization, researchers often have ignored

the potential impact that initial mode of entry

decisions can have on how the parent firm reacts to

negative performance on behalf of the subsidiary. Our

aim in this article is to provide a conceptual

framework regarding several important factors

influencing firms‘ subsequent commitment to poorly

performing subsidiaries. The performance of foreign

subsidiaries often has been considered as the

dependent variable in most studies. However, the

effects of foreign entry mode on subsidiary

performance are not direct. Market entry is just the

first step of a firm‘s operation in a foreign market.

Further management and control are necessary to

achieve the originally designed goals of the

subsidiaries. Although several perspectives have been

used to explain mode of entry into a foreign market,

very few studies have specifically considered the

impact of entry mode on a multinational firm‘s

subsequent decisions and activities.

In this paper, we argue that the initial decision

regarding the investment structure chosen as a mode

of entry into a foreign country will impact the

likelihood of an escalation of commitment to that

investment. Our assertion is that the factors which

make a given type of entry mode attractive may have

different implications for the potential for escalating

commitment should this foreign subsidiary experience

negative performance. Although entry mode may

help manage such uncertainty initially, certain

ownership structures may actually increase the

chances of escalating commitment to a foreign

subsidiary facing subsequent uncertainty. We only

focus on equity-related modes of entry (i.e., joint

venture and wholly-owned subsidiaries) since the

escalation of commitment to non-equity entry modes

is difficult to observe and places no additional firm

capital at risk. We rely primarily on the theoretical

tools of prospect theory and institutional distance

literature in this paper.

The rationale for employing prospect theory in

this paper resides in the argument that upper echelons

are the information interpreters in firms (Hambrick &

Mason, 1984; Hambrick, 1989; Rajagopalan &




483

Spreitzer, 1996). An organization‘s strategic decisions

are made by executives whose reading of the firm

performance and the external business environment

impacts these strategic decisions. People

systematically violate the requirements of consistency

and coherence in making decisions; such violations

occur when people frame differently information

available to decisions (Tversky & Kahneman, 1981).

In the presence of subsidiaries‘ unsatisfactory

performance in host markets, how executives interpret

both financial and non-financial information will

significantly influence their decisions on whether to

escalate the firm‘s investment in these subsidiaries.

We argue that the potential for a parent firm to

escalate its commitment to a subsidiary which has not

met performance expectations is greater when the

parent firm has a larger equity stake in that subsidiary.

Further, we suggest that this likelihood is influenced

directly and also moderated by the institutional

distance between home country and host country. In

addition, we argue that the probability of escalation is

also moderated by the parent firm‘s performance in

the prior period. Finally, we suggest that the

likelihood of escalation is moderated by the cost of

exit. Our proposed conceptual framework is

illustrated in Figure 1.

The paper starts with a review of prospect theory

and escalation of commitment literature. Then

additional related areas of interest related to a firm‘s

likelihood to escalate its commitment to poorly

performing subsidiaries are discussed. These

additional areas include: institutional distance

between a firm‘s home country and host country, the

prior performance of parent firms, and the cost of

exiting a host market. From each of the research

streams presented here, we build on prior arguments

to develop propositions related to the mode of entry

chosen by a firm and the connection between the

foreign subsidiary‘s ownership structure and the

potential for escalation of commitment. Thus, herein

we strive to clarify the role played by ownership

structure in determining whether parent firms will

escalate their level of commitment to poorly

performing foreign subsidiaries.

***Insert Figure 1 around here***

Theoretical Background Foreign Entry Mode

Several different theoretical approaches have been

utilized to explain the choice of entry mode. Each of

these approaches has a unique set of assumptions

about the nature of the entry mode decision and

factors influencing this decision. First, the Uppsala

school views business operation in an overseas market

as inherently risky; therefore, this view advocates a

gradual involvement in the foreign market (Janhanson

and Vahlne, 1977, 1990; Root, 1987). From a

behavior perspective, the Uppsala model argues for

incremental investment in foreign markets. According

to this model, exporting is the best choice when a firm

first enters an overseas market; as the firm acquires

more knowledge and experience in that overseas

market, it will assume a higher level of resource

commitment. Thus, various entry modes can be

marked on a continuum of increasing levels of

resource commitment, risk exposure, control, and

profit potential.

Second, as the major stream of research in the

entry mode field, transaction cost theory has arguably

had the most impact on how researchers view the

entry mode decision. Extant research, which has been

heavily influenced by transaction cost economics, has

focused on minimizing the costs of entry. This theory

emphasizes the relationship between a firm‘s assets

and its need for control. As a result, entry mode

choice is often modeled from an economic

perspective (Anderson, 1993; Anderson and

Gatignon, 1986). Under conditions of high asset

specificity, a high control mode is preferred to

mitigate the threat of opportunistic behavior from

transaction partners. Firms with highly-specific assets

are likely to use a wholly-owned mode to fully

appropriate the economic rents earned from the assets

and to reduce the risk of unwanted dissemination

(Teece, 1981; Gatgnon and Anderson, 1988; Hennart

and Part, 1993; Beamish and Banks, 1987; Hennart,

1988).

Third, Dunning‘s Eclectic Framework (OLI –

ownership, location, internalization advantages)

highlights the importance of location-specific factors

(Dunning, 1980, 1988; Hill, Hwang, and Kim, 1990).

Environmental factors investigated include country

risk, location familiarity, demand conditions, and

volatility of competition. For example, Hill et al.

(1990) proposed that national differences exert

influences on entry mode decision. Similarly, Puxty

(1979) focused on the relationship between cultural

differences and ownership policies regarding overseas

subsidiaries. The greater the cultural distance between

the country of the investing firm and the country of

entry, the mode likely a firm will choose a JV or

WOS over an acquisition (Kogut and Singh, 1988).

The greater the culture of the investing firm is

characterized by high tendency of uncertainty

avoidance regarding organizational practices, the

more likely that firm will choose a JV or WOS over

an acquisition (Kogut and Singh, 1988).

Recently a limited number of authors have

linked the choice of foreign market entry mode to

institutional conditions within the host market

(Rodriguez, Uhlenbruck & Eden, 2003; Lu, 2002; Xu

and Shenkar, 2002; Davis, Desai & Francis, 2000).

This stream of research can be categorized into three

groups: (1) how the external institutional environment

affects a firm‘s mode of entry; (2) how the firm‘s

internal institutional environment impacts its mode of

entry; and (3) how the institutional distance between

the home and the host influences a firm‘s mode of

entry. Because of the relative paucity of extant


484

literature on the subject, this paper focuses on the last

category of institutional theory research (institutional

distance). Lu (2002) compared transaction cost

theory and institutional theory in terms of their

respective abilities to explain entry mode choices.

Prospect Theory and Escalation of Commitment

In a seminal article on the subject of escalation of

commitment, Staw (1976), noted that intuition

suggests that negative consequences should modify

behavior. However, situations arise in which

negative consequences serve to solidify commitment

to a course of action that has produced negative

results. These escalation situations are,

―predicaments where costs are suffered in a course of

action, where there is an opportunity to withdraw or

persist, and where the consequences of persistence

and withdrawal are uncertain‖ (Staw and Ross, 1987).

This commonly observed behavioral phenomenon has

been labeled escalation of commitment by

organizational researchers. The extent of

commitment to a course of action can be described as

a product of perceived costs and benefits (Staw and

Ross, 1987). Escalation of commitment has been

documented in various contexts such as the writing

off of loans (e.g., Staw, Barsade, & Koput, 1997),

waiting situations (e.g., Rubin, 1981), gambling (e.g.,

McGlothlin, 1956), season ticket use (e.g., Arkes &

Blumer, 1985), group decision making (e.g., Whyte,

1993), and economic investment (e.g., Kanodia,

Bushman, & Dickhaut, 1989; Thaler, 1980). In the

case of multinational firms, unsatisfactory

performance on behalf of the subsidiaries exposes

their parent firms the decision of whether or not to

escalate their commitment to the subsidiary; i.e.,

whether to invest more or to divest.

Arguably, one of the most intriguing areas of

business research involves the act of framing and

decision-making (Edwards, 1996; Sharp and Salter,

1997). Among the major determinants45

of escalation

of commitment (Staw and Ross, 1987), psychological

determinants are focused on for this paper.

Psychological determinants of escalation of

commitment are, ―factors that influence one‘s goals

and beliefs about the consequences of an action‖

(Staw and Ross, 1987). Several psychological

explanations are mentioned in the literature, most

prominent of which appear to be those of self-

justification and prospect theory (Brockner, 1992).

Explanations of commitment escalation drawing upon

self-justification posit that receiving negative

feedback can motivate individuals to justify initial

behavior and thus persist in a course of action (Staw,

1976; Staw and Ross, 1987). Integral to the self-

justification explanation is the responsibility

45 Staw and Ross (1987) specified the project,

psychological, structural, and sociological determinants of escalation decisions.

hypothesis, which posits that personal responsibility

will lead to an increase in the tendency to escalate

commitment (Staw, 1976).

Several organizational scholars have pointed to

the power of prospect theory to explain escalation

decisions (Chattopadhyay, Glick & Huber, 2001;

Garland, 1990; Richardson, Amason, Bucholtz &

Gerard, 2002; Schweitzer, Ordonez & Douma, 2002;

Whyte, 1986; Whyte, 1993). In a test of the

universality of prospect theory explanations of

escalation of commitment, framing effects were found

to be significant in both Asian and North American

managers (Sharp and Salter, 1997). In an attempt to

further explain and predict decisions given certain

conditions and circumstances (Edwards, 1996),

especially with regard to risk, researchers have

proposed several possible explanations. Tversky and

Kahneman (1981) contend that prospect theory

involves framing outcomes as either positive/negative

or gains/losses. In this process, an outcome is framed

relative to a neutral reference outcome, or something

which is assigned a value of zero. According to this

zero value, if the outcome is viewed as more

favorable, then it will be framed positively or as a

gain. On the other hand, if the outcome is viewed less

favorably relative to the neutral reference point, then

the outcome is framed as a negative, or as a loss. This

framing of a given decision ultimately impacts the

behavior or action taken. For instance, prospect

theory indicates that a positively framed event (or

gain) will result in the decision maker behaving in a

risk-averse manner, whereas a negatively framed

event (or loss) will result in the decision maker being

more risk seeking.

Kahneman and Tversky (1979) argued that

individuals have a preference for certainty when

making their assessment of possible financial losses

or gains. This ―certainty effect‖ means that

individuals are likely to give higher weights to

outcomes that are certain of occurring versus those

that are merely probable. In the context of firms with

foreign subsidiaries, this suggests that parent firms are

likely to frame post-entry decisions as choices

between certain wealth (maintaining an investment in

a subsidiary) versus uncertain wealth (potentially

withdrawing from the subsidiary). Prospect theory

explanations of commitment escalation argues that

escalation of commitment is a natural outcome of the

way people frame risky decisions (gain or loss) with

respect to a neutral reference point 46

. Upon

receiving negative feedback about a project, decision

makers in an escalation situation will frame future

decisions as a choice between certain and uncertain

losses (Whyte, 1986). Given the uncertainty affect

often surrounding potential losses, in some

circumstances decision makers will choose the

uncertain loss and thus escalate commitment to that

project rather than withdraw.

46 See Kahneman and Tversky (1979, 1981) for a more

detailed explanation of prospect theory.


485

For firms with foreign subsidiaries, the notion of

escalation of commitment is particularly important.

Given that all firms face resource constraints and the

increasingly competitive global market, it is critical

for companies to make sound decisions regarding the

allocation of resources to its foreign subsidiaries. In

circumstances where competitive pressure is intense

and foreign markets are viewed as an attractive source

of new customers, it is possible to envision scenarios

where more short-term leeway is given to a poorly

performing foreign subsidiary than can be justified on

a purely economic basis.

In addition, executives at parent firms may also

be tempted to escalate commitment to a poorly

performing subsidiary because of previous good

performance by the subsidiary. When an existing

subsidiary encounters a stretch of poor performance,

the parent company may initially view this lower

performance as a natural impact of cyclical markets.

Once faced with negative performance information

about a foreign subsidiary, the critical question

becomes how the parent firm will react? If the parent

responds by increasing the amount of resources

allocated to the subsidiary, the parent is escalating its

commitment.

For purposes of this paper, no assessment is

made regarding the soundness of a decision to

escalate commitment to a subsidiary. Whether or not

the decision is a good one cannot be made until after

the impact of the escalation has occurred. Once new

performance information (for periods post-escalation)

is available, only then it is possible to determine the

wisdom of such an escalation. We now turn to the

discussion of how the foreign entry mode affects the

parent firm‘s escalation of commitment when the

foreign subsidiary‘s performance does not meet pre-

set goals.

Foreign Entry Mode and Escalation of Commitment

Although there are different perspectives from which

one can analyze a firm‘s escalation of commitment

once its foreign subsidiary fails to achieve an

expected performance level, we focus on how the

firm‘s initial entry mode influences the likelihood of

escalation (see Figure 1). This topic is important and

interesting because entry mode selection is not only a

fascinating dependent variable but also an influential

independent variable argued to have an impact on a

multinational firm‘s sequential activities in the host

market. However, both strategic management and

international business literature have often ignored

this link. The decision a firm makes regarding which

mode of entry to use for a particular foreign market is

widely viewed as critical to MNE performance and

has received much attention in the international

business literature (for reviews see Chang &

Rosenzweig, 2001, Davis et al., 2000, and Buckley &

Casson, 1998). Yet, how the initial entry mode affects

firm performance has remained as a black box and the

internal mechanism between the independent and

dependent variables has been neglected.

II. Mode of Entry and the Parent Firm’s Escalation

Although there remains a lack of consensus

concerning the antecedents of entry mode choice (Lu,

2002), there is general agreement regarding the

categorization of entry modes as a continuum from

exporting to wholly-owned subsidiary (WOS). The

specific classifications by different authors sometimes

vary slightly based on disparate research purposes and

level of detail. For instance, Griffin and Pustay

(2001) state that entry modes can be categorized as

home country production (exporting), host country

production in firm-owned factories (FDI), or host

country production performed by others (licensing,

franchising, and contract manufacturing). This is only

slightly different from Agarwal and Ramaswami‘s

(1991) classification. According to Agarwal and

Ramaswami (1991), the options available to a firm

entering a foreign market include exporting, licensing,

joint venture (JV), and wholly-owned subsidiary

(WOS).

The selection of different foreign entry modes is

associated with different levels of the parent firm‘s

commitment in the local market, in terms of resources

invested and control retained. The greater control a

firm seeks over the foreign assets/operation, the

greater the amount of resources it has to commit.

With a larger investment being made in the local

market, the foreign parent firms are actually exposed

to higher levels of risk (Delios & Beamish, 1999).

Therefore, local investment is often associated with

more control retained by the parent firms. According

to prospect theorists, individuals place more weight

on ―certain‖ wealth than on ―uncertain‖ wealth. Thus,

commitment escalation is more likely to occur in an

attempt to salvage existing wealth than to acquire

additional wealth. We expect to observe this

phenomenon in play when it comes to multinational

firms dealing with unsatisfactory performance by

foreign subsidiaries in which equity has been

invested. Before we move on to a methodical

discussion of how entry mode may influence a parent

firm‘s escalation decision, we will examine important

aspects of various types of entry mode.

We only focus on equity-related modes of entry

(i.e., joint venture and wholly-owned subsidiaries)

since the escalation of commitment to non-equity

entry modes is difficult to observe and places no

additional firm capital at risk. Different foreign entry

modes involve different degrees of parent firm

commitment, and consequently achieve different

levels managerial control. For example, exporting

involves the least control by the parent firms while

foreign firms selecting a wholly-owned subsidiary

(WOS) are completely responsible to their

subsidiaries‘ performance and have the highest level

of control. Since our interest is how foreign entry


486

modes affect the parent firm‘s escalation of

commitment, equity-based entry modes serve as better

subjects than non-equity ones. Escalation of

commitment can only be observed when managerial

control is present. Parent firms‘ commitment

escalation refers to their continuous investment in a

given subsidiary even though the subsidiary is losing

money or performing at lower than expected levels in

the host market.

Equity entry modes include joint ventures (JV)

and wholly-owned subsidiaries (WOS). A JV is

established when two or more firms join together to

create a new business entity that is legally separate

and distinct from its parent firms. This new entity can

involve almost any combination of foreign and local

owners. A WOS is a business entity established solely

by one multinational firm. A WOS can be established

through building a new venture, or through

merger/acquisition of local firm(s). The WOS mode is

a high investment option and consequently involves

high risk/return potential. The parent firms have

different levels of managerial control when adopting

different modes. JVs require some equity investment

by the firm but which also includes investment by

other parties. That is, a JV serves as a means to pool

necessary resources and to share the risk. In contrast,

a firm using a WOS as a mode of entry contributes all

necessary resources and also possesses absolute

ownership control over the subsidiary. Therefore, JVs

provide the parent firm with a relatively higher level

of managerial control than non-equity entry modes,

while a WOS offers the parent the total control of the

foreign subsidiary.

III. Impact on Escalation of Commitment

When a foreign subsidiary encounters unsatisfactory

performance, the parent firm has three general choices

– immediately exiting the host market, doing nothing

(―wait and see‖), or escalating the investment

(increasing the amount of resources allocated to the

subsidiary) (Witteloostuijn, 1998; Mone, McKinley,

& Barker III, 1998). In our opinion, the latter two

alternatives both can be labeled as ―escalation of

commitment‖. Choosing to ―do nothing‖ in the face of

unsatisfactory performance can be considered as one

type of escalation because of the opportunity costs

that exist related to the next best alternative of

utilizing the invested resources.

***Insert Figure 2 around here***

As mentioned previously, we argue that the

ownership structure of a firm‘s foreign subsidiary

impacts its likelihood of escalating its commitment in

the local market. Figure 2 illuminates the difference

between the scenarios in which the parents of a WOS

or a JV will be either risk seekers or risk averse.

Further, it shows that the slope of the value function

curve for each of these ownership structures is

different. This difference is attributable to the

different levels of equity required by each mode of

entry. A WOS is completely owned by the foreign

parent while a joint venture represents the pooled

resources from, and the shared risks by, two or more

firms. The parent firm of a WOS commits more

energy, time, money and personal responsibility than

in a comparable JV. Thus, a parent firm is likely to

value the wealth of the assets in wholly-owned

subsidiaries more than those firms do whose

subsidiaries are jointly held with other companies.

Therefore, WOS‘ parent firms are more likely to

contribute further resources to their foreign

subsidiaries to keep them alive and to attempt to avoid

losses. This means that the parent company of a WOS

will generally be more risk-seeking than a parent firm

of a JV when their decision alternatives are framed as

losses and more risk-averse when their decision

alternatives are framed as gains. Based on prospect

theory arguments, they are more reluctant to admit the

potential failures indicated by the unsatisfactory

performance of the subsidiaries than their

counterparts investing in joint ventures.

Because of higher levels of equity involved, the

slope of the value function curve for companies

entering foreign markets via a WOS is steeper than

those entering via JVs. This is because the

subsidiary‘s performance will be viewed as either a

positive deviation or negative deviation from the

overall firm reference point. It is likely that, in the

case of prior good performance, parent firms with a

WOS will under-evaluate the risks and over-evaluate

the potential market opportunities in the host country.

In contrast, parent firms with JVs will be less likely to

escalate their commitment to a poorly performing

foreign subsidiary. This propensity is reversed when

decisions involve certain versus uncertain gains.

Wholly owned subsidiaries will be more risk averse

when a certain gain is involved, and because of their

lower levels of equity invested, JVs will be less risk

averse. Hence, our first proposition follows:

Proposition 1: The ownership structure of a

firm‘s foreign subsidiary will impact the likelihood of

the parent escalating its commitment to the

subsidiary. Parent firms with more equity invested

will be more likely to escalate their commitment, all

else equal.

IV. Other Effects Institutional Distance

Institutional distance provides scholars with a more

comprehensive measure of differences between a

firm‘s home country and host country than does

culture distance (Xu and Shenkar, 2002). It is a

measure of the similarity or dissimilarity of the

regulatory, cognitive, and normative institutions of

two countries (Kostova, 1996). The notion of

institutional distance is an extension of institutional

theory, which was initially developed in response to

classical organizational theory's neglect of social


487

influence processes that might influence the behavior

of organizations (Tolbert & Zucker, 1996;

Granovetter, 1985).

Scott (1995) suggests that institutions may either

be regulatory, normative or cognitive. Regulatory

institutions constrain behavior through rules,

monitoring, and sanctions. Actors conform to these

rules, as failing to doing so would be detrimental to

them. Normative institutions specify the roles, rights,

and responsibilities of the individual. These norms,

values, and cultures may be imposed by others, or

may also be internalized. Morally governed behavior

creates stability in the social order as actors comply

with their roles. Cognitive institutions emphasize the

importance of symbols, routines that are taken for

granted as the way things are done, and social

identification (Scott, 1995).

Kostova (1997) developed the construct of

country institutional profile to help measure and

explain differences between different national

institutional environments. The construct of

institutional distance is particularly useful in

examining MNE behavior (Xu and Shenkar, 2002).

Xu and Shenkar (2002) examine MNE investment and

entry mode decisions by utilizing the construct of

institutional distance. They argue that institutional

distance impacts a firm‘s choice of which country to

enter as well as it decision regarding the ownership

structure of the foreign subsidiary.

Furthermore, several studies have shown that

larger differences between the home country of a firm

and the host country of a subsidiary tends to lead to

higher levels of equity participation by local partners

(Contractor & Kundu, 1998; Kim & Hwang, 1992;

Kogut & Singh, 1988). Having local partners

contribute to the subsidiary‘s equity may help

establish local legitimacy. Xu and Shenkar (2002)

argue that (1) a firm is more likely to enter a foreign

market via a WOS or a majority JV where regulative

distance is small and via a minority JV where

regulative distance is large; and (2) a firm is more

likely to pursue high equity control over a JV where

normative distance is small and low equity control

where normative distance is large.

Xu and Shenkar (2002) contend that the

normative dimension of institutional distance has the

most direct influence on organizational practice, and

therefore, on a firm‘s decisions about how to structure

the ownership of new foreign subsidiaries (Xu and

Shenkar, 2002). In addition, they propose that the

choice of ownership structure of a foreign subsidiary

will be directly impacted by institutional distance.

Greater institutional distances are expected to be

associated with lower levels of equity investment.

Wholly-owned subsidiaries are expected to be the

preferred ownership structure only when institutional

distances are relatively small. Joint ventures, which

require less equity contribution from the focal firm,

are expected to be more likely when institutional

distance is greater.

Proposition 2a: Institutional distance between

host country and home country environments directly

impacts the likelihood of escalation of commitment,

regardless of whether the subsidiary is a JV or WOS.

Institutional distance between the home and the

host not only affects a foreign firm‘s selection of

entry mode between WOS and JV, but it also is likely

to have an impact on the firm‘s decisions on post-

entry operations. When the institutional distance

between the host and the home countries is large,

foreign firms are more likely to choose JVs as the

mode to enter the host market. However, the parent

firms may still have to use WOS to enter the local

market because of certain strategic concerns, such as

the concern for reducing the potential for proprietary

knowledge being disclosed outside the firm. In this

condition, firms are actually taking more risks than

those that enter through JVs. When unsatisfactory

performance of a subsidiary is detected, parent firms

of WOS will be more likely to take further risks than

those of JVs. This is a result of the relative difficulty

the parent firm will have in fully comprehending the

environment in the host country. Having one or more

partners (often from the host country) enables parents

of JVs to generally have less difficulty

comprehending the host country environment. Thus,

we propose that institutional distance has both a direct

effect on the likelihood of a parent firms escalating its

commitment to a foreign subsidiary and a moderating

effect between the mode of entry and escalation.

Proposition 2b: Institutional distance between host

country and home country environments moderates

the relationship between subsidiary ownership

structure and the likelihood of escalation of

commitment.

Parent Firm’s Prior Performance

When faced with a poorly performing foreign

subsidiary, how will the parent firm respond? We

argue that the answer to this question depends in large

part on how well the parent company has performed

as a whole in prior periods. Given that decision

makers frame decisions differently depending on their

starting reference point (Tversky and Kahneman,

1981; Kahneman and Tversky, 1979), whether

escalation occurs after receiving negative

performance information about a subsidiary depends

on whether the loss is framed as certain or uncertain.

In essence, our argument here is that the prior

performance of the parent company changes the

reference point from which a judgment is made about

whether to escalate commitment to the subsidiary.

When the loss is framed as an uncertain loss (meaning

that key decision makers within the parent company

believe that the loss is recoverable and have not

cognitively come to grips with the reason for the

loss), we argue that escalation is likely.

The probability of a parent company allocating

additional resources to a poorly performing subsidiary

will be moderated by the way in which this decision is


488

framed. Positive overall performance in prior periods

is expected to establish a generally positive reference

point from which the parent firm will evaluate its

ownership of the subsidiary. Thus, poor performance

on behalf of the foreign subsidiary will be framed as a

loss, leading to risk-seeking behavior. In the context

of allocating resources to foreign subsidiaries,

committing additional resources would be risk-

seeking behavior.

Negative overall firm performance is expected to

be associated with a more negative reference point,

and a lower probability of the parent escalating its

commitment to the subsidiary. This is because

executives of the parent company are expected to

more quickly come to grips with losses at the

subsidiary level than if the parent experienced

positive overall performance in the prior period. For

example, when the firm‘s overall performance have

previously been satisfactory, parent firms of WOS are

likely to adjust their perceptions of local market and

environmental conditions more slowly than those of

joint ventures. Figure 2 graphically illustrates the

differences between the value function curves for

parent firms with WOS and those with JVs. The

purpose of using these graphs, which are extensions

of Kahneman and Tversky‘s work (1979, 1981), is to

conceptually highlight that the propensity to be risk-

seeking or risk-averse is impacted by the level of

equity invested in a foreign subsidiary.

Proposition 3: A parent firm‘s prior performance

moderates the relationship between the subsidiary

ownership structure and the likelihood of escalation.

Cost of Exit

of the factors that a firm considers when making a

foreign direct investment decision is whether the

investment can be withdrawn from the host country.

Staw and Ross (1987) argue that if the cost to

withdraw from a course action is high, the subject will

be likely to extend its commitment. This is thought to

be of particular importance for multinationals when

the closing cost associated with exiting a foreign

market may exceed the short-term losses from

continuing to operate the subsidiary. We classify the

costs of closing a foreign subsidiary into two general

groups – financial and social costs.

The financial costs include the losses of

transaction-specific investments; payments to release

the physical assets, which may be more than the

salvage value of these assets; payments to terminate

employees; and penalties for breaching the contract.

When the investment is transaction-specific, there will

be no alternative use for the invested assets, or the

switching to any alternative usages will be costly. The

specificity of invested assets can be classified as

physical asset specificity, location specificity, human

asset specificity, and dedicated specificity

(Williamson, 1979, 1985). When a firm makes an

international investment, all of these types of asset

specificity may occur and impact the parent firm‘s

escalation decisions. For instance, political risks have

been one of the important considerations that the

multinational concerns when choosing investment

location and entry mode. Should the nationalization

of a foreign investment occur, it would be impossible

for the foreign investors to withdraw the investment.

As a result, the time and money spent on such things

as factories, equipment, and employee training would

be totally lost. In contrast, a JV serves as a buffer that

limits the foreign parent‘s exposure to potential

nationalization of assets in a foreign country. The

financial costs will be shared with other partners.

Therefore, we argue that, in the occurrence of high

financial costs of exit, the parent firm of a WOS

would be more likely to exhibit an escalation of

commitment than those of JVs.

Proposition 4a: The financial cost of exit

moderates the relationship between the ownership

structure of a foreign subsidiary and the parent‘s

likelihood of escalation of commitment. When

financial costs of exit are high, parent firms with a

WOS are more likely to escalate their commitment

than are parent firms with a JV in the same market.

In addition, another potential source of financial

costs may reside in the firm‘s switching between

strategies. These costs depend on both the strategy the

firm is switching from and the strategy the firm is

switching to (Buckley, 2003). A WOS represents a

higher commitment of the parent firm to a given

strategy than does a JV. Therefore, the switching cost

for a WOS is normally higher than that for a JV.

The social costs may not be observed directly at

the time of exit but may make any sequential

investment difficult or costly. These costs include the

damage of the relationship with local partners; the

damage of the relationship with third-party partners;

the damage of the relationship with local

stakeholders, such as the host government, local labor

union, and local suppliers; and damage to the overall

reputation that MNEs of the same home country may

share. We observe that parent firms of JVs are

actually exposed to the social costs of exit. A joint

venture implies the simultaneous commitment of all

parents of the entity. The dissolution of the joint

entity may involve significant social costs that do not

exist for wholly-owned subsidiaries. Therefore, in the

presence of high social costs of exit, we expect that

the foreign parent of a JV escalates more than that of

a WOS.

Proposition 4b: The social cost of exit moderates

the relationship between the ownership structure of a

foreign subsidiary and the parent‘s likelihood of

escalation of commitment. When the perceived social

costs of exit are high, parent firms with a JV are more

likely to escalate their commitment than are parent

firms with a WOS in the same market.

Discussion and Conclusion

Numerous studies have explored how foreign entry

modes are determined while ignoring the question


489

how a multinational‘s entry mode impacts its post-

entry decision making and performance. The selection

of different foreign entry modes is associated with

different levels of the parent firm‘s commitment in

the local market, in terms of resources invested and

control retained. It is critically important for firms

operating in globally competitive markets to make

good decisions when deciding how to allocate

resources to their foreign subsidiaries. Some of

factors which are thought to have the greatest

influence whether a firm is likely to allocate resources

to a poorly performing subsidiary were discussed in

this paper.

In this article we have attempted to clarify the

role played by ownership structure in determining

whether parent firms will escalate their level of

commitment to poorly performing foreign

subsidiaries. We have argued here that the initial

decision regarding the investment structure chosen as

a mode of entry into a foreign country, whether it be

JV or WOS, will impact the likelihood of an

escalation of commitment to that investment.

Drawing insights from prospect theory and from the

concept of institutional distance, we proposed that the

ownership structure of a multinational‘s subsidiary

directly affects the firm‘s potential for escalation of

commitment. We have further suggested that the

relationship between entry mode and a multinational‘s

escalation of commitment is moderated by three

factors – institutional distance between the home and

the host country, cost of exiting the host market, and

the parent firm‘s prior performance. Each of these

factors affect the level of commitment parent firms

demonstrate towards their poorly performing

subsidiaries in foreign markets.

The contribution of this article is in highlighting

the connection between the factors influencing entry

mode decisions and subsequent decisions and

performance by the foreign subsidiary. Other

researchers have tended to focus on identifying the

antecedents of entry mode decisions. We have

purposely focused on the important post-entry

phenomenon of escalation of commitment to a poorly

performing foreign subsidiary. Our paper offers

practical implications. While making initial foreign

entry mode decisions, executives should devote more

attention to the potential effects of their current

decisions on future decisions. Also, when making

decisions about whether or not to escalate their

commitment to a poorly performing foreign

subsidiary, managers should partial out the influences

of the initial foreign entry mode as much as possible.

As a conceptual piece, this paper suffers from

several limitations that are common to all theoretical

articles. Both entry mode and escalation of

commitment are broad fields in management research

and numerous related topics may be explored from

different perspectives. However due to the

exploratory nature of this paper, we only cover the

essential sections of how entry mode may influence

multinational firms‘ escalation. A totally

comprehensive review of these topics would have

made this article significantly longer and more

difficult to read. Additionally, although we argue that

the local performance can serve as a standard to

examine whether the foreign firm accumulates correct

knowledge about the host country, we have no

intention to deny the function of ―luck‖ in strategic

management literature. Given the unpredictable nature

of luck, this paper left it out as one exceptional case in

management research.

In addition to the potential research avenues

which are inherent in the limitations of this paper, we

noticed several other promising areas for future

research. Although the propositions presented in this

paper are extensions of previously-tested theory, it is

important for empirical analysis to refute/verify our

propositions. We believe that each of the propositions

presented in this paper lend themselves to the

operationalization which will be required for such

empirical testing. Survey instruments are

recommended given the subjective interpretation of

social costs and unavailability of financial

information at subsidiary levels like performance and

escalating investments from the parents.

Measurements of major constructs can be found in

management and economics literature. For example,

ownership structure can be operaitonalized as either

dichotomy (i.e., JV or WOS) or continuous (i.e.,

equity percentage owned).

Another area which appears to hold promise for

additional research is investigating the relationship

between escalation of commitment to foreign

subsidiaries and the subsequent performance of those

subsidiaries. Often researchers treat escalation of

commitment as a purely negative phenomenon.

However, it is easy to come up with scenarios and

anecdotal examples where escalation of commitment

could turn out to be a positive choice. As a result,

methodical analysis of post-escalation performance

would be helpful in better understanding escalation of

commitment.

Finally, it would be beneficial for researchers to

investigate the way in which decisions are framed

plays in what international markets are chosen for

foreign direct investment. For example, when

deciding between two markets with the same potential

for new customers, how do executives weight the

importance of such issues as economic turmoil,

government corruption, and social differences? This

is another area where prospect theory and institutional

distance both appear to hold promise in explaining

decision making by executives faced with

considerable uncertainty.

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Appendices


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493

CORPORATE GOVERNANCE OF STATE-OWNED ENTERPRISES IN CHINA

Miaojie Yu*

Abstract In the last thirty years, China has undergone three stages of corporate governance mechanisms, namely, (1) the “power-delegating and profit-sharing” system; (2) the “contracted managerial responsibility” system; and (3) the corporatization of large stateowned enterprises (SOEs). This paper will explore each mechanism, their advantages and disadvantages in detail. The main finding is that the various practices of corporate governance of SOEs are not suitable for China’s SOEs mainly due to the lack of sufficient incentive. Instead, a mixed mechanism of the “control-based” and the “marketoriented” mechanisms is more attractive given China’s unique institutional setting. Keywords: Corporate Governance, State-Owned Enterprises, China * China Center for Economic Research, Peking University, China & School of Economics and Finance University of Hong Kong 1 Corresponding address: Room 908, K. K. Leung Building, School of Economics and Finance, The University of Hong Kong, Pokfulam Road, Hong Kong. Tel: (+852)2857-8501. Email: [email protected]

1. Introduction Today, the corporate governance practices of state-

owned enterprises (SOEs) in China have received

much attention. This is probably because China

maintains a stably fast economic growth over the past

three decades. Its annual GDP growth rate is more

than eight percent over the last thirty years. However,

the performance of its major economic entity, the

SOEs, is still relatively poor. Many economists

believe that the poor performance of the SOEs is due

to the inefficiency of existing corporate governance.

Thus, in this paper, we provide a preliminary survey

of the practices of corporate governance of SOEs in

China over the last thirty years.

As China is currently experiencing a transition

from a planned economy to a market-oriented one, its

economy can be best described to be in the transition

stage. In addition, China has unique institutional

characteristics which probably affect the corporate

governance mechanism of its SOEs. In this paper, we

first investigate the impact of China‘s unique

institutional setting to its SOEs.

Before the economic reform in 1978, SOEs in

China were established in the form of administrative

governance. After that, the reform of the corporate

governance undertook three stages which include the

―power-delegating and profit-sharing‖, the

―contracted managerial responsibility‖, and the

―market-oriented‖ corporate governance mechanisms.

The differences among these mechanisms, their

advantages and disadvantages will be addressed in

this paper to find out if they are suitable to China‘s

SOEs.

It is understood that there are three corporate

governance mechanisms adopted worldwide. One of

these is the Anglo-Saxon ―market-oriented‖ corporate

governance. Another is called the ―control-based‖

mechanism, which is widely adopted in Japan and

central Europe. There still exists another mechanism,

called the ―contingent-state‖ corporate governance

mechanism, which is considered to be the most

attractive one for a transitional economy (Aoki,

1994). As China‘s economy is still in transition, the

contingent-state mechanism may be the most suitable

for its SOEs. In this paper, we try to assess the

abovementioned mechanisms and find out what could

best fit China.

The main findings of this paper include that the

various practices of corporate governance of SOEs in

the past thirty years are not suitable for China‘s SOEs

due to the lack of sufficient incentive provision. The

ongoing reform of corporate governance is a mixture

of ―control-based‖ and ―market-oriented‖ systems. It

still faces some substantial challenge though it is a

significant improvement compared to the previous

practice. To explore such issues, we use the

methodology known as the ―principal-agent‖ method.

This paper forms part of a small literature on

China‘s corporate governance. Classens and Fan

(2002) provided an outstanding survey of the

corporate governance literature on Asia. However, the

practices in China were only briefly introduced due to

the lack of available reference when the paper was

written. Liu (2006) updated the survey by focusing on

the economic effects and institutional determinants of

corporate governance in China‘s listed companies.

Aside from these, some other researches also


494

emphasized the rent-seeking behavior in China‘s

SOEs (Bai et al.2000) and the administrative

governance under China‘s unique institutional setting

(Pistor and Xu, 2005). In contribution to the previous

works cited, this paper instead placed emphasis on

evaluating each practice of corporate governance in

China‘s SOEs over the past years.

The rest of the paper is organized as follows:

Section 2 provides a detailed survey of the corporate

governance practices in China‘s SOEs; Section 3

gives a detailed discussion of the deficiency of each

existing corporate governance practice; Section 4

offers some international comparison of corporate

governance, followed by the policy suggestion for

establishing a new corporate governance mechanism;

and Section 5 consists of a brief concluding remark.

2. The Practices of Corporate Governance of SOEs in China

Over the last thirty years, the reform of the corporate

governance in China‘s SOEs has undergone three

stages: (1) the ―power-delegating and profit-sharing‖

system, which began in 1979; (2) the ―contracted

managerial responsibility‖ system, which began in

1984; and (3) the corporatization of large SOEs,

which began in 1993. In order to have a clearer

picture of the corporate governance in China‘s SOEs,

it will be appropriate to trace the key features and

contents of these three different stages of corporate

governance, and then analyze their advantages and

disadvantages.

Before the economic reform in 1979, the

property rights of the SOEs were completely owned

by the central government and each provincial

government. The managers of all enterprises were

appointed directly by the central and local

governments, which, in turn, were controlled by the

Chinese Communist Party. In this sense, the SOEs did

not have corporate governance. Instead, they were

under administrative governance.

Since 1979, the government and leading

economists noticed that the administrative governance

was one of the main sources of low efficiency and

poor performance of the SOEs. As a consequence, the

first step in reforming the corporate governance of the

SOEs was to expand the enterprises‘ autonomy. After

the successful experiments of the six enterprises in

Sichuan Province, which is one of the relatively rich

western provinces in China, the government expanded

the scale and magnitude of the said reform. The

reform in this step concentrated on allowing the

enterprise to retain a small amount of profits.

Simultaneously, the payments that the workers

received were linked to their productivity. Besides

this, the selected SOEs were also allowed to have

some autonomy on making decisions regarding

product supply, selling superfluous materials, and

establishing an independent enterprise fund.

The second step in the SOEs‘ corporate

governance reform was to establish the ―enterprise

contracted managerial responsibility‖ system. Since

1984, a contract has been established between the

government and the managers of the SOEs in order to

clarify matters regarding the managerial control right

and profit allocation. The major principle of this

corporate governance mechanism is that the

government will charge a fixed quota for each

enterprise. In particular, when the actual profit is more

than the base quota, the enterprise can retain such

extra profit.

Conversely, when the actual profit is less than

the base quota over some period, the enterprise still

has to pay all its profit to the government. In practice,

the enterprise contracted managerial responsibility

system takes three different types. The first type is the

responsibility for paying the fixed quota. This

includes several applications such as (1) the

government fixed the quota, and the extra profit

beyond the quota that is shared between the

government and the enterprise; (2) a progressive

quota of profit remittance; and (3) a simple fixed

quota for those enterprises with low profit. The

second type of the contracted system is that the

government will charge fewer quotas for those firms

that experience losses. The third type is about the rule

of ―two-guaranteed and one-linked‖. The

―twoguaranteed‖ means that the profit remittance and

the approved technology-upgrading projects should be

guaranteed. The ―one-linked‖ means that the total

amount of the workers‘ wages shall be linked to the

actual after-tax profit.

Compared to the previous ―power-delegating

and profit-sharing‖ system, the contracted system

clearly grants more autonomy to the SOEs. However,

its disadvantages became evident over the years. In

the early 1990s, there was a strong demand within the

public to call for a new corporate governance

mechanism. In 1993, the parliament of China, the

National People‘s Congress, passed the proposal

titled, ―the Company Law,‖ which emphasized that

the SOEs should establish the contemporary corporate

governance gradually.

Shortly after, the government selected one

hundred large SOEs as an experiment. At first, the

corporate governance of the selected SOEs took two

different types. Under the first type, the selected firms

were required to set up the board of directors and then

select the managers. However, the government can

still directly appoint professional staffs as board of

directors and managers of the enterprises. Under the

second type, the government established an ad-hoc

committee, the State-Owned Asset Management

Committee, which is the legal representative of all

state-owned assets then the government appointed a

representative of property rights to the enterprises as

the biggest stakeholder of the firms. In a nutshell,

compared to the previous practice, such a mechanism

was more close to the modern intrinsic requirement of

corporate governance.


495

3. The Problems of Existing Practices of Corporate Governance

In this section we analyze the deficiency of each

existing corporate governance mechanism in China‘s

SOEs.

3.1 The Deficiency of Power-Delegating and Profit-Sharing Scheme

Without a doubt, the power-delegating and profit-

sharing mechanism was a very beneficial experiment

in the late 1970s. It broke the role of the traditional

administrative governance. The enterprises were

granted some power to allocate material resources and

share some profit of the enterprises. Essentially such a

mechanism provided incentive for enterprises to

realize the significance of value maximization.

However, since the SOEs at that moment were still

not completely ―firm‖ there was an intrinsic dilemma

on the applied corporate governance mechanism. On

one hand, when the government delegated much less

power to the SOEs, the enterprises could not have

sufficient autonomy to optimize its resource

allocation. On the other hand, when the government

granted too much power to the SOEs, the ―insider

control‖ problem could occur in such SOEs.

The insider control problem is ―a potential

phenomenon inherent in the transitional process‖

(Aoki, 1994). In a transitional economy, since a

principal (i.e., the owner of firms) is actually absent,

the agent (i.e., the manager) of the firm obtains much

―private information‖ such as the revenue and the cost

of the firm. Such private information is very difficult

for the principal to monitor, especially when the

accounting system is incomplete and not transparent.

Hence, the insider (i.e., the managers) will ―shirk‖

and not aim for the firm‘s value maximization due to

the asymmetric information. Instead, the managers

will search every possible chance to seek rent. It

turned out that the ―insider control‖ problem was very

severe in China‘s SOEs in the late1970s and early

1980s.

3.2 The Problems of the Enterprise Contracted System

After realizing that the power-delegating and profit-

sharing mechanism has some intrinsic shortcomings,

China‘s government applied a new corporate

governance mechanism—the enterprise contracted

system. Compared to the power-delegating and profit-

sharing mechanism, clearly the contracted system is a

better corporate governance mechanism because to

some extent, the managers in SOEs have the power to

decide on production and sale. It stimulates the

production incentive of the SOEs; as a consequence,

such a mechanism also increases the government

surplus due to the increase of the corporate tax

income.

However, similar to the power-delegating and

profit-sharing mechanism, it also has the severe

―insider control‖ problem. The essential feature of

this contracted system is the share of property rights

between the state and the managers. This implies that

the managers have partial residual claim and residual

control. Hence, the SOEs have two owners: one is the

absent state; the other one are the present managers.

In this way, the objectives of each of the two owners

are in conflict.

As a consequence, managers will not seek for

value maximization for the enterprise. It is also

interesting to point out that the effect of such an

―insider control‖ phenomenon on national welfare is

ambiguous. On one hand, the negative side of the

―insider control‖ is significant. The managers have

the de facto controlling right. This means that they

can collude with workers to fully implement its

business strategy. Subject to this ―soft‖ constraint, the

outsider (i.e., the government) cannot easily fire the

managers. On the other hand, the ―insider control‖

phenomenon also has some advantages, at least as a

Kaldor improvement. In this situation, some people

get to benefit at the expense of other people‘s loss;

and the aggregate

social welfare also improves.

The idea here is consistent with Shleifer and

Vishny‘s position (1997) that with the administrative

governance, the corruption and bribe might improve

the efficiency. That is because managers can only

obtain a very small share of the profit according to

their contracts. Without the gray incentive, the

managers would not work hard to maximize the

firm‘s profit. However, since the accounting system is

incomplete and lacks transparency, the managers can

safely and easily catch more extra benefit in reality. In

a nutshell, this implicit benefit is the engine of the

value maximization conducted by the managers in the

short run.

This raises another interesting question. In the

long run, do the managers have incentive to maximize

the firm‘s profit under this corporate governance

mechanism? The answer is no for two reasons. First,

the managers understand that the best strategy for

keeping their positions is not to have an outstanding

performance but only to have a ―fair‖ performance.

On one hand, when the performances of managers are

too poor, they will be forced to resign or be dismissed

by the government. On the other hand, even though

their performances are outstanding, they will still not

be treated as professionals with high managerial

capacity. Instead, the government might take these

outstanding performances for granted. For example,

the government might attribute the profit to the strong

foundations of the firm. Hence, it is still possible that

the government will appoint other people to replace

the manager. As a consequence, the optimal strategy

for the managers in this game is to keep a fair

performance. Second, the principal (i.e., the

government) does not need to take the responsibility

for the firm‘s operating performance. The principal of


496

the SOEs is different from the capitalist. This implies

that the principal has an ―adverse selection problem‖

of choosing an agent. It is no reason to believe that

the principal has sufficient incentive to search for the

best agent. Instead, he will just appoint the most

―appropriate‖ person as an agent to maximize his rent

(Zhang 1992). Based on these two reasons, the

managers do not have the incentive to maximize the

firm‘s profit in the long run under this corporate

governance mechanism.

3.3 The Shortcomings of the Current Practice of Corporatization

As pointed out earlier, after 1993, the large SOEs in

China were required to establish modern corporate

governance mechanism. The first trial of such modern

corporate governance mechanism required the

government to directly appoint the specialists to

manage the SOEs. Actually, this is of no substantial

difference from the old mode. It is true that the SOEs

establish the board of directors and various

managerial levels but the problem is that such sectors

are not elected by the stakeholders. Instead, they are

directly appointed by the government. In fact, the

only difference of this corporate governance

mechanism from the traditional mode is having a

different brand name. Furthermore, the relationship

among the board of directors, stakeholders, managers,

and the labor unions are not clear at all. One good

example is that the managers still ask for help from

the government when the SOEs have a hard time in

their operating activities.

The second corporate governance mechanism is

to establish a three-tier network of state-owned assets

management. The top tier involves the State-Owned

Asset Management Committee established by the

central government. It is the legal representative of all

state-owned assets. The second tier is composed of

the investment company authorized by the state. The

lowest tier consists of the numerous SOEs.

Unfortunately, this mechanism still has many

practical problems. In practice, we have two types of

representatives of property right: (1) the government

appoints a representative to the SOEs serving as the

deputy chief manager; (2) the existing chief manager

serves as the representative of the property right. In

the first case, the representative does not have power

to make decisions on the operating activities of the

SOEs. This could be because of the lack of relevant

professional knowledge or because of his non-major

stream position in the SOEs. In the second case, the

situation is even worse. One of the major functions of

the contemporary corporate governance is that the

board of directors can play a monitoring role on the

managers. When the managers also serve as the board

of directors, this function is totally crashed.

3.4 The Inconsistency of Corporatization with the Theory

Moreover, theoretically speaking, the corporatization

of the SOEs in China is also inconsistent with the

prediction of the related contract theory such as the

one posited by Jensen and Meckling (1976). First, the

current practice in China violates the consistency

principle between the residual claim and the residual

control. According to the contract theory, the residual

control implies the voting right. When the residual

claim is inconsistent with the residual control, the

―cheap vote‖ phenomenon will happen. This is

intuitive. When someone has voting right (i.e.,

residual control), he has the power to appoint the

senior managers. However, he does not need to take

the responsibility for the operating performance when

he does not have residual claim. In other words, under

this corporate governance mechanism, there is no

corresponding incentive mechanism to guarantee that

the principal can search and appoint high capacity

professional staffs as his agents (managers). The

administrative staffs cannot switch to the real

stakeholders just because of the existence of the

―State-Owned Asset Management Committee.‖

Second, the contract theory emphasizes that the

compensation remuneration should be directly

relevant to the operating performance. However, the

current practice of the corporate governance in

China‘s SOEs violates this principle. Actually, the

compensation of the managers is far low to their

contributions to the SOEs. It is understood that the

normal profit is the reward of the ability of

enterprisers. When the enterprisers cannot get the

corresponding reward from their effort, who could

expect them to try their every effort to maximize the

firm‘s profit? As a consequence, the ―shirk‖ of the

managers is relatively unavoidable. Someone might

argue that various forms of honors can serve as

substitutes of the compensation remuneration.

However, this is true only after the managers are

satisfied with the monetary compensation.

As pointed out previously, the mismatch

between the compensation remuneration and the

manager‘s operating performance encourages the

―insider control‖ activities. Compared to the

compensation remuneration of the managers from the

private enterprises and various township and village

enterprises (TVEs), the monetary compensation of the

managers in SOEs is still very low. Such a gap

stimulates the rent-seeking behavior. This also

explains why the stock of stateowned assets in the

SOEs is shrinking over the years.

Third, it is understood that the residual claim

should be relatively concentrated. The question is,

who should hold the largest portion of the residual

claims: the large stakeholders, the managers, or the

workers? Traditional wisdom suggests that the

residual claim should be held by the largest

stakeholder of the SOEs (i.e., the government).

However, as previously analyzed, this scheme will


497

cause the asymmetric information between the

principal and the agent. As a consequence, the ―cheap

vote‖ and the ―insider control‖ phenomenon become

prevalent. An alternative scheme is to let workers

have their residual claim. However, this is still not a

good strategy. Although the incentives of the workers

will be improved, it is no help to provide incentives to

the managers. In this way, the effort levels of the

managers are still hard to be monitored. The crucial

point here is that the residual claim is proportional to

the operating risk. Relatively speaking, the managers

bear more operating risk in practice, and they are

more difficult to be monitored. Therefore, in this

sense, it is a better scheme to let the managers share

more residual claims.

4. International Comparison and Reform Suggestions

Today, two categories of corporate governance are

prevalent in a market-oriented economy. These are the

control-based system and the market-oriented system.

Besides these, some economists believe that the

contingent-state corporate governance is suitable to

the transitional economy. In this section, the pros and

cons of these three different mechanisms will be

compared, followed by their implication to the

corporate governance of China‘s SOEs.

4.1 International Comparison

The control-based system is prevalent in Japan,

German, and many other continental European

countries. One of the key features of this corporate

governance mechanism is that the ownership of listed

companies is strongly concentrated in a main bank.

The relationship between the main bank and the

enterprise is stable over the years. Usually the main

bank holds both equity and debt of the enterprise, and

is the largest stakeholder of the enterprise. In practice

the main bank has the ability to appoint the senior

level managers. The advantage of this feature is that it

can solve the insufficient investment problem faced

by the enterprise. In particular, the main bank could

finance long term investment projects.

Another feature of the bank-oriented corporate

governance is that the cross-share holdings in the

control chain are significant. This phenomenon is

very common in several central European countries

such as Austria, Germany, and Sweden (La Porta,

1999). The advantage of this strategy is that it

strengthens the related benefits among the firms and it

mitigates the hostile takeovers. However, the

disadvantage than can be predicted is that the firm‘s

operating behavior is hard to be monitored. The

bankers would monitor the managers, but the question

is who would supervise these bankers? Also, such

bankers are not afraid of the hostile takeovers due to

the crossshareholding. This also reduces their

incentive to maximize the firm‘s actual profit. The

market-oriented type of corporate governance is

popular in the Anglo-Saxon area. On one hand, the

listed companies are financed from the general public

via issuing bonds and stocks. Actually, since the listed

companies have to face the threat of the outside

control (i.e., the hostile takeover), the market-oriented

corporate governance has a better incentive

mechanism. On the other hand, the bank only plays a

minimal role on finance due to the legal restriction

raised by the Glass-Steagall Act in 1933 in the United

States. This act emphasizes that the commercial bank can only provide the short term but not the long term

loan. Hence, such a corporate governance mechanism

is relatively impotent to finance large investment

projects.

In a nutshell, these two mechanisms have their

own advantages and disadvantages. Now the question

is: which one is more suitable to China‘s SOEs? Put it

in another way, can we directly apply one of them for

China‘s SOEs?

The answer is no. This is mainly because

China‘s economy is still at the transitional stage. The

transitional economy is ―path dependent‖ for two

reasons. First, the path of China‘s transitional

economy is ―backward-looking.‖ We need to consider

the effects of the previously planned economy on the

current market-oriented economy. Besides the regular

labor unions in the listed companies, China‘s SOEs

also have some special interest groups such as the

unions of workers‘ representatives and the unions of

Chinese Communist Party‘s representatives. Such

special interest-groups could play some roles on the

formation of the corporate governance in China‘s

SOEs. Second, the path of China‘s transitional

economy is also ―forward-looking.‖ Once we choose

one type of corporate governance mechanism, it

would be very difficult to switch to the other type.

Suppose that the market-oriented corporate

governance is applied directly for China‘s SOEs, ―the

insider control‖ problem could give the managers a

―moral hazard‖ behavior. To avoid this, there is a

need to have a perfect capital market and also a

competitive labor market. However, both do not exist

in China today. The capital market in China has been

established yet it is still far from perfect (Wu, 2005).

At the same time, the labor market is still segmented.

Labor in the rural areas cannot freely move to the

urban areas (Cai, et al., 1997). Hence, the ―insider

control‖ problem still clearly exists in China‘s SOEs.

In other words, the pure market-oriented corporate

governance is not perfectly suitable to China‘s SOEs.

Another possibility is to establish the contingent

governance mechanism. This mechanism emphasizes

that the residual claim is a contingent-state claim. The

control right of the company will be automatically

transferred from the insider to the outsider when the

listed company faces an operational difficulty. When

the insider can successfully keep the internal financial

account balance, he still has residual claim.

Otherwise, he will lose his the residual claim. Hence,

this mechanism can provide the performance

incentive for the insider. However, the contingent


498

governance is valid in a transitional economy only if

there is a matured commercial bank that could serve

as the main banking institution. At present, China is

still a long way far from establishing a matured

banking system.

4.2 Suggestions on Further Reform

This paper has argued that neither the pure market-

oriented nor the contingent-state corporate

governance systems are suitable to China‘s SOEs;

thus what option is left now for China‘s SOEs? Based

on the above analysis, two types of corporate

governance may be applicable. The first mechanism is

that the residual claim should be held by the

managers. In particular, this could be a good

mechanism for small and medium-sized SOEs. In

practice, a mechanism that allows the managers to

purchase large shares of the enterprise stocks may be

used. Since it is not a good idea to let either the

representative of state-owned assets or workers hold

the residual claim, the solution is to disperse the

residual claim into the hands of the managers.

However, one thing should be clear: what is the

relationship between the new stakeholders (i.e., the

managers) and the old stakeholders (i.e., the

representatives of the state-owned assets)?

One possible scheme to distinguish their

relationship is to change the state-owned stakeholders

into the assuming the role of creditors of the

enterprises. This scheme is attractive for two reasons.

First, the state can get a fixed income when the

operating performance of the firm is in a good shape;

however, the state can switch into the insider when

the operating performance of the enterprise is poor.

Second, when the company becomes bankrupt, the

SOEs should pay the debt first to the State according

to the Law of Company passed in the early 1990s.

This, in turn, guarantees that the State will not suffer

loss even in the case of bankruptcy.

It is equally important that the new stakeholders

(i.e., the former managers) cannot continue to serve at

the managerial level. The idea is simple. The

stakeholders are those who are rich in capital

endowment, whereas the managers are those with

high managerial capacity. Although the original

managers might also have high managerial capacity,

their new task is to handle the enterprise‘s assets via

their voting right. However, they can appoint the

people who are excellent in the operating activities as

managers. Under this corporate governance

mechanism, the ―insider control‖ problem can be

mitigated to a minimum level. The only challenge in

this scheme is that it requires the former managers to

have sufficient capital endowments. This is exactly

the case in the small and medium-sized SOEs in

China. In practice, the gray income of such managers

are significant given the existence of the severe

―insider control‖ phenomenon.

This leads us to the question as to what is the

most feasible corporate governance mechanism for

large SOEs? Is it correct to just privatize the large

SOEs in the same way we applied the mechanism for

the small and medium-sized SOEs? The answer is no.

This is because the large SOEs are extremely crucial

for the betterment of China‘s economy. Once the

reform of the SOEs failed, it would be a disaster for

the whole national economy. For example, the failure

of the SOEs reform could cause a large scale of

unemployment and layoffs. Therefore, privatization

might not be the best mechanism for the large SOEs

in China given its potential huge negative effects.

Another feasible mechanism for the large SOEs

is to establish an institute serving as a supervising

outsider. The top candidate of such an institute is a

commercial bank or other nonfinancial institutes. This

is exactly the mode taken by the ―control-based‖

corporate governance. Fortunately, it has been

observed that the recent corporate governance reform

is following this track.

In the late 1999, the Chinese government took a

further step on the corporate governance reform. It

required all large SOEs with good performance to

have initial public offering (IPO), establish joint

ventures with foreign firms, and have cross-

shareholding among different SOEs. As pointed out

by Wu (2005), in particular, this corporate governance

reform took three steps: (1) the administrative

function and business function within the SOEs were

separated; (2) the competition within the monopolistic

industries such as the petroleum and

telecommunications industries was promoted; and (3)

IPO on foreign stock market was implemented.

Accordingly, the ongoing reform is a mixed

mechanism between the ―control-based‖ and the

―market-oriented‖ systems.

5. Concluding Remarks

This paper is an overview of the practices of the

corporate governance reform of SOEs in China over

the last thirty years. More importantly, it explores the

advantages and disadvantages of each mechanism.

In China, the practice of establishing an

appropriate corporate governance of SOEs has been in

existence for more than thirty years. It started from a

trial of granting autonomy to the SOEs from the

government. Shortly thereafter, the contracted

responsibility system was emphasized to improve the

incentive for the managers. Although these two

mechanisms were prevalent in the 1980s among

China‘s SOEs, they caused an intrinsic inconsistent

dilemma. Also, the severe ―insider control‖ problem

seriously discounted the incentives raised by these

two mechanisms for the SOEs.

Recently, the SOEs in China experienced a large

scale of corporization. This paper argues that the

conventional market-oriented corporate governance

system does not fit the unique setting of China‘s

institutions. Instead, a mixed mechanism between the

market-oriented and the controlbased system appears

to be a better fit for China‘s economy. Therefore, it is


499

suggested that China should establish two different

corporate governance mechanisms based on the size

of the SOE.

For the small and medium-sized SOEs, the best

mechanism is to let the original managers hold the

residual claim. However, it is also suggested that a

main bank would serve as an outsider observer of the

enterprise for the large SOEs.

Another challenge is that China‘s commercial

banks also have a lot of problems such as bad loans

and poor reputation. The mixed corporate governance

could work well only if China has a healthy banking

system. Hence, establishing a mature banking system

is a relevant topic for future research.

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